Associations are feeling the effects of multiple factors that have hit the insurance industry. The 9/11 attacks unexpectedly depleted insurance company reserves, while the threat of terrorism has increased risks. Insurers of associations have seen increased claims, most often from water damage, as homeowner carriers have insisted that associations must process claims first, because owner policies are secondary to any coverage provided by the master policy. More recently, drought-fueled wild fires followed by record-setting rains have changed the insurance landscape. These factors, whenever they have occurred, or may occur in the future, result in higher premiums for all associations and difficulty in obtaining coverage for associations with histories of water damage or mold claims. This article provides suggestions to reduce insurance claims and to prevent costs from spiraling out of control when the current insurance climate is influenced by factors like these.
An association’s governing documents are the starting point. Associations must comply with these requirements, and the board cannot implement these suggestions if the documents provide otherwise. Document amendments are an option, but it is always difficult to meet the membership approval requirements for an amendment. Also, changing insurance language may require lender approval. In an extreme case, where the governing documents may require an association to comply with all requirements of federal guarantee programs like Federal National Mortgage Association (aka FNMA or “Fannie Mae”) such as: to obtain an all-risk policy, to pay all deductibles, to insure virtually all attached property in all units against virtually all types of loss and to obtain lender consent for all amendments, there may be little point in reading further. However, if there is flexibility in any of these areas, there may be hope for gaining some control.
An important point is that many governing documents require the association to insure not only the building structure but also the attached components inside individual units, such as carpeting, other floor and wall coverings, built-in appliances, cabinets, plumbing fixtures and other built-in components. The documents may not allow an association to exclude coverage for these components. The lenders, who have a significant influence on insurance requirements in governing documents, consider that these components represent part of the purchase price and want to ensure that the association insures everything that forms part of the security for their loans.
An association might contemplate an amendment that requires owners to insure these components and not require the Association to insure them. However, that type of amendment probably requires lender consent. Also, if it were adopted, and if there were a major casualty that destroyed the unit, the homeowner may not have individual coverage. Thus, the structure of the unit might be rebuilt, but the owner may lack the funds to install critical fixtures, like plumbing fixtures that are needed before the owner could obtain a certificate of occupancy. Under those circumstances, the owner may walk away from the unit causing the lender to foreclose. If an association adopted such an amendment improperly, the lender may seek to hold it liable for the cost of restoring the unit. Since many directors and officer’s liability (aka “D&O”) policies will not defend or indemnity directors on a claim that they failed to obtain the proper types of amounts of insurance, a lender claim like this may result in a denial of coverage.
Thus, if any of our suggestions may require an amendment and lender consent, or may cause an owner to walk away from a damaged unit, thereby dumping an expensive problem in a foreclosing lender’s lap, it is wise to formulate an insurance solution that will provide a safety net to deter owners from walking away, or will prevent lenders from inheriting a significant liability to restore a unit to a habitable condition. For example, an association could adopt a deductible policy that provides that once a certain number of units are damaged, or if the total damage exceeds a certain dollar amount, the association will pay the deductible.
Many older documents require associations to obtain a “fire and extended coverage” policy. This is also called a “named perils” policy because it covers only specifically named causes of loss. Typically, these are fire, lightning, wind, hail, aircraft, riot, vehicles, explosion, smoke, vandalism and malicious mischief. A named perils policy typically does not cover water damage. Thus, for an association that has high water damage claims that needs to gain control over those claims for a period of time to get coverage, it can purchase a named perils policy and eliminate all water damage claims.
The downside risk is that no water damage claims are covered. Not only are water damage claims in owner units not covered, but water damage claims in association clubhouses and common areas of residential buildings won’t be covered either. Unlike homeowners who can purchase a separate policy to insure against their individual water damage claims, the association will have to self-insure those claims. In our view, switching to a named perils policy should be reserved for an association with such high-water damage claims that it cannot obtain any other policy at a reasonable price.
If the declaration requires obtaining “broad form” coverage, that is essentially a named perils policy which expands the list of named perils to include water damage claims, so obtaining a broad form policy will not eliminate water damage claims. If the declaration requires an “all-risk” policy (now typically replaced by “special form” policies), those policies provide coverage for risks except those that are specifically excluded (such as earthquake, war, and many other specifically identified exclusions), but they do include coverage for water damage claims, so only a named perils policy is likely to exclude water damage claims.
Some association documents may require an all risk, special form or broad form policy, but mandate it only if it is commercially available, or if it is available only at a reasonable price. An exemption like this can empower the board to purchase a named perils policy, if a more comprehensive policy cannot be obtained, or it may be language the association can adopt by amendment, if its water damage claims are out of control.
Many associations are also increasing their deductibles to eliminate claims for lesser amounts, and $5,000 is now a common deductible. Some federally-guaranteed loan programs have been permitted to have up to a $10,000 deductible. However, this option makes sense, only if the association can shift the payment of deductibles onto the owners. It doesn’t help, if an association must pay the deductible on every claim. Logically, the chances of having a water damage claim increase in proportion to the number of units in the association. If owners don’t assume part of the risk by carrying their own insurance, associations may be unable to find or keep insurance.
Associations also need to implement some type of deductible “policy” before a claim occurs. Preferably this should be in the recorded declaration, since the courts give recorded covenants a presumption of validity. There are various options available for such policies, each having various pros and cons. They usually break down into variations of imposing the deductible either (1) on the person whose property was damaged in proportion to the dollar amount of the insured loss, or (2) on the owner who is at fault or whose component failed resulting in the damage.
Under the first option, if one owner (or the association) has 50% of the damage, that party would pay 50% of the deductible. The negative aspect of this option is that some owners may be forced to pay even if they had no responsibility for the component that failed. However, they can usually have it covered under their owner’s policy. Under the second option, someone has to find a way to collect the deductible from the owner whose component produced the damage. Assume a plumbing leak in a second-floor unit caused 80% of the insured loss in the unit below. That owner may get 80% of the insurance proceeds, but will be short in an amount equal to 80% of the deductible. It may require a lawsuit to force the second-floor owner to pay the shortfall, and who will file it? Thus, a general preference is the equitable apportionment, because the downstairs owner will have to pay 80% of the deductible, but most could be covered under that owner’s individual insurance. Even if the association’s policy provides for an equitable apportionment of the deductible, it could also provide that the damaged owner has the right to sue another party for the deductible the damaged owner had to pay.
Another option is to see if the carrier will exclude just water damage claims, but not other causes of loss. However, there are few carriers that will offer such an endorsement. Also, as indicated above, if there is no coverage for water damage claims in owners’ units, there is no coverage for water damage for any water damage claims in the common area either. A similar option is to exclude certain property from coverage. The property most often damaged is wall, floor and ceiling coverings and drywall. If the association’s carrier will write an endorsement to exclude these components from coverage, it would eliminate a large number of claims. However, many insurance carriers will not write this exclusion. Also, if the association excludes coverage for these components, it is essentially self-insuring them in recreational facilities, common hallways and other common areas. Thus, these last two options should be reserved for extreme cases where the alternative may be obtaining no coverage at all.
Through a document amendment, owners could be required to obtain individual coverage to insure all attached components. The difficulty is trying to verify that each owner has actually done so. For every 52 units in any association, the association must seek verification an average of once a week throughout the year. The more units there are in an association, the more time-consuming verification becomes. When most associations have difficulty getting a majority of owners just to send in a proxy or a ballot for the annual meeting, it could be a logistical nightmare to obtain verification from every owner.
While amendments to implement these options may require lender consent, a couple factors may help to overcome that requirement. Many newer documents require lender approval only by “eligible lenders.” This means lenders who have notified the association that they want to vote on such amendments. Of course, lenders almost never provide such notification.
In conclusion, the association’s policies on insurance and deductibles really should make units fully habitable after catastrophic losses. However, providing coverage for every conceivable loss, regardless of amount, and for every owner’s interior damage, is a recipe for an undesirable claims history and an inability to find an affordable policy and perhaps any policy at all. Absent a disastrous claims history, the best options for most associations are probably increasing deductibles to reduce the number of claims, shifting the deductible burden to owners for smaller, non-catastrophic claims, and providing an association-paid deductible for larger or catastrophic claims. However, before implementing any policy, each association should consult with its insurance professional and its legal counsel to make sure it is not inviting an unreasonable risk.