This article was first published by Estates Gazette, January 2018

When owners of freehold non-mortgaged buildings set up building insurance, they are free to choose the insurer, the sum insured, the level of deductible and other business conditions. They may have to factor in localized risks such as flooding or subsidence to ensure that they are fully covered, but, if the worst happens, they will usually have the discretion to negotiate the settlement and decide. to apply the product to the reclamation of the property. , or just to pocket them for a rainy day. However, once lenders are introduced, the homeowner does not have the same freedom to purchase insurance, what risks are covered, and how to handle the product. In the case of investment properties, which are leased to tenants and billed to a lender, things can be even more complicated. This article provides an explanation of some of the different terms used to describe the various insurable interests in commercial property and an analysis of the tensions that may arise.

Interest from lenders

The adequacy of building insurance is a key factor in real estate finance transactions, as the underlying asset is the basic security of the loan. When a lender has provided financing to a borrower to acquire a property, they will want to ensure that the property is adequately insured for the cost of its reclamation and for the loss of any rental income. The lender will also want to be assured that they have access to the insurance proceeds so that they can control whether to order the borrower to use it for prepayment of the loan or to rehabilitate the property, and that loss of rent insurance will serve interest and principal payments. due under the loan. In addition to establishing these facts at the due diligence stage and insisting that a compliant policy be a prerequisite for debit, the lender will request a copy of the policy after each annual renewal, and there will also be commitments. pending in the facility agreement that the premiums will be paid and the terms of the policy will not be waived. Non-compliance can often be a named event of default.

However, as a further step, the lender will want their interest in the property reflected in the policy. There was a protocol in place until 2012 with the Association of British Insurers, which meant that if a lender’s interest was noted on a borrower’s insurance policy, in case the borrower would terminate or change the policy, the insurer would notify the lender and give them a grace period to allow the lender to arrange their own replacement coverage.

This protocol is now complete and lenders have been forced to be more prescriptive in their insurance requirements. Lenders may wish to be “composite insured” with the borrower and benefit from the “first beneficiary” provisions attached to the policy. Alternatively, they can insist on a “standard mortgage clause”.

Composite insurance

This term applies when there are two or more parties with separate insurable interests in a property, although in the same insurance contract. Each party has the right to directly claim against the insurer and receive payment under the policy, even if the other party has violated any of the terms of the policy. In the lender / borrower scenario, the lender, as a composite insured, would be able to negotiate a claim settlement based on its own priorities, rather than those of the borrower.

Beneficiary of the loss

This term refers to the party to whom the insurance proceeds will be paid, if not to the insured. When a lender is named as the primary beneficiary, the insurer is required to make payment directly to the lender.

In the past, composite insurance and loss beneficiary status were generally only appropriate for larger transactions due to the cost and inconvenience of organizing them. However, following the end of the protocol, it largely becomes the only acceptable position for lenders in real estate financing transactions. The arrangement takes full control of the borrower with the lender able to take over any claims from the borrower and it may even delay the process.

The composite insured should not be confused with Spouse insured – this allows all interested parties to secure their own interests in the property and therefore to assert their own claims. Insurers will generally insist that an additional premium is payable for the benefit of joint insurance and will often impose a disclosure obligation on all insureds as well. Disclosure requirements are particularly onerous for lenders who will have little or no working knowledge of the property and the particular risks associated with it. As risks are communicated to the lender in a monitoring report, institutional lenders are sensitive to being deemed aware of a significant issue when the recipient of the report may not recognize the importance of an issue. and know how to disclose it to the insurer.

Standard mortgage creditor clause

This provides that the insurer undertakes not to avoid or vitiate a policy in the event of a false declaration, act or omission by the borrower or to terminate the policy without first notifying the lender and him. give the option to pay renewal fees. This would only benefit the lender if it is not a composite insured and does not have its own insurable interest.

Insurance conditions in leases

Fixed-rent commercial leases will generally contain a commitment by the landlord to insure the property, an obligation for the tenant to repay it for the cost of doing so and, with the exception of any act or omission by the tenant that would vitiate the policy or limit the product, an obligation of the owner to rehabilitate the property with any product received. Loan contracts are drafted in such a way as to require the borrower / lessor to apply the proceeds of the insurance to the repayment of the loan, subject to the provisions of the professional lease. However, if the property is vacant at the time of the damage, as would be the case with absence between rentals, the effect of the standard wording of the loan agreement would require the borrower to repay the loan. This would leave the borrower without funds to return the property to a rental condition and potentially prevent them from re-renting the property as an investment, as planned.

There is a great potential for confusion around the terminology adopted by lawyers, parties and insurance professionals. In particular, the terms “co-insured”, “co-insured” and “composite insured” mean different things for different parties, and it is important to ensure consistency between the wording of the policy and the obligations set out in the policies. loan contracts.

Letters from brokers

In more complex or large real estate finance transactions, rather than simply reviewing insurance policies as part of the due diligence process, the lender may require a letter from the borrower’s insurance broker confirming that the policies in place comply with the provisions of the letter facility. This exercise may take longer if the lender and broker use different language or insist on their own standard form. The lender’s duty to disclose is again a strongly negotiated issue in such letters. Lenders will want to avoid any obligation in this regard, especially large institutional lenders whose asset management function may not be aware of individual disclosure requirements, with the consequent risk that a disclosure trigger will be overlooked. The Loan Market Association introduced its own form of broker letter in 2016, which only imposes a disclosure obligation on a lender if it becomes a mortgagee in possession. However, lenders who do not use LMA documentation always insist on their own form of letters and these should be carefully considered by the borrower and his advisers.