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Property Banking E-briefing

    • Financial institutions

    03-04-2012

    Insurance in Real Estate Finance transactions

    Insurance is usually a critical element of a lender’s security on any real estate finance deal. The ABI’s recent withdrawal from its agreement to notify lenders in advance of any cancellation or alteration in insurance cover for the property the subject of the loan should encourage lenders to review the insurance requirements they include in their facility agreements and consider whether they maximise their security. Against this background, this note examines recent developments in practice which may impact upon lenders’ approach to insurance, and the options available to lenders to ensure they can exercise control over the scope of cover and proceeds of claim.


    Types of insurance required by lenders

    The facility agreement will usually set out in detail the lenders’ requirements in relation to insurance. Typically property damage and business interruption insurance  will be required, the latter usually covering loss of rent. These insurances will provide cover against the risk of damage to the secured asset and disruption (consequent on insured damage) to the income stream of the Borrower. Contractor’s all risk insurance  will be required on development projects. Other insurances lenders may consider including in their requirements will include public and products liability cover and, in appropriate cases, environmental insurance (where environmental risk is perceived).


    Terrorism cover

    Cover against property damage caused by terrorism is offered by some, but not all, insurers as standard. To avoid any uncertainty, a lender should therefore always ask for confirmation that the insurance maintained by the borrower includes terrorism cover. Each insurer is free to use its own definition of terrorism: they may in practice follow one of the definitions used in legislation such as the Terrorism Act 2000, although there is no requirement that they do so. Care should be taken to check that the wording of the definition contained in the relevant insurance contract is consistent with any definition which may be contained in an obligation contained in a lease or other document.


    “Noting” of a lender’s interest

    The implications of noting a lender’s interest on an insurance policy is widely misunderstood. It is often assumed, incorrectly, that it provides the lender with the right to any insurance proceeds paid by an insurer. In fact, a lender whose interest is noted, is currently entitled to no more than notification by an insurer of cancellation or non-renewal of the policy or of any amendment to the terms of cover.

    This entitlement was formalised in 1992 in an agreement between the Association of British Insurers (“ABI”) and the British Bankers’ Association (“BBA”).

    However, the ABI has recently announced that it intends to withdraw from this agreement. The notice period for the withdrawal, and the approach of individual insurers on a case by case basis, have yet to be confirmed, but the outcome will be that banks will no longer be able to rely on receiving notice from insurers of changes that might affect their security.

    In light of this development, it is worthwhile reminding lenders of the other options available to them, which are set out below.


    Loss payee clause

    This is a clause requiring the insurer to pay any proceeds actually paid out to the party named in the clause as loss payee. From a lender’s perspective, this is obviously an improvement on having its interest noted on the policy. However, the lender would not be a party to the insurance contract and therefore could not enforce compliance by the insurer with the loss payee clause: this would have to be done by the insured. Lenders might argue that the Contracts (Rights of Third Parties Act) 1999 gives them the right to directly enforce compliance by the insurer with the loss payee clause. However, the vast majority of insurance policies expressly exclude the application of the 1999 Act, and insurers are unlikely to agree to any request by a borrower to remove such an exclusion from the policy. It is possible for a lender to be named as a loss payee as well as an insured (see below): in situations where there is more than one insured party, it will be in the lender’s interest to be a loss payee, to avoid any debate about who is entitled to receive any insurance proceeds paid by the insurer.


    Joint Insurance

    This is preferable to the two options referred to above, as it provides a lender with a contractual right to indemnity – and therefore a right to claim - under the policy. However, a joint insured will have an identical interest with other insureds, with the result that a fraud or non-disclosure by one insured will entitle the insurer to avoid the policy as against all insureds. The effect of this can be mitigated by the inclusion of so-called “mortgagee protection” clauses (sometimes referred to as “non-invalidation” clauses), which may state that a lender’s right to cover under the policy will not be affected by certain defaults of the borrower insured, or any alteration to the subject matter of the insurance which increases the risk of destruction, damage or liability. Such clauses can be of assistance to a lender, but need careful scrutiny to ensure that they cover all the types of circumstances in which an insurer could refuse indemnity, e.g. fraud, non-disclosure, breach of warranty or of any condition precedent to the insurer’s liability.


    Being named as a co-insured on a composite policy

    This provides the maximum security for lenders. A composite insurance policy is one in which each insured party’s interests and rights are separate, and, crucially, not dependant on the compliance by other insureds with their obligations under the policy. The practical effect of this is that one insured is able to recover under the insurance even though another insured may be in breach of its obligations and not entitled to recover. However, specific forms of wording (often known as “multiple insured” and “non-vitiation” clauses) are required to be sure that an effective composite insurance contract is in force. In addition, an insurer of a composite insurance policy is likely to charge an increased premium in return for being exposed to an increased risk of having to provide an indemnity under the policy. It also worth noting that a lender named as an insured will usually be subject to all the obligations which bind any other insured under the policy, such as claims notification requirements and the duty to disclose material facts, although the latter duty can be diluted by adding clauses to the policy wording which limit the Lender’s duty of disclosure (although for obvious reasons insurers may be reluctant to agree to them).  Composite insurance, although desirable, may not be available for all types of properties: for example, in our experience, insurers may be reluctant to agree to a composite insurance arrangement for block policies covering large portfolios of residential property, where a lender’s interest is limited to part of the portfolio. In such cases, there may still be some, albeit limited, benefit, in noting a lender’s interest: in this regard the ABI’s withdrawal from the agreement referred to above is therefore significant.


    Reviewing insurance policy wordings

    Facility agreements sometimes contain prescriptive requirements for the insurance policies to be maintained by the borrower. Lenders will therefore need to consider whether they should review the wordings of the policies to check whether they comply with those requirements. This can be a time consuming process as the policies will often contain terms which do not entirely match the wording of the facility agreement requirements but which materially comply with them. A more cost effective approach  may be to obtain a letter of undertaking from the borrower’s broker (see below) which confirms that the borrower’s required terms are contained in the borrower’s insurance policies.


    Broker letters of undertaking

    A borrower’s insurance obligations can be usefully supplemented by a letter of undertaking from its insurance broker confirming that insurance is in place in accordance with the requirements of the facility agreement. As the borrower’s insurance adviser the broker should be able to comply on behalf of the borrower with many of the insurance obligations contained in the facility agreement, such as confirmation that the required insurance is in place and ensuring that premiums are paid in accordance with policy terms.


    Conclusion

    Confusion can arise when dealing with insurance, because the jargon, practice, and legal principles peculiar to the insurance market can be easily misunderstood by those not familiar with it. However, with a little knowledge and care, and, where appropriate, specialist advice, the value of insurance to lenders’ security can be increased immeasurably. 

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