Published on: March 27, 2018
By Stephen Marcus
When we talk about insurance, which we do frequently, we talk about its complexities, and there is no question that insurance decisions are complicated, confusing and often intimidating for condo boards. But it isn’t the complexity of insurance that creates the biggest risks for board members and the association’s they govern; it’s the type of coverage and the amount: Many boards don’t buy the kind of insurance they need or enough of it to cover the property their associations own and the liabilities they face.
This is a problem we see in associations of all types and sizes and in all the key coverage areas: property, liability and fraud.
I’m going to start with liability, because I’m staring at a recent headline that should unnerve any board member who sees it: A court levied a $20 million judgment against an association found to be negligent in the injury of a child who suffered permanent brain damage when struck by a metal bar that fell from a swing set.
The tragedy for the child and his parents can’t be understated. But the damage to this association was also devastating. The association had only $2 million in liability coverage, creating an $18 million gap that owners will have to finance through a special assessment, a bank loan, or both. How would you like to be the owners facing that bill, or, arguably worse, the board members informing them of it?
Think that couldn’t happen to you? Think again. Many condo associations use the Fannie Mae secondary market requirement as their guide. Fannie requires $1 million in liability coverage for associations as a condition for purchasing loans on condominiums in those communities. There are three important points about this requirement:
- It is the minimum coverage Fannie will accept; and
- It hasn’t been adjusted since 1979;
- Just because you meet the Fannie Mae minimum doesn’t mean you have enough insurance for your community.
Multi-million-dollar liability awards, which were the exception 30 years ago, have become the norm. For most condo associations today, a $1 million liability policy will provide about as much protection as throwing a deck chair off the Titanic.
How Much Is Enough?
How much coverage should you have? The glib, but accurate answer: As much as you can afford. A high-rise with a swimming pool, sauna, and tennis courts has more exposure and requires more insurance than a small town-house community with no amenities. But insurance experts suggest that even the small, limited-exposure association should have at least $5 million in ‘umbrella’ coverage over the Commercial General Liability (CGL) limits, the Directors’ and Officers’ Liability (DOL) limits, and the non-owned and hired automobile limits. For higher risk communities, they say $15 million in total coverage might be a reasonable minimum, bearing in mind, of course, that a large claim could exceed the policy limit regardless of how much insurance you buy.
Robert Masse, an agent in the business lines division at W.T. Phelan & Co. Insurance, tells me that the premium difference between $5 million and $15 million is about $600. In a 100-unit community, that comes out to about $6 per owner – a cost the owners facing that $18 million assessment would have happily accepted had they been given the choice.
Even associations that have “adequate” insurance, may discover that they have less coverage than they thought they had purchased, depending on how their insurers treat attorneys’ fees in a liability claim. Some carriers put those fees “inside the limits” of the policy, which means they will deduct attorneys’ fees from the policy limit. If you incur $3 million in legal fees in defending a $20 million claim the $20 million in coverage you thought you had could be reduced to $17 million, leaving you with a $3 million insurance gap.
Inside-the-limits policies are also known as “wasting” policies – because they can shrink in the face of a claim. The cure: Know what you’re buying. When you’re shopping for insurance, compare a “wasting policy” with one that puts legal fees outside the policy limits, covering them as part of the claim. If you like the cost and coverage provided by the wasting option, you could purchase excess insurance under an umbrella to close a potential coverage gap.
Property Insurance: The Worst Case
Property insurance should be fairly straightforward: You want enough insurance to cover a worst-case scenario: Your buildings are destroyed and have to be rebuilt. The problem – and complexity – comes from determining how much that would cost. Many boards assume that their coverage limit – the maximum their policy will pay – should equal the original insured value of the property. But a 20-year-old building valued originally at $25 million could not be reconstructed for anywhere close to that amount today. And a $25 million coverage limit won’t come anywhere close to covering a total loss. Even a policy offering extended replacement cost, which some do, may not be enough.
A “guaranteed replacement cost” policy which the insurer agrees to pay whatever the actual replacement cost turns out to be, might provide adequate protection, but most insurers offer “stated value” policies, which link the coverage limit to a stated value on which the insurer and the association agree. The important thing about stated value is, it’s an estimate. If the estimated value is too low, the insurance coverage based on it will be inadequate.
Your insurance agent can provide the estimate, but most agents will readily admit that they aren’t valuation experts. Boards will be better-served, and associations better protected, by getting an “insurance replacement appraisal” from an independent expert. You should update the appraisal at least every three years to reflect changes in replacement costs. The fee for the insurance appraisal will be a small price to pay to avoid the multi-million-dollar deficiency that would result from being inadequately insured.
Ordinance or Law
Many under-insurance problems arise because boards forego coverage they need in order to reduce costs. Ordinance or law coverage is a good example – or a bad one – of this kind of penny-wise-pound-foolish decision. An ordinance or law endorsement provides coverage for the cost of meeting code requirements that didn’t exist when a building was constructed. If an older building is destroyed or severely damaged, a standard policy won’t pay anything toward the cost of adding a sprinkler system that wasn’t installed in the original structure. The ordinance or law endorsement gives you that protection.
Some insurers offer $250,000 or $300,000 in ordinance or law coverage automatically as part of the property insurance policy; many don’t include it at all. If your policy doesn’t include this coverage, or if you want more than the insurer’s automatic add-on (and you do), you’ll have to ask for it.
A separate endorsement, which boards often exclude, would pay demolition costs, which also aren’t covered in the master policy. One association discovered just how important these coverages can be when the combination of an outdated replacement cost estimate and the lack of ordinance or law coverage left it more than $4 million short of the funds needed to reconstruct after a devastating fire.
In addition to sharing the cost of a massive special assessment on owners, the board members responsible for this insurance coverage gap will almost certainly be sued by one or more owners, who will contend that the board did not fulfill its fiduciary obligation to maintain adequate insurance for the community. And, adding costly insult to expensive injury, few Directors’ and Officers’ liability policies will defend inadequate-insurance claims; most specifically exclude that coverage.
Boards that underestimate the replacement value of their community often make the same mistake when obtaining fidelity insurance to cover a financial loss if a hacker, a manager or a board member steals association funds. The Massachusetts condominium statute requires insurance equal to three months of association expenses. But as with liability coverage (remember that $18 million swing set judgment), meeting this statutory requirement won’t necessarily match the association’s potential exposure.
If your expenses total $100,000 per month, the Massachusetts law says you need $300,000 in fidelity insurance. But most associations have reserve accounts totaling hundreds of thousands or several million dollars or more. Some have large bank loans on which they are drawing, as well. So unless you can assume a thief will considerately steal only the amount covered by insurance, that $300,000 is insuring only a portion, and possibly only a small portion, of the funds you have at risk. You want enough property insurance to reconstruct your community if it is completely destroyed, and you want enough fidelity insurance to reimburse the association if every dime it has is stolen.
Deciding not to purchase the right kinds of insurance in adequate amounts is a form of gambling. People who obtain adequate insurance – which means closer to the maximum than the minimum – assume that a worst-case disaster could happen to them; people who fail to insure or under-insure assume the opposite. “It happened there, but it can’t possibly happen here.” That is a good bet if you’re right, (or if the assumption of risk is reasonable, given the association’s finances and/or the nature of the risk). But it is a horrific bet, with potentially devastating consequences, if you’re wrong.
Perhaps this is a bet you are willing to make when dealing with your own house or your health; but it is a bet you should never make when dealing with other people’s money, and the boards making decisions for their associations are dealing with other peoples’ money, not just their own.
Owners will grumble about an increase in association fees, but they will do a lot more than grumble about a multi-million-dollar insurance gap they have to finance. They will look for someone to blame, and they won’t look any further than the association’s board. Obtaining adequate insurance for the association is the board’s responsibility; the liability for failing to do so may be theirs as well.