Should an agent insure a property for the mortgage amount when the replacement cost is less because the lender insists on it to protect their interest?
“In our area, selling price values are soaring but replacement values are steady,” an agent asks. “For new purchases or refinancing, the loan officer will absolutely accept nothing short of the loan amount and they become angry and very threatening if we don't do exactly as they demand. The insurance companies refuse to insure for more than replacement cost. What do we do?"
The lender's position is understandable, but misguided. Clearly, they want to protect their investment. That investment consists of two components: the real estate, such as land, home and outbuildings, and the loan itself.
Insurance is the mechanism designed to protect against the pure risk of loss to the real property. However, the loan itself is a speculative business risk, and that's not the function of insurance.
As an example, the purchase price and loan amount for a home is $200,000—for the sake of simplicity, exclude a down payment. This $200,000 represents market value, not insurable value. The cost to rebuild the home itself might be $140,000, with the $60,000 balance being the value of the land and other structures. The purchase price includes the value of land, all structures and even other property that may not be covered by a homeowners policy.
The purchase price may also include the perceived value of the location. But the cost to rebuild the homes would be virtually identical.
In the example above, a homeowners policy would never pay more than $140,000 if the home was completely destroyed, unless required to by a state's valued policy law—another reason for not insuring the loan amount. There has been no damage to the land or the location value—or at least the policy isn't going to pay that amount—so it would largely be pointless to insure the property for more than the structural replacement costs.
It does not serve the bank's interest in any way to be the mortgagee on a policy with a policy limit equal to the loan amount because neither the insured nor the bank will ever collect that amount. The policy will only pay an amount based on the valuation method included in the contract.
This is the case if no valued policy law applies. If it does, then the insured could actually profit from the loss by insuring the loan amount rather than the replacement cost of the property. This would violate one of the fundamental tenets of insurance and, conceivably, could create a moral hazard.
If an insurance company issues a replacement cost—or worse, an ACV—policy with a limit greater than the actual cost to repair or replace, it may be in violation of the insurance laws in most states. States typically require that rates/premiums be adequate, not excessive and not unfairly discriminatory.
What these banks are asking is that the insurance company issue a policy with an excessive premium—payment for coverage the insured can never collect without a total loss and triggering of a valued policy law, which has a likelihood of maybe 1-3%—and that's probably illegal.
To respond to these issues, a number of states have passed laws prohibiting a lender from demanding an insurance amount in excess of the replacement cost of the property.
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