One of the biggest mistakes a real estate investor can make is to assume that all types of property insurance are created equal. Make sure you learn and understand the difference between Basic, Broad and Special form coverages as well as the difference between Actual Cash Value vs. Replacement Cost before making coverage decisions.
Basic, Broad and Special Form Coverages
There are three industry-wide property coverage forms available to real estate investors: Basic, Broad and Special coverage. There can be up to a 30 percent difference between these policy forms, and it is up to you as the investor to determine if the additional exclusions associated with the cheaper coverage forms is really worth the risk for you. After all, that is exactly what insurance is: a game of risk, both by the carrier and the investor.
Perhaps not surprisingly, Special Form Coverage is the best and in turn, the most expensive coverage form an investor 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 that any loss occurs. The burden of proof falls on the insurance company to prove that the peril (or problem) that caused the loss is specifically excluded in the policy. There are six standard exclusions that come on every Special form policy: Mold and Fungus, Wear and Tear, Sewer and Drain Back-up, Earthquake, Flood and Intentional Tenant Damage.
Some of these “exclusions” can be purchased as an endorsement or stand-alone policy and others cannot. Furthermore, if your location falls in a tier 1 or 2 county (meaning a county that touches coastal waters or 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 is the second coverage form most carriers offer to investors. Basic form coverage can save you approximately 25-30 percent per year (depending on the carrier), but comes with some additional exclusions to ones listed above, that you will need to consider. Basic comes with additional exclusions: Collapse, Falling Objects, Theft of property owner’s possessions (such as copper pipes or air conditioning units), Weight of Ice, Sleet or Snow damage and Water damage.
With Basic Form coverage, the burden of proof falls to the investor rather than to the insurance carrier to prove that the loss was caused by “included peril,” meaning something that is covered by the policy.
Broad Form Coverage is the form coverage that falls in between Special form and Basic form. It is basically Special form minus theft coverage. It typically saves you 10 percent from a Special form policy. For the additional 10 percent, most investors and insurers agree that it is a better option to simply purchase Special form coverage.
The next piece of the puzzle 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 20-25 percent cheaper than a Replacement Cost policy and allows you to be insured to a lower value per square foot but does figure depreciation 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 depreciation that was initially levied against you.
Let’s say you suffer a partial loss at your property, a kitchen fire that causes $30,000 of damage. The assigned claims adjuster will visit the property and determine how much useful life was left in what was damaged. For a nice, round number let’s say they depreciate the loss at 40 percent, meaning 12,000 will be depreciated from the $30,000 loss. That leaves you with a payout of $18,000.
Let’s say you have a $3,000 deductible. Then they will take your $3,000 deductible out of the settlement, leaving you with an Actual Cash Value settlement of $15,000 to cover your $30,000 fire loss. If you are on an Actual Cash Value policy, this is all you can recover.
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 remaining repairs out of pocket, submit the receipts to your insurance carrier and they will reimburse you for up to $12,000. The only part that is not recoverable to you on an RC policy is your deductible.
As a side note, depreciation is extremely difficult to determine until the loss occurs. It is taken off of the date of the last updates, not the original year built. Everything depreciates at a different rate, but the average is about one percent per year. Roofs deteriorate much more quickly, however, due to the exposure to the weather.
In the next issue, this series will continue with a full review of the concept of co-insurance and why you should avoid it at all costs.
Things to Consider When Deciding on an ACV or RC Policy
1. Consider what your plan would be in the event of a total loss.
Would you rebuild the property or would you sell the land and move on to another property? If you would not rebuild the property, then choose Actual Cash Value (ACV) because with RC you will be paying more to the insurance company than you will ever recover. Remember, you have to actually make the repairs at the property to be able to recover your depreciation.
There are two reasons you must concern yourself with what your plan would be in the event of a total loss and not so much a partial loss:
a. You most likely can make the repairs (or have access to someone who can) for substantially less than what your insurance carrier thinks you can.
b. 60-65 percent of the investors insured with us that suffer a partial loss and are on Replacement Cost, never come back and recoup any depreciation. Not because they don’t want to, but because the ACV settlement was more than enough to make them whole again.
2. Factor in your leverage situation.
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. Often times, they require Replacement Cost coverage.
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 is high risk to me?
If not, then Basic form might be a better option.
2. If my location is a flip, will the property still be in my possession when the temperatures get cold?
If not, then Basic form might be a better option.
3. Is Theft Coverage a concern?
If the location is occupied, then the threat of theft damage should be diminished. As you can probably imagine, theft most often occurs at vacant locations. If the location is a flip or undergoing renovation, ask yourself if there will be enough owned materials and appliances at the location to make sense carrying theft coverage? Keeping in mind that your general contractor’s tools and materials are NOT covered under your policy.
Understanding how insurance forms and policies work go a long way in adequately protecting your investment properties. Avoiding overpaying for unnecessary coverages, can be just as important as eliminating any coverage gaps that could harm the stability of your business. Providing the right coverage at the right time is what sets NREIG apart from all others. Visit nreig.com for more information and to receive an insurance proposal.