Insurance Mistakes that Lenders Make

Kevin J. Connolly

Preliminary

• RTFP: Read the Fine Policy• Insurance is a contract• That pays money or money’s worth• Upon the occurrence of a fortuitous event• In which the policyholder has an insurable

interest• In the property-casualty world, keep the

difference between First and Third Party coverage clear

Why Insure the Collateral?

• Tangible property is subject to loss or damage through casualty.

• Failure to preserve the security for the loan might seem to be a lapse in care.

• Insuring the property against casualty loss just makes sense.

But then…when there is a loss…what do you—the lender—intend to do with the insurance proceeds?

Whither the Insurance Proceeds?

• There is more than one way to secure the proceeds for the lender– Loss Payee– Mortgagee

• Options– Keep the money and pay down the indebtedness– Apply the money to repair or replace the lost

property– Keep the money until the borrower repairs or

replaces the collateral

How MUCH Proceeds?

• The amount paid is not directly tied to the size of the mortgage debt.

• The size of the debt stands as a limit on the amount that the mortgagee can intercept (sometimes) but the amount paid depends on many factors.

• First of all, the loss has to be “covered.”

Covered?

• The loss has to be to property• At the site described in the Declarations• Damaged or destroyed by or as a result of a

covered cause of loss• Many things are not covered property

(underground, DEMCABS)• Many causes of loss are not covered, or require

special policies (e.g., “boiler & machinery”)

Exclusions

Building & Realty • ♦ Land,• ♦Water,• ♦ Bridges,• ♦ Roadways, walks, patios, and other paved

surfaces.• ♦ Retaining walls that are not part of a

building.• ♦ Bulkheads, pilings, piers, wharves, and

docks.• ♦ The cost of excavations, grading, back

filling, or filling.• ♦ Foundations below the lowest basement

floor or, if there is no basement, the surface of the ground.

• ♦ Underground pipes, flues, and drains.•

Plants and Outdoor Property exclusions:

♦ Outdoor grain, hay, straw, and other crops. ♦ Outdoor trees, shrubs, and plants (unluss they are the insured’s

merchandise). ♦ Outdoor radio or television antennas, including satellite dishes,

their lead-in wiring, masts, and towers. ♦ Outdoor signs, other than signs attached to buildings. ♦ Outdoor fences.

DEMCABS ♦ Deeds, ♦ Evidences of debt, ♦Money – including food stamps, ♦ Currency, ♦ Accounts, ♦ Bills, ♦ Securities –lottery tickets are not securities.

• And then there are excluded causes of loss…

Causes of Loss

• The insuring clauses promises to pay for losses “caused by or resulting from a covered cause of loss”

• A separate schedule is usually attached to identify which causes of loss are covered

• Open Peril forms, such as the ISO CP 10 30 Special Causes of Loss form, cover all perils except those that are excluded

• Named Peril forms, such as the ISO CP 10 20 Broad Form, cover only the perils that are listed

Causes of Loss

• We could spend a whole hour discussing causes of loss.

• Here are just a few significant points.– Even the most liberal coverage is going to exclude some causes of loss, such as war, nuclear release, and government activity.

– Some excluded causes have corresponding special coverage• Mechanical Breakdown Exclusion::Boiler & Machinery• Flood Exclusion::Flood Insurance

Value

• The property can be valued on the basis of the cost to replace it with new or like-new property.

• This is “replacement cost” valuation.• The primary alternative is “Actual Cash Value.”• ACV = Replacement Cost minus depreciation.• This is not depreciation in the ACRS sense, but a

simple valuation reflective of age, condition, etc.

Valuation

• Under a Replacement Cost policy, the full value is not paid unless the property is replaced or rebuilt.

• Most insurance companies will pay only the ACV until the policyholder proves that the property has been replaced or repaired.– The difference can be substantial. – Delayed release of the insurance proceeds can undermine the

payment amount.– Lender liability claims have been seen with slimmer bases than

this.• Access to the insurance proceeds to pay for the repair is

frequently negotiated…but if it isn’t…

Show Me the Money

• In some States (e.g. Texas), the mortgagee has no duty to make insurance proceeds available to pay for the repairs.

• In others (e.g., NY) the mortgagee has to reimburse the cost of repairs (up to the insurance proceeds) but no duty to advance money during the repairs.

• California takes a approach that appears to be unique—so far. The obligation of good faith and fair dealing mandates making the insurance available unless the security is inadequate or the loan is non-performing.

How Much Money?

• Insurance Company has options:– Pay the “value” of the property– Pay the cost to repair or replace with like-kind and

condition property– Perform the repair or replacement with like-kind

and condition property– Take the property and pay an agreed value or

value set by an appraisal proceeding• They will of course minimize the payment

How Much Money II?

• Coinsurance– Most occurrences result in partial losses– Policyholder might realize substantial premium savings by

under-insuring the property– Insurance requires the policyholder to refrain from under-

insuring the property– Most policies require the policyholder to insure the property

for at least 80% of its insurable value• Blanket coverage usually requires 90% coverage• Builders Risk usually requires 100% coverage

– Payment for partial losses is pro-rated if the policyholder fails to purchase the required amount of the insurance

How Much Money III

• Co-insurance can be daunting if the building is a legacy structure, e.g., masonry block building, that would be very expensive to rebuild– Unless the building is landmarked, the usual solution is

“functional valuation” based on the cost of reconstructing a building that is functionally equivalent

– Co-insurance can be sidestepped with an Agreed Value Endorsement• Insurance company does not agree to pay the Agreed Value• This applies solely to satisfying the required amount of

insurance

How Much Money IV

• Deductible– This is a portion of the loss that is not paid by

insurance– Usually stated as a fixed dollar amount

• The “basic” deductible amount is $500 per occurrence• Higher deductibles lower the premium/lower

deductibles increase the premium

– Some policies have a special deductible, e.g., for Named Storms: the deductible is a percentage of the loss or, in some cases, a percentage of the limits

Insurance Proceeds ≠ Substitute Collateral

• Payment is based on cost to repair/replace covered property

• Lots of things are not covered, or are covered for limited amounts

• There may be legal mandates on how you apply the funds. Demolition and Debris Removal can use up the insurance

• Valuation issues are always present

• Maybe insurance proceeds are a poor substitute for the collateral

Sundry Property-Casualty Mistakes

• Nomenclature– “All Risk” insurance does not cover all risks

• Call for Special Causes of Loss or equivalent• “Fire, Lightning, extended coverage, vandalism and malicious

mischief” is swallowed by the current forms

– Current insurance forms refer to Commercial Property Insurance, not Comprehensive Public Liability

– CGL insurance should be comprehensive—covering everything that is not excluded—but more and more insurance companies will endorse coverage down with “Classification Limitation Endorsements” that often eliminate all or nearly all coverage

TRIA, Terror and Humbug

• September 11, 2001 changed many perceptions

• Insurance companies reacted to 9-11 in the traditional insurance way: they sought to eliminate coverage.

• What coverage could be had was prohibitively expensive.

TRIA, Terror & Humbug

• Congress enacted the Terrorism Risk Insurance Act.• Once the insurance industry as a whole has

incurred $10B in annual losses, those insurance companies that have satisfied their own deductibles are eligible to receive a federal of up to 85% of the losses

• No event has been certified as meeting the criteria for being designated as an event of terror, and the bar is pretty high.

TRIA• Caveat: Some insurance companies have expanded the terrorism

exclusion far beyond the narrow definition in the statute• “the use or threatened use of force or violence against person or

property, or commission of an act dangerous to human life or property, or commission of an act that interferes with or disrupts an electronic or communication system, undertaken by any person or group, whether or not acting on behalf of or in connection with any organization, government, power, authority or military force, when the effect is to intimidate, coerce or harm a government, the civilian population or any segment thereof, or to disrupt any segment of the economy.”

• The “occupy” movement would fit under this definition, as might sit-ins, teach-ins, and similar civil disobedience.

• These things are essentially nuisances; but to discover that you have no insurance coverage is just an unnecessary complication.

Additional Insured

• This is a liability insurance concept• You CAN name an additional insured in a property

policy, but it’s a mistake• Under the standard commercial property conditions,

misconduct or concealment by any insured (during the underwriting of the policy or the presentation of a claim) will vitiate the whole policy

• Mortgagees who are covered by the standard mortgage clause are immune to this because the policy is construed as if the mortgagee had its very own policy.

Additional Insured

• This is a method of using someone else’s insurance to pay for your losses

• An additional insured on a liability policy should have the same coverage as the named insured parties…but many insurance companies have written AI coverage down to limit it to vicarious liability for the acts and omissions of the Named Insured…or to eliminate coverage for the active negligence of the additional insured party

• AI parties MUST be named as such by an endorsement to the policy

• RTFP

Additional Insured

• Why does a lender care?– Use the borrower’s insurance to pay for losses and

loss adjustment expenses– Even without liability, lenders get sued anyway– Receivership– Foreclosure

• Other transitional issues

Additional Insured Endorsements

• The gold standard in construction is the ISO’s CG 20 10, which makes the Additional Insured into an insured party for liability arising out of the continuing operations of the named insured

• Subcontractors can’t cover the owner this way (see CG 20 28 04 13)

• Coverage for completed operations requires a different endorsement

• Certificates of Insurance are inadequate as evidence of coverage

• You need to see the whole policy because coverage also depends on the “other insurance” clause in the policy

Additional Insured

• Loss Runs are the only way you can be sure that the coverage has not been used up

• There is no substitute for seeing the policy• The availability of AI coverage varies from State to

State• AIs do not get notice of cancellation/non-renewal

(Mortgagee coverage under property insurance is different.) It takes more (much more) than a note on the Certificate of Insurance to change this.

Texas Anti-Indemnity Law• Indemnity is subject to the usual limits, but this law also prohibits requiring

constructors to cover anyone else as an Additional Insured• Except

– Wraps– Breach of Warranty– Required by loan/financing document– Required by Sureties as a condition of executing the bond– Rights pursuant to the Workers’ Compensation Laws– Oilfields (which have their own statute)– Pertaining to governmental immunities– License agreements with railroads– Copyright infringement– Construction of residential property and public works– Joint defense agreements once executed

• The insurance industry is spending lots of money to get similar laws enacted nationwide.

Bonding• Surety bond provides a guarantee from a solvent third party. We

use archaic language– Bonds are “conditioned for” the desired result– Sureties and principals are not discharged by performance: they are

“exonerated”• The form of a bond is a formal acknowledgement of an

indebtedness with a condition that, if performed, the parties to the bond are exonerated.

• In construction, the usual bonds are Payment Bonds and Performance Bonds

• Payment Bonds are conditioned for the payment of amounts due to subcontractors, laborers and material suppliers for labor, services and materials

Bonding

• Performance Bonds are conditioned for the performance of the work

• Construction Bonds are typically exonerated by an Owner Default

• If you want coverage for an owner default then you want a Completion Bond– Very expensive– Very hard to get– Usually replaced by personal guarantees and/or

standbys

Bonding

• Lenders like to have “dual obligee” bonds• This has disadvantages– Any obligee can compromise the bond– Lender should demand terms that require Owner to

notify Lender of any Notice of Intent to Terminate and Demand for Conference with Surety

– Put this in the Construction Contract and it will be binding on the surety

– Remember you can draft to require Lender’s assent without making Lender take control of bond proceeds

Bonding

• Better approach for Lenders– Include the bond and proceeds in the collateral– Reserve the right to name a new beneficiary of the

performance bond– Do not take control of the proceeds unless you are

prepared to be accountable for them as a trustee– Require notice to Lender of Owner’s intent to terminate

and call for surety conference– Surety should recognize Lender’s rights – Include these terms in the contract so that surety is

bound to them