The impetus of this article is simple – we are asked multiple times a day by well-intentioned investors to improperly insure investment units for ‘Actual Cash Value’ (ACV) coverage instead of ‘Replacement Cost’ (RCT) coverage for the simple reason that there is a fundamental misunderstanding between the concepts of Actual Cash Value, Replacement Cost, and the seldom-used term “Agreed Value”. Due to this misunderstanding, combined with the fact that investors are always looking at the cost of insurance and how it affects cash flow, most investors unknowingly assume that the terms ‘actual cash value’ and ‘agreed value’ mean the same thing.
THEY DON’T.
Is The Property Paid-Off or Does it have a Mortgage?
Let’s start from the beginning before we delve into defining the three types of claims coverages mentioned above. To begin, if you have a mortgage on the property to be insured, there is a 99.9999% chance that it includes an often-ignored ‘insurance clause’, usually in boilerplate language, that states that hazard insurance is to be in-force at all times during the course of the loan term and that if insurance is not in place or if does not meet the lender’s basic requirements for insurance, they (the lender) have the right to ‘force-place’ insurance (at a MUCH higher premium) and add that cost to the payoff balance of the loan itself. Yes, it’s in your mortgage documentation even if you have never read it and, as the cliché goes, “ignorance is no excuse.”
Generally, it is written in a manner such as the example below.
“For the entire term of the loan, hazard insurance for the named property with special form coverage must be obtained and in-force at all times in an amount equal to the replacement cost of the property, as determined by the insurance company, from an insurance company with a rating of “B+” or better by the A.M. Best Rating Guide, with “XYZ Mortgage” as the mortgagee on all policies, with no more than a 1% deductible.”
The language itself may vary some, but that is a good example of what your insurance clause usually states. If you purchase insurance with ‘actual cash value’ coverage (which is almost never a good idea in the first place) you are in immediately default of this insurance clause and the mortgagee may, as is its legal right under the terms of the mortgage, force-place coverage to protect its interest in the property and charge the extremely high premium directly to you.
However, if you do not have a mortgage on the property and it is paid in full, you are free to self-insure and/or purchase actual cash value coverage if you choose to do so; but you really need to understand just exactly what that coverage is to make certain that you don’t lose a dollar later just to save a nickel now.
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(A) REPLACEMENT COST
Replacement Cost, often abbreviated as ‘RCT’ or ‘RCV’ is defined in insurance terms as “the cost to “replace the damaged property with materials of like kind and quality, without any deduction for depreciation.” In other words, what it costs to repair the property after a loss or to rebuild the ‘sticks and bricks’ after a total loss without any concern about depreciated value. This is the coverage that you want to have in place when an unexpected loss happens.
How Replacement Cost is Determined
The ‘replacement cost’ amount (sometimes referred to as the ‘reconstruction cost’) is not a number simply plucked from thin air by the insurance company; it is arrived at in a very logical manner. You see, companies pay millions of dollars a year in licensing and usage fees to have access to information provided by a company known as Marshall Swift/Boeckh (known commonly as MS/B). This company, in the simplest terms, is a huge behemoth founded in 1930 that focuses on local building cost information and property valuation technology for the property and casualty insurance industry. This company maintains accurate building costs data for every county and every zip code in the country in almost real-time fashion, updating their database information every 60 to 90 days. When we obtain the physical information about your property (square footage, year built, construction type, finish-out grade, etc.) this data is input into their estimating system and based upon the physical characteristics of the property – as well as its geographic location – an estimated replacement cost value is determined. This is the amount that insurance companies provide coverage for. In addition, each company may have its own ‘safety buffer’ that it adds to whatever value is determined in order to make certain that enough coverage exists in the event of a total loss. This means that you may provide the same information to three companies and yet get three different replacement costs coverage amounts back. They will all be within the same general range of value and it does not mean that they are incorrect, it simply means that each company has its own ‘buffer’ amount that it adds to the estimated replacement value and this is often the reason for the differing amounts.
If you, as a property owner, provide inaccurate information about the property and the estimated replacement cost value is less than what is actually required in the event to rebuild or replace the property after a total loss, it is not the insurance company or agent that is at-fault for under-insuring the property due to the fact that quotes and valuations are based upon information provided by the investor/owner.
The 80% Co-Insurance Clause. Going on with replacement cost coverage, virtually all property insurance policies written for replacement cost coverage also contain an embedded co-insurance clause requiring that the property be insured for at least 80% of its estimated replacement cost value in order to even qualify for replacement cost coverage. The purpose of this is to make certain that owners are not intentionally under-insuring their property to save money yet expecting ‘full replacement cost coverage’ in the event of a covered loss. In short, co-insurance is a penalty imposed on the insured property owner by the insurance carrier for underinsuring the value of tangible property or business income. This penalty is based on a percentage stated within the policy (usually 80%) of the amount under reported.
As an example:
A property actually valued at $100,000 has an 80% coinsurance clause included in the policy but is only insured for $75,000. Since its insured value is less than 80% of its actual replacement cost (it’s only at 75%), when it suffers a covered loss (any loss), the insurance payout will be subject to the co-insurance penalty. For example: It suffers a $20,000 loss from water damage. If underinsured, you would only recover $75,000 ÷ (.80 × 100,000) × 20,000 = $18, 750 (less any deductible required by the policy).
In this example the underreporting/co-insurance penalty would be $1,250.
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(B) ACTUAL CASH VALUE
Actual Cash Value (ACV) is defined in insurance terms simple as “Replacement Cost minus Depreciation”. It does not mean that in the event of a loss that this is the amount of money you are going to receive. Whereas replacement cost provides coverage to fully replace or repair any covered claim or loss, actual cash value does just the opposite. It takes whatever the replacement cost is determined to be at the time of loss and then calculates and subtracts the estimated depreciation. It does this for ALL covered claims that occur – not simply for a claim resulting in the total loss of the property. A common question is “how much will the depreciation be?” and the answer is “No one knows until the claim actually happens.” It’s literally a guessing game.
Depreciation is defined as:
“The decrease in the value of property over a period of time, usually as result of age, wear and tear from use, or economic obsolescence. Actual physical depreciation (wear and tear from use) is subtracted from the replacement cost of insured property in determining its actual cash value (ACV); courts in some jurisdictions have allowed insurers to deduct depreciation due to economic obsolescence as well.”
As the author of this article and an investor myself, I have to ask the question “Why even bother having insurance?”
As previously mentioned, almost all mortgage documents specifically require replacement cost coverage anyway and any policy with actual cash value coverage fails to meet the lender’s insurance clause and the lender then has the right to force-place coverage for a premium much higher than what you would pay by simply purchasing the right type of insurance in the first place.
In short, if you have ACV coverage on your property (unless there is a very specific reason that it was knowingly purchased), my opinion is that there is little or no point in even having property coverage at all. If the issue it is purchased is simply to save money on the insurance premium, it’s faulty logic from the start due to the fact that you, as the insured, stand to lose much more financially in the event of a claim, any claim, than you would on the small amount of money spent in additinal premium due to purchasing replacement cost coverage in the first place.
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(C) AGREED-VALUE
Agreed Value is seldom used when insuring real property though it is often confused with ‘Actual Cash Value’ above and this is why so many investors ask for ACV coverage; they think that they are actually asking for an ‘agreed value’ amount. THEY ARE NOT.
Agreed Value (AV) is primarily used for tangible property or collector autos that are insured for a pre-determined amount by both the insured as well as the insurance company. A common example is jewelry. If you had a watch that you purchased for $10,000 and you wanted to have it insured for its ‘agreed value’ under your homeowner’s policy, you would provide a copy of the purchase receipt (or recent appraisal) verifying this amount to the insurance company and they would add this watch to your policy in an ‘agreed’ amount of $10,000. In the event that the watch was stolen or lost, the company would issue you a check for the $10,000 that had previously been agreed, even if the watch (for whatever reason) had actually dropped in value to only $8,000. You would still get $10,000 since both parties had previously agreed on a flat $10,000 value for the item.
Conversely, if the watch had increased in value to $15,000, you would still only get $10,000 for the same reason just mentioned; both parties had previously agreed on a flat value of $10,000. Unless you had the item re-appraised and the value increased on your policy, the prior valuation is what had been requested.
This does not generally apply to property insurance and ‘Agreed Value’ and ‘Actual Cash Value’ ARE NOT the same thing. Agreed Value is seldom ever available for real property insurance.
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In summary, when requesting insurance coverage, it is important to understand that the only two policy choices for claim indemnification are either Replacement Cost coverage or Actual Cash Value – and that each one is decidedly different from the other. In addition, your lender probably has very specific insurance requirements under the terms of the loan and in the event that your property has no loan and you are requesting actual cash value coverage, you need to ensure that you are doing so for the right reasons and that you fully understand the financial risk that you are actually taking.
So you’re a landlord and you maintain strong leases and good tenant-screenings - what’s the worst that could happen? How about being sued for renting a haunted house? Are liability suits arising from alleged paranormal activity covered in YOUR dwelling policy?
While most property owners are familiar with typical exposures such as bodily injury, invasion, or privacy, and wrongful eviction (which themselves are not even covered in most landlord dwelling policies because they are ‘personal’ injury issues), this is one of the more unusual and interesting liability issues that we at InsuranceForInvestors.com have seen in a while and we thought it was worth sharing just to prove the point that any property owner can be sued for virtually any perceived wrong. You don’t have to be guilty to be accused - but you must still pay legal costs to defend your innocence…
Read the Actual Story Below from CBS New York:
TOMS RIVER, N.J. (CBS New York) – Nighttime is fright time for a Toms River couple who claim the house they rented is haunted.
Jose Chinchilla and his fiancée Michele Callan say they hear eerie noises, that lights flicker, doors slam and a spectral presence tugs on their bed sheets. The couple even called in investigators with the Shore Paranormal Research Society. The group classified the activity as “paranormal” but that it did not indicate a haunting, according to their website.
Chinchilla and Callan are suing the landlord for their $2,250 security deposit claiming the paranormal activity forced them out of the home only a week after moving in. However, the landlord believes the couple was actually spooked by the $1,500 a month rental fee and made up the ghost story to get out of their lease. The landlord has filed a counter suit against the couple. A hearing is expected at the end of this month.
Read Original Story
“Why is it so hard to find insurance for my vacation or short term rental property?”
I hear this question a lot. Because of that, I thought that answering it first would be the best place to start with this new article series about insuring short-term and vacation rentals. However, be prepared as this article is very thorough and it’s a loooong answer to a short question. There, I said it – you’ve been warned.
To begin with, insuring short-term and vacation properties is tricky – and it requires some specialized and not-too-common insurance knowledge to make sure it’s done right as protecting these properties and their respective owners is not as easy as issuing a simple homeowner’s policy. From the perspective of the consumer it shouldn’t be a big deal, after all, it’s just another rental house, right?
Uh, wrong…
Yes, it’s true that the physical property itself hasn’t really changed regardless of whether it’s owner-occupied, occupied by a full-time tenant with an annual lease, or rented on weekends and holidays to vacationers. However, the exposure that the property represents to the insurance company changes significantly with each scenario. Therein lies the problem. You see, contrary to popular belief, insurance companies (despite all of their advertising and rhetoric) actually don’t like insuring things that they consider to be ‘high risk’ or ‘outside the norm’. They (like all businesses) want to make as much money as possible while losing as little as possible at the same time. Knowing this, they can’t accurately predict losses on vacation property because, quite simply, none of them really understand it and they have never made a study as to the profitability versus losses in this market. The most common (but certainly not all) reasons that insurers refuse to issue coverage for short-term and vacation rentals are listed below.
THE PHYSICAL PROPERTY – Part I (Tenant Damage) – Although the property itself hasn’t changed, with vacation rentals the insuring company’s exposure to a physical loss at the property increases exponentially. We’ve all heard the cliché “never purchase a used rental car”, right? The reason is simple, human nature tends to allow people to treat items that they don’t own and have responsibility for maintaining differently than similar items that they do own and maintain themselves. The same holds true whether it is a rental car or a rental home. We’ve also all heard of individuals renting luxurious hotel suites and doing thousands of dollars’ worth of damage for absolutely no reason other than because they simply thought it was fun. Behaviors change, especially when people are out vacation to have a good time and when they are staying in property that is either much more comfortable and higher-end than their own residence or when they are staying in areas that foster poor behavior (such as downtown areas in metropolitan cities where tenant travel to attend festivals and enjoy the ‘night life’). Because of this, short-term and vacation rental properties have a much higher propensity to suffer ‘tenant caused damage’ than does an annually-occupied rental property which the tenant occupies as a primary residence and for which he or she may have to worry about eviction, the loss of a deposit (which most vacationers simply consider part of the cost of their vacation) and/or the inability to obtain a future rental home because of a bad rental reference. Full-time tenants, generally speaking, have more to lose by being bad tenants than does someone renting a property for four days never to be heard from again.
THE PHYSICAL PROPERTY – Part II (Location) – In addition, unlike most tenant-occupied properties that exist in average urban areas and built-out neighborhoods near fire hydrants, fire stations, and emergency services; short-term and vacation property often present an entirely different risk. Few, if any, vacationers are looking to spend $400 a night renting a home in downtown Abilene, Texas. However, there are numerous short-term tenants seeking vacation rentals in the mountains near ski lodges, in coastal areas near the beach, or in thriving metropolitan areas such as downtown Manhattan or Los Angeles where property values are very high. In each of these scenarios, the geographic location is a big factor as described in the five most common considerations listed below.
A. ISO / PPC Fire Protection Class – This is one of the biggest initial considerations for property insurers. Before we go too far, “ISO” stands for “Insurance Services Office” and “PPC” stands for “Public Protection Classification”. It is important to understand both of these terms in order to understand how they relate to insuring vacation property. ISO is the national ‘think tank’ for the insurance industry, providing risk analysis data, policy forms, and other insurance-related services and products too numerous to mention. All insurance companies use ISO. Without going into its history beginning in the early 1900’s, ISO’s Public Protection Classification (PPC) gauges the fire protection capability of local fire departments to respond to structure fires in virtually all areas of the country. The three primary rating criteria used in making this determination include Fire Alarms1, Engine Companies2, and the community’s Water Supply3. ISO analyzes the relevant data mentioned above and then assigns a numerical Public Protection Classification (PPC) ranging from 1 to 10. Class 1 represents superior fire protection (the best) and Class 10 (the worst) indicates that the area’s fire-suppression program does not meet ISO’s minimum criteria. The higher the PPC class number the greater the risk of loss by fire, therefore; the greater the risk to the insurance company and the higher the insurance premium. Classes 9 and 10 are considered “Unprotected” and most insurers will not issue coverage for any property located in a PPC 9 or 10 area at all. Unfortunately, these two ‘unprotected’ areas are exactly where many vacation rental properties are located by virtue of the fact that they are in the mountains, on the coast, or otherwise outside of urbanized or municipal areas.
1 How well the fire department receives fire alarms and dispatches fire-fighting resources, evaluation of the communications center, number of operators at the center, the available telephone service and the number of telephone lines coming into the center, the listing of emergency numbers in the telephone book. Field representatives also look at the dispatch circuits and how the center notifies firefighters about the location of the emergency.
2 The number of engine companies and the amount of water a given community needs to fight a fire, the distribution of fire companies throughout the area, training of fire personnel, how often the company checks or tests its pumps and regularly inventories its nozzles, hoses, breathing apparatus, and other equipment.
3 This focuses on whether the community has sufficient water supply for fire suppression beyond daily maximum consumption. Issues evaluated include pumps, storage, and filtration and to determine the rate of flow the water mains provide, fire-flow tests are conducted in the community and the distribution of fire hydrants is taken into consideration.
B. Wind Exposure – Like the PPC classifications just described, there are many areas of the country, where many vacation properties are located, that have a high exposure to loss by windstorm or hurricane. Obvious examples include Florida, Alabama, Mississippi, Louisiana, and the Gulf Coast of Texas. Because of this, many property insurers issue coverage for the physical structure but specifically exclude in writing any coverage whatsoever for wind-related losses. In these areas, property owners must purchase a separate ‘wind policy’ from the State’s authorized ‘wind risk pool’. The policies are often expensive (depending upon the desired coverage amount) and there is little or no ability to shop for better rates – it’s literally a ‘take it or leave it’ decision.
C. Brush / Fire Exposure – Just like the wind coverage just described, it is common for vacation properties, especially those in California, to be located in ‘brush areas’ which present a high likelihood to loss by uncontrolled brush fires due to the large amount of dry tinder available as a fuel source as well as the coastal winds which further fuel the flames and cause these random fires to spread quickly, engulfing large areas and causing tremendous insurance losses.
D. Flood Exposure – No different than the wind and brush fire exposures previously addressed, many vacation properties also have a higher-than-average exposure to flood damage, whether through tidal surges or floods (coastal homes) or floods caused by rising lake levels or rivers breaching their banks. Flood coverage is not included in standard property policies. An individual flood insurance policy must be purchased in addition to the actual property policy (and/or wind policy) and the maximum coverage limit is usually $250,000 for the structure and $100,000 for contents. If more coverage is needed, an ‘excess flood’ policy will also be required (think of this like an ‘umbrella policy’ for flood damage).
E. Coastal Exposure – Properties located in coastal areas present a mixture of risks for most property insurers – (1) the potential for increased mold claims due to high humidity, (2) damage due to windstorm / hurricane, (3) flood damage, (4) unique and unacceptable construction conditions such as home on raised piers or stilts.
THE PHYSICAL PROPERTY – PART III (Construction and Risk Characteristics) – Again, not to beleaguer the point, but insurance companies by and large all want to insure properties that are similar in nature and present an average or below-average risk of loss. However, many properties have unique architecture or construction features which, aside and apart from any other issues, also make them completely ‘unacceptable’ and outside of the ‘appetite’ for almost all insurance companies. Without going into great detail as to ‘why’, some of the most common ineligible property characteristics include (but are certainly not limited to):
- Solid Log Construction
- EIFS Exterior (Exterior Insulation Finishing System)
- Raised-Stilt construction (examples are raised coastal properties)
- Properties built on steep grades with varying foundations (part slab / part stilts, etc)
- Properties located on more than five acres
- Properties with liability exposures such as boat docks
- “Unprotected” properties in PPC 9 and 10 areas
- Properties with a high number of past losses
- Homes with complicated roof lines and large roof areas
- ANY historical property
- Any property with a solid-fuel heating device (such as antique wood-burning stoves like many cabins have)
- Properties with wooden shake roof
- Properties that are not easily visible to neighbors
- Properties with custom or unique architecture, such a three story homes or art-deco construction
THE PROPERTY’S RECONSTRUCTION COST – In addition to the five geographic considerations that we just mentioned, many vacation properties also have replacement or reconstruction values that exceed $500,000 and often $1,000,000 or more. Because most personal property insurance companies are in the business of issuing coverage for standard homes that present ‘average’ risk, these values often exceed the company’s coverage threshold that most insurers have in place (most are up to $500,000 per property with some going up to a maximum of $1,000,000). Properties exceeding this amount are ‘unacceptable’ to most insurers regardless of the PPC class or any other factors.
THE OWNERSHIP STRUCTURE – The ownership structure of the property is also an issue with regards to who is the ‘Named Insured’ policy owner. Common ‘in the box’ insurance companies will almost never issue a policy in the name of a corporation or LLC even though that may be how the property is titled. From the perspective of these companies, any property titled in any name other than (sometimes) a Trust or an individual’s name is automatically considered to be a commercial property – regardless of whether that is actually true or not. Therefore, if the vacation property is in a LLC or company name, that one issue alone will prohibit most insurers from issuing coverage.
OCCUPANCY – This is also one of the biggest issues for insurers and their primary reason for denying coverage. Homeowner Policies are intended for owner-occupied residences that are occupied by the primary owner on a regular basis. This includes policies for second-homes that are not rented out to others at any time. These policies specifically prohibit rental to tenants and/or boarders during the term of the policy. However, many property owners have exactly this type of policy in place – which probably means they really aren’t insured at all even though they may be paying premiums. Dwelling policies are normally intended to insure non-owner occupied residences owned by the insured but rented to others – but only if they are rental on a full-time basis to the same tenant. With regards to vacation property, there is no single ‘full-time tenant’ in place and the short-term occupancy directly violates the underwriting and eligibility guidelines for the insurance carrier.
LIABILITY EXPOSURE – This is another big issue. The term ‘liability’ is often (and incorrectly) used as an all-encompassing term that is assumed to mean ‘all liability risks’. This is a very dangerous interpretation of the word and there are three very specific types of liability that you as a rental property owner should be aware of. Unfortunately, in most cases, only premises liability is included in insurance policies for non-owner occupied property – which means you as the property owner often have no liability protection whatsoever for ‘personal liability’ issues.
Premises Liability – As just mentioned, this is the first of the three types of primary liability that vacation property owners (or any landlord) should be concerned with. It’s also usually the only type of liability included in dwelling policies. Premises liability is a liability coverage included in most dwelling policies which protects against legal and medical costs for premises-related issues such as bodily injury and property damage. Examples of these types of claims might be a guest who is injured because a deck railing breaks when leaned against and causes him or her to fall and sustain an injury. Another example might be a guest who slips in a porcelain or steel bathtub and sustains injuries and then pursues legal action claiming that the property owner had not properly installed non-slip traction strips or a grab handle. With regards to someone else’s property being damaged or destroyed due to the vacation property itself, consider what would happen if the vacation home were to catch fire and burn, thereby destroying the guest’s clothing, luggage, and other personal belongings as well as destroying his or her vacation and creating additional expenses. Another very real claim would be a large branch from an established tree which hangs over the driveway. If this branch were to unexpectedly break and fall onto the guest’s vehicle – which is parked in this driveway – the property owner would be responsible for all damages to the vehicle and/or any damaged personal property inside. Premises liability does not cover the property owner for issues such as invasion of privacy, wrongful eviction, libel, slander, or other such issues.
Personal Liability – Personal liability is the second type of liability that all landlords should be concerned with – and it’s also the one seldom included in dwelling policies. Unlike premises liability, personal liability is the coverage necessary to provide protection against legal and settlement costs associated with personal torts such as the invasion of privacy, wrongful eviction, libel, slander, and other similar issues. Obtaining this coverage often requires a second type of liability policy aside and apart from the original property insurance.
Animal Liability – Animal liability is very seldom discussed and almost never thought about – until it’s needed (and not there). This is very important for property owners who allow their guests to brings pets with them, such as those vacationers renting lakeside property or mountain cabins and bringing their large-breed dogs with them to in order to play outside and enjoy the outdoors. It doesn’t sound like much, but what happens if and when that animal – who is unfamiliar with the environment and/or any nearby neighbors – attacks a neighbor or his or her child that happens to be outside? What if the animal attacks another neighbor’s pet or livestock? This is a very real liability issue that insurers take into consideration and which most property owner’s never even think about.
EXTENDED VACANCIES – Lastly, most insurers won’t offer coverage for short-term or vacation rental properties due to the fact that they are concerned with unknown vacancies. When a typical rental property goes vacant, it is usually in an urban area and there is normally another tenant in place within a month or so and the property is maintained and made ready for the new tenant. However, vacation properties may be located in remote areas outside of the city limits and the insurance company really has no way to judge how long periods of vacancy will last. Properties in ski areas may be vacant for six months until the ski season comes back around. The same is true for beachfront property which may be unoccupied for long periods of time during cooler weather or during hurricane season. Because of this, insurance companies run the risk of unaddressed maintenance issues turning into very expensive claims due to the fact that the property was vacant and no one was around to remediate potential problems such as leaking faucets or pipes which may leak for weeks or months before being discovered. There are also concerns regarding weatherization and properties not properly being weatherized prior to vacancy in cold weather. Theft and vandalism are also concerns.
In summary, properly insuring vacation and short-term rental properties requires a specific knowledge of insurance as well as markets willing to take a risk on insuring these types of properties. Our company understands this market very well and we are experts at insuring all types of vacation property in numerous areas across the country. If you would would like us to develop a proposal for your short-term rental property, simply complete the vacation property form below and either fax it to (512) 692-2631 or email it to info@insuranceforinvestors.com.
Vacation Property Form
As someone who writes prolifically about real estate and insurance, this article, as compared to others I have written, is relatively short, however, given some of the recent conversations I have had with investors and some of the recent classes I have taught, I feel it is necessary.
Unfortunately, insurance as a whole is normally viewed by consumers as a commodity or a ‘necessary evil’ that must be obtained when purchasing property and it is usually quoted and purchased with little or no actual knowledge of the policy itself on either the part of the buyer or even the agent providing it.
Because of this, as well as the nature of insurance law, the lack of professional knowledge had by many agents, and the many confusing semantics used within the insurance industry, there is a great deal of confusion between such terms as “Additional Insured”, “Additional Interest”, “Mortgagee”, “Loss Payee”, and “Named Insured” and they are used interchangeably as if they all mean the same thing – BUT THEY DON’T! Unfortunately, this confusion can result in unintended financial loss and unnecessary litigation far into the future and long after the policy has been first issued. All it takes is one claim or loss for the parties in the policy to find out how they really are, or are not, protected and that words actually matter.
For example, when working with investors and non-standard types of insurance situations, it is inevitable that the party requesting the insurance coverage asks to have someone else (usually the seller in a seller-financed transaction) inappropriately listed as an “Additional Insured” on the policy without understanding what he or she is really asking for. What the purchaser (and “Additional Insured Party”) fails to realize is that this provides absolutely no protection whatsoever for the party listed as the “Additional Insured” with regards to the physical property in the event of a physical or financial loss.
The purpose of this article is to finally, in real-life language, explain the difference in these terms so that you, the real estate professional and/or investor, are able to appropriately protect yourself and your interest in any property being insured, whether via wrap-around mortgage, traditional lending, or any other purchase scenario.
NAMED INSURED
The term “Named Insured” refers to the owner of the insurance policy and it is the party listed on the Declaration’s Page. The “Named Insured” is the only party that has authority to make any policy changes, file claims, receive refunds and claim payments, cancel the policy, or make any other such modifications.
In addition, the Named Insured MUST have a primary insurable interest in the property and be the titled owner.
ADDITIONAL INSURED
This is probably the single most misunderstood insurance term that is misused and misapplied on a regular basis. An “Additional Insured” is a party listed on an insurance policy that has some type of liability interest in the property. The “Additional Insured” has absolutely no right or authority to make any policy changes or to cancel the policy. Also, contrary to popular belief, an “Additional Insured” is ONLY afforded liability protection under the liability portion of the policy and there is no coverage whatsoever for physical losses resulting from such things as vandalism, theft, fire, wind and hail, and so on.
For example, with regards to residential property, if a property were seller-financed and the seller was actually carrying back a mortgage note and they were listed as an “Additional Insured” on the policy instead of as a mortgagee (described further below), then in the event of a physical loss (the home burned to the ground), the seller would have absolutely no legal right whatsoever under the policy to receive claim funds to pay off the mortgage debt and/or there would be no control of managing claim funds to ensure repairs.
However, if there was litigation involving the property or its use and the “Additional Insured” was named in the suit for any reason, the policy provides liability protection for legal and defense costs for the “Additional Insured” and the insurance company issuing the coverage would have a ‘duty to defend’ any and all “Additional Insured parties” listed in the policy. The most common example of this actually involves commercial policies, such as general liability, whereby a general contractor, for instance, may be listed as an “Additional Insured” on a subcontractor’s insurance so that in the event of a liability claim caused by the subcontractor (such as faulty work, property damage, or bodily injury) where the general contractor is also listed in the suit or claim, he or she receives coverage for legal and defense costs from the subcontractor’s policy.
Many buyers and sellers in a wrap-around mortgage transaction prefer to have the seller listed as an “Additional Insured” rather than as a “Mortgagee” simply because they don’t want to blatantly alert the underlying lender that there has been a transfer of the property. The unintended consequence of this, however, is that the coverages and protections afforded to the seller (who is technically a second mortgagee) are greatly reduced and limited now to liability protection only.
ADDITIONAL INTEREST
An “Additional Interest” is nothing like the “Additional Insured” though they sound similar. An “Additional Interest” is a party listed in an insurance policy that has an “interest” in being notified whenever a policy cancels or has a major change made to it. In other words, this party is simply being made aware of the change – nothing else. There is absolutely no coverage whatsoever afforded to an Additional Interest. An example of a party who may need to be listed as an “Additional Interest” is a loan servicing company who is managing the loan for a seller-financed transaction. The servicing company has no insurable interest in the property and has no coverage under the terms of the policy, but it does have an interest in being notified if or when the policy is canceled so that it may contact the mortgagee and either have the policy reinstated or request updated proof of any new replacement policy.
It is important to understand that Mortgaee’s and Additional Insured’s automatically get notifications of all policy cancellations and/or major changes and that only other parties associated with the loan in some capacity (but have no insurable interest) should be listed as “Additional Interests”.
LOSS PAYEE
The “Loss Payee” is another very misunderstood term which is most often associated with automobile loans – though it is very applicable to commercial and residential property as well. In regards to insurance, a “Loss Payee” (which automatically includes any mortgagee) is the party (or parties) to which any payment being made under the policy in relation to a claim or loss will be made before being released directly to the Named Insured.
For example, assume that you own a property for which “XYZ Bank” is the mortgagee. A kitchen fire occurs in this property and a claim is filed for the damage, which is estimated to be at $85,000. When the insurance company releases the $85,000 claim check, it should be made out to both you (the Named Insured policy owner) as well as XYZ Bank (as the mortgagee and loss payee). This means that XYZ Bank must verify the claim and then endorse the check over to you – or the contractors performing repairs – before it may be cashed. The reason for this is simple; XYZ Bank has a financial interest in the property via the mortgage loan and they want to make certain that they maintain control of the loss payment to ensure that the loan is either paid off (in the event that repairs are not performed) or that the money does in fact go towards repairing the property that is collateralizing their loan – and not to paying for your upcoming ‘around the world’ vacation.
MORTGAGEE
So far we have described the difference between an Named Insured, Additional Insured, Additional Interest, and a Loss Payee; now let’s discuss the true meaning of what a “Mortgagee” really is.
A “Mortgagee” is the entity that actually originates and holds the Promissory Note and Mortgage loan on real property; otherwise known as the bank or the mortgage lender. The Mortgagee extends financing to the “Mortgagor” – who is the homeowner or borrower in the transaction.
By default, all Mortgagees listed in an insurance policy are also automatically considered as “Loss Payees”, meaning that, as in the section above, any claim payments should theoretically be made to both the Named Insured as well as every Mortgagee listed. If a party who has made a mortgage loan to the Named Insured is not listed in the policy, whether intentionally or unintentionally, then that Mortgagee will not be afforded any rights or coverages under the terms of the policy itself.
As you can see, there is a big legal difference between these terms and having an interest listed incorrectly can have unintended and far-reaching consequences in the event of a loss, default, or other such situation. Your agent should know the difference between these five terms, however, the reality is that the vast majority of licensed agents are salespeople with quotas to meet and they seldom, if ever, deal with investor-related transactions and therefore often don’t know the difference between these coverage position themselves. If you have any questions or would like to discuss your own insurance needs, please feel free to call us at (800) 299-8994 or email us at info@insuranceforinvestors.com
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.
This may be a short article, but it’s an important one – especially with regards to insuring seller-financed ‘wraparound’ mortgages. Since the insurance industry is founded on the principals of risk, contract law, and civil liability, properly insuring properties purchased in this manner can be a challenge, especially when titled in a trust, and the issue of ‘legal‘ title versus ‘equitable‘ title often arises with regards to who has an ‘insurable interest‘ and who doesn’t.
EQUITABLE TITLE – This type of title refers to the actual enjoyment and use of a property without absolute ownership. It is the interest in the property held by a buyer (vendee) under a purchase contract, contract-for-deed, or an installment-purchase agreement. The buyer (vendee) has the right to demand that legal title be transferred upon payment of the full purchase price after the final installment payment has been made. This interest is transferable by deed, assignment, subcontract, or mortgage. Equitable title is conveyed to the buyer (vendee) as soon as the seller (vendor) actually countersigns and agrees to the offer to purchase. In other words, Jack agrees to purchase a home from David under a contract-for-deed’ arrangement. In layman’s terms, a contract-for-deed means “you (buyer) fulfill your part of the contract (pay the balance in full) and ONLY THEN do I (seller) have the obligation to transfer the deed to you.” Jack takes ‘equitable title’ in the property as soon as David agrees to the contract and signs it. However, the legaltitle (which defines absolute ownership) is not formally transferred from David (seller/vendor) to Jack (buyer/vendee) until he has made his last installment payment under the contract and paid the agreed-upon amount in full, whether he pays the balance in one year or over a period of thirty years. Also, with equitable title, the vendee (purchaser) benefits from any increase in value between the date of the agreement and the final delivery of the deed once the balance is paid in full. If the property increases in value the vendee gets the increased valuation of the property; if the property value declines the vendee in turns suffers that as well.
Equitable does not give the actual legal title to the property like it would if a buyer were using a mortgage. Equitable Title means giving the buyer an “equitable position” in the property. The legal title is conveyed only after the buyer has satisfied the contract.
The reason that equitable title and not legal title is conveyed in contract-for-deed purchases as mentioned above is because there is no deed of trust filed, this only occurs AFTER-THE-FACTonce the purchaser (vendee) fulfills the contract agreement, and legal title can only be transferred by a deed.
LEGAL TITLE – Legal title is the ownership of property that is enforceable in a court of law, or one that is complete and perfect in apparent right of ownership and possession, but that unlike equitable title, carries no ‘beneficial interest’ in the property. In other words, in the example of David and Jack above, David holds the ‘legal’ title to the property and is the ‘legal owner’ while Jack only has ‘equitable title’. However, with his ‘legal’ title, if the property goes up in value, David cannot benefit from this change and retroactively increase his sales price to Jack to make more money. As another example, if valuable minerals were discovered on the property, David could not ‘benefit’ from this change in the property either.
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When utilizing traditional mortgage financing involving a bank or institutional lender, there is promissory note, a mortgage, and a deed of trust signed and filed. This deed of trust is what transfers legal title from the seller to the buyer. The seller of the property transfers legal title to the new buyer at closing because the contract price has been paid in full by the bank or lender – and now it’s up to the borrower to repay the lender in installments. The buyer now has both legal and equitable title. In turn, the buyer collateralizes the bank’s loan with the property being purchased and the legal title still remains with the buyer unless there is a foreclosure. If a foreclosure occurs on the property, the deed (and legal title) is transferred to the lender so that the lender then retains legal title.
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.
What are the main differences between a short term rental policy and a regular landlord (dwelling) policy?
A standard ‘dwelling’ policy is normally used to insure non-owner occupied properties that are occupied by the same tenant(s) on a regular full-time basis – such as an annual lease. They do not provide coverage for property which is vacant for more than 30 to 60 days at a time. These are also sometimes referred to as ‘landlord’ policies. These policies may be issued in a DP-1, DP-2, or DP-3 policy coverage form and, depending upon the company, normally include liability coverage (personal, premises, or both). The underwriting guidelines and property eligibility requirements for dwelling policies often specifically exclude, in very clear language, coverage for any properties that are rented on a seasonal or short-term basis.
A short-term rental policy is also a type of dwelling policy as mentioned above, however, they are underwritten and issued through very specialized companies that do not consist of well-known companies like State Farm, Farmers, Allstate, Nationwide. These well-known national companies do not have an ‘appetite’ for these types of short-term risks and they simply will not cover them. Also, a short-term rental policy, depending upon the unique characteristics and nature of the risk itself, may be written as a specialized dwelling, a bed and breakfast, or even as a hotel/motel. What determines how the policy is to be written and issued is dependent upon the unique liability aspects of the risk as opposed to the physical features of property itself. For example, is the property also occupied by the property owner? Are there employees on site (gardner, kitchen staff, etc)? Is the property rented only for a few days as a time or is it rented for weeks or sometime months at a stretch? How many units or apartments are present (ie: two family, four-family, six apartments, etc)? Is the property titled in the name of an individual person or a corporation? These are just a few of the many considerations. In addition, depending upon how the property is insured, the policy may contain varying types of liability coverage such as innkeeper liability, premises liability only, or all three combined. Each risk is unique and each policy is designed specifically for that risk. Finally, policies for vacation and short-term rentals are always more expensive than the same policy for the property if it were occupied year-round by the same full-time tenants.
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What if I have a second-home that I use part of the year and rent out the rest of the year for vacationers and/or weekend rentals?
As mentioned in answer to the question above, each policy is designed specially for the risk to be insured. Normally, a typical homeowner’s policy, which is what is commonly used to insure second-homes, will not provide any coverage whatsoever if the home is rented out to others while not in use by you as the owner. Even if this is your second home that you live in part of the year, you will still need to obtain a policy designed for short-term rental exposures.
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How should I insure my short-term rental property if it is also my primary residence? Will my homeowner’s policy cover me? For example, I live in central-Austin and rent my home out for a couple of weeks a year during special events like ‘South by Southwest Music Festival’.
You really should read this claim summary article directly related to this question. Renting your home to others is a specific violation of the homeowner’s insurance contact and in the event of a claim resulting from any party that the property is rented to, you will more than likely find yourself without insurance coverage. Even in this is your own primary residence that you occupy 98% of the year and only rent out 2% of the year for special events, that 2% rental exposure is what causes a problem and violates your insurance contract. You need a specialized homeowner/short-term rental policy to protect yourself against physical loss and litigation and this policy is probably going to cost more than your current existing homeowner policy does now.
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Why does insurance for short-term rentals cost more than regular ‘landlord’ insurance?
The reason short-term rentals cost more than a regular ‘landlord’ policy is due almost entirely to the difference in liability exposure that is represented. With regards to a rental property occupied on a full-time basis by the same tenant(s), this is considered to be the tenant’s primary residence and the liability exposure is average. The landlord is not responsible for the tenant’s personal belongings and there are normally no unusual hazards related to the premises. However, with short-term and vacation rentals, the liability landscape changes. In this situation, the property is often considered a ‘commercial venture’ with high rental rates by the insurance companies due to the revolving nature of tenant occupancy. In addition, many of these properties are located in desirable areas near lakes, hillside slopes, etc and they often have unique property characteristics such as large balconies, swimming pools, hot tubs and Jacuzzis, boat docks, and so on which pose a higher probability of physical injury to tenants. Also, since these properties are not the tenant’s primary residence and they are rented for special occasions and outings, less care is normally taken by occupants with regards to the property and their behavior can be more reckless with regards to alcoholic beverages and similar. For an example of some of the liability issues related to vacation and short-term rentals, read some of our claim summaries.
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Why don’t other insurance agents and professionals know about insuring short-term rentals and why was mine insured incorrectly in the first place?
In a word, apathy. Most insurance agents and brokers are simply salespeople (not risk managers or problem-solvers) that work for well-known captive ‘personal lines’ companies that primarily sell home and auto insurance and that compete based on price with every other company on TV and radio. These companies have a very limited ‘appetite’ for the type of business that they will write and the agents, as a general statement, never make any effort to learn any more than they absolutely have to in order to sell their products. While most insurance agents and brokers are good people that mean well, the dirty little secret is that very few of them actually understand the ‘in and outs’ of the very industry that they actually represent and virtually none of them have ever sat down and read the policies that they themselves are selling to others. Without meaning to sound negative, the fact is that most agents are simply order-takers that sell insurance products to meet their company’s quotas and they rarely know what questions to ask; they normally only know the very basics of home and auto insurance (if that); and virtually none of them have any first-hand experience in business ownership, contract law, the civil court system, or real estate investing.
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How do I know if my vacation or short-term rental is properly insured?
Unfortunately, if you are even asking this question, the immediate answer is that it probably isn’t and you are wide open to physical loss, litigation, and financial ruin. As mentioned above, most agents no little or nothing about real estate investing (especially short-term rentals) and without intending to sound trite, if your rental property was properly insured, you would already know it and you wouldn’t have to ask.
As the landlord and owner of a short-term rental property, you’re obviously concerned about the potential for a loss or claim arising from your guests – but what could really happen? After all, they’re probably only in the home for a few days, right?
Below are some of the claims we have experienced related directly to short-term rental exposures. As a disclaimer, many of these actually occurred prior to the property owner’s contacting us to properly insure the homes – and, unfortunately, the claim itself was simply the catalyst for the call. We obviously cannot provide any identifiable details related to the claimants themselves or their associated properties, but we can give you a summary of the issues as they occurred. While you yourself may never have a claim of any type (and we hope that you never do), it’s important to understand that no one is immune from disaster and unexpected situations can arise without notice.
Rotted Railing
At a rental property in a lakeside location, which was being rented to a family for a 4-day vacation, the wife of the couple renting the home, while having morning coffee, leaned against the railing on a deck built approximately four feet above a hillside slope. The post holding the railing upright broke loose from the deck (due to rotted wood the screws were anchored into) and she fell off of the balcony and several feet down the slope. This was on the morning of the second day of their occupancy. She suffered a broken arm, lacerations, and a mild concussion. The family brought litigation against the property owners for her injuries, financial loss due to lost income and contracted household services, and pain and suffering due to the children seeing their mother injured along with the sudden and unexpected termination of a planned vacation period. The owners were found negligent with regards to property maintenance, especially related to occupant safety (due to the rotted wood around the railing). Settlement Amount: $46,000
Tree Branch
During a couple’s stay at a rental property located in an area populated with a number of large trees, they parked their Cadillac Escapade in the property’s driveway under a canopy of large established oak trees. A late-night storm approached and during the wind and rain, a medium-sized branch from one of the trees unexpectedly broke and fell onto the roof and hood of their SUV. Over $20,000 of physical damage occurred to the vehicle. They filed a premises liability claim against the property’s insurance policy only to have the claim denied because the policy had been improperly issued by the agent as a standard ‘dwelling’ policy – not as a short-term rental exposure – and there was no coverage. The property owner’s policy was cancelled due to an improper risk being insured and the vehicle’s owners filed a suit against the property owner. The property owner chose to fight the suit but without insurance to cover legal costs, he paid over $4,500 in legal fees, lost the suit, and was ordered to pay the $20,000 in damages in addition to the other party’s legal fees and ancillary costs associated with the rental vehicle and other expenses.
Property’ Owner’s Dog Destroyed Wedding Dress
Approximately 3,000 square feet of a very beautiful (and very large) owner-occupied home in a very-desirable area of Central-Texas was regularly rented out on weekends and holidays for $350 – $500 per night. Because of this size and layout of the home, the owner-occupant lived in one portion of the home and rarely had interaction with the guests renting the other portion. The home was complete with a large pool, sport court, and other amenities. On this particular weekend, a group of young women (college friends) had rented the available portion of the home as a ‘weekend getaway’ and bridal event prior to one of the women getting married within the next two weeks. The would-be bride had brought her $4,200 wedding dress with her in order to show off to her friends. After returning from an afternoon out at the pool, the bride-to-be discovered that the property-owner’s dog had ventured into the part of the home that they had rented and had proceeded to tear up and urinate on her wedding dress as it laid upon on of the bed. She was furious and in tears and inflamed emotions obviously made a bad situation worse. The property owner filed an insurance claim only to be denied coverage due to the fact that the policy had been improperly issued as a standard homeowner’s policy (with one of the well-known ‘big-name’ companies) and that because the property was being partially used as a short-term rental with the increased liability exposure. The policy was immediately terminated (due to the risk violating eligibility guidelines) and the property owner ended up having to unexpectedly pay over $6,000 in damages, rental refunds, and other costs prior to the wedding. In addition, the owner was forced to finally purchase the proper coverage (as a Bed and Breakfast with Innkeeper Liability) – but the uninsured financial loss had already occurred.
Kitchen Fire
A group of four young men from California had rented a small home in a trendy area of Central-Austin for one week in order to attend the annual ‘South by Southwest Music Festival’ held each year. The home was the primary residence of another couple who only rented it out twice a year in order to take advantage of the additional income they could receive at a rental rate of $2,000 per week. They would stay with friends during the time that the home was rented. The home itself was insured by one of the ‘big name’ insurance companies as a standard homeowner’s policy. However, during the week that it was being rented, one of the tenants inadvertently started a grease fire in the kitchen that ended up causing a large amount of damage in addition to a great deal of resulting smoke damage to the remainder of the home. The owner’s filed a claim on their homeowner’s policy – which was quickly denied – due to the fact rather than occupying the home as owner-occupants as the policy required, they had actually rented the property to others (especially on a short-term basis) and that was a blatant violation of the policy language. The owners tried pursuing legal action against the tenants responsible for the fire, but all four were young males (musicians) under the age of 25, each lived in an apartment or with friends, they were out-of-state, and none of them had any renter’s insurance with liability coverage or any monetary resources for which to sue for. The result was that the homeowners had to slowly make repairs to their home paying for all labor and materials with their own money. While they utilized labor from friends to lower costs, they still had to purchase new materials, manage the City’s permitting process, obtain inspections, and perform the work themselves. The total repairs took over six months and cost over $25,000.
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.
