Under-insurance a Looming Problem for Community Associations

Published on: January 22, 2006

Picture this, although it’s not a pleasant image. A fire caused by an electrical short swept through your community last night. No one was hurt, fortunately, but one building was destroyed completely and two others suffered extensive damage. Your first thought as a member of the board of directors: Buildings can be repaired or replaced. Your second thought: It’s a good thing our insurance will cover the costs. But will it?

There is no question that your association’s insurance policy should protect the community. Associations have a legal obligation to maintain the types and amounts of insurance their declaration and/or applicable statutes may require. If the statutes are silent or the documents are vague, as is often the case, then boards must make a reasoned assessment of the association’s risks and insure them appropriately. Failure to do so constitutes negligence, subjecting the association and possibly individual board members to claims by owners and the owners’ insurance companies.

Maintaining adequate insurance is the board’s responsibility; it is not the responsibility of the community manager or the insurance agent, unless they have specifically assumed that obligation, and relying on them will not protect the board from claims of negligence if there is not sufficient coverage.

But despite that potential liability, and notwithstanding the common sense arguments for maintaining adequate insurance, it is probably safe to say that many boards and many owners don’t have any idea what their policies cover until they drag the documents out of a drawer in order to file a claim.

A Painful Mismatch

Needless to say, standing in the freezing rain, staring at the smoldering ruins of a gutted clubhouse or the rubble left by a devastating storm is not the time to determine that the association’s policy will not provide the funds needed to rebuild. But that is precisely the crisis your community could face if the cost of replacing damaged buildings exceeds the value the insurer has “assigned” to them. How could that occur? Because construction costs increase over time.

Partly because of the massive reconstruction efforts under way in hurricane-damaged areas of the Gulf Coast and other recent disasters, building costs have increased by more than 100 percent in the past six months alone. That means a community with a policy that would replace a building valued at $2 million would have only half of the funds needed to rebuild that structure if it is destroyed.

Associations may be able to avoid this potentially devastating shortfall by obtaining a “guaranteed replacement cost” policy, which will pay to restore a damaged property to its pre-disaster condition even if the construction costs exceed the property’s assigned value. That coverage is highly desirable, but it is also difficult to obtain. If your insurance company does not offer guaranteed replacement cost (and most do not) or if you are unwilling to pay the higher premium associated with this coverage, you should make sure your policy limits always match the estimated replacement cost of your community’s buildings. To do that, you can ask your agent to confirm that there is sufficient coverage, or have an insurance appraiser review your policy at least annually and update the estimated replacement value based on current construction costs in your area.

Closing a Gap

Accurate and updated replacement cost estimates may not provide the protection your association needs, however. Even a guaranteed replacement cost policy may leave you short of the funds required to rebuild or repair a damaged structure. That is because most policies specifically exclude losses resulting from “governmental orders.” Governmental orders would include a condemnation order for a damaged structure or building code requirements that may not have been in place when the building was constructed but that will apply to any new construction or renovation undertaken today. So while your $1 million policy would restore your damaged building to its original condition, it won’t cover the added cost of installing sprinklers, creating parking spaces, increasing setbacks, or making other changes a modernized building code may require. To close this gap, associations need ordinance or law coverage, which is available as a fairly low-cost endorsement to a standard master policy.

Another potentially serious insurance lapse associations often encounter occurs not in their association policy, but in the coverage individual owners should have, but often don’t obtain. Many owners assume incorrectly that the association policy covers everything, including their residences and everything in them. This is a problem not just for the owners, who may have huge uninsured losses, but also for the association itself. Uninsured or under-insured owners may not be able to pay their share of the association policy deductible or they may not be able to make needed repairs for which they are responsible in their own properties. An obvious example: Untreated water damage in one unit could trigger a mold outbreak affecting adjacent units and the common areas. Because associations have a clear and compelling interest in ensuring that owners obtain adequate individual coverage, attorneys are increasingly recommending that communities amend their documents to make this a requirement.

Property values, risk profiles, and insurance requirements all can change over time, so boards should review their insurance policies periodically, to make sure they have and maintain the coverage they need. As part of this periodic review, boards should also assess, or reassess, the financial strength of their insurance carrier. Having all the insurance the association needs to recover fully from a disaster won’t help much if the association’s insurer doesn’t survive.

Termination Clauses

Recovering from a disaster will be difficult under the best of circumstances. You want to make sure the association’s governing documents don’t impede the recovery effort. Many documents contain what could be a significant stumbling block, in the form of an automatic termination provision specifying that if the renovation costs exceed a stated percentage of the development’s market value, the association will be terminated unless a specified percentage of the owners vote to rebuild. It is hard to imagine many situations in which rebuilding would not be the best choice. Displaced owners will need some place to live, and while the association’s insurance should cover the replacement value for rebuilding purposes, it would cover only the current market value if the association decided to dissolve. Because of this, most communities would be better served by turning the standard termination language on its head, making the rebuilding decision automatic and requiring a vote of owners to terminate instead.

Provisions governing the handling of insurance claims could also create unnecessary problems if they aren’t drafted properly. For example, the board should be designated as the insurance trustee, authorized to receive insurance payments. Otherwise, the disbursements could be delayed. The documents should also name the association as agent for each unit owner and for the holders of liens on all units. This will give the board the authority it needs to adjust all insurance claims under the master policy, including those covering damage inside individual units.

Before you begin planning the reconstruction/repair of your community, you should review your insurance policy to make sure you comply with all the reporting requirements and meet all the filing and notice deadlines. Many policies will provide advance payments to finance emergency measures (shoring up damaged structures or removing debris, for example) and there is certainly nothing wrong with accepting those payments, as long as you don’t sign any releases that might limit the damages you can recover in the future. Have the association’s attorney review any insurance documents, including the final settlement offer, before you accept it. You want to make sure the compensation the insurer provides reflects the coverage to which you are entitled.

Proceed with Care

Once you know what the insurance will cover, you can begin formulating the reconstruction plans. The pressure to rebuild quickly will be intense, but caution and careful planning are essential. It is far more important to handle the construction project properly than to complete it rapidly.

  • Approach the work as you would if it had not resulted from a disaster.
  • Don’t hire the first contractor who arrives on the scene with a back-hoe, a construction crew, and a promise to “fix everything like new.” 
  • Obtain competitive bids from at least three contractors. 
  • Verify the capabilities and the reputations of any companies you consider.  Check their references and demand proof of their insurance coverage.
  • Before you solicit bids from contractors, have an engineering firm assess the damage to your community, and ask that firm also to prepare the specifications for the construction bids. 
  • Once you select a contractor, have the association’s attorney either draft the contract or review it before you sign. 
  • Plan to hire a construction manager to oversee the project; the association’s property manager probably will not be the best choice for this task.

Have both the construction manager and the association’s consulting engineer monitor the project, reviewing the work and workmanship at every stage. You don’t want to find out at the end of this process that your disaster recovery project has left the association with another disaster on its hands.