This article was first published by Estates Gazette, January 2018

When owners of unmortgaged freehold properties put in place buildings insurance, they are free to choose the insurer, sum insured, level of excess and other commercial terms. They may have to factor in localised risks such as flooding or subsidence in order to ensure they are fully covered but, if the worst happens, they will generally have the discretion to negotiate the settlement and decide whether to apply the proceeds in reinstatement of the property, or simply to pocket them for a rainy day. However, once lenders are introduced, the owner does not have the same freedom around placing insurance, what risks are covered and how to deal with the proceeds. In the case of investment properties, which are let to tenants and charged to a lender, matters can be even more complicated. This article provides an explanation of some of the different terms used to describe the varying insurable interests in commercial property and an analysis of the tensions that can arise.

Lenders’ interests

The adequacy of buildings insurance is a key factor in real estate finance transactions, as the underlying property is the core security for the loan. Where a lender has provided finance to a borrower to acquire property, it will wish to satisfy itself that the property is adequately insured for the cost of reinstating it and for the loss of any rental income. The lender will also want comfort that it has access to the insurance proceeds so it can control whether to direct the borrower to use these in prepayment of the loan or in reinstating the property, and that loss of rent insurance will service any interest and capital payments due under the loan. As well as establishing these facts at the due diligence stage, and insisting on a compliant policy being a condition precedent to drawdown, the lender will request a copy of the policy following each annual renewal, and there will also be ongoing undertakings in the facility agreement that premiums will be paid and policy terms will not be made void. Failure to comply can often be a named event of default.

However, as an additional step, the lender will wish its interest in the property to be reflected in the policy. There was a protocol in place until 2012 with the Association of British Insurers, which meant that if a lender’s interest was noted on a borrower’s insurance policy, then in the event that the borrower cancelled or amended the policy, the insurer would notify the lender and give it a grace period to allow the lender to arrange its own replacement cover.

This protocol has now ended, and lenders have been forced to be more prescriptive in their requirements around insurance. Lenders may wish to be “composite insured” with the borrower and to benefit from “first loss payee” provisions attached to the policy. Alternatively, they may insist on a “standard mortgagee clause.”

Composite insured

This term applies when there are two or more parties with separate insurable interests in a property, albeit within the same insurance contract. Each party has the right to claim against the insurer directly and receive payment under the policy, even if the other party has breached any of the terms of the policy. In the lender/ borrower scenario, the lender as composite insured would be able to negotiate a settlement of claim to suit its own, rather than the borrower’s, priorities.

Loss payee

This term refers to the party to whom insurance proceeds will be paid, if not to the insured party. Where a lender is named as first loss payee, the insurer is required to make payment to the lender direct.

In the past, composite insurance and loss payee status was usually only appropriate to larger transactions because of the cost and inconvenience of arranging it. However, following the end of the protocol, it is widely becoming the only acceptable position for lenders on real estate finance transactions. The arrangement takes control squarely away from the borrower with the lender able to take over conduct of any claim from the borrower and it can even delay the process.

Composite Insured should not be confused with Joint Insured – this allows all interested parties to insure their own interests in the property and therefore to bring their own claims. Insurers will generally insist that an additional premium is payable for the benefit of joint insurance and will also often impose a duty of disclosure on all insured parties. Disclosure requirements are particularly onerous on lenders who will have little to no working knowledge of the property and any particular risks associated with it. To the extent that risks are imparted to the lender in a monitoring report, institutional lenders are sensitive to being deemed aware of a material issue when the recipient of the report may not recognise the significance of an issue and know to disclose it to the insurer.

Standard mortgagee clause

This provides that the insurer agrees not to avoid or vitiate a policy in the event of a misrepresentation, act or omission of the borrower or to terminate the policy without first notifying the lender and giving it the opportunity to pay a renewal fee. This would only be of benefit to the lender when it is not a composite insured and does not have its own insurable interest.

Insurance terms in leases

Rack rent commercial leases will generally contain a covenant by the landlord to insure the property, a tenant obligation to reimburse it for the cost of doing so, and, save for any acts or omissions by the tenant which would vitiate the policy or limit the proceeds, a landlord obligation to reinstate the property with any proceeds received. Loan agreements are drafted so as to require the borrower/ landlord to apply any insurance proceeds in repayment of the loan, subject to the provisions of the occupational lease. However if the property is vacant at the time of the damage, as would be the case where there are voids between lettings, the effect of the standard loan agreement wording would require the borrower to repay the loan. This would leave the borrower without funds to reinstate the property to a tenantable condition, and potentially prevent it from re-letting the property as an investment, as intended.

There is much potential for confusion around the terminology adopted by the lawyers, the parties and insurance professionals. In particular the terms “joint insured” “co-insured” and “composite insured” mean different things to different parties, and it is important to ensure consistency between the policy wording and the obligations written into the loan agreements.

Brokers’ letters

In more complex or valuable real estate finance transactions, rather than simply reviewing the insurance policies as part of the due diligence process, the lender may require a letter from the borrower’s insurance broker confirming that the policies in place are compliant with the provisions of the facility letter. This exercise can become protracted if the lender and the broker adopt different language, or insist on their own standard form. The lender’s duty of disclosure is again a heavily negotiated issue in such letters. Lenders will wish to avoid any obligations in this regards, especially large institutional lenders whose asset management function may not have knowledge of the individual disclosure requirements, with the consequential risk that a disclosure trigger is overlooked. The Loan Market Association introduced its own form of broker’s letter in 2016 which only imposes a disclosure requirement on a lender if it becomes a mortgagee in possession. However, lenders who do not use LMA documentation are still insisting on their own form of letters and these need to be considered carefully by the borrower and their advisers.