When purchasing or refinancing commercial or multifamily real estate property, buyers are required by lenders to secure insurance coverage that meets minimum standards. Although lenders set these requirements, oftentimes the minimum requirements are just that – the minimum coverage you should seek to protect your property or new acquisition. There are many confusing provisions built into these lender requirements. The goal of this article is to break down the provisions and guide you on what you need to consider as part of your overall comprehensive risk management and insurance program for your real estate property.
In almost every case, lenders require the following basic standards be met for an insurance program:
- That insurance companies must be in good financial standing. Often lenders require an A.M. Best rating of at least an A with a financial size of $50-$100 million in policyholder surplus.
- Proof of insurance, either in the form of a certificate of insurance or copy of the policy.
- Notice of cancellation within 30-60 days if the policy is canceled.
Consideration: Individual vs. Master Policy Approach
The main coverage lenders are going to focus on is Property Insurance since it secures the loan. Owners of commercial and multifamily properties can take an individual or master policy approach for property insurance. A master property insurance program, typically for portfolios with over $50 million in insured values, provides coverage across your portfolio rather than a policy for an individual location. This approach takes advantage of greater purchasing power and geographic spread of risk often with broader coverage.
Under a master policy, lenders will require you to provide evidence of sufficient limits covering your entire portfolio inclusive of the property they have an interest in. This means you may need to provide them with a schedule of insurance that shows the specific allocation of limits to their property. If there are no lender requirements regarding whether an individual or master policy is acceptable, it would be wise to confirm with them, in particular for acquisitions prior to closing, what they would accept and the means to satisfy their requirements.
Consideration: Adding Specific Provisions
Lenders also will look for specific provisions within the property coverage, such as replacement cost coverage; loss of rent coverage; coinsurance percentages; terrorism coverage; equipment breakdown; ordinance or law coverage; and deductibles. Evacuation and relocation expenses are usually not required by lenders, but can provide needed additional funds after a loss. Lenders differ on some coverages and limits required, but all are important components of a property policy that should be specifically addressed according to your exposure and appetite for risk. For instance, whether or not the lender requires it, it is advisable to provide coverage for situations where an ordinance or law requires you to rebuild the location under increased building codes or, worse yet, to demolish a location if a significant enough portion of the building is damaged and deemed uninhabitable. Limits for this coverage should be contemplated based on the age of the building, the applicable jurisdiction and the availability of coverage in the insurance market.
Consideration: Deductible Levels
Deciding the most economical deductible for your portfolio is another area where you may be at odds with the lender requirements. Lenders will typically require a $10,000 or $25,000 deductible. Depending on your appetite for risk, you may be able to take on additional risk within your program and, in doing so, exceptions will need to be sought from the lender. A common solution is to have a larger deductible on the policy and negotiate an indemnification provision whereby the insurance will allow you to evidence a lower deductible to satisfy lender requirements.
For example, if you take a $500,000 deductible on your master property policy in order to comply with a $10,000 deductible requirement, the insurance company can endorse the policy to agree that the $10,000 deductible will apply for that property. A separate indemnification agreement can be entered into between you and the insurance company to satisfy the difference as a result of the lower deductible. Entering into this type of arrangement requires deep analysis of your loss experience, but if losses are low there is the opportunity for lower ultimate costs.
Consideration: Catastrophic Perils
Lastly, there may be very specific requirements for catastrophic perils, such as earthquakes, floods and windstorms if the property is in an area prone to these natural disasters. Specifically, flood coverage is required if the building is in a flood zone deemed a special flood hazard area. Availability of coverage for these locations is often through a combination of coverage with the National Flood Insurance Program (NFIP) and Excess coverage on your Property Policy.
Once again, this is an area where your risk management objectives for your portfolio may differ in terms of deductible levels and limits carried, which both have an impact on the cost and availability of coverage in the insurance market. Similarly, earthquake coverage and capacity is limited, so understanding the amount of coverage required and the acceptable deductible levels are very important for a property in an earthquake zone. Regardless of the lender requirements, your properties in these areas should be modeled to determine the probable maximum loss you are exposed to from any single catastrophic loss and the coverage should be structured accordingly.
Consideration: Enhanced Liability Coverage
Lenders will require that policies include them as an additional insured under your Policy to cover them from lawsuits resulting from property damage or bodily injury to others. They also will require specific Excess limits depending on the size and use of the building, which oftentimes will require an Umbrella or Excess Policy. Basic liability coverage typically will satisfy lender requirements. However, there are many areas where enhanced coverage can be put in place to provide additional protection. Some examples include separate limits per location, hired or non-owned automobile liability coverage and broadened contractual liability. In addition, many insurance companies that write coverage for commercial and multifamily real estate are specifically looking only to cover the lessors’ risk for that location. In the event you perform any construction activities at the location, coverage should be contemplated under your polices, as well.
Lenders may require other policies, such as workers’ compensation or automobile or pollution coverages, but understanding your risk is important to make sure you have a comprehensive risk management program in place, regardless of their requirements. By ensuring your properties are well maintained and mitigating loss wherever possible, you will improve the risk profile of your locations, thus reducing the long-term cost of insurance. Some additional considerations worth contemplating include periodic loss control inspections, proper maintenance of equipment and mechanical systems, and programs focused on mitigating hazards, such as slip-and-fall situations as discussed in the Ask the Expert column on page 2 of this issue.
Philadelphia, PA, 19102