October 2010 The RMA Journal52

Credit Risk

••Construction lenders should have a blanket builder’s risk insurance policy in which the lender is the initial named insured.

ConstruCtion lenders have traditionally required their bor-rowers to provide builder’s risk hazard insurance at loan closing to protect the lender’s capital investment in the loan collateral. Long-standing industry risk management practices require that construction loan files include documentation of hazard insurance, but too often construction lenders discover that their capital investment has not been fully protected. New and improved best practices in this area of credit risk management should include a blanket builder’s risk policy in which the lender is the initial named insured.

Blanket Builder’s Risk Insurance Better Protects the Lender’s Exposure

by GreG DillarD

The RMA Journal October 2010 53

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Builder’s risk insurance is a temporary form of property insurance designed to protect buildings, primarily residen-tial structures, during the course of construction. In fact, it’s often referred to as “course of construction” insurance. Blanket builder’s risk policies are sometimes used to pro-vide property coverage on multiple construction projects at different locations. Most builder’s risk policies provide protection on an annual basis from the time construction begins until the completed structure is put to its intended use. However, the recent recession and the slowing of new home sales have prompted insurance companies to limit the number of multi-year renewal policies offered.

Construction lenders need better protection. They spend millions of dollars each year tracking builder’s risk insurance policies that were selected and purchased by their borrowers to protect primarily the lender’s capital investment at the construction site. If there is a problem with the builder’s risk insurance following a loss, it can also become a problem for the lender. Also, if there is a problem with the borrower resulting in a foreclosure, the lender typically loses the in-surance protection that was underwritten for the borrower.

Too many lenders treat hazard insurance, title policies, and surveys as “checklist items” without really understanding the document that has been submitted. How the lender is named as loss payee makes a big difference. Also, a form indicating evidence of insurance provides more proof of coverage than just the certificate of insurance. | by richarD hamm

rMa’s Course Construction Loan Management reviews the many documents involved in commercial con-struction loans, including various types of commer-cial insurance. And Greg Dillard’s article in this issue of the Journal does an excellent job of explaining the ins and outs of builder’s risk insurance.

Many years ago, RMA’s Commercial Lending Newsletter provided another excellent article on insurance—this time on the topic of how the bank is named as loss payee. Both articles address a com-mon shortfall of the loan documentation process: the tendency to treat documents as “checklist items,” or things to be collected and checked off the extensive list of due diligence in a typical construction loan. Collected, but not reviewed and understood.

When it comes to property hazard insurance, it makes a big difference how the bank is named as loss payee on the document that evidences the insurance. To summarize, being named as loss payee, certificate holder, or additional insured enables the bank to collect claims proceeds if the insured party is entitled to a claim. However, the stronger mortgagee or lender loss payable designations establish a separate contractual relationship between the insurance company and the bank, such that the bank can collect a claim without being subject to any defense the insurance company may have against the borrower, such as fraud or arson.

It’s generally recommended that lenders obtain ac-tual policies in order to know in detail the relationships among the borrower, lender, and insurance company.

Also Check Borrower’s Insurance Coverage for Lender

Loss Payable Designation

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October 2010 The RMA Journal54

Vacant-dwelling or real-estate-owned (REO) insurance adds to the lender’s costs if the borrower defaults.

Builder’s risk insurance faces other challenges. State insurance regulators do not classify it as prop-erty insurance, which has closely regulated rate filings and stan-dardized policy forms. Instead, builder’s risk insurance is typically regulated as an inland marine form of insur-ance, characterized by

rate filings that offer much more flexibility and policy forms as well as coverage that may vary significantly from one insurance company to another. For instance, some insurance companies provide lower coverage limits or higher deductibles for theft and vandalism losses. (This is especially true given the recent frequency of copper theft from construction sites.)

Coinsurance ClauseSome, but not all, builder’s risk policies include a coinsur-ance clause. Coinsurance clauses can reduce claim payments following a loss if the borrower has not purchased insur-ance equal to value. Lenders and borrowers are inclined to purchase builder’s risk insurance equal to the loan amount. However, if the borrower or owner has invested substantial equity, insuring for the loan amount may subject both the lender and the borrower to a coinsurance penalty in the event of a significant loss. Preferred builder’s risk policies do not contain a coinsurance clause.

Soft Costs CoverageSoft costs coverage is automatically included by some carriers, while other insurance companies offer the pro-tection as an option subject to additional premium. Soft costs coverage provides payment for some of the tangible indirect costs incurred following a major loss, such as loan origination fees, realty taxes, architects’ and engineering charges, legal and accounting fees, interest expense on the loan extension, and other necessary expenses incurred to expedite repair. Preferred builder’s risk policies provide soft costs coverage at no additional cost to the borrower.

In addition, most builder’s risk policies do not pro-vide earthquake coverage, though the coverage is readily available in most areas of the United States. Imagine for a moment that the devastation in Haiti or Chile was cen-tered in the most concentrated area of your construction loan portfolio. Then imagine learning after the fact that earthquake damage is not covered by most of the policies your borrowers purchased to insure their construction projects. Some changes should be made to the bank’s

standards for builder’s risk policies to protect the lender against a potentially devastating peril that individual bor-rowers routinely choose to self-insure when the lender can ill afford to assume the aggregate risk.

Lenders Need to Be ReadyTable 1 offers some aggregate numbers to consider. The U.S. population exceeded 300 million in July 2008 and continues to add more than 3 million legal residents through birth and naturalization each year. While the 2010 Census will provide more current data, it has been estimated that the United States needs to produce more than 1 million new housing units per year to replace demolished housing stock and to house the growing population.

During 2009, the U.S. produced just 572,200 new hous-ing units, including only 435,100 single-family homes. Housing is one major industry where production takes place primarily on site and the actual work is difficult, if not impossible, to outsource abroad. When the economy recovers, the banking industry will once again be called upon to finance the construction of new homes. This time, lenders should finance construction more profitably and with less risk.

Advantages of Blanket Builder’s Risk InsuranceBy aggregating more construction projects under blanket builder’s risk insurance policies, the banking industry can realize significant benefits:• Overheadexpensescanbereduced.• Broadercoveragecanbeprovided(includingcoverage

for theft, vandalism, earthquakes, and soft costs).• Morestableaggregatelossratioswillenableinsurance

Imagine for a moment that the devastation in Haiti or Chile was centered in the most concentrated area of your construction loan portfolio.

Table 1New Privately Owned Housing Units Authorized*

Year Total Single-Family Duplex 3 and 4 Units 5 or More Units

2000 1,592,300 1,198,100 30,600 34,300 329,300

2001 1,636,700 1,235,600 31,800 34,200 335,200

2002 1,747,700 1,332,600 37,200 36,600 341,400

2003 1,889,200 1,460,900 40,900 41,600 345,800

2004 2,070,100 1,613,400 43,000 47,400 366,200

2005 2,155,300 1,682,000 39,300 44,700 389,300

2006 1,838,900 1,378,200 35,300 41,300 384,100

2007 1,398,400 979,000 28,100 31,500 359,000

2008 905,400 575,600 16,800 17,600 295,400

2009 572,200 435,100 9,800 10,100 117,200

*Data from the U.S. Census Bureau.

The RMA Journal October 2010 55

underwriters to price the coverage with more certainty using a sharper pencil.The construction lender is the only stakeholder in the

construction loan transaction who can reduce transactional/operational risk and earn additional revenue by aggregat-ing builder’s risk property insurance on construction loan collateral. This position represents a tremendous untapped opportunity for practically every construction lender. His-torically, the construction lender has provided the majority of the capital invested at the job site. Why should the lender remain silent at loan origination, totally dependent on the borrower to select and purchase the insurance protection for the loan collateral?

Going forward, each construction lender should have a single, blanket builder’s risk insurance policy underwritten with the construction lender as the initial named insured. The administration of this blanket insurance policy should be automated via an online builder’s risk insurance facil-ity that will empower construction lenders to offer their construction loan clients the option to voluntarily purchase comprehensive builder’s risk protection at discounted rates under the lender’s policy. The plan is similar to offering group property insurance for both residential and commer-cial construction projects because, like other forms of group insurance, the coverage is provided under a single master contract that is more comprehensive and less expensive than individual policies or small-group coverage.

Borrowers should voluntarily purchase coverage online as an endorsement to their lender’s master contract at rates up to 25% lower than the borrowers could have obtained on their own. Both the borrower’s interest and the lender’s interest are covered by the blanket policy. However, con-struction lenders are better protected under the single, uniform blanket policy that continues providing prepaid protection for the lender’s investment even if the borrower defaults on his or her loan. Lenders enjoy leverage in the insurance market, which enables them to obtain the desired builder’s risk coverages under their uniform blanket policy.

A lender-based online builder’s risk facility can convert a source of risk for the lender—that the borrower will not provide comprehensive, continuous builder’s risk insur-ance to protect the lender’s investment—into a source of additional noninterest income for the lender via a referral fee or a commission paid to the lender’s licensed insurance subsidiary. The result is that builders will obtain broader coverage for less money while construction lenders earn more income with less risk. Offering lender-based builder’s risk insurance in conjunction with your construction loans is an idea worth considering. v

••Greg Dillard is president, OMNI Insurance Services, Winder, Georgia. He can be reached at gdillard@onlinebuildersrisk.com.

Unfortunately, many lenders rely more frequently on a certificate of insurance (a one-page summary of cover-age), declaration page (the first page of the policy), or agent’s binder (temporary evidence of coverage until the final policy is issued).

This brings up a final point: A certificate of insur-ance is not definitive evidence that a policy has been issued and is in full force and effect. The Association for Cooperative Operations Research and Develop-ment (ACORD) establishes various forms and insur-ance data standards. ACORD Form 24 is a certificate of property insurance, while ACORD Form 28 is evidence (preferred) of commercial property insur-ance. (See www.acord.org for a complete list of forms. This tip is courtesy of Michael L. Weissman. See his article on p. 56, “Lender’s Failure to Notify Insurer of Foreclosure Proceedings Invalidates Coverage.”)

As with any documentation, be sure to consult your bank’s loan policy and/or legal counsel for specific guidance on loss payee endorsements and the steps required to obtain and review evidence of insurance in all secured lending situations, not just commercial construction loans. v

••Richard Hamm is president of Advantage Consulting & Training, Huntsville, Alabama. He is also an RMA instructor and a member of The RMA Journal Edito-rial Advisory Board. He can be reached at advantagecons@bellsouth.net.

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