A storm is brewing between insurers and the government over the future of flood insurance. Laura Oliver and Julia Heyn consider the legal implications.
If Noah were alive today he would surely insist on taking out insurance against flood risk. Even without Noah’s pessimism, concern about flooding over recent years stems from more than the British obsession with the weather. There is a wealth of evidence that weather patterns are changing and that surface water flooding is an increasing problem.
After the wettest June in 100 years prompted headline reports on flooding, the size of the repair bill warrants a serious review of the risks and implications of flooding to property owners, occupiers and lenders alike. This is particularly true since the current deadlock between the Association of British Insurers and the government threatens the future availability and affordability of flood insurance.
In 2000, the ABI and the government agreed a Statement of Principles on the Provision of Flood Insurance. It committed the insurance industry to providing flood cover for domestic and small business premises as widely as possible. In return, the government committed to ensuring that flood risk was appropriately managed and that long-term commitments were made during the period of the Statement in order to reduce flood risk.
The Statement was always a temporary measure. In the ABI’s view, it was problematic for a number of reasons. New entrants to the insurance market do not have to adhere to the Statement and, as a result, they have been able to avoid offering insurance in highrisk areas leaving existing insurers at a commercial disadvantage. The ABI also believes that the Statement hinders the development of specialist flood insurance for high-risk properties and limits incentive for the uptake of resilience measures to protect properties. The Statement does not apply to any property built after 1 January 2009, nor does it apply to all commercial properties (only those qualifying as a “small business” which is undefined in the Statement).
The expiry of the Statement in June 2013, combined with increasingly sophisticated and available information on all sources of flood risk (river, coastal, groundwater and surface water), is now prompting insurers to review their method of assessment for all properties. The improved assessment of surface water flood risk in particular is beginning to impact on the number of properties assessed as being at material risk of flooding.
A brighter outlook?
Several alternative models are being considered by the government including a pooled model (Project Noah), a flood levy similar to the Pool Re model used for insurance against terrorism and a pure risk-based model. The Environment Secretary, Caroline Spelman, did not commit to any of these in her speech at the ABI Property Conference on 22 May 2012, but she did say that the government were “looking carefully at the models” and alluded to “the beginning of a solution”.
All property owners need to be aware of the consequences of these potential changes. Where properties are owned freehold, without finance and owner occupied, the property owner may be happy to weigh up the benefit and cost of insurance against the risk of flooding. However, where property ownership is complicated by leases and financing, the picture is not quite as straightforward.
Issues for landlords and tenants
Typically in commercial occupational leases, flood is specified as an insured risk which the landlord is required to insure against and the tenant must reimburse the cost of doing so. However, in particularly high-risk areas, insurance may not be available or may only be available at a high cost.
No insurance available
The landlord’s obligation to insure may be subject
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to a carve-out where cover cannot be obtained or there may be “uninsured risks” provisions in the lease. However, if the obligation to insure is absolute, the landlord will be in breach of its contractual obligations if insurance cannot be obtained. The landlord may then find itself liable not just for reinstatement of the damage but may also face additional claims if the tenant suffers losses over and above those it would have suffered had the landlord not been in breach.
If the landlord is able to rely on a carve-out to its obligation to insure or if flooding is a risk not specifically dealt with in the lease as an insured risk, the cost of repairs will usually fall to the tenant under its repairing liability or under the service charge provisions although service charge caps may limit recoverability. Even if reinstatement does fall on the tenant, the landlord may not be in the clear. The solvency of a tenant (and therefore its ability to pay the rent) could well be undermined if it has to repair significant damage caused by flooding.
In recent years, there has been a trend towards the inclusion of “uninsured risks” provisions in leases. The popularity and acceptability of such provisions arose out of concerns that terrorism would become uninsurable but, if properly drafted, they will transfer the risk of damage by all uninsured risks from the tenant to the landlord. Where “uninsured risks” provisions are in place, the landlord can usually choose whether to terminate the lease or reinstate at its own cost. If the landlord chooses to reinstate, the rent payable by the tenant is usually suspended until reinstatement is completed.
Insurance only available at high cost
If insurance for high-risk properties remains available, albeit from niche insurers at higher premiums and with higher excesses, the landlord may still be able to rely on a carve-out from its obligation to insure. Such obligations are often phrased by reference to cover being available at “reasonable rates”, but this concept is far from clear-cut. For example, should “reasonable rates” be assessed in the context of a property at high-risk from flooding or in the context of the market as a whole?
If the landlord chooses to insure again flooding at a high premium, it will usually be the case that it can recover the cost from the tenant. When negotiating leases in relation to high-risk properties, tenants may therefore want to consider whether the landlord should be obliged to seek the least expensive deal and consult the tenant prior to putting such cover in place.
Issues for lenders
For a lender, problems will arise if the unavailability of flood insurance affects the underlying value of the secured property.
This issue coincides with increasing pressure on banks to ensure they are adequately capitalised which has resulted in greater importance being placed on the robustness of any collateral they hold for credit risk mitigation purposes. Where the collateral consists of high flood risk property, and flood cover proves unobtainable, the collateral may be considered inadequate and banks may not be able to rely on it to reduce the amount of capital that they need to hold in respect of the borrower’s credit risk.
Assessing the risk
It is not widespread practice for solicitors to commission a flood risk report as part of the usual due diligence process. RICS guidance recommends that surveyors should be aware of how flood issues affect properties, but full investigation will usually require specific instructions from the client. The unwary lender could therefore find that where flood risk is an issue, its security is worth significantly less than it thought.
Where new security is being taken, lenders should consider requiring a desktop flood risk report. In addition to assessing the potential risk of flooding from surface or ground water, a good report will advise on the availability of insurance and the potential to develop the site. It may also recommend steps which could be taken to reduce the risk.
Even if a flood risk report discloses that a property is in a high-risk area, a site investigation may negate the concerns raised by the report or a specialist may be able to suggest preventative measures to reduce the risk of flood damage. These measures could be included as conditions subsequent to drawdown.
Plugging the risk
Typically, the borrower’s covenant to insure will not refer to specific risks but will be phrased by reference to the lender’s requirements or to what a prudent property owner may insure against. The heightened awareness of flood risk may prompt lenders to specifically require insurance against flooding regardless of cost. Either alternative could pose problems for borrowers who might find themselves inadvertently in breach of their loan covenants.
For lenders, the information covenants in the loan documents should be sufficiently wide to ensure that if flooding ceases to be available on normal commercial terms, the borrower will be under an obligation to notify the lender. In the event of notification, the lender should be able to require a new valuation to test the loan to value ratio.
It is unlikely that the inability to insure against flooding will, in itself, amount to an event of default, but there may be an impact on the loan to value ratio which the borrower has covenanted to maintain.
And the moral of the story?
Property owners, occupiers and lenders alike should understand the level of risk for their properties. Flood risk reports may provide a useful assessment but the small print in existing leases and security documents also needs to be reviewed carefully and professional advice may be required.
Of course, insurance alone does not necessarily provide all of the answers. Even where it is in place, it may not cover all of the losses and consequences of flooding. In a strained economic climate, occupying businesses may not survive the disruption caused and the fall out may have a serious impact on underlying values.
A previous version of this article was published in Property Law Journal on 28 May 2012