Recorded Webinar: Insuring Wrap-Mortgages

There are many issues involved when insuring wrap-around mortgages and, unfortunately, many investors and buyers are unaware of the potential problems and liabilities that they themselves may be inadvertantly creating by following bad advice, ignoring good advice, or simply refusing to address the issues of loan servicing and insurance billing because they are ‘inconvienient’.   We hope this webinar video is both informative and useful to you.

WRAP MORTGAGE FAQ’s – What is an ‘Insurance Score’ and is My Credit Score Used in Determining Premiums?

Just as your credit (FICO) score is a tool used by creditors to determine whether or not to extend credit based on past financial and payment history, an insurance score is a tool used by the vast majority of insurance companies to determine premiums. It is important to understand that an insurance score and your credit score are not the same thing – though your credit score does have an impact on your insurance score. Confusing? In short, an insurance score is a rating computed and used to represent the probability of a client filing claim during the coverage term – not to determine creditworthiness. However, this score is largely based on an individual’s credit rating and it will definitely have an impact on the premiums he or she pays for coverage; a higher score (meaning higher risk to the company) will result in higher premiums and a lower insurance score (meaning less risk to the company) will result in lower premiums.

Individual insurance scores are based, in large part, on credit ratings because historical insurance data reveals a direct correlation between poor credit ratings and a higher number of insurance claims. However, while all companies are required to use the same basic criteria in determining insurance scores, they do have latitude to take other client information into consideration as well depending upon the company’s ‘risk appetite’.

Insurance scoring models vary by company, but the one thing that they all have in common is that they are built from various credit report factors, combined with insurance claim and profitability data, to produce a numerical algorithm which, in turn, produces a rating.  It is important to understand that insurance scores are not intended to measure creditworthiness, but they do take credit information into consideration such as age of oldest accounts, ratio of total balance to total credit limits, number of open revolving accounts, and number of revolving accounts with balances greater than 75% of limits, etc. Therefore it is possible for someone with a high credit (FICO) score and excellent payment history to actually receive a poor insurance score.  Like it or not and regardless of whether or not you agree with it, almost all insurers consider credit report information in their underwriting and pricing decisions as a predictor of profitability and risk of future losses.

For More information about Insurance Scoring Click Here

The Problem of Residential Insurance in the Name of an LLC

As an investor and insurance broker working with investors, I have property owners contact me on a regular basis stating that they ‘need’ to purchase a dwelling insurance policy in the name of their LLC for their rental property. When I tell them that what they want really isn’t possible and that the policy has to be issued in their name personally, they become very defensive and irate, and insist that I don’t understand what they are asking for. I normally try to again explain how the property should actually be insured, but I am almost always cut-off with the words “I don’t think you understand, the property is in the name of my LLC, not my name personally.”  Few people are able to comprehend the fact that the property being titled in the name of a company or LLC has little or nothing to do with the actual coverage provided by the insurance policy itself – but it DOES dictate how the policy must be issued and what company will issue it.  Unfortunately, I’ve become very accustomed to this.  They also can’t understand why they often need to provide their social security number and date of birth.

The problem here is that these property owners don’t really have any idea what they are asking for and they are ‘demanding’ something that doesn’t really exist (more on that in the next few paragraphs.)

Before we go too far, there are some important concepts that you must first understand with regards to insurance contracts in order to better understand why it not usually possible to issue a policy like this in the name of an LLC.

THE BASIC PURPOSE OF USING AN LLC

What many owners and investors fail to realize is that placing the property in the name of an LLC or Trust really doesn’t have anything to do with insurance whatsoever – it is a strategy to allow anonymity (although not as good as a Trust), minimize personal legal liability exposure, and have the ability to take advantage of various real-estate related tax deductions. It really doesn’t do anything from an insurance standpoint except dictate the manner in which the policy has to be issued.  However, few people actually understand the nature of property and casualty insurance contracts and they, therefore, assume that the policy must be in the name of the same LLC that has legal title to the property.  This simply isn’t so.

The basic reason for putting a property in the name of an LLC is simple. If a property is titled in the name of an LLC and there is a litigation involving the property, the Plaintiff, under normal circumstances, can only sue and seek damages from the assets of the LLC itself – which aside from the property (which usually has a first-lien mortgagee) are minimal.  In theory, this protects the individual owner’s personal assets from being attached to the suit and liquidated for damage awards if the Plaintiff wins the suit. Of course there are situations in which the LLC is voided by the court, such as in cases of gross neglect, when the LLC documentation has not been properly created, or when the LLC is considered null because of the owner/member’s failure to maintain a minute book and similar, but those are all legal issues having nothing whatsoever to do with insurance.

THE PROBLEM WITH INSURING RESIDENTIAL PROPERTY IN AN LLC

To begin with, a dwelling policy, which is the type of policy used to insure one and two-unit residential rental property, is a personal insurance product.  In other words, it is a type of personal insurance policy – just like an automobile or homeowner’s policy.  An LLC is a corporate entity.  Therein lies the rub.  You can’t issue a personal policy for property titled in a corporate or company name any more than you can insure a 20-story office building on a personal homeowner’s policy. They are mutually-exclusive.

From a physical standpoint, it’s still the same building with the same tenants and the same rent – and from the point of view of the investor/owner – the risk hasn’t changed and it’s “silly” that an insurance company won’t issue the policy in the name of the LLC.  However, from the insurance company’s perspective (and they are the ones assuming the risk and issuing the policy), even though the building itself maybe the same, the liability nature of the risk has changed in that it is now a commercially-owned property.  This is the same situation that would exist if you opened a new courier business (ie: ABC Couriers) and took your personal ‘daily driver’ vehicle and transferred the title to your new company.  The vehicle would still be the same with no physical change, but it would be owned by “ABC Couriers” (no longer you personally) and you would be required to purchase a commercial automobile policy since your previous personal auto policy does not generally cover vehicles legally owned by or titled in the name of a business.

Furthermore, when insurance companies provide quotes for personal insurance (including dwelling policies), they must first verify the actual risk that they are potentially insuring – which is why they almost always require a social security number, date of birth, and/or other personal information. This information is almost always required except for those few companies that do not use credit scoring and which only issue very basic and very minimal coverage or those companies which will issue coverage without this information (though the ‘base premium rate’ is automatically higher from the start when this information isn’t provided). Insurers use this information to search for previous claims and losses, prior lapsed insurance, and to assist in developing an insurance score for the party requesting the new coverage. However, LLC’s don’t have a social security number, they don’t have a date of birth, and the insurers issuing the coverage have no way of verifying past insurance history.

In addition, most insurance companies clearly state in the guidelines and eligibility requirements for dwelling policies that an LLC cannot, under any circumstances, be a ‘named insured’ on any dwelling policy for the reasons already mentioned.

Again, an LLC is a legal corporate entity that cannot normally be used to purchase a personal insurance policy regardless of what the property owner has been told by other parties or what he or she ‘wants’. If the property owner absolutely insists that the insurance be in the name of an LLC, there are only a couple of options available; either issue a policy with a non-standard or surplus-lines company that will allow this (which usually results in a lesser-quality policy with fewer coverages) or issue a commercial policy. Both options are more expensive and neither is an ideal way to insure the property.

HOW TO INSURE PROPERTY TITLED IN THE NAME OF AN LLC

There are really only three ways to issue a dwelling policy for property titled in the name of an LLC, and these are really dictated by the eligibility guidelines of the insurance company issuing the policy itself, not the agent, broker, or property owner.

# 1 – Individual as Policy Owner and LLC as Additional Insured

The first, and best, method of insuring a property like this is to issue the policy in the name of the individual owner (since he or she is the managing member of the LLC) and then list the LLC as an Additional Insured. This is normally the only way to issue coverage with a ‘standard’ insurance company which provides better coverage and lower premiums.  In the event of a claim, the policy owner (who also owns or is a member of the LLC) can file and manage the claim, receive claim payments, make policy changes, and so on.

In this situation, the policy must be issued in the name of an individual (ie: ‘Named Insured’) who is a member of the LLC, normally the managing member. The reason for this is because the insurer must have a social security number, date of birth, and other personal data in order to develop and insurance score and verify past claims history (remember, LLC’s don’t have this!).  The LLC (which has an ‘insurable interest’ because of the legal title) is then listed as an ‘Additional Insured’ party so that it is afforded liability coverage under the policy.

In the event that there is litigation involving the property, such as a tenant suing for injuries sustained due to the property’s maintenance condition, the insurance company has a ‘duty to defend’ the named insured (individual listed on the policy) as well as the LLC since it is listed as an ‘Additional Insured’.  The liability portion of the policy will pay for legal, defense, and/or any settlement costs resulting from the claim or loss.  Both the individual and LLC are covered.

# 2 – Non-Standard Policy in name of LLC

As an exception to method #1 above, there are only a few (only one or two) standard companies that will issue a policy with the LLC actually being listed as the ‘Named Insured’ policy owner. The catch to these few companies is that (a) they are more expensive than others (b) they charge an ‘endorsement surcharge’ in addition to the regular premium for having the LLC as the named insured, (c) they normally have at least a minimum 2% deductible requirement, and (d) they won’t insure properties over 20 years of age.  Because of these four items, this normally isn’t an option.

If, for whatever reason, the property insurance must absolutely and positively be in the name of the LLC (and from an insurance perspective there really isn’t one), then the second option is to issue coverage through a non-standard ‘surplus lines’ company (such as Lloyd’s of London).  These insurance carriers are normally very financially secure, however, they operate under a different set of state insurance codes and laws than do ‘admitted’ or standard companies, which means that they can write their own policies with endorsements, coverages, and exclusions tailored specifically for the individual risk or property being insured.  One of the biggest concerns here is that the cost of the policy is almost always (100% of the time) much more expensive than a ‘standard’ company.  There is also a 25% ‘minimum earned premium’ due as soon as the coverage is issued and these companies must also charge state taxes along with various fees, which can sometimes total hundreds of dollars. In addition, they usually offer less coverage and they use third-party claims services to manage losses – which often creates a disappointing claims process for the policy owner.

This is an option, but it’s not the first choice.

#3 – Commercial Policy in Name of LLC

The last option, which is also not recommended, is to insure the property with a commercial policy with the LLC as the policy owner.  Again, there are issues with this as well.  First of all, depending on the characteristics of the property, this normally has to be done in the non-standard or ‘surplus lines’ market mentioned above – which means more premium. Secondly, many of these companies simply won’t issue commercial coverage on a residential property with habitational exposure.  Finally, if a company is willing to issue a commercial policy in the name of the LLC for a residential property, the premium itself will be so cost-prohibitive that there is no point in purchasing the policy.

In summary, LLC’s are excellent corporate entities for the purposes of taxation and reducing liability, but they are often misunderstood and misapplied to insuring residential property and many investors and property owners spend a great deal of time and effort debating and worrying about a fairly irrelavent non-issue. Should you have questions, please feel free to contact us at (800) 299-8994 and we will be happy to answer any questions that you may have.

Common (and BAD) Advice About Insuring Wrap-Mortgages

If you are involved with seller-financing and you have read any of my articles regarding insurance for these types of transactions, specifically wraparound mortgages, you have probably picked up on a common theme running through all of them – which is that there is a lot of bad advice being given by people with little or no knowledge of insurance and it can cause you BIG problems later on.  This includes Realtors, attorneys, and even other insurance agents and brokers.  In fact, we ourselves have heard advice that is not only completely wrong but which can almost certainly be construed as intentional insurance fraud – and this was from another insurance ‘professional’ with years of experience.

The reason for this misinformation is because insurance is often treated (at best) as a commodity or viewed (at worst) as a ‘necessary evil’.  This apathy and the general lack of importance attached to insurance is what drives the ability for those with no actual insurance knowledge to become ‘overnight experts’ with the ability to direct the  insurance-purchasing decision of others.  In addition, most licensed insurance agents are simply salespeople that have no first-hand experience with real estate, property investing or contract law and who make very little effort to educate themselves with anything truly insurance-related beyond just the bare minimum knowledge required to sell a basic policy.

In fact, the paragraph below is actually posted on the web site of a legal firm with experience specializing in wraparound mortgages.  It is shocking (actually, not really that surprising) that an established legal professional would provide inaccurate advice like this, but this firm is not alone – this is the same type of misguided information parroted to buyers and sellers across the country.  As an insurance professional, I don’t even know where to begin tearing apart the text below.  It is incorrect in virtually every sentence and, if this advice were to be followed, there is also a very real potential for intentional insurance fraud.

Wrap-Around Mortgages: The Problem of Escrow

As you may already be aware, there is an enormous amount of information on the internet about wraparound mortgages and the ‘new’ seller-financing alternatives currently being used in today’s market. Too bad most of it’s wrong or incomplete.

Unfortunately, much of the information that exists is written by those, including real estate attorneys, with no first-hand experience or knowledge in insurance, insurance law, and other key areas of knowledge. They unintentionally end up providing only about 75% of the information actually necessary (which may or may not be accurate) that the other 25% pertaining to insurance, escrow accounts, and Trusts (depending upon the transaction) is simply left out altogether as if these things don’t really matter.  The fact is that they are left out because most ‘experts’ have no clue whatsoever about these key topics or how to deal with them – so they just omit them and the reader never knows the difference.

First things first, let’s get the obvious questions out of the way.

• Yes, wraparound mortgages are completely legal.

• No, you are not required to notify the underlying lender that a transfer of the property has taken place.

• Yes, the lender has the right (not obligation or requirement) to exercise the acceleration clause’ (aka ‘due-on-sale’ clause), but there is a 99+% chance that they won’t – at least not for several years until interest rates increase.

Now that we have gotten past the ‘Big Three’ questions, let’s get onto the subject of property insurance and escrow accounts… the red-headed stepchildren of the wraparound mortgage industry.

One of the biggest hurdles regarding wraparound mortgages is that of hazard insurance. The documentation and transfer of property is the easy part, it’s the property insurance itself that presents an obstacle.  The reason for this is because of the fact that an insurance policy is a very straightforward legal contract between the policy owner (who must have an ‘insurable interest‘) and the insurance company. These contracts are NOT assignable (like a real estate contract is) and insurance is not designed to work in a situation such as a wraparound transaction where the parties are trying to ‘skirt the system’ (for lack of a better term) and keep the underlying lender in the dark about the transfer of property. Trying to be creative and somehow ‘modify’ an insurance contract or make it magically fit the needs of the wrap transaction is like using a screwdriver to paint a wall; it’s not designed to perform that specific task and you’ll end up disappointed with the results. Rather than discussing the many pieces of bad advice and improper (or even illegal) ways to insure these properties, this article is going to focus only on the aspect of the escrow account itself.

This may be elementary, but before we go forward, it’s important to understand just exactly what an escrow account really is.

Without going into too much detail, an escrow account, which is usually required by the original mortgage document and which is established in the name of the original borrower, is a separate account established by your lender or loan servicer used to collect and hold funds to pay your annual property taxes, insurance premiums, and/or other charges when they become due.  This account is normally established by the lender as soon as the initial closing occurs. The reason is simple; the lender has a first-lien position on the property and they want to maintain control of the loan by making certain that all taxes and fees are paid and that the property, which is collateralizing their loan, is always fully insured against a loss.  If an escrow account didn’t exist, there is always the possibility that the borrower could fail to pay his or her property taxes each year – which may result in a County tax lien that supersedes the lender’s original lien position (regardless of the amount of taxes due). Also, if the property suffers a loss and the insurance has been terminated for non-payment, the lender has no collateral any longer and they may very well lose part or all of their money on the loan.  Each month when the borrower makes a mortgage payment, part of the amount goes to the Principal and Interest balance of the loan and a small part is ‘siphoned off’ and deposited or credited to this separate escrow account. Each year the lender receives a bill for the insurance and taxes and they, in turn, use the money in this account to pay these bills in full until the following year.

When purchasing a property with a wraparound mortgage, the seller (original borrower) normally has an escrow account already established with the lender with funds in it – and this is where the problem begins.

You see, this escrow account is the name of the original borrower (the seller) and NOT in the name of the new wraparound buyer and all parties are trying to keep the transaction ‘invisible’ so that the underlying lender is not notified about the property transfer.

When the transfer happens, the new buyer must obtain property insurance in his or her name. However, if the initial transaction is not set up correctly (which they seldom are) and no third-party loan servicing agency has been contracted to set up a NEW escrow account in the name of the NEW BUYER, then there is an immediate built-in problem.

Because most attorney’s and agents dealing with seller-financed transactions have no experience and little or knowledge about insurance, bad advice is given and  the sale is usually set up so that the new insurance policy is simply sent to  the underlying lender to be paid from the original existing escrow account (with the silent hope that the lender doesn’t see the name change and cause a stir).  The problem here is that this escrow account is in the name of the original borrower (the seller in this case) and NOT in the name of the recent buyer – who is the ‘named insured’ policy owner on the new insurance.  The mortgagee can’t and won’t release funds from John’s escrow account to pay for David’s insurance.  Period.  They can’t use one party’s money in that party’s account to pay for someone else’s insurance.

Hence the problems of (1) who pays the insurance and (2) what does the lender due now that they have been tipped-off as to the transfer of the property?

The normal result is that the insured has to then contact the insurance company issuing the policy and take responsibility for either paying the premium in full (which few can afford to do) or otherwise set up monthly billing arrangements. The obvious concern here is that the new buyer owner fails to pay for the policy and it cancels for non-payment of premium.  This happens about 50% of the time and it results in continuous cancellations, reinstatements, and possible permanent loss of insurance depending on how many times this occurs.  Without intending too sound too harsh, many (not all)  buyers of seller-financed property have already had past credit and/or financial-responsibility issues and leaving them in full control of paying yet another bill and making certain the property is always insured is normally not a very good idea and it’s an absolute set-up for future long-running issues and constant babysitting of the loan.

THE SOLUTION

The best solution to the potential problems mentioned is to treat the new wraparound exactly like a traditional mortgage loan.  The new buyer should pay the first  year’s insurance premium in-full at the closing table and then a loan servicing agency should be contracted to set up the management of the wraparound sale from the day it closes.  This servicer should establish a brand-new escrow account in the name of the new buyer and fund it with each monthly mortgage payment.  The bill for the insurance (as well as property taxes) is sent to the loan servicer each year who in turns pays the entire amount from the buyer’s escrow account.

WHAT ABOUT THE ORIGINAL ESCROW ACCOUNT?

Good question… Herein lies another issue to consider.  This escrow account, which presumably has funds in it, is in the name of the seller – who is probably now far-removed from the sale and just glad to have it done and in his or her past.  However, it continues to get funded even more each month as this underlying mortgage payment is made by the loan servicing company. With this in mind, one of two things can normally happen.

# 1 – the seller can send the mortgagee/lender proof of the taxes and insurance being paid in full (the new buyer or loan servicer must provide this information to the seller who in turn provides it to the underlying mortgagee – which means the parties must stay in contact with the seller at least on an annual basis). Once this proof of payment has been sent, the seller can now request that the ‘overage’ in the escrow account be returned to him or her and, in theory, forwarded onto the new buyer.  The obvious concern being the steps and effort involved as well as the fact the seller can technically keep this money once it has been sent by the underlying lender.  The wraparound documents may state that the seller ‘assigns’ this escrow account to the new buyer, but this is really only between those two parties – not the underlying lender. The original lender did not agree to the assignment and their consent can’t be construed simply because the other two parties agreed amongst themselves to the assignment.  Furthermore, escrow accounts can’t be ‘assigned’ any more than your checking account can be ‘assigned’ to your next-door neighbor.  If the seller chooses to keep this money, the only real recourse is for the buyer to pursue litigation against the seller, which really isn’t an option anyway since it will probably cost more in legal fees than the amount of escrow money actually returned and because of the nature of these sort of issues, it could possibly notify the underlying mortgagee of the transfer and litigation – and now the due-on-sale clause can become a very real issue.

# 2 – In some states, the seller (original borrower) can request that his or her escrow account be canceled and that he or she be solely responsible for paying all taxes and insurance as well as sending in annual proof of payment to the mortgagee.  In theory this eliminates the problem altogether.  The ‘gotcha’ to this is that this possibility varies by state and there must usually be less than 65% of the balance still owed (a 35% equity position). When dealing with wraparound mortgages, this is normally not possible because of the fact that if the property had that much equity it would have probably been sold on the open market with traditional financing in the first place and if the seller was in a foreclosure or pre-foreclosure position with the lender, the lender is probably not going to take on even more risk and allow the escrow account to be canceled so that the seller (who was previously in default)  now has control of tax and insurance payments due directly to the past financial problems and payment history of the loan itself.

SUMMARY

As you can tell, the original escrow account is almost always the ‘fly in the ointment’ regarding seller-financing, however, the problems posed with insuring wraparound mortgages can be greatly diminished if managed and dealt with properly at the beginning instead of waiting until all legal documents have been signed and executed and then dealing the after-the-fact problems as they occur.  InsuranceForInvestors deals extensively with wrap-mortgage situations and we are more than happy to help you minimize your insurance-related headaches.

Why Insurance Companies Don’t Promote Dwelling Policies

As an investor or owner of rental property, the most common type of insurance that you will purchase is known as a ‘dwelling’ policy.  These policies are similar to a homeowner’s policy in many ways, but instead of a primary residence, they are used to insure non-owner occupied property (click here to read about the various types or versions of dwelling policies).  However, these policies vary greatly from one insurance company to another with regards to what they actually cover (and more importantly, what they don’t cover) and very few agents know very much about them at all.  In fact, if you do happen to already have a dwelling policy insuring one of your rental properties, there is a better than average probability that it is a very basic policy form and that you are poorly insured.

So the question is: “Why do so few agents know anything about the dwelling policies they sell?” and “Why don’t insurance companies provide very good coverage with these types of policies?”

The answer is simple: Neither the insurance companies nor the agents themselves want to be in the business of insuring rental property.  This is not the ‘target market’ for either party.

The truth is that all personal insurance companies such as Farmers, State Farm, Nationwide and other well-advertised insurers will happily accept your premium dollars for such things as normal homeowner and automobile insurance – and they all compete with one another based solely on price (the ‘whose cheaper’ business model) – but when it comes to rental property, they simply don’t want the risk and they only offer dwelling policies as an ‘and that too’ type of product because they have to. They don’t advertise their dwelling policies, they don’t train their agents in insuring rental property (and few agents have the initiative to learn themselves), they often provide as few coverages and as many policy exclusions as they possibly can, and they price these policies to be more expensive than traditional homeowner insurance.   This is normally the type of business that they prefer to shy away from.

Simply put, these companies do not want to be in the business of inuring rental property. Period.  Because of this, they offer little and charge much.

In fact, some insurance companies actually pay much smaller commissions to agents for selling a dwelling policy than they do for a comparable homeowner’s policy – sometimes as much a 66% less.  Because of this demotivating factor, agents have even less desire to sell or service these policies.  As far as these companies are concerned, the obvious idea is to make as much money as possible while taking on as little risk as possible.  Generally speaking, non-owner occupied properties present a higher risk for loss than an owner-occupied residence due to maintenance condition, pride of ownership (which tenant’s by definition don’t have), property age, property value, and the fact that more often than not they are located in less-desirable areas.  Rental properties also have a high rate of vacancy due to tenant turnover which results in claims due to damage from vandalism and copper theft.

In addition, most personal-lines insurance agents and brokers work within a very small box with a limited scope of knowledge and experience.  Rather than being insurance professionals, they are more often than not just salespeople with limited insurance knowledge and quotas to fulfill. Their primary objective is to sell home and auto insurance (again based primarily on ‘whose cheaper’) and they care little about insuring rental units – often because the company that the agent represents usually has a poor or limited dwelling policy product for the reasons already mentioned and they themselves have no first-hand experience or concept of being a landlord – which means that they don’t normally understand the realities of managing cash flow or the liabilities associated with high deductibles and physical losses, invasion of privacy, discriminatory housing, premises liability, and other such things.  All of these things combined mean that you (the investor-consumer) often pay high premiums for poor coverage.

Like other types of insurance, dwelling policies vary a great deal from company to company and price alone should never be the determining factor.  A few examples of how these polices differ depending upon the insurer are below:

• Some companies provide liability insurance with their dwelling policies while others do not. If liability coverage is not included in the policy (which is common), you must ‘extend’ the liability provided in your homeowner’s policy over the rental unit(s). This is not automatic.  If you do not contact your agent and have your homeowner policy changed (or ‘endorsed’) to provide liability coverage over the rental unit – then you are not protected against any liability claims.

• Other companies do provide liability coverage in their dwelling policies, but they only include ‘Premises’ liability and NOT ‘Personal’ liability.  This can be a big deal.  ‘Premises’ liability provides coverage or injuries or issues arising from usage of or because of the physical property itself, but it does not protect you against ‘Personal Injury’ claims such as discriminatory or unfair housing, invasion of privacy, slander, defamation, and/or wrongful eviction.

• Most companies, because they do not want to be in the business of insuring non-owner occupied property, only sell the most basic ‘DP-1’ policy form.  Again, this is because this particular policy version offers the least coverage (which lessens the insurer’s risk with regards to claims).  The policy may have endorsements added and have a fancy name such as “DP-1 Plus” or similar, but they normally still don’t cover such things as vandalism and water damage.

• Few companies will issue dwelling policies in the name of an LLC while other will.  Most companies consider any policy issued in the name of anyone other than the individual owner to be ‘commercial’ insurance.

• Finally, some companies require as much as a minimum 2% deductible for all dwelling policies while others will allow 1% or less.

As you can see, there can be a very big difference from one company to the next regarding the type of dwelling coverage provided as well as the experience and motivation of the agent.  Dwelling policies, while certainly not uncommon, are often mis-sold and incorrectly issued and it is up to you – the investor/consumer, to make certain that you are properly insured against loss and litigation on your own rental property.

The Sticker Shock of Short-Term Rental Insurance

If you have read Part I of Insuring Vacation or Short-Term Rental Property, then you have an understanding of how and why these properties differ from a typical one-tenant rental unit. 

However, there are some other things that you should be aware of as well; first and foremost… 

(1)   Insurance for short-term property insurance is ALWAYS (yes, 100% of the time) more expensive than a standard ‘dwelling’ policy for the same property if it were occupied full-time by the same tenants.  

(2)   Even though you’re paying money for insurance premiums and you may think you have insurance covering your vacation rental property right now, you probably don’t and you are completely unprotected in the event of a loss or any type of litigation involving the property or the tenants. 

(3)   Very few companies provide any type of coverage for vacation rentals and this is a specialized area of insurance. 

(4)   If you don’t want to change you rinsurance policy to be correct for the actual short-term rental exposure because you are afraid that it’s going to cost more and affect your cash flow, see # 2 above. 

For example, if you were paying $800 a year for dwelling insurance for a single-family property that was rented to the same occupants on a full-time basis and you decided, for whatever reason, to begin renting that same property on a seasonal or short-term basis; you would most likely pay $2,000 or so for comparable coverage with a new policy designed for short-term rental exposures. That’s right, the premium more than doubles in many cases. 

Unfortunately, there is no way around this and it simply is what it is. Although the physical property itself may not have changed, short-term rentals represent a significantly higher liability exposure to insurance companies and the premiums are adjusted accordingly because of this reason. 

Using the example of the $800 policy mentioned above, although it may sound counterintuitive, what is even more expensive is not telling the insurance company that the property is used for short-term or vacation rentals and keeping the existing dwelling policy in place with no changes. Your premium may stay at $800 per year (less than the $2,000 you would pay if the policy were modified correctly), but you are not insured – you’re simply making a free $800 annual donation to whatever company issued the policy. In the event of a claim, especially related to any type of liability, the policy is going to be deemed null and void due to violation of the company’s eligibility guidelines and you are going to be left high and dry with absolutely no insurance protection (read our article about claims related to short-term rentals). If the claim were related to property damage (ie: hailstorm), you may or may not be covered (depending on the company and who reviews the claim) but your policy will be immediately terminated afterwards. In the event of a liability claim, you’re almost guaranteed not to have coverage in any shape, form, or fashion.  In short, you’ll probably end up paying 100% of any amount due for losses, legal fees, tenant injuries etc. completely out of your own pocket – which is more than what the premium itself costs.

Understanding Your Insurance Score

What Is An Insurance Score? How Is It Determined? How Does it Affect My Premium?


Your insurance score is a snapshot of your specific ‘insurance risk’ at a particular point in time – but it is important to know that it is not the same thing as your credit (FICO) score, although they are similar in nature. As a standard underwriting consideration, an ‘insurance score’ is a rating used by insurance companies to assist in determining insurance premiums and which is made up of several factors, just one of which is your FICO score (which is why you and all other members of the policy are often required to provide a social security number when requesting a new insurance quote). Other factors, depending upon the type of insurance, may include your driving record, past claims history, occupation, property data, and many more ‘data points’. Evaluating these factors together helps insurers determine if you qualify for their underwriting programs, and at what rate. Although there are a few common data points that all carriers are required by law to utilize in order to maintain a consistent basis of measurement, such as your FICO score and driving record for auto insurance, each insurance company still has its own proprietary formula for determining a customer or prospective customer’s insurance score depending upon the company’s own ‘appetite’, target market, and underwriting parameters. For example, a standard company such as Safeco Insurance may place a higher value or ‘weight’ on a person’s FICO score than on their driving record or claims history to determine premium while a company such as Progressive Insurance, which handles both standard and ‘non-standard’ drivers, may do just the opposite and place a higher weighted average on the driving record and past claims history than on the FICO score itself. In both scenarios the same data is used, but it is up to the individual company to decide how it is used as it relates to their desired customer base, insurance products, and appetite for risk.

While many people complain about the use of their credit scores when determining insurance rates, it is often because they either don’t understand the reasoning behind this scoring or they have simply have lower FICO scores themselves which leads to higher insurance rates. Regardless, the complaints are unfounded and moot as carriers still require the use of this information regardless of its popularity. The reason is simple. The insurance industry is founded and operated on statistical probabilities and actuarial data – not ‘gut feelings’ – and it is a well-proven fact that an individual’s FICO score has a direct correlation with the likelihood and severity of future claims. Generally speaking, the lower the FICO score, the higher the probability is that a claim, or multiple claims, will be filed.

‘Soft Hits’ and What Your Agent Actually Sees

Unfortunately, there are two very prevalent, but false, myths surrounding the use of credit-based insurance scores. The first myth is that your agent sees your credit report and the second is that shopping for insurance affects your credit (FICO) score because of the credit inquiries.

To begin with the first myth, your agent never sees your credit report at all and he or she has absolutely no idea whatsoever as to what is or isn’t contained in your credit file. From an agent’s perspective, all he or she ever sees is a numerical score, usually ranging from 01 to 31 (with 01 being the best at 31 being the worst) that appears on the quote itself. The agent has no idea what data points are being used to comprise this score or which ones are the most heavily weighted. The agent doesn’t even have the ability to research this data and it is completely confidential. In other words, the agent is ignorant of any of the facts and data behind the score and all he or she sees is the premium provided by the insurance company itself.

Regarding the second myth, the fact that insurance companies are pulling data from your credit report does not affect or lower your FICO score because of ‘excess inquiries’. When an insurance company requests your credit data, it is coded as an insurance-based inquiry which is treated as a ‘soft hit’ by the credit reporting bureaus. This means that it does not count against your credit score because the pre-existing data is being requested for the purpose of determining an insurance rating, not because you are actively seeking to obtain new credit – as in the case of applying for a new credit card or purchasing a new home or automobile. This inquiry is no different than if you were applying for a new job and your employer ordered a credit report to verify your financial history and indebtedness. It is a ‘non-issue’.

What Happens if You have No Insurance Score?

Finally, if you are searching for new insurance, there is a small likelihood that the insurance carrier may not be able to locate you in the credit reporting system and no insurance score can be determined. This is referred to as a ‘no hit’. These ‘no hits’ most commonly occur:

* when an incorrect social security has been entered;
* after a recent marriage or name-change when credit files may not be fully updated; and
* with youthful drivers or immigrants who may have no established credit history.

In the event of a ‘no hit’ situation, the insurance company providing the quote will automatically default to the highest-risk insurance tier (and premium) for the risk in order to offset their inability to pull data and accurately determine the correct premium and risk category.

When Are Insurance Scores Re-Evaluated?

Generally speaking, insurance scores are automatically reevaluated each time a policy is renewed or when a new insurance quote is requested. You cannot request that an insurance company reevaluate your insurance score mid-term during the time that a policy is already in force. It will be reviewed only at renewal.

Do All Insurance Companies Use Insurance Scores?

Yes and No. All ‘standard’ insurance companies utilize insurance scores when determining premiums and quoting news risks. However, there is a separate part of the insurance market, referred to as ‘non-standard’ companies, which do not normally use this scoring model and which may operate with different underwriting guidelines and under a different section on the state insurance code. These companies specialize in those individuals and businesses with either low FICO and insurance scores, excessive loss histories, or which represent an increased risk. Examples include drivers with no prior insurance, numerous accidents and moving violations, or those without a state-issued driver’s license (such as a Mexican National with a Mexican ‘Matricula Consular’ – which is issued to Mexican Nationals living outside of Mexico). The excess and surplus lines market is also considered ‘non-standard’.

The companies doing business in this part of the insurance market offset their risk in not using insurance scores by reducing the available coverage options available in their polices (thereby substantially reducing their risk in the event of a loss) and by establishing initial ‘base premiums’ which are usually much higher than those found in the standard market.

Premium Financing Explained

As someone who works daily with commercial and ‘non-standard’ lines of insurance, it is very common for me to get phone calls or emails from customers asking why a company they have never heard of is sending them a premium bill instead of the actual insurance company that issued the policy.

The answer is premium financing, also known as premium funding.

This is a little longer article, but in order to understand the reasons why premium financing is often used, it is equally important to understand the concept of ‘non-standard’ insurance markets in order to put the need for premium financing into context.

STANDARD INSURANCE

Most people are familiar with ‘normal’ insurance, such as for a home or automobile, whereby the insurance company issues the policy and then either sends a monthly bill or drafts the premium on a monthly basis from the customer’s account or credit card.  This type of insurance is referred to as ‘standard’ lines insurance because it is very commonplace, routine, relatively low-risk, and ‘standard’ in the day-to-day world of insurance.  Generally speaking, it’s personal ‘cookie cutter’ insurance with the only difference being who the customer is and what limits of coverage were purchased.  Common examples of ‘standard’ policies include most automobile, homeowner’s, umbrella, motorcycle, and boat policies.  Well-established companies such as Travelers, Safeco, and others who are ‘standard’ insurance companies issuing this type of coverage are designed for regular billing cycles and regular premium installments paid directly to the company itself.  Once a policy is issued and the initial premium payment is made, the remaining balance is then broken into equal installments and paid by the customer over the course of the remaining policy period.  In addition, these policies are ‘unearned premium’ policies, which simply put, means that any premiums paid to the insurance carrier but not yet ‘earned’ are returned to the customer in the event that the policy cancels or is terminated.

As an example, let’s assume you purchased a six-month automobile policy for a total of $600 and you paid the premium in full when the policy was issued so that you did not have to make monthly payments. Halfway (3 months) into the policy you sell your vehicle and cancel the policy.  Although you paid for the entire six-month term, you were only actually insured for the three months prior to requesting a cancellation.  This means that the insurance carrier had not yet ‘earned’ the additional three months of premium ($300) which you and prepaid when the policy was first issued and they must, therefore, return this ‘unearned’ premium money to you on a pro-rata basis.

This makes perfect sense and most people understand this type of billing and, once explained, they also understand the concept of ‘unearned premium’ refunds for these policy types.

‘NON-STANDARD’ INSURANCE

However, when dealing with commercial insurance and/or higher-risk policies, the legalities, rules, and billing parameters relating to insurance change.

Many insurance risks which cannot be written in the standard market for any number of reasons, such as most vacant property, general liability, professional liability, commercial coverages, and similar needs, pose a much higher risk of claims and larger payouts to insurers and they usually require detailed manual underwriting. These are not ‘cookie cutter’ policies that can be easily issued online and each one represents a completely different risk to the insurer.  Because these types of risks don’t fit into a normal (or ‘standard’) box like a home or auto policy and because each customer may have unique coverage needs and a unique level of risk, these policies are issued in the ‘non-standard’ market (also referred to as ‘surplus lines’).

Agents writing ‘surplus lines’ business are required to have a special license (which most don’t have) and the insurance companies doing business in the non-standard market are not the same companies that you are familiar with in regards to normal personal-lines insurance.  In fact, although they may have billions of dollars in assets and hundreds of years in business, you probably haven’t heard of many of them. Although there are hundreds of others, Lloyd’s of London is the most well-known ‘surplus lines’ or ‘non-standard’ insurer.

The laws and regulations governing these ‘non-standard’ insurers are different (and often more stringent) than the laws and regulations governing ‘standard’ companies and these non-standard insurance companies often charge a policy fee and they are also required to charge state tax.  I would go into the many differences between these insurers and their ‘standard’ counterparts, but that is for another article.

PREMIUM FINANCING / FUNDING

Now, about premium financing…

When issuing a policy with a non-standard insurer, such as general liability or coverage for a vacant home, the companies doing business in this area of the insurance marketplace require that the entire premium be paid in full at the time the policy is issued.  There are no monthly or quarterly billing options and all the money is due immediately.  Period.

Given the fact that many of these policies may be $10,000 or more, that often presents a bit of a financial problem to many clients. Even for an investor who has a new home which needs vacant dwelling coverage, an $800 or $1,500 insurance bill might be a tough check to write depending upon what other debts he or she may have as well as  the available cash flow.  Enter premium financing.

Because of the situation that arises when the insurance company needs payment in full but the client may not have the financial resources to pay the entire amount due, special premium finance companies have been created to allow insurance customers to make regular installment payments while at the same time making sure that the carrier is paid as required.

These companies specialize in the funding or financing of insurance premiums, just as other companies finance cars, homes, and boats.  Because of the legal and regulatory issues relating to ‘surplus lines’ insurance (which were previously alluded to), the customer makes the initial down payment to the finance company (usually 25% plus taxes and fees) and the finance company then pays the premium balance, in full, to the insurance carrier on the customer’s behalf. The customer in turn begins making regular installment payments to the financing company.

Before we go much further, you should know that the reason that finance companies require at least 25% of the premium as a down payment (plus all taxes and fees) is because most of these non-standard policies have a 25% ‘minimum earned premium’ clause written into them from the carrier from the date the policy is bound. To prevent against a customer canceling a policy and leaving the finance company financially responsible to the insurance carrier for this minimum earned premium due, they simply require that it be paid up front before the financing agreement will be activated.  The is true across all premium financing companies.

The way that the financing companies make a profit is by charging interest on the ‘loan’ that was paid to the insurance company on behalf of the customer.  This is no different than an automobile loan, although the interest rate for premium financing is usually between 16% and 25% regardless of which company is used.  Don’t let the interest rate shock you.  While this sound like a high rate of interest, the fact is that most policies are only a few thousand dollars or less and the actual interest paid over the term of the policy is often between $50 and $100 a year.  This is about the same as if you were paying monthly on a standard company with a $5.00 monthly service charge and it sure beats writing a $3,000 check all at once.

In summary, premium financing is a very common practice and it is not at all unusual in the surplus lines or non-standard marketplace.  Also, most financing companies are very similar to one another with the same interest rates and funding process.

Understanding ‘Reconstruction / Replacement Cost’ Coverage

When it comes to determining how much value you should insure your property for, one issue that seems to continually cause confusion and misunderstanding is that of a property’s reconstruction amount, also commonly referred to as its replacement cost. 

It is important to understand that the reconstruction cost (replacement value) is the amount that the insurance company estimates it will cost to completely rebuild the property from the ‘ground up’ with like-kind materials at the current labor rate and materials cost for the geographic area in which the property is located.  This amount also includes often disregarded or forgotten ‘soft costs’ such as architectural fees, permitting fees, and the cost of demolishing and/or removing the damaged structure prior to rebuilding. 

From a strictly insurance-based perspective, the reconstruction cost of a home has absolutely no relation whatsoever to the property’s purchase price, the mortgage loan amount, appraisal value, or market value.  In other words, the reconstruction cost is a completely independent value with no correlation at all to any other property-related value.  For example, you may have purchased a property that appraised at a market value of $230,000, but because of the seller’s personal situation you were able to negotiate terms and purchase it for $180,000.  After providing a 20% down payment of $36,000, your mortgage loan balance is only $154,000.  Although there are several different values associated with this property, none of them have anything at all to do with what it may actually cost to completely rebuild it after a loss. 

How Reconstruction Costs are Determined 

Another common area of misinformation for property owners is regarding how a property’s reconstruction cost is actually determined by the insurance carrier. As opposed to common belief, this is not simply a ‘blind guess’ as to the cost of replacing the property.  This formula is a little complex and it may vary somewhat from company to company depending upon the data points used, but the process (which is simplified below) is generally the same. 

Most companies in the United States pay an enormous amount of money each year in order to have full access to the Marshall & Swift/Boeck (MSB) construction database. This is an experienced and well-respected third-party company that maintains accurate construction costs (materials and labor) for every single zip code in every county in the United States.  This database is updated every 90 days and it is usually very accurate. 

When requesting a new quote for property insurance, you agent may ask you many questions regarding the property’s physical features, such as the square footage, number of stories, construction type, roof material, exterior walls material, what floor coverings are used, etc.  The purpose of these questions is to understand exactly how your property is built so that this information can be input into the carrier’s reconstruction cost software. Once this data has been obtained and input into the system, the software works with the MSB database to compare labor and material costs for the area and determine a fairly accurate amount of what it is expected to cost to rebuild the property at current labor and material rates. 

The reason that two different companies may have two completely different reconstruction costs even when using the same data has to do with how the company calculates its own internal cost estimate, not with the MSB database.  For instance, company ‘A’ may develop a reconstruction cost of $100,000, but within their internal calculations, they may add an additional 20% for labor costs, 5% for ‘soft costs’, and 22% for materials while company ‘B’ uses only the hard costs provided by Marshall & Swift/Boeck. 

The purpose of this is to err on the side of caution and attempt to include an additional margin in order to offset any unforeseen fluctuations in actual costs after a loss.  Each company’s reconstruction cost formula is proprietary and agents have no idea exactly how each company calculates the end cost or what margins are included. All agents have access to is the final estimated cost of replacement. 

Do All Companies Use the MSB Database? 

While over 90% of ‘standard’ companies utilize the MSB database, there are still a few who do not. The primary reason for this is simply the cost of access.  Some smaller or regional insurance companies simply cannot (or will not) pay the annual fee to access the MSB database and they, therefore, choose to utilize their own internal construction cost data. While they are well within their rights to do so, the danger to consumers is that these companies are not specialists in the construction field and their data is usually updated (inaccurately) only every few years rather than on a quarterly basis.  This means that customers and property owners run the severe risk of being underinsured in the event of a fire or other loss due to changes in labor and materials. The insurer has little or no liability due to the fact that they may have actually insured your property at ‘full replacement cost’ as their policy may have indicated, but it may have been an inaccurate reconstruction cost from the beginning as determined by their own inaccurate internal system. Other companies, usually ‘non-standard’ insurers, have absolutely no reconstruction cost estimator whatsoever and they simply ask you, the customer, how much you want to insure your property for. This is nothing more than a dangerous wild guess on your part and without having an actual reconstruction estimate, you have no way of knowing whether or not the property is accurately insured. 

Can Two Properties Built Exactly Alike Have Different Reconstruction Costs? 

Absolutely! Labor and material costs can vary a great deal from one geographic area to another.  For example, here in Texas a home in El Paso may have a reconstruction or replacement cost of $150,000; however, that same house with the exact same size and physical features, may have a reconstruction or replacement cost of $210,000 in Houston.  The reason for this, as has already been mentioned, is due to the local building codes, labor rates, materials costs, and other such issues. 

Why Reconstruction Costs for Newer Properties are More Than the Builder’s Sales Price 

One common point of disagreement between an insured property owner and his or her insurance company is that of the reconstruction cost of a property being a great deal more than the actual purchase price of a new home that was only recently built. From the customer’s perspective, he or she may have only paid $200,000 for the property, which includes the builder’s construction cost as well as the equity, land and everything else involved, but the insurance company determines that the replacement cost is actually $225,000. The customer often can’t understand why the reconstruction cost for the insurance company is so much more than for the builder and he or she often argues that the property is being over insured.  This is a logical point of view; however, it is simply not the case. 

When a tract builder constructs a new home, their cost of construction is far less than that of a custom builder.  The reason for this is simple.  When a tract builder constructs a new home, he or she is usually building a great many more at the same time and in the same subdivision or geographic area.  This means that the builder is often purchasing millions, if not tens of millions of dollars, of supplies and materials in bulk. This allows the builder to obtain huge volume discounts on pricing which greatly reduces his or her construction overhead.  

In addition, the builder may use the same labor crews for framing, concrete work, and all other phases of construction.  Because the builder is supplying a steady flow of repeatable work to his subcontractors and these subcontractors are working for extended periods of time in the same areas, the labor rate is also greatly reduced.

This is not the case with regard to custom builders.  Rebuilding a property is always more expensive than first-time new construction. 

If your two-year home that you purchased from the original builder for $200,000 is destroyed in a fire, the contractor or builder that you hire to rebuild the home will not have the same deep discounts on his labor and material costs.  In addition, he will have the added expense of obtaining new blueprints, architectural and permitting fees, debris removal, etc. which the original builder either did not have or which was also greatly reduced.  This means that your $200,000 home may cost $250,000 to rebuild. 

Why Older Properties Often Cost more to Rebuild 

It is also important to understand that older properties may cost even more to rebuild.  In addition to all of the other aspects already described, older properties may have unique architectural features that are difficult to replicate with today’s codes and materials and some of this work may require craftsman specializing in such things as tin ceilings, ornate molding, and similar work; all of which increases the construction cost. 

Are Reconstruction Costs Automatically Updated When My Policy Renews? 

Yes and no, it depends upon the company issuing the policy.  Most standard companies automatically re-process the reconstruction cost when a policy renews using the information previously provided.  This is why property owners may see both their premiums and reconstruction costs increase on an annual basis. 

However, if there have been any improvements or alterations made to the property, such as room additions, elevation changes, interior remodels, or other such changes, the reconstruction or replacement cost listed on the policy will be inaccurate as it does not include these new modifications unless the insurance company is notified and this new data is included.  This is why you should always contact your agent any time you make changes to your home or property that may affect what it ultimately costs to rebuild. 

In summary, there is much more to properly insuring your property for its actual replacement value than simply pulling a number out of the air. There is a methodical and well-established process for determining actual costs that may be incurred and there is little or no relationship between the reconstruction cost of a property and the loan amount, appraisal, taxed, or market value.  These numbers are all completely independent of one another and it is your responsibility, the property owner and insured customer, to make certain that your policy contains enough coverage to completely indemnify you (make whole financially) or replace the property in the event of a loss.