In Part 1 of this series we touched on the importance of insurance provisions in commercial contracts, the use of outdated terms, and additional insured status. In Part 2, we reviewed the difference between a deductible policy and a self insured retention.
Today we hope to provide some clarity to the distcintion between being named as a Loss Payee compared to a Lender Loss Payee.
In a financing agreement, a lender might request to be named as a Loss Payee. The first reaction should be “why aren’t you requesting to become a Lender Loss Payee”? Without an understanding of insurance law principles, this distinction is commonly ignored or misunderstood.
Secured lenders seek to protect themselves from a debtor’s default by perfecting a security interest in certain of the debtor’s assets (commonly land, buildings, equipment, or inventory). As a means of further protection or simply as a credit enhancement, the lender may also require that the collateral be insured. If the collateral is insured by a legitimate, rated, commercial insurance carrier, the lender will be more likely to lend money because in the event of a catastrophic loss, the debtor will receive insurance proceeds with which the loan can be paid off and the lender made whole. The lender sometimes goes one step further and requires the borrower to name the lender as a Loss Payee on the policy.
However, in certain instances, an insurer has no obligation to pay because of a policyholder’s misconduct or failure to comply with certain policy provisions. For example, the insurer can often avoid any indemnity obligation because of the policyholder’s fraud, failure to give timely notice, failure to sit for an Examination Under Oath, or intentional acts. In those instances, the lender would be exposed to an uncovered loss; the contract term which bargained for insurance would be ineffective because of the policyholder’s misconduct.
The practical implication is that if a borrower commits arson – burning the building, equipment, and inventory in an attempt to collect insurance proceeds – the insurer may have zero liability to a Loss Payee. On the other hand, had the lender bargained to be named a Lender’s Loss Payee (the simple addition of one single word), then the insurer would be obligated to indemnify the lender, regardless of the acts or misconduct of the policyholder.