The ongoing downturn in the real estate market is forcing many professionals to make tough choices on where to trim expenses. While during a hot real estate market realtors would not consider dropping their errors and omissions (E&O) coverage, when business is slow and earnings are down, some professionals question the need for — and the cost of — E&O insurance. The fallacy in that reasoning is the assumption that E&O insurance is valuable only when client contact is high. Yet the coverage is also crucial when former clients have become dissatisfied with their earlier transactions.
Understandably, the current financial situation is foremost in the minds of many real estate professionals. According to the 2010 National Association of Realtors (NAR) Commercial Member Profile, realtors’ median annual income swooned nearly 31 percent in 2009. The earnings picture does not look brighter this year. While home prices nationally did rise 3.6 percent for the 12-month period ending Aug. 31, according to the S&P/Case-Shiller Home Price Index, offsetting that good news are several persistent problems.
The recent pricing gain follows a plunge since 2007 of 22.6 percent in the median price of previously owned homes, dropping prices to 2003 levels, according to the NAR. In especially hard-hit regions, prices have dropped more than 50 percent since the real estate bubble burst in 2006. Meanwhile, millions of additional foreclosures are anticipated in the next few years, which would add to the existing oversupply of homes and drive down prices further. Some 11 million homeowners currently have mortgages exceeding the value of their homes, and 4.8 million of them are more than 60 days past due on payments, a 30 percent increase from a year ago.
Fearful of their job security in an economy with its highest unemployment rate in a generation, many potential buyers are staying out of the market. In July, following the expiration of a federal tax credit for homebuyers, home sales fell a record 26 percent from July 2009 levels. August sales rebounded but still were 19 percent below August 2009 levels, the NAR reported. Given those conditions, many real estate experts are predicting additional drops in home prices over the next few years, until the home inventory glut has been eliminated.
Liability Problems Ahead
Real estate professionals should keep in mind that all these factors can signal E&O liability problems ahead. Because claims can take three to five years to develop, fallout from today’s transactions will not appear immediately. Clients upset about the plummeting value of their recent real estate investments may file suit against any professional involved in the real estate transaction, starting with the real estate agent and broker.
In those lawsuits, the two hot-button allegations are:
- Failure to disclose pertinent information and misrepresentation of other information, all of which eventually harmed the plaintiffs financially.
- Upselling where plaintiffs allege they were talked into buying an unaffordable house. They claim their agent facilitated a loan that provided affordable payments initially until the buyer could flip the property, which the agent assured could be done at a substantial profit.
Of course, many of those claims are frivolous. Markets heat up and markets cool down. Some buyers and sellers are either skilled or lucky in timing their transactions to take advantage of those market cycles, and some are not.
Regardless of the legitimacy of those claims, real estate agents or brokers who represented their clients professionally and conducted themselves ethically with other agents and their clients could still find themselves named as defendants in E&O lawsuits. The cost of defending those cases typically starts at $10,000 and has been known to reach $30,000. Some claims are more difficult for agents and brokers to successfully defend, and in those cases the transactions can have the appearance of impropriety, even if the professionals represented the clients as well as possible.
One example of a typical claim is if an agent or broker was a party in a transaction and did not disclose that information to all the other parties in the deal.
Another example is if an agent or broker did not inform a buyer client that the property involved in the transaction was being flipped quickly at a significant profit, even though the current owner made no substantial improvements to the property.
This is not the time for real estate professionals to drop or weaken their professional liability coverage. The premium savings would be a small fraction of the defense and settlement costs that the uninsured professional might have to shoulder.
Claims-Made and Prior Acts
Some professionals consider dropping their E&O insurance, mistakenly believing that the premiums they have paid for years have secured them future coverage for claims arising from past transactions. However, that is not how professional liability insurance works as it is written on a claims-made form.
At the end of a policy year, there often is no indication whether a claim will arise from a transaction that was completed during that period. A claim might not be filed for years. However, unlike occurrence-based insurance, claims-made coverage generally applies only to claims made against the insured during the time the coverage is in effect and requires the policyholder to notify the insurer of the claim within the policy period or during the 30- to 90-day tail period after the policy period ends.
Since the policyholder often will not become aware of a claim during the 14- to 15-month combined policy and tail period, E&O insurers offer prior-acts coverage. This policy provides insurance coverage for claims arising from transactions completed years earlier, as long as the policyholder has maintained continuous coverage with prior-acts coverage during that entire period.
Another E&O coverage problem sometimes occurs even when agents and brokers do not drop their E&O coverage, but instead switch insurers for cheaper rates. During negotiations over the new policy, various coverage options are typically reviewed, sometimes including eliminating prior-acts coverage. Dropping that coverage can be tempting because of the resulting reduction in premium. However, that could be a costly mistake since neither the new policy nor the expiring policy would cover claims relating to past transactions if those claims arose after the original policy’s tail period had expired.
The financial constraints of a tough economy don’t provide an excuse to skimp on professional liability coverage. Doing so can be as dangerous for real estate professionals as would neglecting fraying nets for high-wire acts just because they are performing for smaller audiences.
Donovan is senior vice president of professional liability for Liberty International Underwriters.
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