Real Estate Insurance: The Transfer of Risk
A breakdown of the different ways you can (and should) insure against risk
Today we are going to dive into the world of real estate insurance.
I have spent a LOT of time on this subject in the 20+ years I worked full time for real estate companies.
Insurance is a fascinating financial product that shares similarities to:
Private equity, venture capital, and stock investing.
Investment banking.
Sports betting and assembling a professional sports team.
In each case someone is making a calculated and well researched investment (or bet) in hopes that they will make money.
Insurance is a financial instrument where insurance companies earn smaller guaranteed payments (premiums) while putting big dollars at risk (claims). Their goal is to make more money on the premiums than they pay out in claims over years and decades.
I will break down the basics of real estate insurance in a way you can understand and use. As a real estate investor, you will need (and likely be required to carry) insurance to protect you, your investors, your lender, and your property.
Today we will cover:
What insurance actually is
Types of real estate insurance
Premiums, limits, deductibles, policy term, & exclusions
Insurance policies
Insurance certificates
Lender insurance requirements
Working with an insurance broker
How to handle an insurance claims
Why you should strive to be a good customer to the insurance carriers
Let’s dig in.
What Insurance Actually Is
At its most basic level, insurance is a financial transaction: small amounts of guaranteed money for major risk protection.
For example, you own a property that would cost $200,000 to re-build if it were destroyed. You don’t have $200,000 sitting around, so you would be in a bind if the property were destroyed.
Enter the insurance company aka carrier (ex. State Farm, Liberty, Allstate, etc).
They offer to insure the property for $1,000 per year.
You pay the $1,000 at the beginning of the one year policy.
The insurance carrier will pay the cost to rebuild the property IF it is destroyed. Either way, they keep the money you paid them.
This same concept applies to many other types of insurance: auto, life, health.
The person buying insurance pays a small fixed amount. The insurance carrier keeps the money and only pays if there is a claim (damage, a medical procedure, etc.).
Now let’s get specific to real estate insurance.
Types of Real Estate Insurance
I am going to focus on insurance you would have as a personal real estate investor.
[Note: if you own a real estate company (or any other company) with employees, there are many other types of “corporate” insurance you would want such as worker’s compensation, crime, etc. Talk with your insurance broker to learn more.]
There are two types of insurance you will want as a real estate investor: property and liability.
Property Insurance - Insuring Physical Objects
Property insurance covers physical objects from damage, theft, and destruction. Effectively, anything that could harm the object. In the case of real estate, “objects” are:
The building and anything attached to it such as HVAC and lighting.
Any supplies stored in the building such as light bulbs and carpeting.
12-24 months of rental income you could lose while the building is being repaired if the tenants are unable to occupy the building and pay rent.
Think of property insurance as insuring against damage. How could the property be damaged? Fire, theft, hail, storm, wind, earthquake. It could be anything.
Liability insurance is totally different.
Liability Insurance - Insuring You From Being Sued
Liability insurance covers you if you are sued.
Let’s say your tenant or one of their customers/employees trips just in front of the entrance to the tenant’s suite. They break their arm and have medical bills. They could sue you.
If you are sued, the liability insurance coverage kicks in to defend the lawsuit and pay for damages (if any).
In summary, property insurance protects the building and rents. Liability insurance protects you if you are sued.
Pro tip: For additional liability protection beyond your standard policy, consider an umbrella policy that provides extra coverage (typically $1-5M) for a relatively low premium.
Additional Pro Tip: If you are developing a property from the ground up, property insurance will be known as “Builder’s Risk” and liability insurance will be known as “Owner’s Interest”.
So far, so good.
Now let’s dive a level deeper.
Premiums, Limits, Deductibles, Policy Term, & Exclusions
There are five key factors that come into play with insurance:
Premiums: how much you have to pay for insurance each year.
Limits: the maximum amount the insurance carrier will pay if there is a claim.
Deductibles: a small amount you pay if there is a claim (in addition to the premiums).
Policy Term: the length of the policy (ex. 12 months).
Exclusions: what is NOT covered.
Let’s briefly discuss each one.
Premiums
Premiums are the fees you as the person buying insurance pay. It is the insurance carrier’s revenue.
Limits
Limits are the maximum amount the insurance carrier will pay if there is a claim. Two examples:
$200,000 property claim and the policy limit is $150,000.
The carrier will pay $150,000 (policy limit < claim).
$100,000 property claim and the policy limit is $150,000.
The carrier will pay $100,000 (policy limit > claim).
Pay attention to your limits to make sure they give you adequate coverage.
Deductibles
If you have ever paid attention to a health insurance claim, you are probably familiar with a deductible. It is the additional amount you have to pay (in addition to your premium) in the event there is a claim. In the $200,000 example above, the deductible might be $1,000. You would pay this as part of the claim, but you only pay it in the event that there is a claim. The concept is that you will have to cover minor costs and the insurance carrier only steps in for more “major” claims.
Policy Term
This is the length of the policy. Most policies for real estate are 12 months.
Exclusions
Certain events will not be covered under your typical property or liability policy. If you want this coverage, you will need to buy a separate (and often more expensive) policy for this specific risk. Sometimes they are included in your property policy with higher deductibles. Examples of exclusions include: (i) earthquake risk in California, Oregon, and Washington, (ii) hurricane risk in the Gulf of Mexico region, (iii) hail risk in Colorado and Texas, and (iv) environmental pollution.
Note that “wear and tear” is almost never covered by insurance. The 20 year old HVAC unit that stops working will not be a covered claim.
Pro Tip: Look out for “vacancy exclusions”. Vacant buildings are at higher risk for theft and vandalism. Most policies exclude coverage for vandalism and theft for buildings (not suites) that have been vacant for 90+ days. Make sure you read your policy to understand this risk and consider better lighting and/or security for vacant buildings.
Let’s transition to the actual policy.
Insurance Policies
An insurance policy is the document provided by the insurance carrier. It is a legal document that outlines all the terms of the policy.
In an ideal world you would receive a draft of the document 30 days before the start of your policy period. In the real world, these normally come 10-60 days after the policy starts.
A good insurance broker will help you negotiate the best deal points of the policy and compare the options from multiple insurance carriers.
Think of the insurance policy as adding all the specific details of the items we have discussed so far (premiums, limits, deductibles, etc.).
The policies are long and written as legal documents. For the industrial property I own, the policy is 50+ pages. A practical approach for those of you who cringe at the idea of reading one is to focus on the following:
Is your name and/or legal entity correct?
Is the property address correct?
Are the dates in the policy term correct?
Review the premium, limits, deductibles, policy term, & exclusions.
Review the vacancy exclusion language.
Make sure you know who to contact if you have a claim.
Most of the time you won’t have a claim. But when you do, you don’t want to be caught discovering that you didn’t have the coverage you thought you did.
Is there an easier way to understand your policy?
Yes.
Enter insurance certificates.
Insurance Certificates
Whereas a policy includes all the legal language of your policy, an insurance certificate is a one page document that summarizes your policy.
It will list the type of coverage (property, liability), limits, deductibles, policy term, and sometimes exclusions.
It is also where the insurance carrier will add “additional insured” parties as required by other documents you sign such as a property management agreement or loan agreement.
An “additional insured” has limited coverage under your policy in the event of a claim without having to pay anything for this coverage.
This is especially true for lenders.
Lender Insurance Requirements
If you have a loan on your property, you will have a set of loan documents as discussed in Debt: An Amazing Tool with Strings Attached.
The loan documents will list various lender insurance requirements that must be met for the lender to give you the loan.
These could include:
The types of coverage: property, liability, earthquake, etc.
The amount of coverage: example - property insurance equal to the full replacement cost of the building.
The maximum deductible allowed: example - $1,000 or $5,000.
Make sure you price out insurance coverage that meets the lender requirements BEFORE you sign the loan agreement.
An insurance broker can be very helpful in this process
Working With an Insurance Broker
You want to work with an insurance broker that specializes in real estate insurance.
They will help you compare insurance options to find the best combination of price and coverage. They know what is “market” and they will help you find the right fit for you.
Ask people you know who have invested in similar properties for a referral. A good insurance broker will make a world of difference.
They will also help you work your way through a claim.
How to Handle Insurance Claims
Insurance claims are a whole separate animal. They can be simple or long and tedious.
I won’t go into much detail, but here are what I believe are the best practices having navigated claims ranging in size from $25,000 to $10,000,000+.
Communicate early. If you think there MAY be a claim, let your insurance broker and carrier know immediately. There is no penalty or risk of an increased premium next year if there doesn’t end of being a claim.
Ask questions. You will likely be assigned a “claims adjuster” by the insurance carrier. Ask for clarification of the process and timeline.
Be persistent. Claims adjusters often have an unmanageable workload. Don’t be a jerk, but be persistent.
It is a process. Not a fun one, but one that can be navigated. It will help if you are already a good customer.
A note on asset classes and claims. Different asset classes tend to have different types of claims and frequency of those claims.
Multifamily and 1-4 Unit Residential: highest claim volume from “slip and falls” and kitchen fires.
Retail and Office: “slip and falls” are most common claims.
Industrial: theft of copper and other “recyclable” materials are most common claims.
Go in eyes wide open as you consider your asset class and strive to be a good customer.
Why You Should Strive to Be a Good Customer to the Insurance Carriers
What does it mean to be a good customer to the insurance carrier? It means:
You pay your premiums on time. This is their revenue.
You maintain your property well and have good standard operating procedures. This leads to lower risks of claims.
You are loyal. You don’t switch carriers every year.
An insurance company will look at you (their customer) in terms of how you have performed over the life of the relationship. Remember that their goal is to make more money on the premiums than they pay out in claims over years and decades.
You are more likely to have lower premiums each year (and a better claim outcome) if you have been a customer for five years without a claim than if you are three months into your first policy year with the company.
Don’t necessarily change carriers every year to save a few bucks. Think of it as a long term partnership.
Pro tip: as you build up a portfolio of properties, look into putting them into a single “portfolio” insurance policy. This could save you money and make things simpler to operate.
Closing Thoughts
Don’t be intimidated by insurance. Understand that it plays an important role in the world of real estate investing.
View it with curiosity and always be learning.