Insurance is a part of virtually every transaction. Lenders want the security for a credit facility appropriately insured. Lessors and lessees alike want real and personal property protected by insurance. Buyers and sellers look to first-party and third-party policies to insure items sold and support the allocation of risk in indemnity provisions.
For all its pervasiveness and importance, insurance terms may be treated as boilerplate when, in fact, the circumstances of a particular transaction may warrant a more nuanced approach. In order to avoid future disputes, fulfill the intents and expectations of the parties, and add value to the transaction, corporate counsel should be familiar with the following five insurance tips:
1. Additional Insured v. Loss Payee
Lenders will often require borrowers not only to maintain appropriate insurance protecting the security for a credit facility, but to name the lender in some fashion by endorsement to the appropriate insurance contract. Lessors may compel lessees to procure insurance for the leased premises on behalf of the lessee and lessor. Buyers may insist that the seller add the buyer to existing policies insuring the sold property to protect against losses occurring prior to closing. Lenders and borrowers, buyers and sellers, lessors and lessees should all carefully review provisions requiring counterparties to name others as loss payees or additional insureds.
While an “additional insured” is a party to the insurance contract, depending on the applicable law, a “loss payee” may or may not have standing to pursue a claim for breach of contract for failure to provide coverage. Likewise, a “loss payee” may or may not be considered a third-party beneficiary for purposes of enforcing a claim for policy proceeds. In some jurisdictions, a “loss payee” may have no greater right than to enforce the insurer’s obligation to name the loss payee in whatever payments, if any, are made by the insurer. For contractual requirements obligating others to obtain insurance for the benefit of the counterparty, such provisions arguably should require “additional insured” status as opposed to the designation of a “loss payee.” Alternatively, in other situations, where the insurance is procured by the lender and intended only to protect the financial interest of the placing party, the designation of “loss payee” may be appropriate for the borrower.
2. Policy Assignments
Many agreements contain language requiring the seller, in the event of an unresolved claim or new loss occurring prior to closing, to assign to the buyer all rights, title and interest in insurance proceeds relating to such claim or loss, subject to qualifications. However, many insurance policies (covering both first- and third-party claims) include anti-assignment provisions prohibiting the transfer of the policy or rights under the policy without the written consent of the insurer.
In most jurisdictions, anti-assignment clauses do not prevent an insured from making post-loss assignments of claims, which by definition do not alter the risk assumed by the insurer. Although, in other minority jurisdictions, including Texas, anti-assignment provisions may be strictly enforced, even as to post-loss transfers. If the buyer intends to have recourse for policy proceeds against both the seller and the insurer, when transacting in a minority jurisdiction, alternative provisions may be necessary to protect the buyer’s interest in unpaid insurance proceeds.
3. Insurable Interest
Recovery under a first-party insurance policy (commercial property, builders risk, crime/fidelity) requires, as a matter of public policy, that the insured have an “insurable interest” in the damaged items for which coverage is sought. The necessary “interest” may be satisfied by ownership or when the claimant/insured will suffer an economic loss if the property is destroyed. When property that is the subject of a pending claim is transferred, the question becomes: when is the requisite insurable interest measured and can a party lose or acquire an “insurable interest” in a transaction?
Generally, insurable interest is determined either at the time the policy is issued or at the time the loss is sustained. Secured lenders and borrowers, for example, are each generally understood to have an insurable interest in collateral for a loan. Accordingly, a borrower may lose an insurable interest as a result of foreclosure − but only with respect to post-foreclosure losses. A lender may retain an interest in and claim on insurance proceeds for a pre-foreclosure loss only to the extent that any indebtedness remains after the foreclosure. If the lender’s debt is satisfied by a foreclosure, the borrower retains all rights to insurance proceeds or to claim against an insurer for any deficiency relating to a pre-foreclosure loss.
Applying these general principles, whether or not, for example, a lessor has an insurable interest in a lessee’s personal property, or whether a transferee has an insurable interest with respect to pre-transaction losses, will depend on the facts and circumstances of a given case. At a minimum, transactional counsel should be aware of the potential impact that different transactions and contractual terms have on a party’s insurable interest and the concurrent right to pursue coverage under applicable insurance.
4. Policy Limits, Self-Insured Retentions, Deductibles and Co-Insurance
While many transactional insurance requirements define the limits of insurance necessary to secure an asset, property or other collateral, in practice, those policy limits may be subject to self-insured retentions, deductibles or co-insurance penalties. A self-insured retention, or “SIR,” is the uninsured amount of loss or damage above which the policy’s limit attaches. A deductible is the uninsured amount that erodes or fits within the policy’s limit. If the policy contains a co-insurance clause, and the value of the insured property exceeds the applicable co-insurance percentage at the time of the loss, the amount actually payable may be substantially discounted in proportion to the excess uninsured amount − regardless of what limit is proscribed in the policy. In a large commercial insurance program, the SIR or deductible may be significant − totaling tens or even hundreds of millions of dollars. In order to ensure that, in the event of a loss, the lender, lessor or buyer is not looking respectively to the borrower, lessee or seller for recovery, in spite of specific insurance requirements, contracts should address not only policy limits, but also terms relating to retentions, deductibles and co-insurance.
If the risk for which insurance is required in a transaction is truly substantial − requiring tens or hundreds of millions of dollars in capacity − excess coverage may be required. Parties relying upon counterparties’ insurance should consider and affirmatively address the prospect that excess policies may be used to satisfy insurance requirements. In the event that excess coverage is permitted, all parties should ensure that the terms triggering excess coverage are broad enough to permit an additional insured or loss payee − lender, lessor or buyer − to exhaust the limits of underlying insurance if necessary.
5. Claim Valuation and Allocation of Proceeds
Commercial property insurance of the type that may insure the security for a credit facility, leased premises or the subject of a purchase and sale agreement (“PSA”) typically covers more than just the loss or damage to the property itself. Depending on the policy, commercial property insurance may include coverage for business interruption, i.e., lost profits, and (among other things) the extra expense incurred to continue operations in spite of a covered occurrence. Coverage may also extend to other items, such as the cost incurred to investigate and submit a claim to the insurer.
When the insured property is the subject of a credit facility, lease, PSA or other agreement, the interests of the counterparties in these different coverage parts may vary. To avoid disputes over who is entitled to recover these amounts when a claim is made, care should be taken at the outset to define which party is entitled to which policy benefit. Moreover, when the claim is submitted and paid, equal effort should be made to identify and appropriately allocate policy proceeds among the parties according to their interests.
In many policies insuring real property, the value of the claim depends on whether the damaged property is actually replaced. If the property is replaced, the insureds will often be able to claim the actual cost incurred for replacement. If the damaged property is not replaced, however, the insureds, additional insureds and loss payees may be left with “actual cash value,” i.e., replacement cost less accrued depreciation. Again, to ensure that the claim value is maximized, some accommodation for repairs should be addressed by the parties at the outset in a transaction.
Every transaction has its complexities. And every lawyer wants to anticipate and address important contingencies. The insurance terms in complex contracts often have important implications for parties and counterparties. By better understanding insurance and the five issues addressed above, clients and counsel can avoid risk and add value to a deal.