Time and time again borrowers, (investors/contractors/ rehabbers), are puzzled by the amount of insurance the lender is requiring. The borrower is buying something cheap, primarily doing cosmetic fixes yet the lender is insisting on a greater amount of insurance than what the borrower is anticipating.
There are always multiple ways of looking at things so let’s look at the process a typical insurance agent goes through when they are asked to quote for insurance. Step one is to gather information such as property address, sq footage, year built, type of foundation, type of roof etc. The insurance agent then enters the information into some type of software system, Marshall Swift is one of the more commonly used ones, and a number comes out. This number takes into consideration material and labor cost for that zip code using licensed contractors and trades. Usually this number is larger, sometimes considerably larger than what the contractor is in it for. Premiums will be higher because of the larger amount of insurance.
Now let’s look at a claim scenario. If a property is not insured for a minimum of 80% of what the INSURANCE COMPANY deems the amount of insurance should be, a coinsurance penalty will be assessed during the claim process and the replacement cost coverage might be reduced to Actual Cash Value. This combination severely impacts the claim amount. When something like this occurs, the borrower may walk and the lender now owns a burned down or damaged property with not nearly enough insurance proceeds to rebuild.
- Borrower buys house for 70K
- Borrower puts 30K of improvements into house
- Borrower is in property 100K
- Agent puts in all the property characteristics and insurance value should be 200K
- Home is insured for 100K, ( amount of loan)
- Home burns to the ground
- Insurance company says you must insure for AT LEAST 80% OF OUR DETERMINED VALUE SO min insurance amount must be 160K, (80% X 200K)
- Borrower insured for 62.5%, ( 100K divided by 160K)
- Insurance carrier depreciates home to determine Actual Cash Value and then pays 62.5% of that amount
In almost all cases this will result in a shortfall and there will not be nearly enough money to rebuild the property. Either the borrower or the lender is left with a loss.
The above occurs more frequently than one realizes depending on location of property, how often someone is on the jobsite and how well the property is secured. Many times damage happens when the home has been totally fixed up, is in escrow or listed for sale. All too often when the home is complete, vandals come in and take plumbing, water heater, AC and appliances while damaging the home at the same time. Or in the colder climates, squatters come in and light a fire to keep warm… and burn down the house. The insurance company’s amount of insurance, while perhaps costing more than one would like, will assure there is enough money to rebuild the property.
Ross Diversified Insurance Services is a 25 year old national insurance agency that works with investors, contractors, mortgage originators and servicers of any size insuring residential and commercial properties including rentals and distressed assets/foreclosures. Ed Babtkis, President of Ross Diversified, can be reached at 800-210-7677 or on his cell 714-697-8733.