Property Insurance Coverages, Part I, An Overview
Dan Harkey, at DanHarkey.com writes great articles about real estate on his website. You can read more articles by visiting his website. In this article, he discusses “Property Insurance Coverages, Part I, An Overview”
This overview of property insurance has relevance to property owners, real estate agents & brokers, mortgage agents & lenders, insurance agents & brokers, escrow officers, and title insurers.
This article is broken down into part I and part II. Part I pertains to insurance concepts in general. Part II pertains to insurance in relation toreal estate transactions.
What is property insurance?
Insurance is a form of protection whereby insurance companies collect premiums en masse and use those premiums to pay out reimbursements for accidental damages. The business strategy is to collect more premiums and payout fewer claims! The purpose is to make a profit for the company and the stockholders. The insurance industry is systematically regulated and operates nationally and worldwide. There are many types of coverage and policies to insure for different risks.
An insurance policy is a written legal contract between two principal parties. The third party, the lender, has a security interest in the property
and a financial interest in the insurance policy but is not a principal.
a) Insurance company (the insurer)
b) Insured party, business, or entities being insured (the insured).
c) The Lender, as an additional insured party that has a security interest in the property (the lender).
d) Each of these three parties willingly enters an insurance contract with coverages, exclusions, policy limits, limitations of coverage such as personal property, and considerations about the parties’ obligations, rights, and responsibilities.
e) The distinction between and importance of these three parties should be emphasized. Many borrowers and realtors fail to realize the important component of the lender. Although not a principal in the insurance contract, the lender requires protection of their security interest rights. https://www.investopedia.com/terms/p/property-insurance.asp
Real Property insurance is a complex subject because there are so many subsets of property, business, and personal coverages. Real property insured categories include homeowners, condo/co-op, commercial property, renters, mobile & manufactured homes, liability, and personal property. A peril is an event that causes damage or destruction to a home or property. Covered risks are referred to as insured perils. Examples of insured perils are fire, windstorms, hail, theft, vandalism, and earthquakes. Covered claims are because of damage caused by sudden and fortuitous events which occur by chance. Insurance is not for property damage that occurs over time due to lack of timely maintenance, wear, and tear deterioration, or faulty workmanship. Insurance companies calculate the probabilities of claims and losses and issue coverage accordingly. Profit is the 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 was once a private investigator investigating fraudulent claims, including arson. Insurance adjusters are experienced and intelligent people. They know when a claim is bonified and when to deny coverage. Non-covered perils such as flooding, earthquakes, riots, etc., require “riders or endorsements” to gain coverage. A knowledgeable commercial lines insurance broker is necessary. A crucial element of insurance is that you may not assume that any event is covered unless your policy of insurance specifically states so. It is imperative that the insured party read the insurance contract. Disappointed insured parties are everywhere for all the obvious reasons. Very few ever read the policy!
Insurance company executives are not fools. The business model of providing hazard insurance coverage is designed for maximum profits – for the insurer. Their premiums are invested heavily in the securities market, usually reaping a fat profit. Risk exposures are high because of highly leveraged securities investments, including derivatives contracts. The federal government will always bail them out with taxpayer dollars if they suffer substantial economic
losses. Insurers will insure almost anything. They will insure the continued vitality of an opera singer’s voice, a professional golfer’s hands, the health of a 3-million- dollar-racehorse, or the potential loss of a derivatives contract. But 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 company risk in insuring derivatives and had to be bailed out by the taxpayers in April 2009. AIG did not understand the risks which they insured. The taxpayer bailout was the healthy sum of $185 billion because of derivatives losses. The U.S Treasury sold its final shares of AIG in December of 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 today in 2022. The insurance industry is like a cartel. Only a limited number of companies are allowed. The admitted members draft regulations in their favor but are also regulated by the Department of Insurance in the various states. (California Department of Insurance or other similar state agencies for other states).
General agents are agents of insurance companies rather than the policyholders. Insurance brokers are dual agents who represent both the company and the insured. 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. The insured parties may be forced to pay legal costs and suffer a delay in reconstructing the building for an extended period. The alternative is to engage in binding arbitration or expensive litigation against mammoth-sized companies with bottomless pockets of money. While completing the loan application, a borrower or the borrower’s agent may object to the lender’s requirement that the subject property is insured up to the full 100% replacement cost coverage of the building (security property) and 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. From a lender’s point of view, insurance should be sufficient so that the lender can recoup the principal balance, accrued interest, and expenses in a claim situation. Borrowers should rely on counsel from their insurance broker to guide them for appropriate decisions regarding the types and amounts of coverage, alternative coverages, and appliable 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 on paying the debt off or even reducing it. As the Federal Reserve pumps more money into the economic system, there is a corresponding reduction in the dollar’s purchasing power (debasement). With debased dollars paying off the debt assumes that payments would be made from severely diminished valued dollars (cheaper dollars). Goods, services, and construction cost services cost incrementally more. Real estate may benefit from inflation because values increase, but the glee quickly becomes a downer when everything costs incrementally more. Each dollar becomes worth less and less. In the past ten years, markets have been stable with little notice of inflationary pressures. We are now in a period of an accelerated speed trap, attempting to keep up with a race between increased premiums and costs, all related to inflationary pressures. There is constant pressure on rising prices of original construction, regulatory compliance, and the rising cost of required building enhancements during inflationary times. A borrower may be focused on saving money but is uninformed or ill-informed about the negative financial unintended consequences of recovering to expenses of a claim. If the borrower does not follow the recommendations of his mortgage broker or his qualified insurance agent or broker, then bad things may happen. 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. The insurance company is fully aware that they are protected from this problem of under-insurance because of their policy limits.
Inflation causes prices of building materials, appliances, heating & air- conditioning, municipal approvals, including revised building codes, and labor to go up substantially, and over time this process compounds prices. Whether intentional, uninformed, or negligent by the borrower’s insurance agent or real estate or mortgage broker, the insured parties may find themselves underinsured and must pay for 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.
I do not think that property insurance industry participants, including insurance agents/brokers and real estate agents/brokers, are vocal enough
about the magnitude of this national problem!
Replacement cost coverage (RCV):
RCV is the amount required to replace the damaged or destroyed property with the same or similar substitute quality as it was originally built. This may be difficult, if not impossible. Insurance for enhancements, betterments, building codes, and current zoning ordinances to bring the property up to today’s standards require a different form of insurance or endorsement and are not included in the definition of insurance replacement cost. 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 probably not economically feasible. Because of these differences, replacement cost insurance may not be quite understood by the public purchasing insurance policies as a protection mechanism.
Replacement cost verbiage in the insurance policy does not reflect current codes, ordinances, regulations, designs, and available materials. Assuming that a property was built in 1946, the policy contemplates reconstructing the building to those same 1946 standards. Older properties may be characterized by now 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.
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 not work correctly or are inadequate. Insurance carriers may not be willing to write policies to cover all the new requirements. An insurance policy is not designed to replace the need to invest additional capital in upgrading or bringing the property into current compliance with the idea of raising rents and enhancing value.
Interested parties may visit www.insurance.ca.gov for an overview of insurance products and definitions. Extended replacement cost coverage:
This type of insurance is additional; however, it is more extensive and expensive protection. The coverage protects the insureds against sudden increases in materials or construction costs. Some carriers will offer extended replacement options as an endorsement that may cover up to an additional increase of 20% to 25% of the replacement cost up to the policy limits. However, 20% or 25% may not be enough to pay for higher prices and new government-mandated upgrades.
Actual cash value policies (ACV):
An insured party may choose the coverage that is referred to as actual cash value coverage. With this coverage, a loss would be calculated to include the depreciated fair market value of the damaged or destroyed dwelling at the time of the 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 that you would expect to receive by selling the property on the open market. This form of insurance may significantly alter the underwriting by a lender. This form of coverage is more common for older commercial and industrial properties. An (ACV) policy is a bad idea in almost all cases. Zoning and building ordinance Insurance:
This additional coverage is intended to cover the cost of repair or reconstruction that requires upgrades or updating to meet current building codes and current building standards. Examples may pertain to weather, fire safety, wiring, or handicap accessibility. Some coverage forms are called Improvements and Betterments Insurance Coverage. This form of coverage is usually in the form of policy endorsements. These coverages vary in what they are called, what is covered, and what different insurers exclude.
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. Also, the damage is not covered due to poor maintenance or workmanship, general wear & tear, pest infestations, power failure, nuclear hazards, government actions, intentional loss by the insured, and home-based business liability.
Many insurance policies for both residential and commercial have language referred to as a coinsurance provision which covers the issue of under-insurance. A coinsurance clause in property insurance contracts ensures that the policyholder must insure their property up to an appropriate value so that the insurer will receive a fair premium for the risk. Coinsurance clauses require that policyholders insure up to 80, 90, or 100% of the replacement cost of the structure(s) and appurtenant(s). Coinsurance penalties will be applied on claims for under-insurance and will differ with companies and policy types. Effectively, a coinsurance penalty triggers a contractual requirement that the insured party pays a portion or penalty in their financial loss using a calculation formula in the policy. Some
insurance companies provide step-up coverage endorsements to reflect higher replacement costs due to inflation. Whether or not the policy contains a coinsurance penalty provision, the insured party could find themselves being significantly underinsured in the event of a hazard claim, a result may require the insured party to pay for a portion of their loss and a portion of the cost of reconstruction, including betterments and enhancements. The insurance company may pay up to the policy limits and leave the under-insured party hanging out for the remainder.
Under-insurance is more prevalent now than in the past because of the upward cost pressure caused by inflationary increases in construction costs. For example, lumber has gone up dramatically as have other materials and labor. 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 replacement cost has doubled to $400 per square foot, not counting the land value. Housing replacement cost estimates may be from $200 per square foot for entry-level production homes up to $1,000 to $1,500 per square foot 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 wish to discuss methods and data sources for calculating current 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. Here are a few comments relating to the claims department functions. There are many complexities and problems in this department. Claims departments tend to have high turnover.
a) Insurance claims are sometimes paid, paid in part, and/or denied.
b) The insurance adjuster is an agent of the company and does not represent the insured party.
c) There is always pressure on the adjuster to minimize payouts.
d) Lack of adequate insurance adjusting capacity for significant crises such as hurricanes, giant fires, floods, and building collapses like the Florida condo complex.
e) Company strength, attitudes, and relationship to insured parties differ. When a carrier advertises that “you are in good hands,” the insured party may want to watch for other parts of their bodies. This is the conclusion of Part I.