Insurance is an important part of commercial real estate finance and whilst it may be viewed as forming a relatively small part of the overall transaction, it can often be the last thing that gets resolved, potentially holding up completion of the deal.

Primarily, lenders want to ensure that the key collateral that underpins their debt “the asset” is protected in the unfortunate event that it is damaged or destroyed, which could impact its value and the income stream generated from it.

Crucially, insurance plays an important role as it affords lenders an element of protection in ensuring that any insurance proceeds are used to either reinstate the property or repay the loan.

To achieve this, a lender will have taken security over the asset as a guarantee of repayment of the loan by the borrower by way of a finance agreement, which is a legal contract between both parties. The agreement will contain detailed provisions as to the specific insurance requirements imposed by the lender on the borrower.

This article looks at these insurance provisions and the role they play. Providing a brief history and development of the Insurance industry and explaining where we are today.

We have also highlighted some common misconceptions and issues, as well as discussing the relationship between all the relevant parties involved.

Brief history & background

It has been nearly 10 years since the demise of the “Protocol” agreement between the Association of British Insurers and the British Banking Association, which was designed to automatically protect a lender’s interest as mortgagees of a property. Under this agreement, insurers agreed to automatically note the interests of a lender under the

insurance policy and notify them of any cancellation or alteration in cover, thus providing a grace period to allow a lender to arrange its own insurance if the borrower failed to maintain the required level of cover.

Whilst the demise of this agreement is cited as the catalyst for the greater scrutiny of insurance provisions that we have today, in reality, the Protocol became largely redundant during the financial crisis and it was this crisis itself that led to the greater examination of the risks faced by lenders. As a result, lenders began to make more specific and onerous demands on borrowers, in particular, that they be named as a composite/co-insured party on the borrower’s insurance policy and that they also benefit from a loss payee provision.

Present day challenges

There continue to be conflicting views between lenders and insurers as to the role lenders should play in the insurance process and the protections they should be entitled to.

These opposing viewpoints, as well as a lack of a ‘standardised’ insurance industry view, usually results in many additional hours of work for all the parties involved.

For example, the inclusion of a loss payee provision in favour of the lender will ensure that the lender will have control over any claims proceeds in the event of a loss. If the lender is also composite insured, they will be able to negotiate settlement of the claim to suit their own priorities, rather than those of the borrower. Generally, parties will acknowledge in the finance agreement that they must abide by any lease requirements, i.e. that any proceeds be used to reinstate or repair the property. However, if no lease exists, the proceeds of

the claim could be retained by the lender to pay-off the loan. In such circumstances, the borrower will not only be left with a damaged building, but any loss of rent claim is also likely to be restricted.

Skill and experience is therefore required if your advisor is able to negotiate a compromise position for a loan transaction in which the lender, insurer and borrower are all comfortable. The problem, however, is that not all insurance advisors will have specific real estate expertise, and some will have insufficient exposure to real estate finance agreements to fully understand the implications. It should also be assumed that the advisor will act in the borrower's best interest and won't perform due diligence on the lender's behalf unless specifically asked to do so.

Lenders may attempt to extend the duties of the borrower’s advisor by requesting that a broker letter be provided to the lender’s specification. Brokers, on the other hand, are increasingly unable to meet such requests and will, at best, issue their own carefully drafted letter to meet the requirements of their own internal legal department, which is likely to limit or exclude any liability to the lender. Given the limitations of such letters,

some lenders will forego the requirement of a broker letter in its entirety, instead relying upon an independent insurance review of the borrower’s insurances. Insurers are also increasingly willing to issue their own letters directly to the lender, setting out their position with regard to the requirements of the finance agreement.

Things to consider and look out for

Because neither borrowers nor lenders are insurance specialists, they must rely on their advisors to fully comprehend what they’re signing up to. Insurance advisors play an important part in this process. A variety of issues or misconceptions that frequently cause problems with Real Estate finance transactions are listed below.

Composite Insured vs. Co-Insured

You sometimes come across ‘Composite insured’ status being expressed as a requirement for ‘co-insured’ status. Whilst some insurers deem the two

interchangeable, others consider ‘co-insured’ to be the same as ‘joint insured’. In most circumstances, this is unlikely to be what the lender anticipated and, more importantly, will not provide the non-vitiation protection that a composite

insured status affords where the borrower has invalidated the policy (see further clarification below on Non-Vitiation).

Being composite insured also imposes disclosure obligations on the lender, which is a fundamental principle of insurance, in that all material information that could have an affect on the policy needs to be disclosed to insurers. Lenders, though, routinely seek to remove or dilute these by way of the obligations imposed on

the borrower under the finance agreement. However, it could be argued that as a lender’s interest in the asset is purely financial, it is understandable that they look to extract themselves from disclosure obligations. Insurers would dispute this, citing occasions when a lender maybe in possession of information not otherwise known to the borrower and which would be deemed material by them.

In such circumstances, insurers would expect the lender, as composite insured, to disclose such information.

Many insurers are of the view that the cover afforded to them by the insurance policy by being composite-insured should also mean that the lender acts as if they were the main insured i.e. they adhere to the disclosure obligations that come with it. However, whilst most insurers will initially push back on removing this obligation, “given it’s a fundamental principle”, most insurers are likely to accept a lesser obligation restricting the lender’s obligation to such facts known ONLY to them and the specific team involved in the transaction.

Repayment of loan vs reinstatement of the property

Despite what is actually stated in many finance agreements, policy wordings are designed to ensure that claim proceeds are used to repair or reinstate the

damaged property. There is currently a lack of case law relating to circumstances in which an insurer must pay claim proceeds direct to a lender. Whilst many finance agreements include language acknowledging that leases will require claim proceeds to be spent on repairs or reinstatement, some insurers are now insisting upon lenders to ‘certify’ that the finance agreement does not conflict with the requirements of any leases and that the insurer will be indemnified by the lender

if, having settled the claim to the lender, they are subsequently exposed to claims from tenants arising from a lease or even under an ancient piece of legislation – the Fires Prevention (Metropolis) Act of 1774.

Notification obligations and renewals

Whilst the borrower’s insurance arrangements may be deemed acceptable by

the lender from the outset of a transaction, lenders will routinely want to be notified of any changes to the policy (for example, changes to the extent of the cover, any reductions in sums insured or any increase in deductibles/excesses),

or if the policy is to be repudiated, rescinded, cancelled or avoided.

Under the terms of the finance agreement the borrower will be obliged to provide such notification to the lender, but lenders may also seek to impose a similar obligation on the insurer – this, in part, replaces similar obligations that existed under the Protocol agreement. Whilst understandable from a lender’s perspective, almost all insurers will reject such requirements, as it could restrict their future ability to impose terms resulting from material changes to the risk. In addition, insurers just don’t have the internal infrastructure in place to deal with such an administrative burden.

For this reason, the whole subject of notice provisions has become, perhaps, the single largest area of conflict between insurers and lenders in recent times. Where insurers are prepared to provide prior notice to a lender, this is often restricted to where this is due solely to non-payment of premium. Careful negotiation is therefore required to ensure that insurers will extend this to include notice for any other reason and that they will at least notify the lender of their intention to decline an otherwise ‘valid’ claim.

Non-vitiation clauses

A non-vitiation clause is designed to prevent an insurance policy from being vitiated or avoided against an insured party in certain circumstances. However, finance agreement non-vitiation clauses often differ from the non-vitiation language used in the insurance policy itself, with insurance policies invariably requiring a party benefiting from non-vitiation provisions to have some level of responsibility as previously outlined, and some clauses ceasing to apply when a criminal act has been committed by the borrower. Many insurers therefore feel that provisions

of the finance agreements should be aligned more closely with those of the insurance policy.

Subrogation rights

In most cases finance agreements impose an obligation on the insurer to waive its rights of subrogation against not only the lender, but the also the borrower, all ‘secured parties’ forming part of the loan and any tenants of the particular asset.

Whilst this may be generally accepted by some insurers, recently, we’re seeing others indicating that their subrogation rights should be retained in circumstances, for example, where the borrower has invalidated the initial cover but the lender has still benefited from the cover by virtue of it being composite insured under the policy.

Rating requirements

The majority of finance agreements will require the borrower’s insurer to be generally acceptable to the lender at all times and in some cases maintain a minimum security rating with a number of specified rating agencies. This may impact the borrower in limiting the choice of insurers available to them and, with insurers often subscribing to only one, or perhaps two, agencies, it may not even be a feasible or sustainable requirement. In addition, arguably, the most appropriate barometer for measuring an insurer’s ability to pay a claim is the insurers Financial Strength Rating, rather than its Credit Rating, which actually measures the strength of its corporate operation.

Responsibility for insuring

Does the borrower actually insure? Situations where the borrower is not the party responsible for insuring the asset can be a major challenge when arranging finance and needs to be identified as early as possible in the process. The relevant lease provisions will need to be checked and separate negotiations undertaken with

the party responsible for insuring along with their insurer. A view may then need to be taken as to whether either the finance agreement obligations are amended to reflect what is possible to achieve or if the borrower may have to take out additional insurance cover to fully protect the lender’s interest.

The insurance market, much like the real estate market, has historically been cyclical and, in a difficult market, it is not just premiums that rise. Whilst the real estate insurance market has been somewhat shielded from such peaks and troughs, nevertheless, insurers are increasingly resisting some lender requirements contained in finance agreements and this is likely to become more common. The same insurer might even object to provisions accepted in a previous period of insurance, or in respect of a different borrower’s finance agreement.

If an insurer agrees to a lender’s insurance requirements for a particular borrower, it should not be taken for granted that the same insurer will agree the same clause for another borrower. Each risk is underwritten on its own merits and a small borrower seeking finance on a portfolio of vacant warehouses for instance, isn’t going to have the same leverage with insurers as a large borrower with occupied office space, sophisticated risk management capabilities and whom are paying substantial premiums.

Conclusion

The insurance provisions under finance agreements continue to come under greater scrutiny from insurers, especially in the current climate. This has inevitably led to increased negotiation and time spent between all parties involved.

Whilst some insurers have established ‘standardised’ responses that deal with the majority of these requirements, more often than not insurers will push back and insist on their usual terms and conditions. Lenders will continue to be faced with increasing

incidences of insurances not meeting their requirements, resulting in a need for these to be reviewed and also an understanding as to the potential implications.

It is hoped that, over time, a compromise position will be reached between lenders and insurers, although this is likely to require lenders accepting that they need to have a greater understanding of insurance provisions and perhaps questioning the rationale behind their insurance requirements.

In the meantime, Howden Real Estate has a dedicated Due Diligence team who act as independent adviser to a number of lenders, in providing advisory services on both real estate and construction finance transactions.

This includes general advice on an ad-hoc or formal basis as well as additional support and training on insurance-related topics. We provide general advice as to the current insurance market practice, as well as providing commentary on the finance agreement insurance requirements to ensure they are sufficient for the nature of the transaction. 

To speak to our Real Estate team, please email or call: 

Ben Thompson, Associate Director

[email protected]  +44 (0)7761 516524

Kevin Luckett, Associate Director

 [email protected]  +44 (0)7761 516526