Introduction In commodity finance structures it is usual for the lender to require the borrower to arrange insurance cover for the goods that serve as collateral for the loan. This is because if the goods are damaged, lost or stolen, the borrower may be unable to repay its indebtedness under the loan when due.
Simply ensuring that insurance exists is, however, insufficient. In the event of the borrower suffering a loss covered by the policy, the lender may want itself to be able to exercise direct rights over the proceeds of the insurance claim. This may be because the borrower fails to pursue a claim or because the borrower becomes insolvent.
When it comes to ensuring that the lender will have adequate rights over the proceeds of an insurance policy in respect of the goods, the devil really is in the detail. This high-level briefing aims to identify the features – as well as some pitfalls – associated with four types of insurance interest that might be obtained by lenders in commodity finance structures:
- A lender’s interest ‘noted’ on an insurance policy
- A loss payee clause in the policy in favour of the lender
- The assignment of a policy or its proceeds from the borrower to the lender
- A policy to which the both the lender and the borrower are party
A. Noting an interest While previously a common practice in the mortgage lending industry, the ‘noting’ of a lender’s interest on an insurance policy is no longer considered to be of material value and is not common practice in the commodities sector.
Although the terms of policies will differ, simply noting the interests of a lender on the policy would not normally in itself give the lender any right to be paid the proceeds of the policy. The effect of noting may be that the insurer will advise the lender if the insurance policy is at risk of lapsing or becoming invalid, e.g. where the borrower does not pay any premium, or whether a claim on the policy is made. The fact that a lender’s name and interest are noted on the policy does not however make the lender a party to the policy with a right to claim against the insurers. The lender should make sure there is a contractual obligation on the insurer to give it the appropriate notices that is requires.
B. Lender named as ‘loss payee’ A ‘loss payee clause’ is a clause in the policy that states that the proceeds of any claim by the borrower under the policy must be paid by the insurer, not to the borrower but instead to the lender.
A loss payee clause will be legally binding on the insurer as a term of the policy but nevertheless may not provide the lender with the security it would expect. This is because, as the lender is not itself a party to the insurance policy, it will have no right (at least at common law) to enforce the loss payee clause directly.
It may be the case however that the lender can enforce its rights under the loss payee clause under the Contracts (Rights of Third Parties) Act 1999 (the Act). The Act allows a third party to enforce a term of the contract if the term expressly states that it may do so or if the term “purports to confer a benefit” on the third party. A well drafted loss payee clause that identifies the lender as the party to whom the proceeds of the policy is likely to at least “purport to confer a benefit” on the lender within the meaning of the Act.
It should be noted however that the Act can be excluded by agreement between the parties to the policy. Indeed, clauses excluding the rights of third parties to enforce the terms of insurance policies are commonplace. Without a direct right of enforcement of the loss payee clause under the Act, the value of the loss payee clause to the lender is significantly undermined.
For example, if the insurer wrongfully refuses to honour the loss payee clause, and the lender has no direct right to sue the insurer, it will be up to the borrower to enforce the clause in its own name. Whilst the borrower or its liquidator can be expected to have an interest in the successful outcome of an insurance claim, without enforceable rights under the loss payee clause the lender will not have direct control over the handling of the claim against the insurer.
The lender should therefore ensure (as a term of the facility agreement with the borrower) that the insurance policy must at the very least not exclude the rights of third parties under the Act - and ideally that the policy should state in express terms that the lender will have a direct right to enforce the loss payee clause pursuant to the Act. These are matters which the borrower will be responsible for ensuring are addressed in the policy and which the lender will need to verify itself by checking the policy.
A further drawback with a loss payee clause as a form of security is that the rights of the lender under the policy are dependent upon the validity of the borrower’s claim. If the borrower’s rights are lost, e.g. because the borrower fails to give full disclosure to the insurer at the outset of the insurance, breaches the terms of the policy or has no insurable interest the lender’s security is lost too. These are matters over which the lender has no direct control.
C. Assignment Lenders will often seek to take an assignment of a borrower’s insurance policy as part of their security package. It is more common for the lender to take an assignment of the proceeds of the policy rather than an assignment and novation of the policy itself.
An assignment of rights will only be permitted if the policy does not prohibit it, but such prohibitions are relatively common, not least because the identity of the person able to bring a claim is part of the risk profile as perceived by insurers when agreeing to provide cover. Insurers may perceive a financier – with no ongoing relationship with the insurer – as being more likely to bring a claim under the policy and at an earlier stage than the borrower.
For such an assignment to be a legal assignment (and not only an equitable assignment), notice of the assignment must be given to the insurer. A legal assignment would allow the lender to bring claims directly against the insurer in its own name – and as such it would not be necessary for the lender to join the borrower as party to the proceedings against the insurer. Like having the benefit of a loss payee clause, an assignment of an insurance policy is only as valuable to the lender as the policy itself. If the policy can be terminated because of something the borrower has not done, for example non-payment of premium, and as a result the insurer can deny cover, the assignment of the insurance policy is worthless to the lender as a form of security.
If possible, when taking an assignment of an insurance policy, a lender would be advised to obtain direct assurances from the insurer as conditions precedent to the disbursement of funds:
- that the policy delivered by the borrower is the policy in force and has not been amended or otherwise varied;
- that the insurer will give the lender a sufficient period of notice before the policy is cancelled or allowed to expire (as this will give the lender an opportunity to ensure that replacement insurance is arranged or to exercise its other rights against the borrower); and
- that the insurer has not previously been given notice of an assignment of the policy or its proceeds to another person.
D. Lender as party to the policy The best position for the lender to be in from a legal perspective is to be named as co-insured under the policy, along with the borrower. The appropriate insurance is so-called ‘composite’ (rather than ‘joint’) insurance, whereby the borrower and the lender are deemed to have separate policies with the insurer. The policy should state in clear terms that any breach of the policy by the borrower will not affect the rights of the lender under the policy. This will allow the lender to bring claims in its own name even where the borrower has breached its obligations to the insurer. Clearly, increased costs may be associated with such insurance.
Conclusions Lenders seeking direct rights over the proceeds of their borrower’s insurance policy should consider carefully the manner in which they wish to obtain such rights. Where a lender wishes to be the beneficiary of a loss payee clause or to take an assignment over the borrower’s insurance, the lender should monitor closely the terms of the policy as agreed by the borrower with its insurer to ensure that the lender’s rights are not excluded, e.g. by provisions excluding the Contracts (Rights of Third Parties) Act 1999 or the borrower’s rights of assignment. Unless the lender is party to the policy itself, with rights against the insurer independent of the borrower’s rights, it risks losing the protection of the insurance in circumstances where the borrower breaches the terms of the policy.