When providing finance for the sale of equipment, the mortgagee should confirm that his interest is correctly defined in the Insurance Policy
Recently, in a local newspaper, there was a story about a convenience store owner who suffered a fire that nearly destroyed the entire store. Prior to the loss, the store owner was lucky enough to convince a bank to lend him some money for operating capital. After conducting an investigation and being unable to find sufficient reason to fully deny the store owner’s claim, the insurance company reluctantly issued a check to the store owner for a fraction of the policy limits. The check, however, did not also name the lender. The check provided by the insurance company for the damage to the store owner was a paltry sum and only covered a fraction of the costs it would take to rebuild. Therefore, the store owner took the money and left town for greener pastures. The lender learned of the loss and subsequent claim adjustment by the insurance company and decided to make its own claim against the insurance company to cover its loan. Unsurprisingly, the insurer responded that the lender was not listed on the policy as any type of “insurable interest” and therefore owed the lender nothing. Following several rounds of correspondence between the lender and the insurer, the lender decided that it had sufficient grounds to sue both the insurance agent and the insurance company.
After some intense discovery battles during the litigation, the lender was able to obtain a court order to obtain copies of the insurance company’s underwriting and claim files. These documents provided important information including the insurance application submitted by the storeowner, the identities of the various “insurable interests” under the policy, coverage effective dates, what coverage applies and deductible(s).
The underwriting file revealed that the insurance agent had neglected to include the lender’s name as a loss payee on the insurance application. However, when questioned during his deposition, the agent admitted that the store owner did inform him of the identity of the lender and that the lender needed to be identified on the policy as an “additional insured” or “loss payee”. The agent, fresh out of college not yet familiar with the customs and practices of the insurance industry, scrupulously testified that he simply forgot to inform the insurance company that the lender needed to be included on the policy. When further questioned by the bank’s attorney, the agent said that the lender’s interest should have been defined as a “lender loss payee.” While the insurance company fought as hard as it could as long as it could, it eventually concluded that it would likely lose at the trial. Just days before the trial after many, many depositions, the insurer sent a check to the lender for the full amount remaining under its loan to the storeowner.
This example shows that a lender or anyone financing the sale of equipment, i.e., mortgagee, has little control over whether or not his customer notifies the insurance agent of its insurable interest under the storeowner’s policy and even less over the agent in informing the insurance company of that interest. That is why the mortgagee should take the initiative to independently confirm with the insurance agent and insurer that his “loss payable” interest is properly reflected on the policy. However, knowing that one should just be a “loss payee” on the policy is not enough information. Loss payables need to make sure that their interest is correctly reflected on the policy.
Here are a couple of other illustrations of the operation of loss payable clauses.
* Tornado Bowling Alley, LLC (“TBA”), secured a loan from Johnson Bank. The bank granted the note for the loan without securing an interest in any of TBA’s property. This loan is similar to commercial paper. The loan is based upon the good reputation of the person or firm that is borrowing the money. Due to the nature of the transaction, TBA’s insurance contract showed Johnson Bank as a “loss payee”.
A windstorm totally destroyed TBA’s bowling alley including the roof, automatic pinsetters and all thirty-two of the finely polished oak lanes. TBA chose to rebuild as soon as possible. During the process of planning the rebuilding, it became obvious that TBA did not have enough insurance. TBA wanted all of the insurance proceeds and did not want its insurer to give any money to the bank.
The insurer could not ignore a loss payable on its insurance contract and issued a draft that included the names of both TBA and Johnson Bank. Angry that it could not think of a way to avoid paying out on the claim, the insurer did not allocate the amount of the losses to each party. It was up to TBA and Johnson Bank to decide how much each would receive. Had it been described as a lender loss payee, Johnson Bank’s claim would be first in payment preference.
* Torches, Ltd. owned a building and business personal property. It borrowed money from a lender, which was named as a loss payee on Torches’ insurance contract. Torches suffered a severe fire loss. The insurance company’s special unit investigator (“SIU investigator”) conducted an investigation and concluded that the loss was caused by arson and that the owners of Torches had started the fire. (The SIU investigator’s compensation structure by the way, is such that the great majority of his salary is based on how many claims he can have denied in a given year).
Unsurprisingly, Torches’ insurer declined to make any payment for the loss. The lender also presented a claim for its interest, but the insurer denied the claim. The insurance company contended that the lender’s recovery right as a “loss payee” was no better than that of the insured. The lender did not choose to hire an attorney skilled in suing insurance companies and had to eat its loss.
Lenders Loss Payable
This category of loss payables deals with creditors, mortgage holders or trustees. An insurer will pay these insurable interests even though no money is owed to the named insured.
* Fast Eddie’s Machine Tool Company (“Fast Eddie’s”) obtaining financing from Smart Finance Company for a new drill press. Fast Eddie’s suffers a fire loss. Based on various alleged ‘red flags’ such as personally hand delivering its sworn proof of loss to the insurance agent, the insurance company’s SIU investigator concluded that the president of Fast Eddie’s committed arson. As a result, Skinflint Insurance Company declined to honor Fast Eddie’s claim. However, Skinflint Insurance Company after much prodding from Smart Financing Co.’s attorneys decides to honor Smart’s claim as a “lender loss payee”.
When Skinflint Insurance Company makes payment to Smart Finance Co., the insurance company acquires the bank’s rights against Fast Eddie. This means that Skinflint Insurance Company can sue Fast Eddie’s to get back the monies it paid out to Smart Finance Co. Fast Eddie also will likely need a good attorney.
In any secured finance scenario, the prudent mortgagee must ensure that the collateral pledged as security for the loan is protected against potential loss. This is advisable whether the collateral is comprised of real estate, equipment, inventory or another form of asset. In order to protect such collateral against losses due to fire, flood or other casualty, the mortgagee should make sure that its borrower provided adequate evidence that the collateral is appropriately insured against loss. Obtaining a certificate of insurance, however, is not the end of the game. The mortgagee should also require the insurance policy to be modified so that it also protects the mortgagee through a policy endorsement which describes the mortgagee’s interest in the collateral as that of a “lender loss payee”. A mortgagee must ensure at the outset that such endorsements are correct and valid. Otherwise, the mortgagee may not obtain the benefit of the policy in the event of a loss.
The designation “lender loss payee” is distinguishable from “loss payee” in that a lender loss payee is deemed to have separate contractual rights of recovery under the insurance contract independent of the rights of the insured, whereas if the mortgagee is named as “loss payee,” their right of recovery will be conditioned upon, or subject to, the actions of the insured. Thus, if the insurance company’s investigation concludes that insured had engaged in conduct that would negate the benefits afforded by the policy and thus release the insurer from its obligation to pay the insured under the policy, the mortgagee, if properly identified as “lender loss payee,” should still recover under the policy, regardless of the insured’s purported misconduct. In contrast, the mortgagee identified merely as “loss payee” will be subject to the same coverage defenses and exceptions applicable to the insured. Thus if the insurance company assert that the insured committed arson, the mortgagee still has a right of recovery regardless of the insured’s alleged conduct. In contrast, if they have a “loss payee,” the mortgagee will have to fight hard to recover.
To best ensure itself when lending money to its customer a mortgagee should do the following:
- Obtain a certificate of insurance which identifies the mortgagee as a “lender lost payee on its customer’s anticipated insurance policy;
- Confirm this status in writing with its customer’s insurance agent (put’s the agent on the hook for possible liability if the agent forgets to do so);
- Obtain a copy its customer’s insurance policy to see that it is, in fact, listed and identified on that policy as a lender loss payee;
- On the policy’s subsequent renewal dates so long as the customer’s loan is outstanding, confirm with the insurance agent and insurance company that the mortgagee’s interest as lender loss payee remains on the policy; and
- In the event of a loss under the policy; keep a close watch on the insurance company’s adjustor to make sure that the mortgagee’s interest is paramount to that of its customer, the named insured under the policy.
When dealing with an insurable interest, the mortgagee should always remember Ronald Reagan’s maximum about dealing with the now defunct Soviet Union: “Trust but verify.”