Published on: April 28, 2015
“My condo community is insured for full replacement value,” the board’s president announced confidently. “Our manager assures us,” he added, “that we have all coverage we need.” I hear these confident assertions often, and they make me shudder. Many condo associations have learned through painful experience that their full replacement policy may not fully cover a devastating loss. Some association managers and insurance agents have found themselves in serious legal and financial trouble for suggesting that it would.
These cautions require some explanation, beginning with why a policy that promises full replacement cost might actually provide something less than that. The policy’s limit ― the maximum coverage it will provide ―is based on an estimate of what it would cost to rebuild your property today. If that estimate is accurate, the community (with some limitations) may be adequately insured. But if the estimate isn’t accurate, you will have three significant problems:
- The policy may not fully cover a large claim, requiring a special assessment on owners to make up the difference. Even a policy offering “extended replacement cost” – usually 125 percent of the cost estimate – may not be sufficient.
- An inaccurate replacement cost estimate might trigger the co-insurance provision in many policies. Most policies require coverage equaling at least 100 percent of the estimated replacement cost. (Although some older documents require only 80 percent, we think coverage should be set at 100 percent.) If the actual replacement cost is $1 million, you would need a $1 million policy. But if you estimated the replacement value at $800,000 and purchased insurance in that amount, you would have only 80 percent of the coverage the insurer requires and the co-insurance requirement would apply. If you file a $50,000 property damage claim, the insurer will cover only 80 percent, requiring the association to cover the rest. This is one way a full replacement policy may not provide full coverage. (An “agreed amount endorsement,” through which the insurer accepts the stated value as accurate, will eliminate the co-insurance penalty.)
- The board is responsible for selecting and maintaining adequate insurance for the community. This creates your third problem. If the insurance coverage falls short, some owners will almost certainly sue the board, and very few Directors’ and Officers’ liability policies will defend deficient insurance claims; most specifically exclude that coverage. On a large claim with a large deficiency, the board’s potential exposure could be huge. How do you reduce that risk?
Whatever It Costs
The best protection for the board and for the community is a “guaranteed replacement cost” policy. Unlike a typical policy, which is capped at the stated limit, a guaranteed replacement cost policy will pay whatever the replacement cost actually turns out to be. If you buy a $1 million policy but it costs $1.5 million to rebuild a damaged structure, the insurer will pay the full amount.
But even with this policy, there are potential gaps you need to close. First, you will want to include an “agreed amount” endorsement, also necessary, as noted earlier, in a stated value policy.
You will also need an “ordinance or law” endorsement to cover demolition costs and the cost of adding features required by the current building code (a sprinkler system, for example) that were not required when the building was constructed. And you should adjust the coverage limits, as necessary, to reflect increases in labor costs and building materials beyond those a reasonable inflation factor might offset.
Following Hurricane Katrina, skyrocketing oil prices (which increased the cost of just about everything), labor shortages and no small amount of gouging left an estimated 70 percent of residential properties with less insurance than they needed to pay reconstruction costs. For a more recent example closer to home, consider the ice dam crisis this past winter, when anyone with a large shovel and a small conscience was charging any price they could quote with a straight face to clear snow from rooftops and remove ice dams.
Although a guaranteed replacement cost policy (with an ordinance or law endorsement with an adequate limit and periodic construction cost adjustments) will unquestionably provide the best insurance coverage for most communities, this coverage isn’t widely available. Many insurance companies don’t offer it and those that do are very selective about the properties they will accept. If this option isn’t available, or isn’t available at a price you are willing to pay, a stated value policy is the best alternative, but remember: This coverage is only as good as the value estimate on which it is based.
Estimating Replacement Value
An estimate, by definition, is an educated guess, and for insurance purposes, you want the most educated guess you can get. That’s not going to come from a close friend who “knows a lot about insurance,” and it probably isn’t going to come from an insurance agent, either. Agents know insurance, but they aren’t valuation experts. Your most educated and most reliable estimate will come from an independent insurance appraiser with expertise in multifamily properties. The appraisal should include estimates for building code changes and increases in construction costs, and it should be updated every two to three years to keep up with changes in codes and costs. You’ll have to pay for those updates, but they will cost considerably less than the initial appraisal. Also make sure the appraiser’s agreement does not state that you can’t rely on the value estimate. An estimate on which you can’t rely is like a boat with a hole in its hull — it isn’t going to float.
Protecting the association by insuring it properly is arguably a board’s most important obligation. It is also an area in which few board members have any particular knowledge or expertise. So boards should rely on the advice of experts both to make informed decisions and to demonstrate that they have exercised due diligence in the decision-making process.
If you purchase the coverage and the limits your insurance agent recommends, will the agent be liable if the coverage turns out to be insufficient? Logic suggests that this assumption is reasonable, but industry practice and a string of court cases suggest otherwise.
A Special Relationship
With few exceptions, courts in many jurisdictions have concluded that insurance agents are required to advise their clients, and clients can reasonably rely on their recommendations, only if a “special relationship” exists between them. This relationship exists, the courts have said, if one or more of the following conditions apply:
- The agent represents that he/she has expertise in the insurance the client is seeking and accepts additional compensation for providing expert advice;
- The client specifically requests advice on a particular type of insurance, discusses it with the agent, and relies on the agent’s advice, to the client’s detriment;
- There is evidence of a long-standing trust relationship between the agent and the client, going beyond the standard agent-client relationship.
Few associations will be able to demonstrate that they have the “special relationship” with their insurance agent this legal standard requires. Certainly the agents they sue for negligence will argue that they do not.
Boards do have a special relationship with their association manager, and managers probably know more about insurance than most board members. But association managers aren’t insurance experts either. Boards shouldn’t ask their manager for insurance advice, and managers definitely shouldn’t offer it. In fact, we strongly advise mangers to include language in their contracts noting specifically that they are not experts in insurance, engineering, and other specialized areas, and stating that boards should seek advice from professionals who are.
When I worked as an association manager years ago, before becoming an attorney, I considered adding the initials, “NPE” after my name, indicating “No Particular Expertise.” That is good advice for mangers today, and insurance poses by far their greatest liability risk for providing advice they aren’t qualified to give. If the $500,000 in coverage the manager assured the board would be adequate turns out to be $500,000 less than they needed, the association will look to the manager to make up the difference.
Where the Buck Stops
For condominium association boards grappling with insurance complexities, there is no escaping this fundamental and uncomfortable fact: The buck stops with you. Seeking and following the best professional advice you can find won’t absolve board members of the responsibility to understand the coverage they have and to make sure the policy they receive provides the type of insurance and the limits they requested. At a minimum, board members should read their insurance policies, question anything they don’t understand, and follow these best insurance practices:
- Obtain a guaranteed replacement cost policy, if possible, and add an agreed amount endorsement to it.
- On a stated value policy, have a qualified insurance appraiser estimate the replacement value.
- Obtain an ordinance or law endorsement with adequate limits, adjusted periodically to cover increases in demolition and construction costs for both guaranteed replacement cost and stated value policies. Have an insurance appraiser or a construction professional estimate reasonable limits for the endorsement and the cost adjustments required.
- Don’t assume that the coverage your condo documents require will necessarily provide all the insurance your community needs. That may be the case if the documents require full replacement cost coverage, but older documents often require less, which could leave the
association without sufficient coverage and the board vulnerable to allegations of negligence. In an effort to reduce their liability risks, some boards ask their insurance agent to sign a statement attesting that their coverage is consistent with what the documents require. A better option would be a statement saying the policy meets Fannie Mae requirements, which call for 100 percent replacement cost coverage.
- Don’t ask your manager for insurance advice and don’t rely on that advice if it is offered.
- Try to obtain a D&O policy that will cover errors in insurance judgment.
- If a lender’s questionnaire asks if the community is insured for 100 percent of its replacement value, don’t answer the question. Neither board members nor association managers (who are also asked to sign these questionnaires) can possibly know if the estimated replacement value is accurate. If the lender insists on an answer, ask the board’s insurance agent to respond. This isn’t really fair ─ agents aren’t valuation experts, either – but it is necessary to protect boards and managers from incurring liability for responding to questions they aren’t qualified to answer.
Underlying any discussion of insurance coverage is the question of who will be liable if the policy provides less coverage than is needed to satisfy a claim. Condo boards, managers and insurance agents all have an understandable interest in avoiding liability by shifting it to someone else. But the liability question won’t arise if the condominium association is properly insured. Protecting the association, not avoiding liability, should be the primary goal. And boards, their attorneys, their managers and their insurance agents should be working together to achieve it.By Stephen Marcus