Forty-two states have a law that say you can’t require too much dwelling insurance.

Insurance. Just the word can conjure up anxiety and dread in many people, especially those involved with the life cycle of a loan. Most lenders have horror stories of situations where they’re ready to close a loan, only for the closing to be held up or fall apart due to insufficient or expensive insurance. An issue with insurance can lead to a mad scramble to find compliant coverage to get the loan closed.

Indeed, it is important to have a well-thought-out process in place when it comes to insurance. Some lenders prefer to handle insurance review and tracking in-house, and others may use an outside vendor to review and approve initial coverage. Ongoing tracking and compliance is an additional task that must be handled and organized. These moving parts  make insurance an unwieldy part of the loan process—and one that can expose lenders if the insurance is not handled correctly.

Common Required Coverages

Most lenders require borrowers to have the following coverages:

  Property Coverage // Coverage for the dwelling, appurtenant structures, and loss of rental income (if applicable)

  Builders Risk // If the project involves new construction or structural remodeling

  General Liability // Third-party bodily injury and property damage coverage for the premises

 Flood Insurance // For properties located in a Special Flood Hazard Area (properties in a 1 in 100-year flood plain)

The amounts of coverage, loss settlement provisions, and perils covered may vary by lender, but one area that is becoming an increasing hot spot is the amount of dwelling coverage a borrower must carry. Most lenders have a property insurance requirement that contains language similar to the following:

“The minimum coverage must be equal to or lesser of the following:
(1) That the borrower must insure for 100% of the replacement cost of the insurable value of the dwelling and any improvements (if a renovation) or (2) the mortgage or lien amount.”

At face value, this seems like a very easy-to-understand provision. However, as a lender, it is vitally important that all members of your organization understand what amounts of coverage to require and when it may be acceptable to allow for less dwelling coverage than the loan amount.

You should also note that although your lending requirements may not explicitly state what amount of coverage you will accept, that does not exempt you from following the law of the state where your collateral is located. In short, you may not require a borrower to over-insure a property just to meet your loan amount. Penalties vary by state, and violations of these laws may run afoul of both your state’s banking and your insurance statutes, leading to charges of unfair and deceptive trade practices, fines, and possible license suspension. Additionally, if a borrower does have an insurance policy where the property is artificially over-insured, in the event of a loss, the insurance company is still only going to pay the actual cost to replace the property, not necessarily the declared value of the property.

When the Loan Exceeds Replacement Cost

The trend of loan amounts exceeding the replacement cost of the property is typically more prevalent in markets where land values are a driving factor of appraised values, such as in California, Seattle, New York City, pockets of Texas, and parts of Florida where properties are proximate to the water.

However, across the country there are areas where the demand for single-family housing has rapidly driven up the market value of homes, but replacement costs have not risen as quickly. That gap may shrink due to the rising cost of materials and labor; however, the frothiness in the SFR market is expected to continue as more and more people work from home and move from apartments into more spacious single-family rentals.

Indeed, according to a February publication of the S&P CoreLogic Case-Shiller report, the national home price index posted a 10.4% annual gain in December 2020, up from 9.5% growth in November 2020. This was the fastest growth rate since 2013. As a lender, it is important to understand the dynamics between rapidly rising market values and more stable replacement values. In a time of rapidly increasing home values, replacement costs may not increase as quickly.

How to Handle the Situation

So, how do you avoid this situation, and what are your protections as a lender when the replacement cost of the dwelling doesn’t cover your loan amount?

The first step is to require a replacement cost estimator from the insurance agent providing the coverage. Most insurance companies utilize the services of a replacement cost estimator to determine the cost to rebuild the structure(s) they are insuring.

Examples of common estimating software insurers use are Marshall & Swift, a CoreLogic product, or 360Value, which is a Verisk product. Many insurers will integrate this software into their rating systems, pull appropriate public data, and determine the replacement cost of a dwelling automatically.

Many appraisals will also contain a section devoted to the replacement cost of the property, although the appraisal may not always provide an estimate that is as in-depth as the estimate the insurance company provides. There is also the land value of the property to consider. Because land is not an insurable asset, the residual land value of a property will remain your collateral even if the dwelling is damaged or destroyed by an insured loss.

In summary, it is a good idea to understand not only your insurance requirements but also the regulations surrounding them. Resources are available to help you quickly find out how each state’s over-insurance statutes read and what the penalties may be for a violation.

Make sure you have a well-thought-out insurance review and tracking process, and provide your staff with the training they need to understand what you are asking your borrowers to insure. Insurance is a powerful tool to help provide protection for your collateral and to transfer the risk from your borrower to the insurance company. However, taking a commonsense and legal approach to what you require is essential in these historic times.