How much more capital would your investors provide if you exceeded expectations for preserving their capital?

Warren Buffett, the Oracle of Omaha, has a Golden Rule: “Rule No. 1 is never lose money. Rule No. 2 is to never forget Rule No. 1.”

The standard investment rule Buffet follows is to preserve investor capital. This seems like a very easy rule to follow, yet most lenders never get past the numbers in their prospective deals. You probably did a great job underwriting the loan. You have the right to foreclose for nonpayment, and you may have even cross-collateralized against the borrower’s other properties.

Did you forget something? Did you underwrite the risk in your borrower? Buffet tries to preserve investment capital, so should you as a lender try to preserve your capital? Absolutely yes!

Once your loan is closed, will your borrower protect you and your investors? Most likely, no. Once you fund your deal, your borrower’s interest or need in you is over. This makes your borrowers the greatest risk to your loan portfolio.

Builder’s Risk, Worker’s Comp and General Liability Coverage
Simply put, what can go wrong, will go wrong. Consider your typical fix and flip borrower. The borrower provided information that allowed you to provide funding, including proof of insurance. Is the proof real? Is the policy currently in force? Is the coverage right?

Some borrowers believe that a standard homeowner’s policy is all that is needed. Yet there is a vast difference in builder’s risk coverage and a standard homeowner’s policy. The traditional agent provides a homeowner’s policy that will not cover a typical, non-owner-occupied property. That is not the type of policy this lender needs.

In addition, if this borrower was also the contractor, as a lender, you should have received a copy of your borrower’s workers’ compensation policy and general liability coverage too. Missing any of these important coverages could result in your borrower being sued and defaulting on your loan, leaving you and your investors holding an empty bag.

Force-Placed Coverage
Another common mistake for newer lenders is overlooking force-placed coverage. These are coverages for when the borrower’s insurance is cancelled, has lapsed or isn’t sufficient. First, force-placed coverages are expensive. Second, insurance carriers know that when you as a lender are force placing the required coverages, the relationship between you and your borrower is already in the proverbial toilet.

Most insurance carriers want to know about your loan portfolio long before a loan is in trouble. Usually, your initial application is a disclosure about your loan portfolio. Consider the difference between a lender who has only two loans and both loans need to have force-placed coverage and a different lender who has 100 loans with only two properties requiring force-placed coverage. One of these lenders cannot underwrite. Who do you think the insurance carrier will accept?

A different force-placed problem happened recently to a “new” lender in Las Vegas. The lender funded a short-term purchase loan. The borrower did initially provide a homeowner’s policy. A few months into the loan, payments stopped. Unfortunately, this lender made a key mistake. The loan included language allowing foreclosure for nonpayment; however, the note never required the borrower to maintain liability coverage. In this specific case, the lender could not force place the coverage because the contract did not state that as a condition of the loan. Eventually, after multiple court appearances, the lender was able to foreclose. The lender still needed to evict the borrower. Yes, a different court venue was needed to evict. By the time the lender got the house back, the house was missing all copper plumbing and wiring. Rehabbing the house the second time was entirely on the lender’s dime.

Key Person Insurance
Insurance cannot be used to guarantee an investment gain. What kind of coverages can a private lender require of their borrowers? Before that question is answered here, a quick review of other lenders is needed. 

The conventional lending world offers credit-life and credit disability-sickness coverages. You might have heard about that coverage. It is called mortgage protection insurance. Credit life cannot be a condition of receiving a conventional loan. Remember, these policies do not pay the lender “if” the borrower just decides to stop paying. The borrower must die or get sick for the lender to be paid on “credit” policies. Additionally, U.S. Small Business Administration (SBA) guaranteed loans above certain thresholds require key person coverage on the borrowers. Key person could be life insurance or disability-sickness policies on the borrower. The lender is the loss payee. Why place key person coverage on the borrower? Statistically, loss of work resulting from an injury or sickness is still one of the leading causes of foreclosure in the U.S. If your borrower cannot work, he or she cannot earn income, complete their project or more importantly, pay you back.

For any risk you see as a lender, you may be able to seek insurance coverage. The ultimate benefactor of any insurance on a loan are your investors. The bottom line? As lenders, you underwrite the loan, and the insurance solutions you place on the loan preserve lender capital.

Why would a private lender require key person coverage when you already have the right to foreclose for nonpayment? The answer is simple: How long do you want to wait before you get paid back? Foreclosure rules vary by state and municipality. Plus, the borrower’s family could get involved, making foreclosure time-consuming and costly. Key person coverage offers lenders an alternative source of repayment.

Choosing which types of insurance coverages you, as a lender, should require on your borrowers is based on the risk aversion of your investors. How much more capital would your investors provide if you went above and beyond expectations when preserving their capital? Above all, finding a solutions provider that thinks out of the box and focuses totally on the private lending world is key. Insurance agencies and providers are specialized. Be wary of the insurance partner who merely replies that they too offer that solution. Your question to that insurance agent should be “Why didn’t you tell me about this before?”