Property Insurance Coverages: Part I of III
Part I of III
By Dan Harkey
Part I is a crucial foundation, empowering property owners, borrowers, and insurance professionals with a comprehensive understanding of general insurance concepts. This knowledge instills confidence and enables informed decision-making, putting you firmly in control of your insurance needs. It sets the stage for parts II and III, which delve into the specifics of real estate insurance, providing a deeper understanding of this complex subject.
??? Introduction:
Insurance companies play a pivotal role in our lives, protecting our assets and providing security and reassurance. Their primary function is to amass premiums and utilize them to compensate for covered insurance claims. This business model, aimed at collecting more premiums than paying out claims, ensures profitability for the company and its shareholders. The insurance industry operates on a national and global scale, highlighting the significant role it plays in the economy.
Real Estate insurance is a complex subject, intricately woven with many subsets: property, business, and personal coverages. The sheer breadth of real estate insured categories, including homeowners, condo/co-op, commercial property, renters, mobile and manufactured homes, liability, and personal property, underscores the need for a comprehensive understanding. This thorough understanding is crucial and makes property owners, borrowers, and insurance professionals feel more informed and prepared.
A 'peril' is an event that leads to property damage or destruction. 'Insured perils, 'such as fire, windstorms, hail, theft, vandalism, and earthquakes, are the specific risks covered by insurance.
The covered claims are made because the damage is caused by sudden and fortuitous events that occur by chance. Insurance does not cover property damage that occurs over time due to lack of timely maintenance, wear and tear deterioration, or faulty quality. Insurance companies calculate the probabilities of claims and losses and issue coverage accordingly. Profit is motivation.
A few shady insured parties will file claims for reimbursement caused by their negligence or lack of timely property upkeep. A few even intentionally cause damages to collect on the insurance claim. I once worked as a private investigator investigating fraud claims, organized theft, and arson. Insurance and their adjusters are experienced and intelligent people. They know when claims are accurate and when they are fraudulent. ?
Non-covered perils, such as flooding, earthquakes, riots, etc., require additional coverage in the form of “riders or endorsements.” This knowledge empowers property owners to make informed decisions about their insurance coverage, ensuring they are prepared for any eventuality.
One crucial element of insurance is that the insured party cannot assume that any event is covered unless the party comprehensively reviews the coverages and the insurance policy explicitly states so. This thorough review empowers the insured party, ensuring they understand and can make informed decisions about their coverage. Few insured parties thoroughly read and comprehend the substance of their policies, but this is a critical step in the insurance process.
Insurance company executives are not fools. Their business model of providing hazard insurance coverage is for maximum profits—for the insurer. Their premiums are invested heavily in the securities market, usually reaping a fat profit. High-risk exposures are highly leveraged securities investments, including derivatives contracts. Insurance companies are large holders of loan portfolios of large office buildings, now in major decline. The losses will be significant. The federal government will always bail them out with taxpayer dollars if they suffer substantial economic losses.
Insurers will insure anything for a fee. They will cover the continued vitality of an opera singer’s voice, the hands of a professional golfer, the health of a 3-million-dollar racehorse, or the potential loss of a derivatives contract. Sometimes, insurers will insure something that they do not understand. The motivation is always profits.
At one time, American International Group, Inc. (AIG) was the largest property-casualty insurer in the world. It was also the largest provider of retirement savings investments for primary and secondary teachers and healthcare workers. AIG has 71 separate U.S.-based insurance companies and 176 other financial services subsidiaries worldwide.
AIG miscalculated the risks in insuring derivatives and had to be bailed out by the taxpayers in April 2009.
·????? AIG did not understand the risks for which they were insured.
·????? The taxpayer bailout was a healthy sum of $185 billion because of derivatives losses.
·????? The U.S. Treasury sold its final shares of AIG in December 2012 and recouped all losses. AIG is a smaller and wiser company now.
Derivatives are highly leveraged interest-rate-sensitive hedging bets in the financial market. There are currently $610 trillion of notational value outstanding derivatives in the U.S. alone. Derivatives’ risks of loss for any insurance carrier are a financial ticking time bomb, as they were in 2008 and are today in 2022.
Insurance policies are written legal contracts between two principal parties, the insurer and the insured.
In real estate, the lender is a third party with a security interest in the property and a financial interest in the insurance policy but not a principal to the insurance contract.
·????? Insurance company (the insurer)
·????? The Insured party (borrower) may be an individual, trust, business, or entity (the insured).
·????? The lender has a security interest in an insured property and is referred to as an additional insured.
·????? These three parties willingly enter an insurance contract with coverages, exclusions, policy limits, limitations of coverage such as personal property, and considerations about the parties’ obligations, rights, and responsibilities.
·????? The borrower and the lender are principals. The insurer is not. Although not a principal in a loan contract, the lender requires protection of their security interest rights. ?
?? ?The insurance industry is like a cartel:
The Department of Insurance regulates the industry in various states (the California Department of Insurance or similar state agencies for other states). Only a few companies are allowed, and admitted members draft regulations in their favor.
Insurance brokers are dual agents who represent both the company and the insured. General agents are agents of insurance companies rather than the policyholders. Failing to adequately counsel clients regarding the proper insurance products, alternative insurance products, and corresponding add-on endorsements or riders is a breach of fiduciary duty.
When there is controversy on whether the insurance company is willing to cover the loss, negotiating a claim to the insured party’s reasonable satisfaction may require that the insured party hire an independent insurance adjuster representing their interest and not the insurance company’s interest. An insured party could be forced to pay legal costs and suffer a delay in reconstructing the building for an extended period. The alternative is to engage in arbitration or expensive litigation against mammoth-sized companies with bottomless pockets of money. This potential for conflict underscores the importance of preparing for potential challenges in the insurance process.
While completing the loan application, a borrower or agent may object to the lender’s requirement that insurance cover the total 100% replacement cost of the building (security property) appurtenant structures. The borrower might suggest coverage of 50% of the replacement cost because the property’s value may or may not reflect adequate coverage for the replacement cost of the improvements. However, it's important to remember that underinsurance can lead to significant financial risks in the event of a claim, making it crucial to ensure adequate coverage.
From a lender’s point of view, insurance should be sufficient to recoup the principal balance, accrued interest, and expenses in a claim situation. Borrowers should rely on counsel from their insurance broker to guide them in making appropriate decisions regarding the types and amounts of coverage, alternative coverages, and applicable endorsements.
?? ??Inflationary pressures cause insurance premiums to rise faster:
Inflation directly results from the government’s never-ending injections of new fiat currency into the economic system, which becomes a corresponding future debt to the taxpayers. Our future sovereign debt, of course, is a systemic fraud because the Federal Reserve and the leaders of this country never plan to pay the debt off or even reduce it. As the Federal Reserve pumps more money into the economic system, there is a corresponding reduction in the dollar’s purchasing power (debasement). Debasing the dollar assumes repayments of reduced value (cheaper dollars). Goods, services, and construction cost incrementally more.
Real estate may benefit from inflation because values increase, but the glee quickly decreases when everything costs incrementally more. Each dollar becomes worth less and less.
Insurance markets have been stable in the past ten years with little notice of inflationary pressures. Over the last four years, we have been in an accelerated speed trap, attempting to keep up with a race between increased premiums and costs, all related to inflationary pressures caused by our current administration. The taxpaying consumers are the losers.
During inflationary times, there is constant pressure on rising prices of original construction, repair, and maintenance costs, regulatory compliance, and the rising cost of required building enhancements.
A borrower may be focused on saving money but needs to be more informed or ill-informed about the adverse financial consequences of recovering losses in a claim. Good things may happen if the borrower follows the recommendations of his mortgage broker or qualified insurance agent. Discovery may not be until a time has passed with compounded inflationary pressures that the property owner experiences a hazard loss, tenders a claim to the insurance company, and discovers the condition of massive under-insurance. Because of policy limits, the insurance company fully knows they have no liability for this under-insurance problem.
Inflation causes prices of building materials, appliances, heating and air conditioning, municipal approvals, including revised building codes, and labor to go up, and over time, this process compounds prices.
Whether intentional, uninformed, or negligent by the borrower’s insurance agent, real estate, or mortgage broker, the insured parties may find themselves underinsured and must pay a portion of the repairs and reconstruction costs for the loss. Many owners may not have the financial strength to pay for the shortage. The consequence may be to walk away from the property and hand the keys to the lender.
The problem of underinsurance is a nationwide economic catastrophe in the making. Few ever talk about it. Property insurance industry participants, including insurance agents/brokers and real estate agents/brokers, are not vocal enough about the magnitude of this national problem! The agents and brokers are fully aware of the situation in private conversations. An underinsured party filing a claim will let accusations fly, Mr. Fiduciary. It would have been best if you told me I was underinsured. The lawyer community will high-five with delight.
??? Replacement cost coverage (RCV):
RCV is the amount required to replace the damaged or destroyed property with the same or similar substitute quality as was originally built. Insurance for enhancements, betterments, building codes, and current zoning ordinances will require a different form of insurance or endorsement to bring the property up to today’s standards. The definition of insurance replacement cost does not include this form of insurance. Upgrading a property may be tricky, if not impossible.
The insurance definition of replacement cost is hypothetical and not a reality because “the same and substitute the quality of materials” is so radically different over an extended time that it is not economically feasible. Replacement cost insurance may be ambiguous to public purchasing insurance policies as a protection mechanism.
Replacement cost verbiage in the insurance policy needs to reflect current codes, ordinances, regulations, designs, and available materials. A property built in 1946 contemplates reconstructing the building to those same 1946 standards. Older properties may be characterized by obsolete materials such as asbestos and galvanized and lead-based plumbing. An example of upgrades not covered would be replacing 1946 installed single-pane windows with aluminum frames with modern double insulated low-E glass panes with vinyl frames, upgraded anodized aluminum frames, or wood frames.
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Structural designs, engineering requirements, building materials, and add-on standards have changed dramatically over the last 50 years and accelerated during the previous 20 years. Most of these new requirements are government-driven mandates where current insurance products may need to be revised or improved. Insurance carriers may not be willing to write policies to cover unknown risks.
The need to invest additional capital in upgrading or bringing the property into current compliance with raising rents and enhancing value is not part of an insurance policy.?
Interested parties may visit www.insurance.ca.gov ?for an overview of insurance products and definitions.
??? Extended replacement cost coverage:
The coverage protects the insured against sudden increases in materials or construction costs. This type of insurance is additional; however, it is more extensive and expensive protection. Some carriers will offer extended replacement options as an endorsement that may cover a further rise of 20% to 25% of the replacement cost up to the policy limits. However, more than 20% or 25% may be needed for higher prices and new government-mandated upgrades.
??? Actual cash value policies (ACV):
An insured party may choose actual cash value coverage. A loss is calculated to include the depreciated fair market value of the damaged or destroyed dwelling at a loss and up to the policy limits. In other words, replacement cost minus depreciation of the damaged property (ACV=replacement cost less depreciation). It represents the dollar amount you expect to receive by selling the property on the open market. This form of insurance may significantly alter the lender's underwriting.?
This form of coverage is more common for older commercial and industrial properties. An (ACV) policy is a bad idea in all cases.?
??? Zoning and building ordinance Insurance:
Upgrades or updates to meet current building codes and standards require additional coverage. Examples may include weather, fire safety, wiring, or handicap accessibility. Some coverage endorsements are called Improvements and betterment insurance Coverage. This form of coverage is usually in the form of policy endorsements. These coverages vary in what is covered and what different insurers exclude.
??? Policy exclusions:?
Carriers have different exclusions and what they will cover by separate policies and add-on endorsements. Most insurance carriers have policy exclusions including but not limited to ordinance or law, tsunamis, floods, drain & sewer backups, seeping groundwater, standing water, mold, total pollution exclusion, asbestos, lead-based paint, earthquake, earth movement, acts of war, mold/mildew & fungus, acts of war, nuclear, biological, chemical, acts of terrorism, etc. Insurance does not cover damage due to poor maintenance or quality, general wear & tear, pest infestations, power failure, nuclear hazards, government actions, intentional loss by the insured, and home-based business liability.?
??? Coinsurance provisions:
Many insurance policies for both residential and commercial have language referred to as a coinsurance provision covering the under-insurance issue. A coinsurance clause requires that policyholders insure their property for a reasonable replacement cost. The insurer will receive a fair premium for the risks. A coinsurance clause will require that policyholders insure up to 80, 90, or 100% replacement cost for the structure(s) and appurtenant(s).
Coinsurance penalties will be applied to claims for underinsurance and will differ between companies and policy types. Effectively, a coinsurance penalty triggers a contractual requirement that the insured party pay a portion or penalty of their economic loss using a calculation formula in the policy. Some insurance companies provide step-up coverage endorsements to reflect higher replacement costs due to inflation.
If a policy contains a coinsurance penalty provision, a claim may reflect underinsurance. The insurance company will pay up to the policy limits and leave the underinsured party stuck with significant cost overages. The insured party may be required to pay for a portion of their loss. Their portion is part of the cost of reconstruction, including betterments and enhancements.
Under-insurance is more prevalent now than before because of the upward cost pressure caused by inflationary increases in construction costs. For example, lumber prices, other materials, and labor have increased dramatically. Municipal approvals and building standards/codes are much more stringent. Add-on municipal fees (taxes) have gone up.
A mortgage broker/borrower or insurance provider who calculated $200 per square foot a few years ago may find that the replacement cost has doubled to $400 per square foot, not counting the land value. Housing replacement costs may range from $200 per square foot for entry-level production homes to $1,000 to $1,500 for high-end customs.
Lenders and mortgage companies may want to audit their loan portfolios to ensure that property coverages are adequate to offset inflation. Lenders may like to discuss methods and data sources for calculating replacement costs. Most insurers and appraisers use Marshall & Swift cost data to calculate the cost of construction.
Claims department’s function:?
The claims department is an integral part of insurance. It has many complexities and problems. Here are a few comments relating to the claims department's functions.
Claims departments tend to have high turnover.
·????? Insurance claims are sometimes paid, partly, or denied.
·????? The insurance adjuster is an agent of the company and does not represent the insured party.
·????? There is always pressure on the adjuster to minimize payouts.
·????? There is a lack of adequate insurance adjusting capacity for significant crises such as hurricanes, giant fires, floods, and building collapses like the Florida condominium complex.
·????? Company strength, attitudes, and relationships with insured parties differ. When a carrier advertises that “you are in good hands,” the insured party may want to examine other parts of their bodies.
???? Conclusion of Part I. Part II & III covers the following subjects:
·????? Language in deeds of trust and mortgages that require replacement cost coverage:
·????? Insurance binders and certificate of insurance.
·????? How do mortgage lenders protect their financial interest in the event of a reimbursable insurance claim?
·????? Insurance disclosures in a borrower loan application.
·????? Loan processing will assist the borrower in ordering insurance coverage.
·????? The Property Appraisal process:
·????? Types of insurance coverage and short definitions of each.
?My comments are not all-encompassing, nor should parts I, II, and III; an overview is all you should know. The information contained is intended to be an educational overview only. Property insurance is a complex subject and is made more complicated by regulatory infringements, the health of the economy, inflationary pressures, and liability. Any owner/borrower or lender/mortgage broker should consult with a highly competent personal line or commercial insurance specialist to guide them to appropriate and contingent liability coverages. Do not forget a qualified insurance specialist lawyer.
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Thank You
Dan Harkey
Educator &Private Money Finance Consultant
949 533-8315 [email protected]
Visit danharkey.com
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