Are you underinsured? More than likely.
Even though it’s a vital part of a successful real estate investing strategy, insurance is often overlooked by real estate investors and landlords. Given rapidly rising construction costs and the liability landlords face, if you haven’t reviewed your insurance policies lately, there’s a good chance you’re underinsured. In the event of a partial property loss, total loss, or liability lawsuit, if you don’t have the proper insurance, you could find yourself financially devastated, your investing career over, or even worse, your life savings in jeopardy.
With the proper insurance, you’re able hedge yourself against the risk of major loss that would otherwise wreak financial havoc. However, the answer isn’t necessarily having more insurance—usually, it’s about having the correct type of insurance and the correct coverage for your unique risk and exposure.
So how do you determine how much insurance you really need?
1. What is your risk?
Risk is the probability of a negative outcome. Every property has a different risk profile. A single-family rental home with just one tenant carries a very different risk than an apartment complex with thirty tenants. Even if the home and apartment complex are worth the same amount, likelihood of a fire, tenant lawsuit, or other catastrophic event increases with each additional tenant.
A rental property surrounded by farm land has a different risk than a rental property located in the middle of a city sandwiched between other rental properties. If one property catches on fire, they all catch on fire. Of course, if your rental property in the countryside does managed to catch on fire, it may burn to the ground before the fire department can arrive.
When determining how much insurance you need the first thing you want to consider is the risk profile for your property. The higher the risk, the greater the need for good insurance coverage.
2. What is your exposure?
Your exposure is the amount of financial loss you face in the event of a loss. In other words, if something bad happens to, with or on your property, how much could it potentially cost you? This is a big one! Because every real estate investor is in a different financial situation.
Let’s assume you’ve just purchased your first income property. You’re twenty-nine years old, fresh out of medical school and you make $70,000 a year. You have $50,000 in student debt, no savings to speak of, and were just barely able to scrounge up the $64,000 down payment on the loan for a $300,000 investment property you just purchased. What is your exposure? Realistically, about $64,000. If you’re sued by a tenant for $1,000,000 what is the total amount they’re likely to collect in a judgement? $64,000—it’s all you’re worth. So how much insurance do you really need?
Fast forward twenty years. You’re now forty-nine years old, run a successful medical practice, make $400,000 a year, have a networth north of $3,000,000 and own several investment properties. What is your exposure now? At least $3,000,000—if not more. What happens if you get sued for $1,000,000 and are found liable? Nothing good—and that’s putting it mildly.
When determining how much insurance you need, carefully consider your exposure. Exposure extends beyond what you have invested in an individual property. It encompasses your entire financial situation.
3. Pay attention to ratings.
If you’ve owned rental properties very long, you’ve probably have heard the phrase, “A-rated insurance company.” But what exactly is an “A” rated insurance company and why does it matter?
Ratings in the insurance world are a measure of creditworthiness and financial stability. The higher the rating of an insurance company, the greater its ability to repay customer claims in the event of a loss. Rating systems are in place to allow consumers to evaluate an insurance company relative to its peers. Typically, an insurance company with an “A” rating has greater financial stability and wherewithal to pay claims than an insurance company with a “C” or “D” rating.
However, not all “A” ratings are the same. Ratings are determined by independent insurance ratings organizations—and each organization uses its own formula for determining what constitutes creditworthiness. In fact, “A” ratings may vary between the different rating organizations. The main insurance rating organizations include:
- A.M. Best
- Standard & Poor’s
If you have a million dollar policy with a “C” rated insurance company, you may still be underinsured. What good is a million dollar policy if the company who underwrites it may not be around to payout on claims?
4. Review your coverage classifications.
Not all insurance policies are created equal—even when they may appear to be. There are three rental dwelling policy classifications you need to become familiar with: DP1, DP2 and DP3.
The DP1 insurance policy is the most basic insurance policy available for rental properties. It is a “named risk” dwelling insurance policy. This means it only covers perils that are specifically named in the policy. These usually include:
- Fire & Lightning
- Internal & External Explosion
- Windstorm & Hail
- Riot & Civil Commotion
- Volcanic Explosion
- Vandalism & Malicious Mischief
Another important characteristic of most DP1 insurance policies is that they are Actual Cash Value (ACV) insurance policies. An ACV dwelling insurance policy is much like a car policy; the older your rental gets, the less your policy will pay out. If you ever have a major loss, depreciation will be deducted from from any damages you are awarded after the claim. How would you feel to have a $200,000 loss only to find out that your policy will only cover a mere $130,000?
Not surprisingly, the DP1 policy is the least expensive of all rental policies. If you have a really low premium for your rental insurance, you may want to check and see if it’s a DP1 policy. Occassionally, an insurance agent will sell a DP1 policy to an unsuspecting landlord to reduce the cost of insurance. Most DP1 policies leave landlords grossly underinsured.
DP2 insurance polices, like DP1 policies, are named risk insurance policies. However, the DP2 policy offers a more extensive list of covered perils than a DP1 insurance policy. The DP2 policy is considered a middle-of-the-road landlord policy that provides average protection. The biggest distinction between DP1 and DP2 insurance policies is that the DP2 is a replacement cost insurance policy. This means, if your rental property is damaged, your policy will pay the cost of the repair in full without any out of pocket expense other than your deductible.
DP3 insurance is the best insurance policy you can purchase for rental properties in the United States. Most DP3 insurance policies are “open peril” policies. This means they cover all possible perils, with the exception of a small list of perils that are specifically excluded from the policy. Like DP2 policies, in the event of a loss, your DP3 policy will pay full replacement cost on your claim.
Most DP3 insurance policies also provide additional coverages for loss of rental income and liability claims. DP3 policies provide the most comprehensive coverage for Landlords who are looking to get excellent insurance for their rental property.
5. Make sure you’re meeting coinsurance requirements.
Coinsurance requirements often overlooked or forgotten. Typically, an insurance agent will make sure that coinsurance requirements are met when a policy is issued, but if the policy isn’t reviewed periodically, a coininsurance penalty may arise and the policy holder unknowingly ends up being underinsured.
For the majority of landlord policies, if the property is insured for less than 80% of its current replacement cost, it will be subject to a coininsurance penalty in the event of a loss. This means that if your rental property costs $400,000 to rebuild, and you are insured for less than $320,000, any claim made will be paid out at the same ratio. For example, let’s assume the value of your rental property is $400,000, and it’s insured for $200,000—so you’re insured at 50%. If you have a water pipe burst that causes $20,000 in damage, your insurance company will only pay 50% of the repair costs—$10,000 minus your deductible. Why? Because you were insured at only 50% of the value of your property and consequently incur a coinsurance penalty. Check to make sure your rental property is insured at full current replacement value.
6. Have adequate liability coverage.
These days liability is one of the biggest risks of loss to income property owners. Notwithstanding, most landlords do not maintain enough liability coverage. A $300,000 or $500,000 liability policy might sound like a lot—but it’s not.
So how much liability coverage do you need? It depends.
The two key elements in determining liability coverage are risk and exposure. The greater your risk, the more liability coverage you require. The greater your exposure, the more liability coverage you have.
If you own a small apartment complex with thirty tenants, you’re going to need more liability insurance than if you own a small rental home with just one tenant. Why? Because you face substantially more risk. Your apartment complex is thirty times more likely to have a tenant accident. Consequently, you’re thirty times more likely to face a lawsuit.
Your level of exposure also plays into how much liability insurance you should maintain. The greater your networth, the higher your liability limits should be. In a fair and impartial world, your personal wealth should not be a factor in a liability judgment. But don’t be naive. The wealthier your are, the more likely you’re going to be impugned for higher damages—especially if there’s an attorney involved. Just one bad lawsuit can wipe out a life’s savings. Having high liability limits is worth the nominal addition in premium payments.
As a rule of thumb, we recommend landlords have a minimum $1,000,000 per occurrence liability limit with a $2,000,000 aggregate for each property they own. This means that for each claim you’re covered up to $1,000,000 in actual damages per occurence and a maximum of $2,000,000 for the policy period.
7. Consider purchasing an umbrella policy.
Can you still be underinsured if you have high dwelling liability limits? Sometimes.
Landlord liability coverage is associated with your dwelling policy only. Hence, it protects you from inside liablity—or liablity that comes directly from your rental property. For example, if a tenant slips and falls your landlord policy will cover the liability claim—relieving you of any financial obligation for losses.
But what about outside liability—or liability that comes from outside of your rental property? For example, you’re involved in a car accident and found liable for $750,000 in damages. Unfortunately, your auto insurance policy only has a $250,000 limit. What happens now? Simple. The liability generated from your car accident now reaches out and attaches itself to all your other assets—including any equity you have in your rental property. Because of your accident, your rental property—and the income it generates—is put at risk.
This is where an umbrella policy can become a lifesaver. The umbrella policy extends the liability limits of your personal insurance policies and fills in coverage gaps, whereby limiting an outside liability.