NUTS & BOLTS
ASSET COVERAGE
More Insurance Myths Debunked MAKE SURE YOU HAVE THE PROPER COVERAGES IN PLACE BEFORE DISASTER STRIKES YOUR INVESTMENT PROPERTY. by ShawnWoedl EDITOR’S NOTE: This is a continuation of “Debunking the 13 Insurance Myths for the Real Estate Investor,” which previously was excerpted inThink Realty Magazine’s January-February and March- April issues. Whether you are just getting started or are a seasoned investor, our aim is to give you the knowledge and confidence to trust that your assets are protected and your business is secure. MYTH #7 ALL POLICIES AND COVERAGES ARE CREATED EQUAL Basic, Broad and Special coverage are three industry-wide property coverage forms available to you as an investor. Before you choose which coverage form is best for you, please make sure you take into consideration more than just the cost of the policy options. There can be up to a 30 percent difference between these policy forms, and it is up to you as the investor to determine whether the additional exclusions associated with the cheaper coverage forms are worth the risk. After all, that is exactly what insurance is. A game of risk, both by the carrier and the investor. As you can probably guess, Special form is the best and, in turn, the most expensive coverage form you can purchase. It is considered “All-Risk” coverage, meaning that unless there are specific exclusions listed within the policy, then coverage is afforded to you in the event a loss occurs. The burden of proof falls on the insurance company to prove that the peril that caused the loss is specifically excluded. There are six standard exclusions that come on every Spe- cial form policy: 1 MOLD AND FUNGUS 2 WEAR AND TEAR 3 SEWER AND DRAIN BACKUP 4 EARTHQUAKE 5 FLOOD 6 INTENTIONAL TENANT DAMAGE
• About 60 percent to 65 percent of the investors insured with REIGuard who suffer a partial loss and are on Replacement Cost never come back and recoup any depreciation. That is not necessarily because they don’t want to, but because the ACV settlement was more than enough to make themwhole again. If you have a loan on the property, most likely your lender is going to have a set of insurance lending requirements you will have to meet or exceed. They often require Replacement Cost coverage. Now, let’s touch on Coinsurance. Coinsurance is an indus- try-wide property provision that states the amount of coverage that must be maintained as a percentage of the total value of the prop- erty at the time of loss. The penalty is based on a percentage stated within the policy and the amount reported. Common coinsurance is 80 percent, 90 percent or 100 percent of the value of the insured property. (The higher the percentage is, the worse it is for you.) To simplify things, let’s refer back to the example of the partial kitchen fire. The claims adjuster will also determine howmuch the property would have cost to rebuild if it had actually been a total loss. For an even number, let’s say it would take $100,000 to rebuild. The adjuster then refers to the declarations pages of your policy to see you have an 80 percent coinsurance clause on your policy. That means you agreed to be insured by your carrier to 80 percent of the true replacement cost of the policy (which has just been determined to be $100,000). Provided you are carrying $80,000 or more of building coverage, you have met your coinsurance clause. However, if you are insured to $79,999 or less, you will be assessed a coinsur- ance penalty based on the percentage you are underinsured. This is done prior to figuring in the depreciation and the deductible (so the insurer can take the percentage off the larger amount). Now, if you are looking at your declarations pages and scratching your head as to why you are insuring your 1,000-square-foot home for $150,000, then you need to look no further than your coinsurance clause. Many carriers (in an attempt to avoid a coinsurance penalty being assessed to you in the event of a loss) greatly inflate the ITV (In- surance to Value) of the property. The last thing your agent wants is you in his or her office upset after a loss occurs because in addition to being hit with depreciation, you also are being hit with a coinsurance penalty. So the better alternative is to charge you a higher premium for more coverage than you will ever recover in the event of a loss. (At REIGuard, our programworks differently. We work with you to determine what valuation per square foot you want to be insured to. We provide you with Actual Cash Value coverage and NO Co- insurance beginning at $50 per square foot. Replacement Cost with NO Coinsurance begins at $70 per square foot.) •
Some of these can be purchased as an endorsement or stand- alone policy. Others cannot. In addition, if your location is in a Tier 1 or 2 county (meaning a county that touches coastal waters or is one county removed), named-windstorm or hurricane coverage may also be excluded. Be sure to review your exclusions and endorsements pages to make sure no other exclusions have been “slipped in” your policy. One common coverage exclusion that is added is theft. Basic form coverage can save you approximately 25 percent to 30 percent per year, depending on the carrier, but comes with some additional exclusions to ones listed above: • Collapse • Falling objects • Theft (keep inmind, this is for things you own, such as the air conditioning unit and the copper pipes in the wall, not your tenants’ belongings) • Weight of ice, sleet or snow and water damage (commonly known as coverage for frozen and burst pipes). In the event of a loss, the burden of proof falls on you to prove the loss was caused by an included peril. Broad form is the in-between form not often used, since the cost savings provided is not enough to make sense to purchase. It is basically Special formminus theft coverage. It typically saves you 10 percent from a Special form policy. For the additional 10 percent, it is better option to simply purchase Special form. Things to consider when deciding on a Special or Basic form policy: 1 Is my property in an area where weight of ice, sleet or snow and water damage are high risks to me? If not, then Basic form might be a better option. 2 If my location is a flip, will the property still be inmy possession when the temperatures get cold? If not, then Basic formmight be a better option. 3 Is theft coverage a concern? If the location is occupied, then that threat should be diminished. As you can probably imagine, theft most often occurs at vacant locations. If the location is a flip or undergoing renovation, will there be enough owned materials and appliances at the location to make sense carrying theft coverage? Keep in mind that your general contractor’s tools and materials are NOT covered under your policy. The next piece for you to consider is whether you want to be insured on Actual Cash Value (ACV) or Replacement Cost (RC). Actual Cash Value is typically 20 percent to 25 percent cheaper than a Replacement Cost policy and allows you to be insured at a lower value per square foot. But it does figure de-
preciation into the settlement of your claim. Replacement Cost requires you to be insured to a higher valuation per square foot but provides you with the opportunity to recover all deprecia- tion that was initially levied against you. Let’s run through a claims example (all companies settle claims the same way) and then touch on some things to consider when deciding between RC and ACV: You suffer a partial loss at your property after a kitchen fire causes $30,000 in damage. The assigned claims adjuster will visit the property and determine howmuch useful life was left in what was damaged (to figure in the depreciation of the loss). For a nice, round number, let’s say the adjuster depreciates the loss at 40 percent, meaning $12,000 will be depreciated from the $30,000 loss, leaving you with a payout of $18,000. (As a side note, depreciation is extremely difficult to determine until the loss occurs. It is taken off the date of the last updates, not the original year built. Everything depreciates at a different rate, but the average is about 1 percent per year, except for the roof, which deteriorates much quicker due to the exposure to the weather.) Backing the deductible out of the settlement (let’s say it is $3,000), you are left with an Actual Cash Value settlement of $15,000 to cover your $30,000 fire loss. If you are on an ACV policy, this is all you can recover. (And by the way, that money is yours to do with what you want–sell the property with the damage existing and use the money to go on vacation, buy a car … you get the point). If you are on Replacement Cost, you can go back to the carrier and recoup some or all of the depreciation that was taken from you. The way you do this is to first exhaust the initial ACV payment of $15,000 on repairs, make the re- maining repairs out of pocket and submit the receipts to your insurance carrier. Then the insurer will reimburse you for up to $12,000. The only part that is not recoverable to you on an RC policy is your deductible. I always recommend that you consider what your plan would be in the event of a total loss. Would you rebuild the property, or would you clean up the land, sell it and move to another property? If you would not rebuild the property, then there is little reason to pay for Replacement Cost coverage because you would be paying more to the insurance company than you would ever recover in the event of a loss. Remember, you have to actually make the repairs at the property to be able to recov- er your depreciation. There are a couple of reasons why you should think about what your plan would be in the event of a total loss -- and not worry so much about a partial loss: • Youmost likely canmake the repairs (or have access to someone who can) for substantially less than what your insurance carrier thinks you can.
ShawnWoedl is the SeniorVice President of REIGuard and an indus- try-recognized speaker and educator with an emphasis on commercial property and premises liability. Over the last nine years, he has studied extensively on these lines of coverage to bring to you the publication, “Debunking the 13 Insurance Myths for the Real Estate Investor.”
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