Understanding insurance indemnity principles and providing lender protection


Author: Jenny Sargeant, Grace Laws


Real estate finance lenders need to achieve three things:

  • First ranking security over the real estate asset.
  • Maintenance of the real estate asset’s value by ensuring all damage is reinstated (and insurance proceeds applied accordingly).
  • Fixed security over any lump sum payment.

This all sounds simple enough but on nearly every real estate finance transaction insurance requirements are the last to be agreed. It can be helpful for both lenders and borrowers to understand how insurance claims are dealt with by insurers to be able to agree insurance requirements and ensure that the borrower’s broker will be able to deliver on these.

Why is buildings insurance important for lenders?

Lenders lend against the market value of the real estate asset. Insurance is of great importance to them to ensure that any damage which would diminish the market value is reinstated and, if it cannot be reinstated, that there is a payout of the market value of the property.  However, it is important to understand that insurers rarely pay out lump sums because of the way that insurance contracts operate.

Insurance is an indemnity contract

Insurance contracts are different to other types of contract where you bring a claim for damages. In law, an insurance contract is an “indemnity contract”.  So where for breach of any other contract you can make a claim for damages on the basis of the position you would have been in had the breach not occurred (i.e. loss of expectation), for an insurance contract the claim is limited to the insured party’s actual loss.

This is why, when we make an insurance claim, insurers will require evidence of the loss. If you made a claim on your home insurance policy after a break in the insurer would only pay out on being presented with receipts for items that had been stolen.  Where a building is damaged the insurer will want to pay out against the contractor’s invoices for the remediation works.  This is because the actual loss at this point is the cost of repairing the damage.

The insurance payout will always be the cost of reinstatement unless reinstatement is not possible (most likely because planning permission cannot be obtained). It is at this point that the actual loss becomes the market value of the property and a lump sum is paid out by the insurers of this amount.  Buildings insurance policies will generally state in their terms that the insured must use insurance proceeds to reinstate unless reinstatement is not possible.

You will see the difference between reinstatement cost and market value flagged in property valuations. The valuers will specify the market value of the property but also the reinstatement value – this second value is the cost of rebuilding materials and labour.

Lender control over reinstatement sums

Facility agreements generally require insurance proceeds to be applied towards reinstatement. There is often a negotiation between borrower and lender about who has control over any payments paid out by insurers in anticipation of reinstatement works being carried out.  Where the amount is low the lender will be happy for the reinstatement sums to be paid direct to the borrower and applied towards reinstatement.  Where sums become larger, the lender is more likely to see the reinstatement sums as being akin to a capital payment and want them paid into a blocked account whilst works are ongoing, so the lender can ensure that they are applied against the contractor’s invoices.  Usually a threshold is agreed above which payments should be paid into a blocked account.

Lender control over lump sum payouts

Lenders will always want lump sums to be paid into a blocked account. Fixed security can only be taken over bank accounts where these are blocked and the borrower has no ability to access the account.  Fixed security is important because it takes priority over unsecured creditors and holders of floating charges on insolvency.  If the building burns down and the value is substantially reduced and cannot be reinstated, it will be critical to the lender that it ends up with a fixed charge over the insurance proceeds.  Facility agreements usually contain an obligation for the borrower to pay lump sums into a nominated blocked account.

First loss payee and/or composite protection

Even with a borrower covenant to pay lump sums into a blocked account there remains a risk that if the borrower fails to do this the lender has to rely on contractual remedies (i.e. calling an event of default for breach of covenant). As with all claims the outcome is dependent on the covenant strength of the borrower at the point a judgement is made.  The best protection for lenders is therefore not to rely on the borrower’s covenant to pay insurance proceeds into the blocked account but to have insurance proceeds paid to the blocked account by the insurer direct (cutting the borrower out of the loop).  There are two ways of achieving this:

First loss payee

A first loss payee endorsement can be added to insurance policies (regardless of whether the policy is joint, composite or just in the name of the borrower) requiring the insurer to pay out proceeds direct to the lender. Often a minimum threshold is specified (which, once reached, triggers an obligation that sums be paid to the lender direct).  This often matches the borrower’s obligation to pay larger capital sums into the blocked account (as discussed above).

Composite insurance

Instead of having joint insurance or insurance in the name of the borrower alone, the lender can be a composite insured party. This means that the lender has its own separately insured interest, and payments will be made to it first to the value of the outstanding loan, ahead of any payments being made to the borrower.

Conclusion

Insurance requirements are really important to lenders to ensure that the real estate asset is reinstated if damage occurs, to maintain the value against which the lender has lent. If this is not possible then the lender will want to ensure it ends up with fixed security over any lump sum payout.  It is important for borrowers to understand how important control over insurance proceeds is for a lender.  However, this needs to be balanced with the borrower’s need to apply the insurance proceeds (where this is possible) to reinstate the property.  This will be particularly important where the borrower has tenants and is bound by landlord obligations to carry out repairs promptly and in accordance with the principles of good estate management.

As with all insurance discussions in financings, it is best to specify requirements at the outset of a transaction and engage the borrower’s broker earlier on, so that negotiation of insurance requirements does not hold up the transaction timetable down the line.

Jenny Sargeant, Partner, Fladgate LLP (jsargeant@fladgate.com)

Grace Laws, Associate, Fladgate LLP (glaws@fladgate.com)

 

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