Named Insured vs. Additional Insured vs. Additional Interest vs. Loss Payee vs. Mortgagee – What’s the Difference?

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   



The Problem of Residential Insurance in the Name of an LLC

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

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

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

THE BASIC PURPOSE OF USING AN LLC

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

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

THE PROBLEM WITH INSURING RESIDENTIAL PROPERTY IN AN LLC

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

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

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

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

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

HOW TO INSURE PROPERTY TITLED IN THE NAME OF AN LLC

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

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

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

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

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

# 2 – Non-Standard Policy in name of LLC

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

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

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

#3 – Commercial Policy in Name of LLC

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

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

How To Insure a ‘Wrap’ Without Notifying The Lender

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?

Keep Reading…

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.

Wrap-Around Mortgages & Claims – The Loss Payee Clause

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 clause of 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”  

or

“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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Common (and BAD) Advice About Insuring Wrap-Mortgages

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

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

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

Wrap-Around Mortgages: The Problem of Escrow

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

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

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

• Yes, wraparound mortgages are completely legal.

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

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

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

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

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

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

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

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

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

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

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

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

THE SOLUTION

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

WHAT ABOUT THE ORIGINAL ESCROW ACCOUNT?

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

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

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

SUMMARY

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

Legal Title versus Equitable Title

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.   

A Quick Explanation of ‘Insurable Interest’

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.

Don’t Fear The Due-On-Sale Clause

Every week I work with buyers and sellers of residential property who are utilizing seller-financing (specifically wraparound mortgages) and trying to obtain the appropriate hazard insurance while at the same time going out of their way not to tip off the underlying lender that a sale has taken place.  Everyone involved is terrified of somehow notifying the underlying lender and triggering the ‘acceleration clause’ (referred to as the ‘due on sale’ clause) found in the underlying mortgage contract. In every case that I have worked with thus far (which are hundreds) this fear is generally uncalled for and it originates more from ignorance about the potential use and implementation of this clause rather than the reality itself.

To begin with, the ‘due on sale’ clause is, and has for decades been, a common provision in a mortgage or a deed of trust which allows the lender or mortgagee to demand immediate payment in full of the remaining balance of the loan if the mortgage holder transfers the property.  Simply put, a due-on-sale clause is a standard provision in a mortgage or deed of trust that states that the lender has the right to demand that the entire balance of the loan, at the lender’s sole discretion, may be called due upon any transfer of the property used to secure the promissory note.

Although the lender has the contractual right, it isn’t a law and they do not have a hard and fast obligation to call the note due in the event of a sale.  Again, this is a contractual right of the lender, not a legal requirement. This means that if a transfer takes place, the lender may (or may not), at its sole discretion, decide to “call the loan due.”

Notice that in the paragraph above it was stated that the lender the due on sale clause is triggered by a ‘transfer’ of the property – nothing at all has been said regarding the word ‘sale’.  Technically, a ‘transfer’ is any transaction which transfers any ownership or title to the property, whether it is equitable or legal title. This can take numerous forms and can even consist of a common lease-option (which is an executory contract whereby a transfer of ‘equitable title’ occurs) even though the lessee hasn’t even exercised his or her option to actually purchase the property yet.

The common, and often mistaken belief, is that transferring any property already secured by a mortgage with a due-on-sale clause is somehow illegal. This is untrue due to the fact that triggering this clause is a matter of civil, not criminal, liability. By definition, in order for something to actually be considered “illegal”, it must first be in violation of a criminal law, code, or statute and there is currently no state or federal law which makes it a crime to violate a “due on sale” clause.  In other words – these transactions are legal.

As it has already been stated, if a lender does find out about the transfer, it may at its option, call the loan due and payable and if the borrower is unable to pay the loan, then the lender always has the option of initiating foreclosure proceedings.

So, when considering a seller-financed purchase or sale, such as those utilizing a wraparound mortgage, the question to ask is whether or not both parties are willing to enter into a transaction subject to a mortgage containing a “due on sale” clause and risk getting caught.  This is often a ‘risk versus reward’ situation that normally makes sense to do. More often than not, the seller has been denied short-sale options, he or she is unable to sale the property to a buyer that can obtain traditional financing, and the mortgage is in arrears and facing possible foreclosure if the sale does not occur soon so that payments are caught up and the loan brought current.  So what’s the risk for the seller? Usually nothing. More often than not he or she is already facing foreclosure and the wraparound mortgage is the only means to prevent that from happening. If the loan does get called due, then the situation isn’t really any worse for the seller than it was before the sale. On the flip side, the buyer may have had past credit-related issues, he or she may not have enough money for a 10% or 20% down payment, or the buyer may not otherwise qualify for a traditional mortgage loan due to employment, income, or other issues.  Without this seller-financing option, the possibility of home-ownership for the new buyer is slim to none. The gamble is usually pretty safe for both parties.

With regards to wrap mortgages, the due-on-sale clause is an obvious issue of concern for any property owner that wishes to transfer (sell) the property and have the new buyer take over the existing loan rather than paying it off as part of the sale as in a normal transaction involving third-party financing.  The downside is that, as already stated, if the lender finds out about the transfer and then decides to call the loan due and the balance is not paid off, the lender could of course choose to foreclose on the property – which means that the seller now has a foreclosure on his or her record and the new buyer is also subsequently evicted in the process, which also means the entire loss of all down payments and other monies paid. This could, of course, lead to other frivolous litigation between the parties. However, the likelihood of this actually happening is pretty low and it really depends on how the real estate market is doing at the time. The reality is that as long as the buyer continues to make the loan payments when they are due, it is unlikely that the lender will actually call the loan due and payable. Given the extremely low interest rates that are expected to exist for the next few years and the current backlog of non-performing assets that banks already have on their books, calling a current and performing loan due isn’t very likely at all.

However, in the past things were different. In the late 1970s and 1980s interest rates were very high, sometimes up to 16% or more, so banks were very keen to enforce these clauses in order to foreclose on properties with lower rates of interest so that they could turn around and resell these homes or lend out the money at a much higher rate.  However, as stated above, with current  interest rates likely to remain low for at least a few more years, a record-high number of foreclosures, and a two-year backlog of new foreclosure processing already awaiting processing by many banks, the probability of this clause being enforced is very, very remote.

Also, something that many buyers and sellers don’t realize is that nobody associated with the transaction is under any contractual obligation whatsoever to notify the underlying lender that any transfer has taken place. Not the original borrower, not the Realtor, not the attorney, not the transaction coordinator, not the title company, and not the buyer. There is no inclusion in the mortgage loan requiring notification to the lender at all – and what they don’t know doesn’t hurt them. Generally speaking, so long as payments are caught up and maintained current so that the lender has a performing asset on their books it’s a non-issue.

Furthermore, from a legal standpoint, choosing not to disclose the sale or transfer to the lender is not considered either fraud or an ethical violation by the Realtor although all parties involved in the transaction should obviously be made aware of the existence of an underlying due-on-sale clause. In addition, many state-promulgated real estate contracts, addendums, and other forms contain provisions specifically referencing ‘subject to’ transactions.  It is also not an ethical issue for attorneys since there have been several rulings concluding that assisting buyers and sellers to conceal a transfer from the underlying encumbrances is not considered a fraudulent act.

The most likely opportunity for the lender to become aware of the transfer of the property is when the buyer is purchasing new hazard insurance.

The concern here is that the lender will receive an evidence of insurance form from the company listing the new buyer as the named insured rather than the original borrower and this will alert the lender and trigger the due-on-sale clause.  While possible, this is seldom as much of an issue as it is made out to be and more often than not it is much ado about nothing.  You see, the insurance departments for banks and lenders are far removed from lending operations and most people working in these departments are hourly data-entry personnel.  As long as they see that insurance is in force for whatever property that they happen to be working on at the time everything is fine.  Also, if the seller (ie: the original borrower) is listed as an additional interest or additional insured (which are two different things) and whoever is working on the file at least sees the seller’s name somewhere on the form or policy, no questions are asked. Don’t be fooled, the personnel working in these insurance departments actually know little or nothing about insurance itself, they are clerks who are simply responsible for making certain that updated proof of coverage is obtained each year for the loans in their work que.  There is also another way to obtain insurance for the buyer in a wraparound mortgage transaction that virtually eliminates the lender ever being tipped of to the transfer of the property, but it is more complicated and some buyers and sellers choose not to pursue doing this due to the fact that the transaction has already been closed and the insurance is being purchased as an ‘afterthought’ or the insurance was set up incorrectly in the first place and it is too late.  To learn more about this strategy, refer to my article “How to Insure a Wrap Mortgage Without Notifying the Lender“.

In summary, there is always the possibility of the loan being called immediately due and payable by the lender, but the chances of that happening are very, very slim and in my personal experience and opinion, it is no reason to worry excessively or forgo the sale.

Why Insurance Companies Don’t Promote Dwelling Policies

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

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

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

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

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

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

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

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

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

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

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

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

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

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