REDUCE REO INSURANCE COSTS by Dave Duffy

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With today’s growing REO portfolios, it is critical that  lenders and investors become familiar with the dynamics of REO insurance and how to reduce the premium costs.  

REO is a different topic of insurance than lender-placed or forced order insurance.  Forced order insurance applies to properties where the borrower still retains title but has allowed his insurance to lapse or cancel.   The lender force places Fire insurance to make sure it’s loan balance is insured.   However, REO insurance transfers the risk directly to the lender, who becomes the owner of the property.  Here’s a quick checklist:

REO Insurance Check Up

Monthly Reporting Form:  A Monthly Reporting Form conserves cash flow by dividing annual premium into monthly installments.   The investor adds new REO and deletes sold REO as they go along.  The monthly billing reflects all the changes made during the month.   Simplicity of administration and accuracy of the billings can be just as important as the rates or coverage. 

Insure to Replacement Cost: The former loan balance, market value, or what was paid for the property have nothing to do with insurance.   Insurance focuses on repairing or replacing the building with like materials and construction.  Insurance does not include land.  The lender now owns the building and needs to insure it much like it would its own office building. Some REO policies retain Coinsurance and Replacement Cost provisions.  If the property is insured to less than 80% of replacement cost, it’s a good bet that the lender will only receive an Actual Cash Value (Cost to repair minus depreciation) or coinsurance adjusted settlement.  This could be far less than needed to make the repairs or rebuild the property.  Make sure coinsurance is deleted and insure near to replacement cost.

Be aware of exclusions: Most lender-placed/REO master policies provide Special Form coverage on dwellings and delete the vacancy clause that relates to the peril of Vandalism.  Fire policies limit coverage in four areas if a home is vacant.   

1. Vandalism, Theft of Building Parts, and Glass Breakage are not covered after 30 days of vacancy.  If the policy extends coverage for Theft, this applies to building parts only, not contents in the structure.  If you were to turn a building on its side, anything permanently attached that wouldn’t fall out, is usually classified as building coverage.  Theft is excluded in some REO policies so confirm this coverage.  Glass coverage can also be purchased but seldom is. 

1. Water Damage caused by frozen pipes or sudden bursting pipes is excluded if:
   1. the heat is not left on in the building
   2. water is not turned off and pipes drained.   

If the property is vacant and water left on, this can be a huge exposure to uninsured loss.   

A Dwelling Basic Form DP1 provides no Water Damage coverage.  This is only what used to be called Fire, ECE, and V&MM.  Water Damage is a covered peril under DP2 Broad Form or DP3 Special Form.   

Regarding Commercial properties, Basic Perils do not provide coverage for Water Damage either.  Broad Form or Special Form is needed to cover Water Damage. Commercial properties also may require more extensive coverage such as Equipment (Boiler and Machinery), Signs, Ordinance or Law, Pollution Cleanup, or Builders Risk that lender-placed programs generally don’t contemplate.  These perils may be added to many REO master polices.

Deductibles:   As a general rule, a minimum $1000 deductible should apply to REO.  Most insurers offer $2,500 and $5,000 or higher deductibles, which are usually good trade-offs in savings.  Also, consider a higher Vandalism Only deductible.  Frequency of small, nuisance claims will eventually lead to rate increases.

Limits:  Master policy lmits of $1,000,0000-$5,000,000 are readily available.  If a lender services CMBS or commercial REO, some insurers can provide limits up to $20,000,000.  It is critical that the REO insurer have the capacity and reinsurance to match the REO portfolio. 

Portfolio Distribution:  Generally, Western & Midwestern portfolios enjoy lower rates.   Be aware of buying REO in Florida and all Gulf states in the first tier counties will be a cost factor from an insurance standpoint.  Insurance rates are considerably higher if the REO is in these areas.   

Liability:  REO is what underwriters classify as an “attractive nuisance.”  Vacant property entices children to play on the premise as well as attracts vandals and vagrants to beat the security. Even though they are trespassing, most likely the lender will be held liable if they get injured.  Another common source of liability claims is from real estate agents and prospective buyers getting hurt when viewing the property.  Severity of claims involving death or serious injury can be catastrophic and easily in exceed of $1,000,000 so an umbrella should be considered.   

If the REO is commercial, only a handful of specialty carriers will provide primary liability coverage on the premises and even fewer if there is an operating business.  The programs usually provide $1,000,000 per occurrence/ $2,000,000 aggregate. The primary liability limit should be coordinated with the lender’s insurance agent to make sure it meets the underlying requirement of the corporate umbrella.   This avoids the aggravation and costs of filling gap layers.

Flood insurance: This exposure is often overlooked by private lenders and investors.  If a property is in a Special Flood Hazard Area, Zones (A or V pre-fixes), flood insurance is required if the lender is federally regulated.  Floods can occur just about anywhere but these are high-risk flood zones.  A National Flood Insurance Plan Flood Policy (NFIP) or private insurer flood products designed for loan servicers are readily available.    

Monthly inspections:  It is important the investor is aware of the condition of the property at all times. Regular inspection may even be a condition of coverage in some policies.  Failure to regularly inspect and take corrective measures may negate a claim payment by some insurers.  An experienced REO real estate agent communicating with a proactive lender can go a long way in mitigating losses. 

Dave Duffy is Senior Vice President for Seattle Specialty Insurance Service.  Dave has specialized in REO and Lender-Placed Insurance since 1978. He may be reached at (800) 597-1866 or Dave.Duffy@SeattleSpecialtyInsurance.com