Ask Henry

Determining Adequacy of Insurance Limits
Dear Henry,
Do you have an explanation as to why Fannie Mae allows the cost approach to be used for determining adequacy of insurance limits? Let me explain.

“The lender wants to be sure the property owner carries adequate insurance to protect the lender.”

If this were the case, why would the lender request the cost approach? The cost approach is a new construction based estimate, not the cost to rebuild after a loss. It may be more accurate to say that lenders need documentation to satisfy Fannie Mae requirements to sell their mortgages into the secondary market. The estimate from the cost approach will satisfy Fannie Mae, but that wouldn’t be adequate insurance to protect the borrower or the lenders’ collateral. The insurance industry has different cost guides.

  • Marshall & Swift/Boeckh – RCT & BVS (not the same cost guide as the MVS books)
  • Xactware – 360-Value
  • e2Value

These are all reconstruction based replacement cost estimating tools. Borrowers that are advised to set their insurance limits based on the “replacement cost” estimate in the cost approach section of the real estate appraisal will be underinsured. They won’t have enough to fully recover from a total loss, and they’ll be in jeopardy of a coinsurance penalty on any partial losses.

So I ask again, can you explain why Fannie Mae allows the cost approach to be used for determining adequacy of insurance limits?

Regards,
J. Nixon

Dear John,
Fannie Mae & Freddie Mac do not require the Cost Approach but permit its use when the appraiser thinks it is necessary. If in your scope of work dialogue with the lender/client a cost approach is asked for I see nothing to prevent you from providing it. I do believe that the reproduction cost you provide could be useful to the lender. I don't understand why using the reproduction cost would result in the property being under insured. There are a variety of ways homeowner insurance policies are written concerning what definition of value will be used to determine the amount of a claim or the amount of insurance needed.

Many insurance policies are based on the Actual Cash Value of the improvements. This is the depreciated value of the improvements. It does not include the value of the site and site improvements. Some insurance policies are based on replacement cost of the improvements. Usually this is less than the reproduction cost. The URAR begins the cost approach with an estimate of the "Reproduction Cost."

HSH
askhenryharrison@revmag.com