Chapter 16

Protecting Your Investment: Insurance and Risk Management

In This Chapter

Creating your risk management plan

Looking into insurance options

After years of accumulating resources, every investment property owner needs to be concerned about protecting her assets through insurance and risk management programs. After working and sacrificing to build your wealth through real estate, don’t be careless and lose it.

The concept of risk management includes much more than simply having an insurance policy. You need to take care to practice proper maintenance and record-keeping and require that others provide you with coverage for their activities. That’s what this chapter is all about.

Developing a Risk Management Plan

Many people get into the world of rental real estate without knowing how much risk they’re exposed to just by owning real estate. You may read stories in the newspaper about lawsuits against deep-pocket defendants without much personal concern, but it’s a reality shock when you’re suddenly considered to be the one with those deep pockets.

Real estate investment property owners need a plan to minimize risks because they’re frequent targets of those who suffer a personal injury or whose property is damaged. Many studies have shown that real estate rental property owners are sued more than any other single type of business entity.

But you can take steps to reduce and control your risk. Consider the following suggestions as preventive actions to minimize the potential of being named in a lawsuit:

• Regularly inspect the property as part of a thorough maintenance program. One of the easiest ways to minimize the potential of being named in a lawsuit is to routinely inspect your property and correct any noted deficiencies, such as health or safety problems. Be sure to comply with all advance notice of entry requirements and access limitation laws before going into the rental unit or going onto the tenants’ exclusive exterior areas. Make and retain copies of your inspections and document that all items were promptly and professionally addressed.
• Listen to and address tenant complaints. Be open and responsive to feedback from your tenants and others expressing concerns. A track record of quick response to complaints is the best defense if you find yourself defending a claim or lawsuit alleging an injury or property damage due to your negligence.
• Transfer the risk to others. Transferring risk from the owner and property manager to the vendor or supplier is sound policy for managing and minimizing risk. You can do this contractually by only using licensed and qualified contractors and suppliers who provide their own insurance coverage. Require that they provide written evidence that they have proper insurance coverage in place naming you individually and the legal entity that actually holds title to your investment property as an additional insured prior to performing work or providing materials.

  If you use a management company to handle the property management for you, make sure that they require insurance declaration forms from all vendors and suppliers documenting $1 million minimum coverage limits prior to doing any work or even making deliveries to your property.

• Remove certain risks or never allow them in the first place. For example, many owners and managers of residential properties have removed diving boards and pool slides. Commercial property owners have restricted access to the roofs of their buildings with emergency door hardware.

Although you can minimize your risks by taking some of these steps, you can’t eliminate all risks completely, and that’s why you need proper insurance coverage. Insurance is a vital element in a risk-management program.

Getting the Insurance You Need

As the owner of investment real estate, insurance coverage is one of your best protections and an essential risk management technique to ensure that you hold on to the wealth that you create.

If you’ve ever sat down with a sharp and assertive insurance agent, you may know that some insurance companies sell you coverage against any possible danger or loss in the world. Experienced insurance agents seem to have mastered the art of describing all sorts of horrible problems that may befall your investment property. But you need to sift through the sales pitch, do further research, and decide which coverage is right for you — and make sure you’re covered at a reasonable cost.

Your goal is to pay only for coverage for events and losses that can occur at your property. The right insurance coverage is worth a lot, but use resources wisely — hurricane insurance in Minnesota isn’t worthy of your precious insurance dollars.

You need to be concerned about lawsuits and having the proper insurance coverage to defend yourself and protect your assets. Insurance not only provides protection against actual losses but also provides a legal defense against the claims made against you as the owner of real estate. The expense of retaining competent legal counsel is what makes the threat of a lawsuit so devastating to many real estate investors.

Don’t assume that all potential losses are covered by your insurance coverage. Your best defense against losses is to properly manage your rentals and assertively eliminate, transfer, or control the inherent risks of owning and managing rental property.

Understanding insurance options

The proper insurance coverage can protect you from losses caused by many dangers, including fire, storms, burglary, and vandalism. A comprehensive policy also includes liability insurance, covering injuries or losses suffered by others as the result of defective or dangerous conditions on the property. Liability insurance also covers the legal costs of defending personal injury lawsuits — a valuable feature because the legal defense costs of these cases are commonly much greater than the ultimate award of damages, if any.

Common coverages

The following list describes the three levels of coverage available for primary policies, all of which include liability coverage. Many insurance companies offer competitive insurance packages especially designed to meet the needs of rental property owners, so remember to shop around.

• Basic coverage: Most companies offer a basic coverage package that insures your investment rental property against loss from fire, lightning, explosion, windstorm or hail, smoke, aircraft or vehicles, riot or civil commotion, vandalism, sprinkler leakage, and even volcanic eruptions.

  This coverage often doesn’t include certain contents, such as boilers, equipment, and machinery unless specifically added as an endorsement. Based on the type of property you have, you may need to consult with your insurance agent about additional coverage that may be beneficial.

  But just because you own a small retail strip center with a couple of plate glass windows doesn’t mean you need to have the special coverage that’s offered. Insurance companies often have minimum policy premiums, so certain insurable items and acts aren’t worth insuring because the potential for a claim is minimal and the costs are high.

• Broad-form coverage: You get the basic package, plus protection against losses of glass breakage, falling objects, weight of snow or ice, water damage associated with plumbing problems, and collapse from certain specific causes.
• Special form: This coverage is the broadest available and covers your property against all losses, except those specifically excluded from the policy. It offers the highest level of protection and may not be much more expensive, but is often a good value. Additional coverages included with special form that are helpful to landlords include vandalism, malicious mischief, and theft — for that occasion when your tenant under eviction decides to vandalize and damage your rental property as they skip out in the middle of the night!

An insurance company can pay owners for losses in two ways:

• Actual cash value: The coverage pays the cost of replacing property less physical depreciation. The standard policies most insurance companies offer provide for actual cash value coverage only.
• Replacement cost: This coverage pays the cost of replacing the property without subtracting for physical depreciation. You must specifically have an endorsement and pay extra for replacement cost coverage. However, we do encourage you to purchase it.

As with homeowners’ insurance policies, the location, age, type, and quality of construction of your property are significant factors in determining your insurance premiums. Be sure to get an insurance estimate before you buy your property to avoid unpleasant surprises (older properties with wood shake shingles located away from fire protection may not even be insurable, for example) and realize the benefits of lower risk properties. For example, newer commercial buildings, and even some residential properties, were constructed with fire sprinklers and alarms that reduce your insurance premiums — so do hard-wired, permanently installed, and actively monitored intrusion alarms).

Some insurance companies have a coinsurance clause that requires rental property owners to carry a minimum amount of coverage. If you carry less than the minimum amount of coverage, the insurance company imposes a coinsurance penalty that reduces the payment on the loss by the same percentage of the insurance shortfall. For example, if you carry only $1 million in coverage when you should have $2 million, you’re only carrying 50 percent of the minimum required insured value. If the building suffers a loss, the insurance company pays only 50 percent of the loss.

Many rental property owners first become investors by renting out their former personal residences when they buy new homes. They may not realize they should immediately contact their insurance agent and have their homeowners policy converted to a landlord’s policy, which contains special coverage riders that aren’t in the typical homeowner’s policy. Because of the increased liability risk for rental properties, some insurance companies may not even offer this coverage, whereas others specialize in this business. Either way, obtain proper landlord’s coverage for your rental property, or you may face the possibility of having your claim denied.

If you own multiple investment or rental properties, consider

• A single insurance policy that covers all locations: Rather than have separate policies for each rental property, you can get better coverage with a single policy. For example, if you currently have three properties each with a $1 million policy, you could get a single policy with a $3 million limit at a more competitive cost.
• An aggregate deductible: An aggregate deductible is the portion of your loss that you essentially self-insure, because the losses at any of your three properties can go toward meeting the aggregate deductible.

Excess liability (umbrella) coverage

Excess liability (umbrella) coverage can be a cost-effective way to dramatically increase your liability protection and is designed to supplement your main or basic policies. An umbrella policy provides both additional and broader coverage beyond the limits of the basic commercial general liability insurance and other liability coverage and this coverage is only available after the primary policy limits have been exhausted.

Your primary policy may have liability limits of $500,000 or $1 million, but an umbrella policy can provide an additional $1 million in vital coverage at a cost of $2,500 to $5,000 per year. Depending on the value of your property and the value of the assets you’re seeking to protect, buying an umbrella liability policy with higher limits may make sense. Umbrella policies are available in increments of $1 million with even lower rates per dollar of coverage as the limits go higher. The most common umbrella coverage amount for the owners of large investment properties now is $5 million at an annual cost of approximately $5,000 to $8,000.

Purchase your umbrella policy from the same company that handles your underlying primary liability insurance package. The reason: If you have two different insurers rather than just one, the companies may have different agendas if legal problems arise.

Additional insurance options

A variety of other insurance coverages also make sense for most rental property owners:

• Loss-of-rents (or business interruption) coverage provides income (enabling you to make mortgage and other payments) if your property is severely damaged by fire or another calamity.
• Workers’ compensation insurance pays employees and covers their medical expenses if they’re injured or become ill as a result of their job. There are workers’ compensation laws in all states; be sure to fully comply with them. This insurance coverage is often available through a government agency, whereas private insurance companies also offer coverage in other areas.

  Although some states may not require you to carry this coverage unless you have a minimum number of employees, we advise carrying workers’ compensation coverage even if you don’t have any employees. For example, any contractor you hire to perform work on your rental property should have his own workers’ compensation insurance policy to cover all of his employees. However, if someone gets hurt and the contractor has limited or even no coverage, his injured employee may target you for compensation. Don’t take chances; this coverage can often be added to your standard insurance policy for little cost.

• Non-owned auto liability coverage protects you from liability for accidents and injuries caused by your employees while working and using their own vehicle. Also, require them to provide proof of a valid driver’s license (with a clean driving record) and proof that they currently have their own auto and liability coverage with reasonable limits.

• Fidelity bonds provide reimbursement if you have a dishonest employee who steals your rents.
• Endorsement for money and securities covers losses caused by dishonest acts of nonemployees.
• Building ordinance insurance covers the costs of demolition and cleanup, plus the increased costs to rebuild if your rental property is partially or fully destroyed and the property needs to meet new or stricter building code requirements. This coverage is extremely important if your property is built at a higher density (more units or square footage or beyond height limits) than current zoning allows; it compensates you for the lost property value if you can’t rebuild the same size building.

• Flood, hurricane, and earthquake insurance are examples of coverage available for a separate cost. This coverage can be critical in the event of a natural disaster. However, these policies often are expensive with extremely high deductibles, making them unattractive for the average small rental property owner. Get quotes nonetheless, and see whether it’s something you think you can afford.

Mold: The heir-apparent to asbestos

One coverage that’s becoming much more difficult to obtain is a type of environmental insurance that specifically covers mold, fungus, and related issues. The number and magnitude of mold claims by tenants of both residential and commercial type properties have become a real challenge to the insurance industry, with some highly publicized lawsuits claiming huge property damage and severe personal injury claims. Although certain insurance companies still offer limited coverage for mold and related causes, specifically inquire as to the exact protection included in your policy. Some policies don’t cover actual damages for property and personal injury but do offer a legal defense.

The best way to avoid claims of property damage and personal injury from mold is to properly maintain your property and only turn over possession of the rental unit or suite in good condition that’s documented in writing. The challenge with most mold claims is that water intrusion and the subsequent concerns about mold typically occur within the tenant’s space in areas where the owner has no access or control. Or the tenant can even be the cause of the source of moisture through negligence or inadequate cleaning.

Thus, the rental property owner must rely on the tenant to minimize the likelihood of mold as well as report any concerns immediately. Many owners now use a lease addendum advising tenants of their responsibilities in this area. (See Robert’s Property Management Kit For Dummies [John Wiley & Sons, Inc.] for the latest on mold claims and more than 200 forms to use when managing your rental properties.) Rental property owners should respond to all tenant concerns promptly and professionally while routinely inspecting accessible areas.

Determining the right deductible

The deductible is the amount of money that you must pay out-of-pocket before your insurance coverage kicks in and is a form of self-insurance (covering the potential loss yourself). Typically, deductibles for small rental property owners range from $500 to $1,000; larger real estate portfolios have much higher deductibles of $5,000 to $10,000. The higher the deductible, the lower is your insurance premium. As your financial ability to self-insure grows, evaluate the possibility of having a higher deductible and using your savings to purchase other important coverage.

Selecting potential insurers

The coverage you can get as a rental property owner varies among insurers, with some firms specializing in real estate. Be sure to interview and select a qualified insurance broker or agent who understands your unique needs. The insurance professional can then provide you with information on the kinds of coverage worth considering. Insurance professionals are either independent brokers or exclusive agents who just write policies for one company.

As with any competitive product or service, speak with multiple independent insurance brokers and a couple of exclusive company agents to ensure that you receive the best value on desired insurance coverage. Keep in mind that the lowest premium is often not the best policy or value for your specific needs.

In addition to the price of a policy and the insurer’s reputation and track record for paying claims, an insurer’s financial health is an important consideration when you choose a company. Insurers can go belly up. Major rating agencies that research and evaluate the financial health of insurance companies include A. M. Best, Moody’s, Standard & Poor’s, Fitch, and Weiss. Each rating agency uses a different letter-grade system. Some companies use AAA as their highest rating, and then AA, A, BBB, BB, and so on. Others use A, A–, B+, B, B–, and so on.

During the financial crisis of 2008, as well as during other times, you may have heard about some insurers getting into trouble despite prior high ratings. That happens, but don’t worry about an insurer going belly up and not paying claims. Insurers are regulated and overseen at the state (and federal) level and troubled insurers are merged into stronger ones.

Just as it’s a good idea to get more than one medical opinion, two or three financial ratings can give you a better sense of the safety of an insurance company. Stick with companies that are in the top two — or, at worst, three — levels on the different rating scales. You can obtain current rating information about insurance companies by asking your agent for a listing of the current ratings.

After you’ve made your decision as to which policies and insurers you want to do business with, be sure that you pay the premium, and insist on evidence that the insurance company has provided coverage. Typically, you receive a written binder as soon as you have coverage; however, your best proof of coverage is a formal certificate of insurance. The certificate of insurance is essential — prudent real estate owners never rely on verbal representations that they’re covered.

Talking with tenants about renter’s insurance

Renter’s insurance is secured by and paid for by your tenants and covers losses to the tenant’s personal or business property as a result of fire, theft, water damage, or other loss. As a rental property owner, you want to encourage your tenants to have this coverage. They pay the premium and you benefit from renter’s insurance because it covers any claims in the event that the tenant or her guest starts a fire or flood. This coverage also can help you avoid a claim in case a tenant’s guest was injured inside her rental unit or caused damage to the rental property.

One of the benefits of renter’s insurance is that when your tenant has a renter’s insurance policy to handle her claims, she is less likely to sue you or threaten you with a lawsuit. Also, if the tenant makes claims against her own policy, then the tenant’s premiums go up rather than yours.

Most commercial tenants have this coverage, but residential tenants often think they don’t need renter’s insurance because they have few valuables. But renter’s insurance covers much more than just their personal possessions; it also protects against liability claims made by injured guests or visitors. The insurance also offers supplemental living expenses if the rental unit becomes uninhabitable due to fire or smoke damage. And it protects the tenant in the event that the tenant causes damage to another tenant’s property. Robert has seen several such lawsuits resulting from the negligence of one tenant who caused an overflowing toilet, bathtub, or sink in her rental unit to become a waterfall into the downstairs unit or common area. You can suggest or even require that your tenants carry renter’s insurance, but be aware that in some areas your competitors may not follow your lead and you may find that you’d have trouble keeping your rentals occupied if you insisted that your tenants carry renter’s insurance.

Dealing with claims

Record all the facts as soon as an incident occurs on your rental property, particularly if it involves injury. Because one of the primary issues in contention is the property condition at the time of the incident, a digital camera is extremely helpful to document facts and minimize extensive disagreements or discussions at a later date or during litigation. You can also use a recording device if you have obtained permission in advance from those involved (preferably the acknowledgment should be in writing).

Be sure to immediately contact your insurance company or your insurance agent. Follow up with a written letter to ensure they were notified and have the information on file.

Put a reliable filing system in place to keep documents handy because litigation may not occur until years after the incident. For example, if a young child is hurt on your property, the statute of limitations doesn’t begin until the child has reached 18 years of age. In these cases, the tenancy records and maintenance records may be subpoenaed and be critical to defending your actions of up to 20 years ago.