Commercial Mortgage Insight

Building Ordinance And Law Risk: Does The Insurance Cover You?

Ordinance and law coverage can protect you if a governmental jurisdiction orders that the undamaged portion of a non-conforming building be torn down. How does it work? The insurance answer man has the answers.

BY BERNARD BROWN

Question: Bernie, I am confused about the need for ordinance and law coverage which is sometimes added to a borrower's insurance program. What does it provide that is not provided by the borrower's standard insurance policy? When is this coverage a good idea? What does it cost? Please explain.

Answer: You are not alone. There is a lot of confusion among borrowers and lenders about this coverage. In fact, we sometimes receive inquiries about "law and order" or "law and ordnance" coverage. Rest assured, it has nothing to do with either riots or explosives!

Let's review what ordinance and law coverage is all about. When a fire or other insured peril occurs at a commercial or multifamily property, a standard "all risk" insurance policy pays only for the replacement or repair of the portion of the building damaged by the fire.

The typical policy does not pay if the local governmental authority then determines that the remainder of the undamaged portion of building must be torn down. An order of government is a specifically excluded peril under most so called "all risk" policies. (As an aside, the reader can surmise that "all risk" is a misnomer when it comes to insurance policies. But let's not go down that road for now!)

The governmental requirement that the building's undamaged portion be torn down and removed can occur if the property is non-conforming as to zoning and the magnitude of the loss exceeds the governmental entity's threshold for allowing repair of the damaged building. The reasons why a particular structure can be non-conforming abound, but our experience is that non-conformance usually results from one of the following:

occupancy does not meet zoning requirements (e.g., residential versus commercial),
the building set-back is not enough,
construction is not up to code, or
there are too few parking spaces for the size or number of units in the building.

When a governmental authority determines that the undamaged portion of a building must be removed, this cause of loss - governmental order - is specifically excluded under a typical insurance policy. Therefore, unless the borrower and his or her insurance agent have arranged for an "ordinance and law" endorsement, the economic loss relating to the undamaged portion will not be paid by the insurance carrier.

An example

Let's take a simple example. Suppose a building owner has a structure that is legally non-conforming and the local governmental threshold is 50%. That is, if a fire or other casualty results in damage to the structure of more than 50%, then the entire structure must be demolished and removed.

Now assume a fire occurs damaging 60% of the structure. The governmental authority requires the undamaged portion (40%) to be removed, so the building owner - and the lender - are looking at an effective 100% loss of the income producing asset.

As already mentioned, the typical insurance policy of the borrower contains an exclusion to the effect that no loss will be paid as a result of an order by governmental authority. Therefore, only 60% of the loss is reimbursed.

If the borrower had added an ordinance and law endorsement, which removes the exclusion and adds back coverage, then the full 100% value would be effectively reimbursed. That is, 60% of the loss would come from the fire recovery and 40% would come from the ordinance and law portion of the policy.

In addition to the loss of the undamaged portion of the structure (Coverage A), the ordinance and law endorsement also provides coverage for the cost of demolishing and removing the undamaged portion of the building (Coverage B) and the increased cost of bringing the new structure up to current code (Coverage C).

In some cases, the total loss involving an ordinance and law claim can exceed the 100% replacement cost of the structure, since it is sometimes costly to bring a structure up to current code.

Coverage is typically provided by an endorsement like the standard one used by many underwriters developed by the Insurance Services Office, CP 0405 1090, "Ordinance or Law Coverage." Some underwriters have their own form or even include it in the basic policy, although this latter possibility is rare, found usually in so called "manuscript" policies put together for large commercial and multifamily developers.

We recommend that any non-conforming property be covered under an ordinance and law endorsement attached to the basic "all risk" insurance policy purchased by the borrower. The cost can be nominal or in some cases, depending upon the reason for non-conformance, up to 25% or more of the basic premium for the all risk policy.

A few lenders are requiring ordinance and law coverage on conforming properties as well. The theory here is that the governmental authority may change code requirements in the future, so it is prudent to have the coverage in place if this should happen. We think this is onerous for borrowers. Instead, why not amend lender loan documents to require ordinance and law coverage when and if the structure becomes non-conforming?

Please Note: The example used above was a simple one that attempts to explain how ordinance and law coverage works. A borrower or lender needs to examine the particular circumstances in each case and discuss it fully with the underwriter or the underwriter's agent.

Flood insurance redux

In one of my previous columns regarding flood and windstorm insurance, I stated that one problem with flood insurance purchased through the National Flood Insurance Program is that only $500,000 maximum is available.

A reader, Heather, who is with a commercial servicer, asked for more clarification on the amounts available under the NFIP. The answer is that $500,000 is available for commercial properties but only $250,000 maximum is available for multifamily structures.

Thus, to take an example, if a multifamily property is a garden type project, then $250,000 per structure would be available. If there were 10 buildings, up to $2,500,000 of coverage could therefore be purchased through the NFIP. If a high rise, only $250,000 per structure.

"Multifamily" and "commercial" are defined by what goes on within the walls of the structure, not whether the multifamily is owned by a commercial developer in the business of making a commercial profit.

Bernard Brown is president of Insurance Advisors LLC, an insurance consulting firm in Greenwich, Conn. He holds the professional insurance designation of chartered property and casualty underwriter and chartered life underwriter and has a bachelor's of business administration from the College of Insurance in New York and an MBA from Harvard Business School. Questions about insurance can be sent to him at insadv@worldnet.att.net.

This article was previously published in the October 2000 Issue of Commercial Mortgage Insight.