After a loan has been originated and the lender’s servicing operation begins their work, there is often anxiety about whether the insurance required at closing is appropriate for the hazard risks inherent to that property type, and whether the limits of liability selected for the insurance requirements are sufficient to fully protect the collateral in the event of a loss. This anxiety can be mitigated, and in some cases eliminated, if the originator analyzes the hazard risk in the manner employed by insurance agents and underwriters. The originator should keep the following points in the forefront of his/her mind when deciding what types of insurance and what limits of liability are consistent with how an insurance underwriter views the risk:
- The insurance requirements should be based on the property’s exposure to loss. What perils (e.g., flood, windstorm, and earthquake) are likely to cause damage to the property based on where it is located? If the building was built before the area’s most recent catastrophe (e.g., windstorm or earthquake), does it comply with current building codes or is there a significant ordinance or law insurance exposure?
- Insurance limits should be based on the property’s insurable replacement cost or in the case of liability exposures, the loss history for similarly situated buildings.
- Lenders, servicers, insurance agents, and insurers all have a stake in assuring that our mutual customer (for lenders and servicers it’s the “borrower, for insurance agents it’s the “client,”and for insurers it’s the “policyholder”) has insurance in force that is adequate to restore a property to its pre-loss condition or to protect the customer from an uninsured liability loss that could cause financial ruin and a default under the existing loan.
As Stephen Dedalus, the protagonist in James Joyce’s “A Portrait of the Artist as a Young Man” said, “I go to encounter for the millionth time the reality of experience and to forge in the smithy of my soul the uncreated conscience of my race.” In a similar manner, an insurance agent analyzes a property and his/her job is to identify the myriad of known loss exposures, imagine the previously unknown loss exposures that could affect a property, and work with the underwriter to design an insurance policy to address those exposures. The art of identifying loss exposures is the key first step to successfully applying a hazard risk-based method of developing insurance requirements for loan documents.
Accordingly, an originator should apply the same principles when making the determination as to which perils should be insured against by the customer for a particular loan and make sure those perils are part of the insurance requirements for that loan. For example, if the subject property is in a low-lying coastal area prone to hurricanes and windstorm risk, the originator should verify whether the property is in a flood zone and, if so, insist that the borrower provide flood insurance and named windstorm coverage as part of the insurance requirements (since flood exposures and hurricane exposures are normally excluded from policies unless added by endorsement). As we witnessed during Superstorm Sandy in 2012, properties in these locations have a significant probability of being damaged by wind forces, as well as surface water (storm surge), which can flood the premises during the storm. As the customer has both types of coverage in place, there should be no ensuing argument with the insurer over which peril caused the loss, since both perils are covered under the policy.
Another situation that arises periodically is hazard-risk exposure that is less obvious in nature. In parts of the country where there are older buildings built prior to the most recent amendments to local building codes, there is a potential that some or the majority of property will not be covered by the policy if an ordinance or law coverage endorsement is not added to the policy. Accordingly, loan originators will need to do a thorough review of the appraisal or inspection report to determine if there are any non-conforming conditions present in the building.
Local building ordinances often have a threshold of damage for properties where if the property is damaged to an extent at or above the threshold (typically 50% or more), the building must be reconstructed in accordance with current building codes.
Standard property insurance forms (e.g., ISO CP 10 30) state “We will pay for direct physical loss of or damage to Covered Property at the premises described in the Declarations caused by or resulting from any Covered Cause of Loss.” Loan documents typically require the ‘Special Form Cause of Loss’ that defines Covered Causes of Loss as follows:
A. Covered Causes of Loss
When Special is shown in the Declarations, Covered Causes of Loss means Risks Of Direct Physical Loss unless the loss is:
1. Excluded in Section B., Exclusions; or
2. Limited in Section C., Limitations; that follow.
1. We will not pay for loss or damage caused directly or indirectly by any of the following. Such loss or damage is excluded regardless of any other cause or event that contributes concurrently or in any sequence to the loss.
A. Ordinance or Law
The enforcement of any ordinance or law:
(1) Regulating the construction, use or repair of any property; or
(2) Requiring the tearing down of any property, including the cost of removing its debris.
This exclusion, Ordinance or Law, applies whether the loss results from:
(1) An ordinance or law that is enforced even if the property has not been damaged; or
(2) The increased costs incurred to comply with an ordinance or law in the course of construction, repair, renovation, remodeling or demolition of property, or removal of its debris, following a physical loss to that property.
Ordinance or Law endorsements (e.g., ISO CP 04 05) fill that coverage void by granting coverage according to the following provisions:
- Coverage A – Coverage for Loss to the Undamaged Portion of the Building
With respect to a building that has sustained covered direct physical damage, we will pay under Coverage A for the loss in value of the undamaged portion of the building as a consequence of enforcement of an ordinance or law that requires demolition of undamaged parts of the same building.
- Coverage B – Demolition Cost Coverage
With respect to a building that has sustained covered direct physical damage, we will pay the cost to demolish and clear the site of undamaged parts of the same building, as a consequence of enforcement of an ordinance or law that requires demolition of such undamaged property.
3. Coverage C – Increased Cost of Construction Coverage
- With respect to a building that has sustained covered direct physical damage, we will pay the increased cost to:
(1) Repair or reconstruct damaged portions of that building; and/or
(2) Reconstruct or remodel undamaged portions of that building, whether or not demolition is required; when the increased cost is a consequence of enforcement of the minimum requirements of the ordinance or law.
- This coverage applies only if the restored or remodeled property is intended for similar occupancy as the current property, unless such occupancy is not permitted by zoning or land use ordinance or law.
- We will not pay for the increased cost of construction if the building is not repaired, reconstructed or remodeled.
If you are now starting to feel a slight sense of panic, you read this policy language correctly. In effect, it says that if your property is damaged at or above the local threshold and you do not have full Ordinance or Law coverage (Coverage A, B, and C) you stand to lose three times; once for the value of the undamaged portion of your building that has to be torn down to meet current building codes, once for the cost of demolishing the undamaged portion of your building, and once for the increased cost of construction you may incur to rebuild up to the new building code standards.
With respect to property insurance, loan documents typically require the property to be insured to full replacement cost. In most instances, this does not cause a problem because there is sufficient capacity in the marketplace to provide replacement-cost coverage at a reasonable price. However, for properties in catastrophe-prone areas, this can sometimes be a problem and the borrower will offer coverage limits that are less than full replacement cost, based on Probable Maximum Loss (PML) or Scenario Expected Loss (SEL) studies that purport to show the unpaid principal balance will be covered in the event of a catastrophic loss. While these studies can provide a reasonably reliable estimate of expected loss for earthquake risk, they are not widely acknowledged to be reliable for windstorm exposure. Accordingly, if the customer requests that the coverage for the loan be provided on a blanket policy or on some basis less than full replacement cost, the loan originator should request a schedule of locations and insurable values to determine if the borrower is reporting adequate limits to cover the replacement cost of the property, in the event of a catastrophic loss.
With respect to liability insurance, the analysis is often hampered by a lack of loss data if the subject property does not have a history of liability claims filed against the property. In addition, the expected loss for a liability claim is very difficult if not impossible to model with respect to claim results. Further, the likelihood of loss and the expected losses vary widely across different property types. Thus, the best source of information for this exposure is to reach out to insurance agents or brokers and get their view on industry data they collect on claim histories by property type. Finally, the loan originator should examine the financial status of the borrower and determine what dollar value of losses that may not be covered by insurance the borrower could sustain and still maintain the debt service on the loan. Originators also may find that this approach is helpful in determining the appropriate deductible or self-insured retention that will be sustainable for the borrower, on a case-by-case basis.
It’s All About the Customer
All of the actors in this commercial real estate play (lenders, servicers, insurance agents, and insurers), should be focused on one question: How do we use our particular expertise in financial services to help the customer succeed? Regardless of the description we apply to customers (e.g., borrower, client, or policyholder), the contracts we have with them should enable them to fuel the growth of their businesses by providing capital and asset protection where and when it’s needed most.
While we can disagree about which party in the value chain should be responsible for certain activities, such as providing evidence of insurance, contract certainty, and the like, my view is that the party that has superior knowledge and control over the data required by the customer has the duty to step up and provide the needed information to all parties whom the customer identifies as critical to the transaction. It is no secret that most customers are willing to pay for services that provide them with speed to market or financial security, and it’s a fact that should not be lost on any of the actors in this play.
Finally, I encourage all the actors in this play to challenge their existing products, systems, and business processes, and ask the question “how does what I’m doing right now, and what I plan to do in the future, create value for my customer?” If you can’t derive a clear answer, you should probably consider doing things differently or risk having your customer find a new dance partner. If we explore this question thoroughly and come up with clear answers, we will have a satisfied customer and we will all be sleeping soundly.