REMEMBER THE LENDER
When insuring real estate, recognize how the presence of loan financing affects loss settlement… and insureds.
By Joseph S. Harrington, CPCU (relying on James R. Mahurin, CPCU, ARM)
It’s worthwhile to hear from risk management and insurance consultant Jim Mahurin every once in a while. Careful readers of this blog will recall Jim’s observations a year ago on the limitations of certificates of insurance. A year later, almost on cue, Jim utilized Rough Notes’ contact form to submit an important observation for every agent and broker placing coverage for owners and developers of real property.
… [A] bank’s problem can become a property owner’s problem if lender’s risk is not considered into the calculation of insurance coverage and limits.
From his work producing reports on the adequacy of insurance coverage in loan agreements, Jim says that a bank’s problem can become a property owner’s problem if lender’s risk is not considered into the calculation of insurance coverage and limits.
(NOTE: Lender’s risk for first party exposure to impaired collateral is distinct from lender’s liability and its corresponding lender’s professional liability insurance. Lender’s liability refers to the responsibility of a lender for an error in the drafting, calculation, collection, or some other aspect of a loan transaction that causes a loss to a borrower or other third party.)
The problem with lender’s risk, Mahurin explains, is that federally insured lenders are required to post substantial cash reserves if the collateral on any loan becomes impaired by physical damage or any other cause. The need to post reserves for collateral-impaired loans almost always makes those loans unprofitable, so lenders are eager to collect insurance proceeds to retire them quickly and get them off the books
That’s entirely legal and appropriate for a mortgage holder described on the policy declarations, but it often leaves a named insured in a tough spot.
A weak hand
After an insured loss is collected by the lender, the borrower (the named insured) is typically asked to go back before the loan committee to reinstate financing in some form.
At this point, the borrower is typically playing a weak hand. The location is closed and/or construction is halted. Local authorities are bringing pressure to clean up the site; prospective tenants are bringing pressure to complete construction and/or reopen—or they may go elsewhere.
The same holds for customers of a business whose operations are suspended by a loss.
If the borrower was not savvy about property insurance coverage conditions before, it soon will be, especially if it is hit by a coinsurance penalty, sees the coverage limit depleted by inadequate debris removal coverage, and has only 12 months of business income coverage for an 18-month delay in opening or reopening.
Beyond that, the loss of franchise value to a previously going concern is typically a multiple of the business income loss.
It follows that agents and brokers are well-advised to ask commercial property insureds about the details of their financing, especially amortization schedules, as well as other sources of cash to meet contingencies following a loss.
When a lender is involved, it’s not enough to consider only balance sheet and financial statement factors when determining limits. An effective real estate insurance program will anticipate and address the dynamics that come into play when a lender claims loss recovery payments to keep its own house in order.
Whenever debt financing is a factor, Mahurin encourages agents and brokers to recommend policy limits for the possibility of a total loss, however unlikely that may seem. In his experience, it happens more often than insureds like to contemplate.
In particular, he urges building property limits that reflect full insurance to value, thus maximizing recovery and eliminating the chance of a coinsurance penalty. He also urges the addition of generally available but rarely used endorsements for increasing the limit for debris removal following a total loss, a shortcoming in coverage he has found to be severe in several cases.
Finally, Mahurin recommends a longer timeframe for business income coverage than commonly used, as demolition and reconstruction often start later and last longer than anticipated.
If premium savings is a concern, he says, look first and foremost to the deductible for relief, not to the coverage limits.
The point here is not to promote Mahurin’s approach to property coverage for debt-financed risks; other risk and insurance practitioners will have different approaches to dealing with them. The point is to recognize how the presence of loan financing affects loss settlement, especially in the wake of a total loss, and how agents and brokers can spare their commercial clients some very unpleasant surprises.
Joseph S. Harrington, CPCU, is an independent business writer specializing in property and casualty insurance coverages and operations. For 21 years, Joe was the communications director for the American Association of Insurance Services (AAIS), a P-C advisory organization. Prior to that, Joe worked in journalism and as a reporter and editor in financial services.