[Note: This article was revised in July 2012. See 10 Steps to a Well-Designed HO 6 Policy.] An owner today of a condominium or townhouse is much more likely to have major insurance gaps in their property and liability insurance coverage than the purchaser of any other personal insurance policy. There are several reasons for that.
First, the basic structural coverage of the standard unit-owners policy (HO 6) is generally quite inadequate. For starters, the perils covered are the equivalent of a Homeowner's Form 2—Named Perils on Building and Contents. The structural coverage limits are usually grossly inadequate. Typically, the Coverage A Structural Coverage under the HO 6 policy is just $1,000. Most unit owners are legally responsible for insuring much more than that. Additionally, coverage for loss assessments is inadequate. This can be loss assessments that are associationwide, such as those that arise when a lawsuit for serious injuries ends up in a judgment that exceeds the association's general liability coverage limit, and the excess is assessed to the unit owner.
This also can include loss assessments made against specific unit owners when a loss is caused by the unit owner's negligence, such as a kitchen fire, and the entire Association Master Policy property insurance deductible is assessed against that unit owner. An HO 6 policy usually comes with only $1,000 of loss assessment coverage. But even if limits for loss assessment coverage are increased to, say, $25,000, in most cases, assessments for deductibles are still only covered under the increased loss assessment policy endorsement for $1,000.
Broadening the Perils Covered
The unendorsed HO 6 policy provides named perils coverage only for both Coverage A structural claims and for Coverage C personal property claims. (This is the unit owner equivalent of a Homeowners Form 2—a policy rarely sold today because of its limited coverage.) An agent for a townhouse or condo unit owner needs to change the perils covered to special perils at least for structural claims (i.e., HO 3) and probably for personal property claims as well (i.e., HO 5). This is especially important in an association because the unit owner cannot directly control the exterior maintenance. So, for example, if the older roof in need of replacing leaks all kinds of muddy water onto a unit's carpeting, hardwood floors, cabinets, furniture, piano, clothing, etc., causing major damage to these items, the unit owner won't be covered at all unless his agent had upgraded the perils covered. ("Water damage from roof leaks" is not one of the "named perils," nor is it an excluded peril under the "special perils" form.
Measuring the Loss Assessment Exposure
Another shortcoming of the basic HO 6 policy is the minimal amount of coverage—usually $1,000—for assessments made against all unit owners for uninsured or underinsured property or liability claims. Three examples, assuming 100 units in the association, follow.
The complex, insured for $5 million, is destroyed by a tornado and costs $8 million to rebuild. The $3 million shortfall would lead to each of the 100 unit owners being assessed $30,000.
There is a drowning at the swimming pool. A lawsuit ensues, resulting in a $4 million judgment. The association carries $2 million of liability coverage, resulting in each unit owner being assessed $20,000.
Heavy rains lead to a massive sewer backup in the complex. Cleanup costs and repair costs total $75,000. The association board did not purchase sewer backup coverage, leading to an assessment of each of the unit owners of $750.
Under the basic HO 6 policy, with $1000 loss assessment and named perils coverage, our hypothetical unit owner will be personally out-of-pocket for $29,000 from the tornado assessment, $19,000 from the lawsuit assessment, and $750 from the sewer backup assessment (not a covered "named peril").
Because additional loss assessment coverage is so inexpensive, I recommend always including at least $25,000-$50,000 additional limits with each HO 6.
A fringe benefit of broadening the perils covered is broadening coverage for loss assessment. Loss assessment coverage applies to those loss assessments arising out of perils that are covered by the particular unit owner's HO 6 policy. When the coverage is broadened to special perils, the perils covered under the loss assessment optional coverage are also broadened. Coverage for sewer and water backup should be added as well, not only because the exposure otherwise isn't covered, but also because by adding that endorsement, sewer and water backup coverage is added to the loss assessment perils covered.
Note that if the unit is in an area exposed to the risk of earthquake, and earthquake coverage is purchased, most increased loss assessment endorsements will not include earthquake automatically. The best strategy to avoid this risk is for the unit owner to strongly lobby the association board to purchase earthquake coverage on all the structures.
Determining the Interior Structural Risk
A second reason for the difficulty in setting up an HO 6 policy with adequate coverage is the difficulty of identifying and measuring the amount of structural insurance that the unit owner is responsible for. The majority of the building structure of each of the units are insured by the homeowners' association. The unit owner is responsible for insuring just the part of the structural interior not covered by the master policy, as spelled out in association documents (typically the "Declaration" rather than the "Bylaws") and any pertinent state laws. The most common language in a Declaration document is that the unit owner is responsible for everything inside the bare walls and bare floor of the unit. This means that the unit owner is responsible for insuring all of the items shown in Table 1.
Unit Owner Structural Responsibility Items
Sample. Replacement Cost Installed
Carpeting, hardwood floors, ceramic tile, any other flooring
Plumbing fixtures (e.g., toilets, tubs, etc.)
Unit owner installed improvements (e.g., screened-in or four-season porch)
Any other improvements made to the unit by all previous owners (usually very difficult to determine, especially for an older unit with several previous owners)
Total Replacement Cost Installed
The installed replacement cost of the items in this particular example is approximately $100,000. Clearly, the HO 6 basic coverage of $1,000 is grossly inadequate.
Discover All Pertinent State Laws
Some states have passed laws limiting how much of a condominium unit interior a unit owner can be held responsible to insure. Minnesota, for example, under the Minnesota Common Interest Ownership Act—Statute #515B.3-113—permits an association to hold a unit owner responsible for no more than "ceiling or wall finishing materials, floor coverings, cabinetry, finished millwork, electrical fixtures, plumbing fixtures, built-in appliances, and all improvements and betterments to the unit, regardless of when installed." In Table 1, each responsibility is within the law. But if there were other requirements, such as responsibility for interior nonload bearing walls, wiring within the walls, etc., the law would supersede the added bylaw requirements and the unit owner could ignore the value of those items when estimating his Coverage A exposure. [Caution: some older townhouse associations are exempt from the law, so make sure the association is covered by the law before relying on its requirements.]
Covering a Unit Owner's Responsibility for the Master Policy Deductible
Yet another reason why the HO 6 policy is so difficult to set up correctly is that more and more associations have changed their rules so that all uninsured or underinsured losses are no longer always assessed association-wide against all unit owners. With significantly rising insurance costs for association master policies in the last few years, more associations have gone to higher deductibles of typically $5,000 or $10,000, but in some cases even $25,000.
The problem with those higher deductibles for a specific unit owner is that if the loss is caused by the negligence of a unit owner, such as a bathtub that overflows or a kitchen grease fire, the association deductible can be the sole responsibility of the negligent unit owner. Unfortunately, in most cases, insurance companies haven't amended their policy forms to provide a way of covering that increased deductible assessment. Some companies have come out with a specific endorsement that the unit owner can purchase which will cover the full amount of the deductible assessment. But most insurance companies have not done so. Many of those remaining companies, however, in the claims department, are covering the unit owner's responsibility for the full association deductible under Coverage A Structural Coverage, providing that that deductible responsibility is clearly spelled out in the official association documents (i.e., in the Declaration) and that the Coverage A limit is high enough to cover both the deductible and the other structural responsibilities of the unit owner.
Communicating with Claims Managers
To set up a unit owner homeowners policy correctly, if an agent represents a company that does not offer an optional endorsement to cover that deductible responsibility, the agent must contact each claims department—ideally the claims manager—and get a clear understanding of how the claims department has elected to cover this deductible responsibility until such time as the underwriting department comes up with a specifically tailored endorsement.
Most of the claims managers of the insurers I represent have determined that they will cover this deductible responsibility under Coverage A. Since the deductible involves responsibility for structural rather than personal property damage, that risk to the insurance company is fairly similar to the risk of damage to the building interior structure and, therefore, the Coverage A structural rates for covering the master policy deductible are fair to the insurance company. If an agent has a client that has a large deductible responsibility, such as $10,000 or $25,000, and that client is placed with an insurance company who flat out won't cover the insured's responsibility if assessed for that deductible, that agent needs to move that client to another company that will cover that responsibility.
11 Steps to a Well-Designed HO 6 Policy
For each HO 6 policy, agents should obtain a copy of all association documents pertaining to the unit owner's responsibility for structural damage as well as the unit owner's responsibility for the deductible. Agents must work with the unit owners to help them determine what it would cost to replace, fully installed, everything structurally that they are responsible for. Agents must change the perils coverage to special perils on building and contents, not only so that there is essentially "all risk" coverage for both, but also so that the perils coverage for loss assessment is broadened.
The following 11 steps are recommended to help agents set up the proper coverage for their clients, using the HO 6 policy for those insurance companies that have agreed to cover the specifically assessed master policy deductible under Coverage A Structural Coverage.
Request a copy of the association "Declaration" document. Make a list of building items not covered by the master policy (e.g., carpet, hardwood floors, tile floors, kitchen cabinets, plumbing and electrical fixtures, built-in appliances, unit owner improvements, etc.). (Be sure that the requirements are within your particular state law.)
Have your client estimate the replacement cost of each of the structural items that are his responsibility. I find it easier and more accurate to write out a list of each type of item and have the client estimate the replacement cost of each category (see Table 1). Total the values. (Don't forget the labor costs in your estimate.)
Find out the current master policy deductible as well as the maximum deductible authorized in the Declaration. Choose the higher (so that your client is protected when the association decides to raise the deductible to the next level).
Add up the totals in Steps 2 and 3. Round up to allow for errors. That total will be the coverage limit for Coverage A.
Add "special perils" coverage to Coverage A, changing perils covered from "named perils" to "all risk" unless excluded. This is important for three reasons: it covers more losses (e.g., water damage to walls and ceiling from roof leaks); it improves coverage for losses subject to the master policy deductible; and it changes the perils covered by loss assessment coverage from named to special.
Increase the loss assessment limits to $25,000-$50,000
Add sewer backup coverage to (A) provide coverage for the direct damage to the unit or contents from sewer backup; and (B) to broaden loss assessment coverage to include assessments for sewer backup (i.e., loss assessment coverage only covers assessments for perils covered by the HO 6 policy).
Assess the need for flood or earthquake coverage.
Buy adequate and consistent liability coverage (i.e., $500,000) in limits equal to your client's other personal liability coverages, or in limits high enough to satisfy the umbrella underlying insurance requirements.
Buy an umbrella policy. Be sure it includes coverage for association volunteer activities including nonprofit directors and officers (D&O) liability coverage in case your client ever serves on the board. nonprofit boards should defend and pay judgment against any unit owner insured by that umbrella policy. Caution: because an umbrella policy only covers claims arising out of bodily injury, property damage, and personal-injury, this umbrella coverage clearly doesn't replace the need for that board to carry D&O coverage.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.