Like I or not, it’s happening. Property and casualty insurance rates are on the rise for the entire nation and they will continue to increase over the coming years. For investors, this may mean diminished cash flow, increased exposure to loss (explained below) and a potential need to look for new insurance coverage. While no one likes paying insurance premiums, consumers have generally become accustomed to years of relatively-low and stable premium prices and any change is automatically viewed as extreme and unnecessary. However, this is not really accurate. In addition to raising rates, many insurance companies will also be making other changes. For example, those companies that have experienced large financial losses in claims for commercial and investment property and that want to begin backing out of insuring these types of risks and lessening their overall exposure to loss in these areas will begin non-renewing policies or raising the renewal premiums so high that they will, in effect, force the customer to find coverage elsewhere. There will be changes within the policies themselves as well, with many ‘value added’ coverages that were not in the original policy but which have since been included in recent years as an additional enticement for purchasing them (such as foundation coverage) being removed from these same policies at renewal. This means not only higher premiums but also less coverage.
The reason for these across-the-board premium increases is simple; it’s not directly related to ‘greedy insurance companies’ trying to make more money as many people would first think, but rather to the BILLIONS of dollars in claim losses that these companies have paid out over the past ten years as opposed to the amount of income generated from the premiums charged to their customers. Despite the assumption that all insurance companies are flush with cash, the fact is that many insurance companies have had to pay more than they have made and some have even become insolvent and gone out of business. Natural catastrophes such as Hurricane Ike, Hurricane Rita, Hurricane Katrina, Superstorm Sandy, the numerous fires and hailstorms in Texas, tornadoes throughout the Midwest, and numerous other disasters – combined with the regular day-to-day no- catastrophic claims – have taken their toll over the past decade and the insurance industry is being forced by sheer necessity to reevaluate pricing, coverage options, and even the types of risks or business they wish to insure.
Yes folks – many changes are ahead.
Add to this that the REINSURANCE rates that these insurance companies themselves pay have increased drastically as well. It’s a little-known fact that insurance companies themselves purchase insurance (called re-insurance) to help cover losses and reduce their financial risks. The reinsurance market is an entire behind-the-scenes industry unto itself and just like the premiums charged by insurance companies to their customers are increasing, so are the reinsurance rates that these companies themselves have to pay. Some have increased by 150% or more – which means hundreds of millions of dollars in new expenses that did not exist a year ago. Most of that expense get the rates that passed onto you and me (yes, I pay for insurance too!)
Many people want to know how insurance companies determine what rates will be charged – but there is no easy answer. The insurance industry runs on statistics and mounds and mounds of actuarial data and it is often slices and diced a hundred different ways and each company has its own way of viewing risk. As a general rule, premiums are adjusted (raised or lowered) depending on several factors, including the type of risk and the past claims history that category of risk has experienced (i.e. Commercial Lessor’s Risk, dwelling policies, etc.), the geographic area that the risk is located in (down to the zip code or County level), how badly the company wants (or doesn’t want) to write a particular line of business in a particular area, and the individual characteristics of the insured (insurance score, claims history, and so on). The amount of the premium change varies tremendously and it is not the same for all risks in all areas.
In summary, be forewarned that like most things in today’s world, insurance rates too are on the rise and they will continue to rise for the next 24 to 36 months before leveling out. There is no longer such a thing as ‘good cheap insurance’ (an oxymoron itself) and if a premium is low compared to other companies, there is a reason – and it is in your best interest to find out what that reason is. Is an important coverage being excluded or removed from the policy? Is the property quoted and insured correctly? Is the company financially stable? You should ask questions before it’s too late and you find yourself in an unexpected situation with little or no coverage despite the fact that you were paying a premium.
This is the first question to address since it is the most relevant to issues involving insurance for properties purchased by a wraparound mortgage and these are the most common issues regularly (and often intentionally) committed by licensed insurance agents, transaction coordinators, and Realtors. Each and every insurance policy issued, regardless of the company, contains a clause or policy condition specifically referencing “Material Misrepresentation and Concealment”. In addition, the principal of ‘insurable interest’ is one of the underlying principals and foundations to all insurance contracts – regardless of the type of property or risk being insured.
MATERIAL MISREPRESENTATION – To begin, material misrepresentation is the legal term used to describe the situation in which an insurance applicant (ie: the new property buyer) either withholds information or falsely reports information that would otherwise have an impact on the decision as to whether or not to issue (or how to issue) a policy being offered by the insurance company. Examples of this commonly include:
The seller keeping his or her homeowner’s policy and intentionally misleading the issuing company. These policies are intended for ‘owner occupied primary and secondary residences’ only. In a wraparound mortgage sale, when the seller transfers title to the property to the new buyer, he or she has transferred legal ownership and no longer has an ‘insurable interest’ in the property.
Stating that the previous owner (seller) is also a ‘co-applicant’ or ‘additional named insured’ on the application in order to ‘fool the underlying bank or lender’ when in fact he or she has actually transferred legal title to the property and has no insurable interest is a ‘material misrepresentation’.
Stating on an insurance application that the applicant has had no foreclosure or bankruptcy in the past five years when he or she has actually experienced one of those unfortunate issues in that period of time. This is also a ‘material misrepresentation’.
All of the issues above relate directly to the insurance company’s underwriting guidelines and ability and/or willingness to issue coverage. As you may guess, some material misrepresentations are more severe than others and may well result in more severe consequences if discovered.
Since all contracts in the United States are bound by the principle of uberrimae fidei (Latin for “utmost good faith” or, more literally, “most abundant faith”), no legal insurance contract exists if you commit an act of material misrepresentation. This means that the insurance company has the legal right to terminate your insurance policy retroactive to the date of its inception. If that were to happen a ten months after the policy was issued (after you filed a claim for example), insurance and contract law would allow the company to ‘flat cancel’ the policy and they would have the legal right to deny any and all claims, and you would be considered to have been uninsured for that entire period of time – which means the underlying mortgage lender would also have the resulting legal right under the terms of the Promissory Note with the original borrower (ie: seller) to obtain ‘forced placed’ insurance at a much higher premium and add the amount of the premium to the payoff balance of the loan or charge the original borrower (seller) directly.
CONCEALMENT– Similar to and often associated with material misrepresentation, concealment refers to the “fraudulent failure to reveal information which one or more parties knows and is aware that in good faith he/she should communicate to another.” Like material misrepresentation, the insurance company has the legal right to ‘flat cancel’ any insurance contract determined to have been issued using fraudulent or ‘concealed’ information.
INSURABLE INTEREST – This term is somewhat difficult to define without using some degree of ‘legalese’ in the explanation, but an Insurable interest exists whenever an insured party derives a financial or other kind of benefit from the continuous existence of an insured object. In other words, an insurable interest means that the policy holder must stand to suffer a direct financial loss if an event or loss (against which the insurance coverage was purchased) occurs. A person has an insurable interest in something when loss-of or damage-to that thing would cause the person to suffer a direct financial loss or other kind of loss. Typically, insurable interest is established by ownership or possession. For example, people have insurable interests in their own homes and vehicles, but not in their neighbors’ homes.
“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?
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.
1How 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.
2The 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):
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 email@example.com.
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.
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.
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.
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”.
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.
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 firstname.lastname@example.org
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.
If you are involved with seller-financing a property with an existing mortgage, the obvious goal is to transfer ownership without tipping off the underlying lender. As stated in my article “Don’t Fear the Due-On-Sale Clause“, the lender, at their discretion if they find out about the sale or transfer, has a civil right under the mortgage contract to call a loan due upon a transfer of the property, but there is absolutely nothing illegal about violating this clause. It’s a contractual (civil) issue, not a criminal offense.
Unfortunately, issuing an insurance policy in the name of the new owner for a property that has been purchased with a wraparound mortgage is normally the biggest obstacle which presents the highest possibly of making the underlying mortgagee aware of the sale. The reason for this deals with insurance law and the fact that both parties are trying to ‘skirt’ the system to keep the underlying lender in the dark about the transaction and insurance is simply not designed for this purpose. Since this article is concerned only with the insurance aspect of these transactions, we will forgo discussing how to record (or not record) deeds and other similar topics and focus solely on the property’s hazard insurance.
There are really only two ways to insure property taken ‘Subject To’ or with a wraparound purchase. The first involves more of a traditional approach as outlined in my article “How to Insure Subject-To Properties” and the second is outlined on this page.
With regards to the due-on-sale clause which causes so much worry in these types of seller-financed transactions, it is important to be aware of an Act of Congress known as the Garn–St. Germain Depository Institutions Act of 1982.
This Act outlines some exceptions to a property transfer in which the underlying lender may not legally enforce the ‘due on sale’ clause in a mortgage. Without listing the entire Act itself, the specific portion of this Act that applies to Wraparound Mortgage and Due on Sale clauses is (U.S.C.) 1701j-3 (Preemption of Due-on-Sale Prohibitions) and more specifically, section (d)(8), “Exemption of Specified Transfers or Dispositions”
Exemption of Specified Transfers or Dispositions
“With respect to a real property loan secured by a lien on residential real property containing less than five dwelling units, including a lien on the stock allocated to a dwelling unit in a cooperative housing corporation, or on a residential manufactured home, a lender may not exercise its option pursuant to a due-on-sale clause upon –
1. The creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property;
2. The creation of a purchase money security interest for household appliances;
3. A transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety;
4. The granting of a leasehold interest of three years or less not containing an option to purchase;
5. A transfer to a relative resulting from the death of a borrower;
6. A transfer where the spouse or children of the borrower become an owner of the property;
7. A transfer resulting from a decree of a dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement, by which the spouse of the borrower becomes an owner of the property;
8. A transfer into an inter-vivos trust (see note below) in which the borrower is and remains a beneficiary and that does not relate to a transfer of rights of occupancy in the property; or
9. Any other transfer or disposition described in regulations prescribed by the Federal Home Loan Bank Board.”
NOTE: For the purpose of clarity, “inter-vivos trust” is the legal term for a revocable trust (aka ‘Living Trust’) that is created while the donor is still alive in order to hold property for the benefit of another.
Fortunately, while written in ‘legalese’, the Garn Act is clear (at least in legal terms) when it specifically states that it applies to residential one-to-four family homes. In other words, while it states the type of real property that is affected, it makes absolutely no mention that it must also be “owner-occupied.”
So, having now mentioned the Garn–St. Germain Act, the question is what does this have to do with property insurance?
Since we have determined that section (U.S.C.) 1701j-3 (d)(8) specifically allows for a transfer into an ‘inter-vivos trust’ (Living Trust), the two parties can take advantage of a specific type of trust known as a ‘land trust’ – which is exempted under this Act. A land trust, which is very common, is a form of revocable living trust which is created by the use of two legal documents. This type of trust consists of a:
1. A trust agreement between the creator (aka “grantor”) of the trust and the trustee that legally defines the trust arrangement; and,
2. A deed from the creator (grantor) to the “trustee”.
In this arrangement, the trustee holds title for the benefit of the grantor and, in this situation; the grantor is also identified as the “beneficiary.” So far all requirements are met.
So, if you as a property owner simply decide to place your property into a land trust for estate planning or anonymity reasons, you have not violated the acceleration (due on sale) clause so long as there isn’t a change in occupancy. Everything is fine.
However, let’s say you are a property owner who needs to sell his or her property and the only realistic option is through the use of seller-financing. The obvious concern you may have is the “due on sale” clause in your mortgage. While there is no ‘perfect’ solution, here’s the best and safest way for completing this property transfer while keeping the underlying lender blissfully unaware that a sale or transfer has ever taken place.
You (the seller) create and sign a trust agreement with the buyer. You (the seller) are both the “Grantor” (sometimes also known as the “Settlor” or Trustor”) and the “Beneficiary” and the buyer is the “Trustee”;
You (the seller) then transfer title to the property to the “Trustee” (the buyer). No violation of the due-on-sale clause has taken place because you (the seller) still remain as the “Beneficiary” of the trust.
You (the seller) then assign your interest under the trust as “Beneficiary” to the new buyer. The buyer is now both the “Beneficiary” and the “Trustee” and this assignment of interest is not recorded in any public record and the lender has no way of learning about the transfer or sale. The buyer moves into his or her new home and begins making payments.
Technically, your assignment of your interest in the trust as the “Beneficiary” to the buyer does constitute a violation of the due-on-sale clause, however, who’s going to notify the original lender? Neither you nor the buyer are going to send a letter or make a phone call informing the lender of the property transfer and there is no public record of the assignment – so it’s a perfectly legal – and invisible – transaction.
To be blunt, there are really only three ways I which the lender might learn about the transfer of the property, the first two being virtually non-existent with the most likely scenario being the third.
The lender notices a name change of the deed. This is extremely unlikely since lenders never have any reason whatsoever to even look at a deed after their initial closing has taken place (unless they are foreclosing) and they certainly don’t have employees at every County clerk’s office scanning every single deed of trust that gets filed. This is a non-issue and you probably have a better chance of getting struck by lightning on the moon than of a lender finding a name change on a deed after-the-fact.
Someone at the lender’s loan servicing location notices that the name on the payment check is different than the borrower’s name. Extremely unlikely. Payment processing centers are usually staffed with uber-apathetic clerks who couldn’t care less about anything else except whether or not a check is in the envelope that they just opened and how much longer they have left before the end of the day. They have virtually nothing to do with mortgage officers or other bank employees and are often actually third-party companies or subsidiaries of the lender that are responsible for servicing loans. The check arrives, they post the payment, open the next envelope… Again, another non-issue.
Different named insured on the insurance policy. This is the most likely cause of the lender getting wind of the transfer. However, since title to the property was transferred into a land trust, the named insured on the policy should actually be the trustee of the land trust itself. The lender won’t have any problem with this since it is a common estate planning strategy that occurs often; especially with high-net-worth individuals. The only caveat to this is that not all insurance companies will allow policies to be issued for a trust in the name of the trustee. Many will but some won’t. There are some carriers whose underwriting and eligibility guidelines specifically prohibit insuring properties titled in the name of a trust. There is no compelling reason for this refusal to insure a trust-held property since there is absolutely no increased liability exposure or risk of physical loss, but it exists with some companies nonetheless and even the underwriters and management staff themselves cannot explain why this is the case – but it is. This may limit your options when selecting a new insurance policy.
While more complicated than the traditional wrap-around insurance scenario where the new buyer must purchase an insurance policy in his or her name with the seller listed as an additional insured or additional interest, if offers more anonymity and liability protection for the buyer and greatly reduces both the visibility of the transfer to the underlying mortgagee and lessens even the possibility of the loan being called due.
As someone who deals with insurance and wrap-around mortgages on a daily basis, I sometimes find it ironic that all parties involved in a seller-financed wrap-around transaction worry a great deal about the new property insurance being sent to the mortgagee in the new buyer’s name and triggering the ‘due on sale’ clause, however, they rarely (if ever) give a moment’s thought to what might happen in the event of an actual claim if funds are made out to the policy owner (new buyer) AND the ‘loss payee’.
As the fourth piece in this series about insuring wraparound mortgages, this article is intended to address the often-ignored issue of property claims and how payment is made by the insurance carrier as well as how it may (potentially) create BIG problems for the buyer and seller in a wraparound mortgage.
Before we go too far, be forewarned that this article (which is a little long) has been a somewhat difficult to write in “layman’s terms” and that it is a little bit detailed and technical because it includes some rather confusing semantics and insurance ‘legalese’. This is not intentional, but there is simply no way to cover this information and describe its relevance without using some degree of insurance-based vocabulary and it is assumed that you, the reader, have some minor familiarity and experience with real estate and mortgage lending. Unfortunately, trying to discuss insurance without using a little ‘insurance-speak’ is like trying to describe water without using the word wet.
To begin with, we must define and explain the actual difference between a “Mortgagee” and a “Loss Payee”, as well as the “mortgagee clause” and “loss payee clause” that are associated with them, as they are often used synonymously (and incorrectly) when speaking about insurance. We will then discuss later in this article how these terms apply to an insurance contract for residential property.
That having been said, here we go…
What’s the Difference Between a Mortgagee, Mortgagee Clause, and Loss Payee?
A “mortgagee“, also known as the “lender”, is defined as the party who holds a mortgage on real property as security or collateral for repayment of a loan. In residential property insurance, the mortgagee is usually automatically included as a ‘loss payee’. This is very different than an automobile policy whereby the lien holder must be specifically added or endorsed as a ‘loss payee’ as their interest as such is not automatic.
A mortgagee clause is simply a clear description how the lender wants their name and address to appear on legal documents. The mortgagee clause is the legal description of the entity that has financial interest in a piece of real property. Some lenders have different mortgagee clauses depending upon the type of loan utilized since the lender may have different offices or locations designed to handle each specific loan type (FHA, VA, Jumbo, 15-year fixed, etc). Getting this information correct is important because it is what stipulates who has the legal right to financial reimbursement in the event of a loss or devaluation of the property.
A “Loss Payee“, on the other hand, is the party to whom insurance proceeds are paid as stipulated in the loss payee clauseof an insurance policy which is purchased by the borrower and covers the real property pledged as security to the mortgagee. With regards to property insurance, the lender is usually listed by default as the “first loss payee” and will be paid to the extent of the balance of its loan with the remainder of the money paid back out to the property owner. Lenders may, at their discretion, simply choose to waive payment in the event of an insured loss and allow the payment to go directly to the borrower in order to make necessary repairs (such as a minor water claim). However, they may also accept payment from the insurance company and then disburse funds as repairs are made, such as when replacing a roof or rebuilding a property after a fire, as a method of making certain that the money actually goes back into the property.
A Loss Payee Clause, which is included in most property policies, is an insurance provision authorizing payment in the event of loss to a person or entity other than the named insured (policy owner) having an insurable interest in the covered property – such as the lender. Under a typical loss payable clause, known as a ‘Standard’ loss payee clause (endorsement 438 BFU NS), the lender is covered for a loss even if the named insured is denied coverage due to his or her actions invalidating the claim. More on that topic later. In an ‘Open’ loss payee clause (which are fairly rare), the insurer isn’t under any obligation whatsoever to make payment to the loss payee if payment for a loss can be denied to the insured. In other words, with a ‘standard’ clause, if the named insured (policy owner) committed an intentional act such as arson, the lender is still entitled to recover the loss from the insurer even if the policy owner isn’t. With an ‘open’ clause, the insurer is not obligated to pay claim proceeds to either the named insured or the mortgagee.
Often, an insurance company will make a claim check payable to both the named insured AND the lender (mortgagee) or they will also sometimes send the claim check directly to the lender itself. It varies. Some of the typical language in a loss payee clause requiring this is below:
“Loss or Damage under this policy shall be paid as Interest may Appear to You and the Loss Payee Shown in the Declarations. This Insurance Covering the Interest of the Loss Payee Shall Become Invalid Only Because of Your Fraudulent Acts or Omissions”
“We will pay for any covered property loss of or damage to the Dwelling(s) or Personal Property to the loss payee named as their interests may appear.”
An Easy Example
As an example for clarification that most everyone can relate to, let’s use an automobile. Let’s assume you own a vehicle with a current ’Blue Book’ value of $20,000 but the remaining balance on your loan to your lien holder, such as Toyota Financing, is only $15,000. The vehicle is worth $5,000 more than what is actually owed on it and your insurance policy has Toyota Finance listed as both the lien holder and loss payee. In other words, not only do they hold the title on the vehicle (because they still have your outstanding loan), but they are also listed as a party to which any claim payments are made. If this vehicle were to be involved in an accident and declared a ‘total loss’ by the insurance company, the insurance company would make a claim check for $20,000 payable to both the policy owner (you) as well as Toyota Finance (the loss payee). Toyota Finance would deduct the $15,000 owed to them for the loan and then release the remaining balance of $5,000 to you. On the other hand, if the policy was issued without Toyota Finance formally being listed as a loss payee, the entire $20,000 payment would be made directly to you (policy owner) – and the lien holder (Toyota) , which no longer has any collateral, runs the risk of you simply defaulting on the loan and keeping the money. With no more collateral securing the loan and with the insured having claim funds paid directly, they lose control of their interest.
The same is true of a mortgagee who makes a $200,000 loan on a property. If the home were to burn to the ground and the policy owner (borrower) decided to simply keep the funds for him or herself and not repay the loan, the lender would no longer have any real property (except for the land) to foreclose upon and the would lose a great deal of money. For this reason, most insurance policies contain a ‘loss payee’ clause.
The Two Types of “Loss Payable” Clauses (‘Standard’ and ‘Open’)
Seriously? Insurance Makes My Head Hurt...
Before we discuss how the loss payee issue affects the parties in a wraparound mortgage transaction, let’s go back through what the “Lender’s Loss Payee” clause in an insurance policy actually is. In order to do this, we must first flash back in history to May 1, 1942 – one week before the Battle of the Coral Sea began and the same day that Disney released the wartime cartoon “Donald Duck Gets Drafted”. It was on this same date that the “Loss Payable” (438 BFU) ‘Standard’ endorsement was formally approved and included in property insurance policies (yes, it’s that old). Since that time, there have been numerous court cases involving ‘loss payee’ provisions (the most notable being Higgins vs. Scottsdale Insurance Company in 2005) so that some states have adopted alternate loss payable provisions (such as the Washington Insurance Commissioner’s WAC 284-21-990), however, the 438 BFU lender’s loss payable provision is the most prevalent in almost all states and it’s probably the one that is included in virtually every homeowner or dwelling policy purchased in the standard insurance market.
Insurers HATE including this endorsement because it gives such a broad and liberalized amount of coverage to lenders (loss payees), but conversely, mortgagees LOVE it for the very same reason. In fact, most mortgage documents, as a condition of the loan, clearly require that property insurance include this endorsement by clearly stating “The policy must include a standard “mortgage loss payee clause” (Lender’s Loss Payable Endorsement 438 BFU or equivalent) in favor of <Lender’s Name>”
The 438-BFU-NS endorsement, in effect, establishes a separate insuring agreement between the insurance company and the lender (who is also the loss payee) irrespective of any agreement with the named insured and it insures the lender for intentional acts of the insured. For example, if the policy owner were to intentionally set fire to his or her home, he or she would not be entitled to any claims proceeds from the policy because of the illegal and intentional act. In short, this loss payable endorsement grants coverage for the benefit of the mortgagee in the event that the policy is voided by some act of the insured. If the lender were to file the claim to recover from the loss, it would be covered because this 438-BFU-NS endorsement protects the lender’s interest against the intentional acts of the insured. In addition, this loss payable endorsement requires that the insurance company “agrees to give written notice to the Lender of such non-payment of premium after sixty (60) days from, and within one hundred and twenty (120) days after, due date of such premium and it is a condition of the continuance of the rights of the Lender hereunder to be paid the premium due within ten (10) days following receipt of the Company’s demand in writing”
In other words, it continues coverage for the lender even after the insured has failed to pay premiums.
Without the inclusion of this lender’s loss payable clause as a measure of safety and security for the lender, it is unlikely that financial institutions would be able to loan the large amounts of capital necessary to purchase homes and commercial property.
So How Does This Clause Affect Wrap-Around Mortgages and Claims?
Okay, after all of this reading the question finally boils down to what affect does this have on the parties in a wraparound mortgage transaction and what happens when a claim is filed?
And now we get to the ‘meat’ of this article…
There are actually a couple of scenarios that can occur, and there is absolutely no rhyme or reason as to which one will happen. In the event of a claim or loss, the funds will either be (a) made out to the policy owner (named insured) – which is the buyer of the property in a wrap transaction, or (b) the funds will be made out to the named insured AND the loss payee(s) – which consist of the underlying mortgagee and/or the seller (if also listed as a mortgagee). And this is where the potential for problems exists. In most cases it is literally a crap shoot as to which will occur and it is nothing that the policy owner has any control over.
The reason for this uncertainty in how claim settlements will be paid out is simple; generally speaking, most claims adjusters are fairly young, inexperienced, ignorant of the actual loss payable provisions in a policy, and under pressure from management to close claims quickly and for as little as possible in order to keep down ‘loss ratio’ expenses. Claims management is normally a ‘starting point’ for most corporate insurance careers because it is a high-stress, high-pressure field and few people do it for more than a couple of years before either becoming burned out or moving upwards to other areas of responsibility within their company. Due to this fact, few claims professionals truly delve into learning the finer points of the policies that they work with and since many are young, they have very little experience in reading, or even comprehending for that matter, detailed contracts written in ‘legalese’ and more often than not, they have simply been hired as claims adjusters, initially trained through a licensing course, and then sent out into the wilderness to adjust and settle claims. In fact, while preparing for this article, I personally called several claims adjusters as well as their managers at several well-known insurance carriers to discuss the loss payee clause and/or lender’s loss payable provisions contained in their respective policies – and not a single person I spoke with had any idea what this clause was or how it really affected their responsibilities as a company after a loss. I had expected a few people to not know what I was speaking about, but I certainly didn’t expect 100% of them to be so uninformed.
When asked whether they paid claim funds to the lender or the named insured after a loss was settled, virtually all of them stated that ‘it depended upon the amount of the claim’ or ‘we don’t know’. The first is clearly a violation of the 438-BFU-NS endorsement since it makes absolutely no mention whatsoever of any dollar amount threshold to decide which party claim funds are paid to. The second answer is simply unsettling (pun intended).
In the case of a wraparound mortgage, let’s assume the following scenario:
The new buyer files a property claim under her or her homeowner’s policy
The original underlying mortgagee (ie: Wells Fargo) is still listed as the first mortgagee
The seller of the property is now listed as the second mortgagee
If the new buyer were to file a claim under his or her new homeowner’s policy and the claim amount was $20,000, depending upon who is handling the claim and how closely that are paying attention to the policy language, it is likely that the settlement check of $20,000 would be made out to the insured as well as both mortgagees – since both are also ‘loss payees’. This means that the buyer would have to get BOTH mortgagees to physically endorse the check before it could be cashed or deposited to pay for repairs. This obviously raises some concerns:
What if it is two years after closing and the sellers, who were facing foreclosure or short sale when entering into the wraparound, are now far-removed from the transaction or no longer easily located or reached?
What if the seller, for whatever reason, simply refuses to endorse the check?
What if the original underlying mortgagee sees that the check is made out to the new buyer and not in the name of their original borrower? Will they call the loan due and payable?
What if the claims adjuster actually pays attention to the policy language and sends the settlement check directly to the first mortgagee (Wells Fargo) for disbursement to the insured? How will the new buyer (who is not the original loan borrower) get this check from the mortgagee?
Of course all of these are just hypothetical ‘what if’ questions, but they are relevant and all are very possible. Because wrap-around transactions, by their very nature, violate the acceleration (due-on-sale) clause in the underlying mortgage, there is always the possibility of the lender finding out about the property transfer when a claim occurs. Having mentioned all of the above, however, I will say that in all of the wrap-around transactions that I have insured and with the resulting losses that have occurred, there has yet to be an instance of the claim tipping of the lender or the lender demanding the loan be paid in full. It simply has not happened. In fact, most claims are just paid directly to the named insured policy owner (even though this is in direct violation of the loss payee clause).
In the event that a claim settlement is either paid directly to the underlying mortgagee or made out to the insured and the mortgagee, the chances are that the mortgagee won’t really make any issue at all so long as payments are current and the property either has been or is being properly repaired so that the loan is still collateralized.
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An insurable interest exists when an insured party derives a financial or other kind of benefit from the continuous existence of the insured object. For example, you derive a benefit from your home not burning to the ground. A party also has an insurable interest in something when loss-of or damage-to that object or item would cause the insured party to suffer a financial or other kind of loss.
As an example of a suffered loss, the house you own is destroyed by a fire. Because of this, it’s value has been greatly diminished and whether or not you choose to have the home rebuilt or simply sell it at a reduced price, the fact remains that you have suffered a financial loss resulting from this fire. The loss is either (1) the loss of value in the property or (2) the cost to rebuild the property. You have an ‘insurable interest’.
However, if it’s your neighbor’s home that burns down, you may feel sorry for them, but you yourself did not suffer the loss and you do not directly benefit from their being able to live in their own home, so you obviously do not have an insurable interest in this property.
A basic requirement of all insurance is that the party purchasing a policy must have an insurable interest in the subject of the insurance. You obviously have an insurable interest in any property you own or any property that is in your possession and with regards to typical property and casualty insurance, this insurable interest must exist both at the time the policy is purchased as well as the actual time a loss occurs.
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.
Though most of us would like to believe that all of our tenants are good people and that they would never intentionally do us, or the property they rent from us, any harm – that is simply not the case.
Renting to tenants is ALWAYS an unknown risk to some degree and like it or not, bad things happen. I am writing this short blog in response to a serendipitous event that occurred yesterday, July 28th. As coincidence may have it, I had just had a conversation with a client regarding questions about tenant-vandalism and property damage. She refused to believe that any one of her tenants might actually cause intentional harm to the home that she rented to them. She did not believe that she needed coverage for vandalism and she chose to purchase lesser-coverage for her properties. Two hours later, as I was driving, I heard a radio news update relating to an arson case in the Austin area whereby the ELDERLY TENANT, who was two months in arrears with his rent and in the process of eviction, intentionally set fire to the rental home he was being evicted from. Though not a case of true vandalism per se (just a minor case of arson!), the story graphically illustrates the fact that, as landlords and property owners, you can never actually judge human behavior or truly screen your tenants and it is up to you to limit your risk and make certain that you are properly insured against any reasonable loss that may occur, whether due to weather, accident, or intentional tenant damage. Remember, insurance is for the things that ruin your life – not your afternoon.
By Shelton Green / KVUE News
Austin fire investigators said on Thursday that it could be a couple more days before their investigation into a house fire from Wednesday will be complete.
On Wednesday investigators said they believed the fire at 6103 Shoal Creek Boulevard was arson.
Michael Joseph Point, 60, had been renting the house for four years, according to Travis County Court records, and was close to $3,000 behind on his rent.
The owner of the house sent Point an eviction notice on July 13. On Thursday, the day after the house fire, Point was supposed to have an eviction hearing in a Travis County courtroom.
“I really can’t make heads or tails of it,” said one neighbor who didn’t want to be identified. The same neighbor says Point left a note on her door at some point before the house fire started. “The note was just … it was an apology for parking in front of the house and it said, basically, that we would know the reason for it by this afternoon.”
As of Thursday evening, Point was still in Brackenridge Hospital. His condition was unknown.
By Katie Friel / News
An Austin-based journalist who contributed to such local publications as the Austin American-Statesman and the Austin Chronicle has been accused of setting fire to his rented Shoal Creek home.
Michael Point, 60, is believed to have poured gasoline throughout the house, which, according to the police affidavit, may have been ignited by the pilot light on the water heater. Point was reportedly found a few blocks from the scene by the Austin Police Department. He was taken to University Medical Center Brackenridge for treatment.
According to the Austin American-Statesman, court documents revealed that Point, who had been a tenant in the home since 2006, had fallen two months behind on his $1,295/month rent. He’d received a notice of eviction on July 2.
Point, a freelance writer, specialized in coverage of music and baseball, the Statesman noted. In addition to local publications, his articles have also been featured nationally.
An Austin Fire Department spokesperson told the Statesman that Point is currently still undergoing treatment at UMC Brackenridge. Upon his release, he will be arrested and charged with arson.