Make sure your properties are appropriately covered if the expected wave of foreclosures hits.

Foreclosures are expected to surge in 2021 because of the pandemic and subsequent financial crisis. Some people believe they may double (or worse).

As a lender, you must be prepared secure insurance on these properties. Whether you are a large lending institution or a private or hard money lender, make sure your lending requirements include criteria that your borrowers must comply with for insuring their properties. You can use the same general guidelines should you need to acquire lender-placed insurance coverage to protect your interest in a property you foreclose.

Here are some considerations for developing those guidelines or shopping for your own coverage. These recommendations focus primarily focus on single-family rental properties and small multifamily locations. Higher unit counts have additional risk considerations. Keep in mind that you should always discuss your coverage with a licensed insurance agent familiar with lender-placed insurance and non-owner-occupied, renovation, or vacant properties.

How Much Insurance Do You Need?

As soon as you begin the foreclosure process, obtain a lender-placed insurance policy on the property for the outstanding loan balance. You may require that borrowers insure the location for up to 125% of the loan value. As a lender foreclosing on a property, you are only able to recover your investment in the property in the event of a total loss. This means that for loans with a lower balance, the insured value will be substantially lower than the actual value of the property. Carefully read the policy to ensure there is no co-insurance penalty the carrier can levy against the property owner for underinsuring a property. (On a proper lender-placed policy, there should be no co-insurance, but be cognizant of it and make sure your agent eliminates it if it’s there).

Be sure your insurance agent knows whether the property is under renovation or vacant. Vacant homes come with certain risks the carrier needs to be aware of in order to afford coverage in the event of a loss. Also, make sure to take appropriate security measures to mitigate theft and vandalism of the property.

Choosing Your Type of Coverage

To minimize exclusions and unnecessary exposures, consider purchasing Special Form property coverage. Think of Special Form as all-Risk coverage. It is the most comprehensive coverage form available for non-owner occupied, renovation, and vacant properties. There are several standard exclusions from Special Form policies, but any peril (cause of loss) not specifically excluded is automatically covered. This leaves the burden of proof on the insurance company to prove to both you and your insurance agent that the loss that occurred was from an excluded peril. Otherwise, coverage is afforded.

Although these coverages can vary, as a standard, Special Form policies typically exclude:

• Mold and fungus
• Wear and tear
• Sewer and drain backup
• Earth movement (including quake and sinkhole)
• Flood
• Poor workmanship and defective maintenance (also extending to faulty zoning and materials)
• Damage caused by vermin
• Intentional damage by tenants
• Power failure
• War
• Neglect
• Nuclear hazard
• Governmental action
• Equipment breakdown
• Ordinance or law

As a side note, many policies have long included a bacteria and virus exclusion; some are now including a COVID-19 exclusion. Keep in mind, however, that property insurance is intended to cover losses as a result of property damage. So even a coverage such as loss of rents (or business income insurance) would kick in only if the property itself suffers damage that renders it uninhabitable.

Several of the exclusions above can be bought back by endorsement or on a stand-alone policy. Others are considered uninsurable by insurance companies. Some coverages that can be purchased separately include earth movement, flood, equipment breakdown and ordinance or law.

Basic Form is the other coverage option available. It is a “named peril” form that has additional exclusions that can harm you. In this type of policy, only those causes of loss named in the policy are covered, and it is incumbent on the insured to prove the loss was caused by a covered peril for coverage to be afforded.

Perils covered on Special Form but excluded from Basic Form are theft, weight of ice, sleet or snow, water damage, collapse, and falling objects. If your foreclosure is vacant, you may be at a higher risk of theft. Water damage as a result of burst pipes, weight of ice, and sleet or snow can be higher risks in colder climates, so consider this exclusion if your foreclosed property is in a cold-climate area. Regardless, be sure to keep the temperature at the property set to 55 degrees or above and shut off the water to avoid possible water damage.

Many lenders require their borrowers to carry Special Form coverage. For an REO property, you should factor in the local climate, season, and safety of the neighborhood, and then weigh those against your appetite for risk.

Choose a property deductible of no more than 2% of the total insured value of the property. This deductible applies to the AOP (All Other Perils) property deductible. The more severe perils of wind and hail (including named windstorm), water damage, and theft/vandalism often come with a higher deductible.

Two Settlement Methods

There are two loss settlement methods choices for you to consider when shopping for insurance. Actual Cash Value (ACV) factors in depreciation when settling a partial loss. Replacement Cost (RC) allows you to recover that depreciation, but it is handled in two payments. First, you will receive a check for the ACV amount (as determined by the claims adjuster) Then you will submit receipts for the additional cost to repair or rebuild in order to obtain reimbursement above the ACV settlement.

You should strongly consider requiring your borrowers to maintain RC coverage. This coverage can help minimize any financial hardship they may experience from not recovering enough money to make them whole again and potentially affect their ability to repay the loan.

On your foreclosure, RC coverage may be overkill. In a total loss, you will be reimbursed for the loan amount regardless of the settlement method. You can clear the land, sell it, and move on. If there is a partial loss and you are on an ACV policy, your reimbursement will factor in depreciation, but that may be sufficient to cover repair. ACV coverage can save 20-25% in premium costs, so you must weigh that savings against the potential need to cover some repair costs if the ACV settlement is not sufficient.

With regards to liability coverage, you (and your borrowers) should carry commercial premises liability with a per occurrence limit of $1,000,000 and a $2,000,000 annual aggregate. Premises liability coverage extends to slip and falls, or personal injuries, that occur on the premises. Defense costs should be outside of these included limits of liability so they do not diminish what is available to settle a loss. For locations with higher unit counts or more stories, consider higher limits.

Insurance For Your Borrowers

As the lender, you should be listed as the mortgagee on the property insurance policy. This ensures that you receive notice before coverage canceling due to non-payment or any other underwriting issue. It also guarantees you are listed on all claim payments for property losses at that location. This protects your interest in the property. For a liability policy, being listed as “additional insured” on your borrower’s policy ensures you are notified if the coverage cancels and extends coverage to you for that property.

If you are notified that coverage is canceled for a property on which you have an interest, immediately obtain a lender-placed insurance policy to protect your interest. You will pay the premium on a policy of this nature but collect it back from the borrower by adjusting their monthly payment.

Maintaining a set of defined insurance requirements and having a relationship in place with a trusted insurance agent who can help you when lender-placed insurance becomes necessary is critical to minimizing your risks as the lender. An agent who understands the real estate investing landscape and can help you design an insurance package to fit your needs is a valuable partner in uncertain times.