RISKVUE ARCHIVE | FEATURE STORIES

Protecting the Hand That Feeds You

Ensuring that your business property insurance policy protects both you and your lender in the event of a security property loss

By Christopher L. Lynch

Neither a borrower, not a lender be; for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.
WILLIAM SHAKESPEARE

If only it were possible to heed the Bard’s caution and conduct business without loans, lines of credit or multiple mortgages. But for most businesses, operating on credit is a necessity, not an option. Unfortunately, a property loss or business interruption due to fire, natural disaster, equipment breakdown, employee negligence or any other factor can quickly strain even the healthiest of lender-borrower relationships. Even if the loss is insured, questions often arise as to who gets to share in the insurance proceeds. As always, it is better to have thought about these contingencies before they arise rather than to try to figure out who gets what after the loss has occurred.

Simply ensuring that the lender is named in the policy may not give the lender, or the borrower, the protection it desires, and it is unwise to place too much significance on the titles, captions or nomenclature used in the policy. Insurers offer different options for giving lenders a right to share in the payment of insurance proceeds in the event of a loss of secured property. Mortgage clauses, loss payable clauses and, to a lesser extent, additional insured endorsements are commonplace in business property insurance policies. But while the different options can provide flexibility, interpreting them can be a source of confusion and frustration.

For example, a mortgage clause generally states that the mortgagee has the right to payment of insurance proceeds in the event of a loss of the mortgaged property. But mortgage clauses take different forms. Under what is typically referred to as a “simple” or “open” mortgage clause, the mortgagee’s right to receive payment of the policy proceeds is derivative of the insured’s rights and obligations under the policy. The mortgagee is simply an appointee to receive the insurance proceeds. Therefore, any act or negligence by the insured that negates coverage for the insured, will also negate recovery by the mortgagee.

In contrast is the “standard,” “union,” or “New York” mortgage clause. In addition to entitling the mortgagee to payment of the insurance proceeds, the standard mortgage clause also states that the mortgagee’s right to receive payment shall not be defeated by any act or neglect of the mortgagor. This type of mortgage clause creates a separate contract between the mortgagee and the insurer and gives the mortgagee rights that are independent of, and may be greater than, the insured. For instance, even if an insured’s failure to file proof of loss in a timely manner precludes it from recovering under the policy, the insured’s failure may not preclude payment of the insurance proceeds to a mortgagee named in a standard mortgage clause.

Giving greater rights and protections to the mortgagee is not always in the best interest of all of the parties. In some policies, if the insured violates a condition of the policy, then the mortgagee must take on additional responsibilities and make sure certain conditions are fulfilled before it can receive payment. Whether and what additional responsibilities might fall to the mortgagee depends on the particular language of the policy in question. Giving the mortgagee independent contractual rights can also affect the parties’ ability to cancel the policy without notice to or consent from the mortgagee, can impact the insured’s option to have the damaged property repaired or replaced, and can limit the insured’s right to unilaterally settle or adjust the loss with the insurer.

Life is no less complicated for lenders given the title of “loss payee” or “additional insured” in the borrower’s insurance policy. Loss payable clauses entitle a named loss payee to payment of the insurance proceeds in the event of a loss of covered property in which it has an interest. As with mortgage clauses, loss payable clauses can take different forms. The traditional loss payee clause makes the loss payee’s right to payment subject to the insured’s fulfillment of all policy conditions and requirements. But insurers may also offer the option of a “lender loss payable endorsement.” This form of loss payable clause is akin to a standard mortgage clause in that it states that the loss payee’s right to payment will not be negated by the act or neglect of the insured.

Additional insured endorsements are evolving creatures in the property insurance context. Depending on the language of the particular endorsement, an additional insured can have rights and responsibilities that fall somewhere within the range between a traditional loss payee and a mortgagee protected by a standard mortgage clause.

Confusion may also arise when the rights given to the lender in the insurance policy do not clearly extend to all of the property in which the lender has a security interest. Mortgage clauses often grant payment rights only for losses of real property or buildings, although some chattels many be included. Loss payable clauses often contain a list of the particular property or type of property (e.g., business personal property) that is subject to the clause. If the clauses do not expressly apply to the same property, or types of property, in which the lender has a security interest, the lender may not be entitled to payment for loss of secured property.

Some policies contain both mortgage clauses and loss payable clauses. Conflicts, inconsistencies or gaps in those clauses can affect a lender’s right to payment. For example, courts have held that a policy containing a mortgage clause providing for payment to a lender for a loss of real property and a loss payable clause providing for payment to the lender for a loss of business personal property, still did not entitle the lender to share in the proceeds paid for loss of business income as a result of business interruption, since business income was neither real nor business personal property. Similarly, a lender protected by a standard mortgage clause with respect to real property but with a traditional loss payable clause with respect to business personal property, may have a difficult time determining exactly what payments it is entitled to if the insured breaches a policy condition. Borrowers should also remember that if the lender does not get its money through the insurance contract, the lender still has the option of getting that money from the insured borrower through enforcement of the loan contract.

As always, the particular rights, privileges and protections afforded by a given policy are dictated by the particular terms of that policy and the circumstances of the parties. Lenders and borrowers should take care to review the terms of their particular policy to try to understand what they are purchasing and what the relationship between the insured, its lender, and the insurer will be in the event of a loss of covered property.

ABOUT THE AUTHOR

Christopher Lynch is a partner in the Insurance Recovery practice of Lindquist & Vennum. He helps business-policy holders resolve disputes with their insurance companies through negotiation and focused litigation. For additional information, contact him at 612-371-3512 or clynch@lindquist.com.

This article is only a general summary for informational purposes and does not constitute legal advice. Consult a qualified and experienced insurance advisor for your specific situation or particular questions.

riskVue | The webzine for risk management professionals
April 2007