REO: A policy, whose time, sad to say, has come

As seen daily in the news, lenders are foreclosing on homes at a record pace. This has created a need for lending institutions–and their agents and brokers–to pay closer attention to the insurance on real-estate owned (REO) property, as it often is called. When they do, they may discover that their program for covering REO property needs a complete overhaul. The proper product for covering this exposure is called REO insurance. In this article, I will provide an overview of it.

At the outset, it's important to contrast REO insurance with lender-placed (forced order) insurance, which most lending institutions have and that sometimes is used to cover REO property. Lender-placed coverage is designed to temporarily insure a property if the borrower's insurance is canceled or lapses. The coverage is simple for the loan-servicing staff to administer, a feature that helps drive sales. It's relatively easy to replace the borrower's property insurance with a fire policy written in the amount of the balance of the loan. These master policies work fine for REO up to a point, but there are a few considerations. One is the litigation exposures from borrowers whose properties are covered by lender-placed insurance. They essentially end up subsidizing the lender's REO insurance rates. Commingling the rates and loss experience for the two coverages invites a class-action suit.
Unlike lender-placed insurance, where borrowers are billed for the premiums, the cost of REO insurance comes out of the lender's pocket. However, this affords agents and brokers greater latitude in managing risk and expense, since they can design programs by using tools not generally available through lender-placed insurance providers. These tools include retrospective rating plans and experience-rated refunds, among others. However, this article will concentrate on the basic facets of REO insurance.
Loss ratio: REO carriers generally seek to maintain a loss ratio below 55%. This can be a challenge, so the agent should ask the insurer to provide loss ratio reports at least semi-annually and review them with the lender. Managing the loss ratio is the foundation for long-term affordability and access to more sophisticated risk management tools.
Monthly reporting form: REO insurance premiums are paid monthly, which helps manage cash flow. The insurer usually requests a beginning list of REO property. On a monthly reporting form, the lender adds and deletes property as it's foreclosed or sold off. The monthly billing reflects all the changes made the previous month. Ease of administration and billing accuracy can become as important to a lender as rates or coverage.
Automatic coverage endorsement: It's entirely possible for a lender's busy REO department to overlook the reporting of a new foreclosed property. Consequently, the automatic coverage endorsement acts as a safety net for the REO portfolio. In the event of a claim, the carrier can backdate coverage to insure a loss on a property that was inadvertently not reported. In contrast, lender-placed policies may confine automatic coverage to the performing portfolio and not extend it to REO property.
Insure to replacement cost: When it comes to REO insurance valuation provisions, lenders may focus on loan balances or market value of the property. They usually have difficulty understanding that these values have nothing to do with insurance. Agents must explain that to properly insure REO property, it needs to be covered for replacement cost–just like any other real estate the lender owns. Also, while lender-placed policies usually delete coinsurance provisions, many REO policies retain them to encourage insuring to value. It's important to point this out to the lender.
Exclusions: The most common residential form used in REO insurance is the dwelling policy special form (ISO form DP 00 03). When used to insure vacant property, it limits coverage for four exposures. Vandalism, theft of building parts and glass breakage are not covered under a typical DP-3 policy after a property is vacant for 30 days. Most master REO policies, however, will include vandalism coverage for vacant property. A comprehensive REO master policy will include theft on residential property as well. Theft is a critical peril these days. Houses are being stripped of their copper wiring, appliances, lighting fixtures, A/C units and anything else that can be carted off. A few years ago, one of our lenders actually had an entire house stolen! Some master REO policies exclude theft, so confirm this coverage.
A fourth peril, water damage, is excluded if the building's heat is turned off, or if the water isn't turned off and the pipes drained. Some carriers may further require antifreeze to be added to toilets.
REO insurance written for commercial property creates the greatest surprises for lenders. Most lender-placed policies cover only basic perils, excluding many of the common REO causes of loss. Quality REO programs can provide broad and special-form perils coverage. Commercial properties also may require more extensive coverage, such as for equipment, signs, ordinance or law, pollution cleanup, earthquake and builders risk. Few lender-placed policies provide such coverage. They can be included in REO insurance policies, however.
Deductibles: The deductibles of lender-placed policies are usually quite low, which adversely affects the loss ratio on coverage for REO property–and hence leads to higher insurance cost for the lender. As a general rule, coverage on REO property should be written with a $1,000 deductible at a minimum. Most REO insurers offer $2,500 and $5,000 or higher deductibles, which usually result in significant premium savings for the lender. Lenders also may want to consider a higher deductible for vandalism only.
Limits: Generally, REO policies offer fire limits up to $1 million for residential property. If a lender services commercial REO, some insurers can provide limits up to $25 million. It's critical that the REO insurer have the capacity and reinsurance to match the average value of the REO portfolio.
Liability: REO is the ultimate attractive nuisance. Vacant property entices children to play on the premises. It attracts vandals and vagrants. Even though such people are trespassing, the lender will most likely be held liable if they get hurt on the property. Injuries to real estate agents and prospective buyers viewing the property are another source of liability claims.
This liability exposure used to be covered under the lender's corporate package policy. Today, most carriers issuing such policies prefer not to cover REO exposures. Few lender-placed programs cover liability exposures associated with commercial REO property–fewer still if businesses continue to operate on the premises. A quality REO insurance program can cover these situations. The programs usually provide $1 million per occurrence/$2 million aggregate limits. Gap layers can usually be avoided.
Flood insurance: If a property is in a special flood hazard area (zones with an A or V prefix), flood insurance should be carried. Coverage from the National Flood Insurance Program or private insurers is available. Usually, a private flood program greatly simplifies coverage, eliminating waiting periods, complex information requirements, elevation certificates and most of the other complications associated with NFIP policies. Certain REO insurers also cover flooding under their master fire policies. Some REO insurers review monthly reports and periodically report flood zones to keep the lender aware of any property with a flood exposure.
Monthly inspections: It's important that lenders remain aware of the condition of their REO property at all times. Regular inspection may even be a condition of coverage with some policies. Failure to regularly inspect and take corrective measures may negate a claim payment. An experienced REO real estate agent communicating with a proactive REO department can go a long way toward mitigating losses.
REO insurance is a rarely discussed specialty product. Unfortunately, its need is growing rapidly. I hope this summary will assist agents and brokers who may be called upon to set up quality insurance programs for their lending-institution clients. Dave Duffy is senior vice president for Seattle Specialty Insurance Services, a managing general underwriter. Mr. Duffy has specialized in lender-placed and foreclosed property insurance since 1978. He may be reached at (800) 597-1866 or via e-mail at davidrduffy@cox.net.