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Property Insurance And The Concept Of Indemnity
We’re going to talk about insurance, everyone’s favorite subject. Probably one of the most boring things in the world to talk about is insurance. However, as a private lender, insurance policies keep those properties that we invest in and we put liens upon. It keeps them safe and keeps us safe and our borrower safe. They’re a good thing. We want to talk to you about property insurance and the concept of indemnity, but before we get into all that fun stuff, I’d like to direct you over to the PrivateLenderPodcast.com/expo. This will be a link to take you to get tickets to the Quest Trust Company Self-Directed IRA Expo that’s happening in Houston. You get a 25% discount with the promo code PLPODCASTS. I don’t get any money from the tickets, but I get pride. Whether it’s realistic or not, my goal is to drive as many people more than any other sponsor at this event because it’s a cool thing to do. August 22nd, the night before the expo, there’s going to be a happy hour at the Royal Sonesta Bar. Come on out if you’re going to be in Houston. You can meet the vendors, a lot of VIPs and other people from Quest. I look forward to seeing everybody.
Let’s get into the heart and matter of the episode. Let’s talk about property insurance and the concept of indemnity. It is an insurance term that is often misunderstood. I want to walk you through a couple of terms and this is one of them. The word indemnity, to put you completely back in school though, it’s a Latin root, indemnis meaning unhurt, undamaged or without loss. That is at the heart and soul of every insurance policy. If something bad happens, then that policy will pay you back to get you to the position that you were in right before the incident occurred. To get back to where you were at the moment before the loss, that’s the whole idea. You’re not supposed to profit from insurance even though I think a lot of people do when it comes to claims, especially I’ve seen on houses. You can do some of the work yourself, save some money. You can make some money. The whole principle of the insurance is to put your property back to where it was right before whatever that incident was. That peril that occurred, whether it would be a hurricane, tornado, fire.
Indemnity insurance is a contractual agreement or an insurance policy in which one party guarantees compensation for the actual or potential losses that are sustained by another party. The insurance company promises to compensate or to pay for the cost of the insured. These policies indemnify or reimburse the assured against claims. That is where the big hang-up gets is with reimbursing. Reimburse is to pay a sum the money that has been spent or lost. The moral of that story is you must spend money in order to get the insurance money. That is the principle behind insurance policies. You’ll say, “Keith, State Farm cut me a check to get started and told me how much I was going to get for my whole claim and I hadn’t even spent a dime.” That often happens with consumer insurance because they’re afraid of bad faith. They don’t want to be seen as not handling claims properly. They’ll come in and a lot of times they’ll go ahead and put down what’s called the actual cash value. Let’s say for example, you have $100 widget that’s five or ten-years-old. The replacement cost is $100. It may only cost you $20 ten years ago, but now it’s $100. The actual cash value would be that replacement cost minus any depreciation and loss of value. You can think of this with your car is a good example.
Indemnity comes from the Latin indemnis, meaning unhurt, undamaged, or without loss.
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To replace your car’s $10,000 but it’s ten years old, the insurance might give you $1,000 for it. That’s actual cash value. What they’ll do is that a lot of times they’ll provide actual cash value up front to let you start the repairs to get the new roof or to get the flood handled, knowing all along they’re going to give you replacement costs. The insurance company wants to see that you’ve actually done the work. They’ll give you an actual cash value to get started in some cases. As the repair work is completed, they will make up the difference from the actual cash value what they’ve already given you what the replacement cost is. That’s a caveat in the rules when it comes to consumer insurance, which is basically what we as lenders demand. It’s a consumer product and consumers as you know, are usually treated better than businesses in this regard or at least consumers, they get the benefit of the doubt of not knowing any different or better. Whereas someone who’s in business should have the wherewithal to make a better decision. From that standpoint, the consumer is generally more protected by the Department of Insurance and the insurance laws of whatever your state is.
What does all of this mean? It means that property insurance should be a mandatory condition of the loan. The borrower must maintain property insurance for the life of the loan on the subject property. This way, if the property upon which you have at first lien is damaged somehow, and if any of you have gone through a homeowner’s claim or flood claim, this is very similar. The insurance company will send the check to the insured. In this case, it’s your borrower, but they have to endorse it and send it to the mortgagee or, in this case, the private lender for their signature endorsement. The lender can demand inspections to verify that the work has been performed and the damage has been repaired in an acceptable condition.
If you haven’t had a significant property claim, you may not be familiar with this and that’s okay. That’s not a bad thing not to be familiar with the claims process. As a lender, I like to let people know what the indemnity and reimbursement process is up front. There will be a draw in an inspection schedule that’s going to coordinate with the number of repairs that need to be enacted on the property to bring it back to either a rentable or sellable condition. To the lender, mandatory, non-negotiable. You get title insurance and you get property insurance. When I say property insurance, I’m coming to you from the Gulf Coast of Texas. That means property, what we call a fire policy, windstorm and flood.
If the borrower doesn’t want to do all that, then you want to put your money out on a property that’s not protected but your duties as a lender once you enforced, don’t loan without a property policy. You need to verify that your name as the lender is listed as the mortgagee and loss payee on the insurance policy. This is a condition before they can even close on the loan and your money is released out of escrow or wired. In demand that your borrower has provided the declaration page of every policy every time it usually renews in six or twelve months. As a lender, you also want to look at the insurance claim to see how much has been damaged. The adjuster will go through and calculate the damage as well until you get that from the insurance claim forms. There’s usually a schedule or a list involved. You can also look at the scope of work from the contractor.
Usually, there’s going to be a general contractor that’ll come through and oversee the job. In my case with my claims, I was the general contractor. I’ve got all my subs lined up. It was a little bit different, but it was the same for me at that time Wells Fargo held my mortgage. I got the check, they signed it. I had to sign it over to them, then they send an inspector out. They saw how much work had been completed and then they released the funds accordingly based upon how much repair work had been completed. That’s the beauty, they send inspectors to verify that these repairs have been completed and up to code. If it’s a city code, for example. Anybody who wants to make sure that the property is brought up in an appropriate condition and a safe condition. If anything were to happen and that borrower was to lose the property, it can give you some headaches if they were to get into some legal disputes on the quality of workmanship. You don’t want to put money on a property that’s going to be tied up in a liability claim.
As a lender, you need to act and inspect quickly so as not to harm borrower’s condition anymore. They’ve already suffered and you’re taking a hit, they’re not getting rent or they’re further behind on the schedule. As a lender, it’s up to you. Once the borrower is ready for an inspection, have that inspection done as quickly as possible. Release those funds on the draw schedule so that the borrower can go back to work and can continue repairing the property. One of the interesting things that you may or may not know that I found out when I was getting my adjusters license. A couple of things actually, if the borrower, let’s say an insurance policy lapse, the insurance company is supposed to let the mortgagee know that the insurance policy is lapsing. The only way you can have an insurance policy is if you have a financial interest on the said property. As the lender, you certainly do have an economic interest in the well-being of that property. You can step in, get a policy on that property. It can do a short-term. Sometimes you can do a month, six months, twelve months. Check with your agent for guidance on that for your area in your state. The lender can get the premium and then add that amount of the premium for the policy added to the loan until they can get right back up.
You must spend money in order to get the insurance money.
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That’s also an indication of trouble for the borrower. Not only is it something that you can remedy with a few $100 for a month, give or take. Check with your agent. I don’t know numbers across the US but it is a solution to a problem and it can also be the canary in the coal mine so to speak. The neat thing about being a lender is let’s say, God forbid your borrower gets into a tight and shady situation and thinks it’s a good idea to burn down the house and collect on the insurance money. That way he pays the lender, no harm, no foul. Everything’s cool and it gets them out of a jam. The fire department does their job and they say, “No, this is definitely arson.” Your borrower is a suspect to say the least and can be prosecuted if believed to have performed insurance fraud. Most property policies arson is excluded or harming the property intentionally is strictly excluded under property policies. You can’t do intentional damage to the property at all. An arson would be intentional damage, therefore it’s excluded. However, as long as the lender would that be you personally, your self-directed IRA, your LLC entity, trust or whatever. As long as it is listed as a mortgagee and a loss payee, the lender can be made whole.
The policy will pay the lender because the lender is a loss payee. They have an economic interest in the policy. They’ve suffered damage, they’ve suffered harm and the policy’s there to make sure that the lender is made whole. That’s my two favorite things about property insurance and I don’t know of another investment where you get insurance policies for it. I always demand property insurance, whether that’s a landlord policy, dwelling policy, flood and wind storm for the Texas Gulf Coast where I live. If you’re out in California, you might want to add seismic or earthquake. It’s a consideration. I don’t live out there, but it’s something that you may want to look at. My personal belief is that all occupants in the property if they don’t own it, they need renter’s insurance just in case something bad happens. When I was in college, my friends’ apartment, the water pipe broke above his living room while he was on Christmas vacation. He had hundreds of classic vinyl albums where a lot of them were ruined from the water. It was a very sad day. As my personal bit, but yes, do not make a loan without it. This is one way that tools like insurance help keep your private money safe, your loans safe, and it’s a great tool. It’s something that isn’t talked about very often and it’s one of those things that I like about private lending.
In recap as a lender, you want to make sure you don’t lend on the property unless you have property insurance. Verify that your name, the lender, is the mortgagee and loss payee on the policy. It’s a condition for closing and demand that your borrower keeps you updated and make sure that, “I’ve got a new policy for the new year.” Review the scope of work or the insurance claim forms. That way you as a lender from away can look at a desktop version of the claim or what the damage is, and they usually have some photos and whatnot in there. You get an idea of the level of damage and what it’s going to take to repair it back to where it was. It puts you back in that position where you were right before the storm, the fire or whatever happened. Send your inspectors out to make sure that the work is done properly and up to local code before you release any funds to the borrower. That’s a good way to protect yourself. They spend the money, you indemnify them. Once the work is satisfactorily completed and you as the lender need to act quickly once a claim has occurred and your receiving money because you don’t want to slow down the borrower at all.
I can’t tell you how frustrating it is to wait for a bank to send an inspector out especially after a big natural disaster like a hurricane or a large flood where thousands of people are affected. It stresses the personnel resources of the insurance company to get enough adjusters out there and to get the claims process going. Remember, even if the issuer does something to the property, check with your agent in your local state laws. You as the lender are still protected even though your borrower is not you as the lender. The mortgagee can still be made whole even if the borrower caused the damage. Thank you and please connect. You can go to the Private Lender Podcast page. I’m also on BiggerPockets, Instagram. Go to the website for everything else and also PrivateLenderPodcast.com/expo for tickets to the expo and 25% off your ticket price. I understand the VIP tickets are going fast. It’s a pretty good value for what you get. I wish the audience in internet land happy and safe, prosperous and fun private lending. We’ll see you later.