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Lenders' security: risks and implications for insurers

FOCUS: Since the longstanding agreement between the British Bankers Association (BBA) and Association of British Insurers (ABI) on noting of interest came to an end at the end of 2012, banks have been looking for alternative ways to protect their interest in insured property.01 Mar 2016

Many lenders have continued to pursue a policy of having their interests 'noted' on insurance policies. However, without any agreed protocol in place these arrangements can be administratively complex, particularly for the insurers themselves. Lenders concerned about the implications of 'noting' are now looking for more formal ways to protect their interest.

There are a number of mechanisms that lenders use to protect their security. The four best known are:

  • noting the lender's interest on the borrower's policy;
  • designating the lender as first loss payee in respect of any payment made under the policy;
  • having the borrower assign the proceeds of the policy to the lender;
  • making the lender a composite insured under the policy.

The level of protection that each of these gives to the lender runs from noting of interest with the least protection, to being added to the policy as a composite insured giving lenders the best level of protection. In contrast, it is likely that the opposite is true for the insurer: administratively, noting of a lender's interest was historically cheaper and easier for the insurer to manage, whereas adding a lender as a composite insured gives rise to quite distinct obligations on the part of the insurer.

In reality, parts of each of these protections are often bundled together when lenders request additional rights of insurers in relation to their property interests. In some cases, particularly those involving real estate finance (REF) facilities, these protections are a legal requirement.

Noting of interest

Noting of interest simply means that the lender's interest is noted on the borrower's policy document. The effect of this is completely dependent on the wording of the policy. Under the old ABI/BBA agreement, the wording endorsed on the policy was “the lender’s interest is noted” and the insurer’s obligations were then set out in the agreement itself. These included the requirement to inform the lender if the policy was cancelled or amended, and to continue with the cover provided that the bank agreed to pay the premium.

Now that the ABI/BBA agreement is no longer in force, it is not clear what an insurer is agreeing to do by noting the lender’s interest on the policy. In our experience, the wording is often vague and unclear. Traditionally, insurers will notify lenders if a claim is made; if the policy is cancelled or not renewed; if a premium is not paid; or if the cover is reduced or invalidated.

What are the implications for insurers?

Noting has no specific legal effect: the lender does not become a party to the insurance and the procedure does not create a separate legal contract between the insurer and lender. In practice, it appears to give lenders little more than the right to be kept informed about the policy.

For insurers, the most important point is to ensure that they have the necessary procedures in place to keep lenders informed. However, even if an insurer fails to comply, it is not clear whether the lender will have any formal legal remedy.

Loss payee clauses

Loss payee clauses designate a third party as being authorised to accept money paid out under an insurance policy - usually a security agent appointed by the lender. In practice, we tend to see these in relation to larger payments, of a minimum of £10,000, rather than in relation to multiple smaller payments.

A designed loss payee generally has no obligations under the policy, but may be able to enforce its right to receive payment under the Contracts (Rights of Third Parties) Act 1999. If the Act is excluded from the policy, a loss payee endorsement can be drafted so that these rights apply to the loss payee only. However, the loss payee will usually have to comply with policy conditions imposed on the insured that are relevant to the claim, such as time limits.

Depending on the wording of the policy, a borrower may be able to change its mind before any payments are made and instruct the insurer to pay someone else, without notifying the lender. This will, however, usually be a breach of the borrower's facility agreement with the lender.

What are the implications for insurers?

As loss payees have no independent right to make a claim under the policy, the insurer still only has to deal with one insured party. In addition, the insurer's obligation to pay the loss payee is dependent on the borrower being able to recover under the policy - so, for example, if the borrower is guilty of non-disclosure, misrepresentation or breach of warranty the insurer can still avoid the policy or decline the claim.

Loss payee agreements do carry the risk to insurers of making payment to the wrong party: should the insurer pay out to the insured instead of a first loss payee then it would be required to pay out twice. However, these clauses will not generally cause too much difficulty to the insurer otherwise.

Assignment of policy proceeds

This refers to the situation where the borrower assigns its right to recover under the policy to the lender. This is not the same as assigning the policy itself, as this would also require the borrower to assign the insured property. Assignment can be either legal assignment, where there is clear intention to assign made in writing and notice has been given to the insurer; or equitable, where the assignment has not been done in writing but the intention to assign is still clear.

Legal assignment gives the lender the right to receive the policy proceeds, and to sue the insurer for the policy proceeds if necessary. It is the borrower's loss that is the measure of indemnity. Assignees rank in the order in which notice of their assignment has been given to the insurer.

What are the implications for insurers?

As with first loss payee clauses, the lender's rights are derivative and the lender has no absolute right to payment. So, for example, if the borrower invalidates the cover, the insurer can still avoid cover or decline the claim. This is because the insurance policy between the insurer and borrower is still intact so, for example, the insurer's duty of good faith is owed to the borrower and not the lender.

The basic position of the lender being in no better position than the borrower is often reversed by the insistence of lenders on mortgagee clauses, the purpose of which is to keep the lender's right to claim intact. An example of this would be a clause stating that the insurance "shall not be invalidated by any act or neglect of the mortgagor or owner of the property"; or that "the rights of any mortgagee shall not be prejudiced by any act of the mortgagor". These clauses also oblige the lender to inform insurers as soon as it becomes aware that the borrower invalidated cover.

Composite insurance

Composite insurance requires two separate contracts of insurance, under which each party insures only its own limited interest and can only recover the amount representing that interest. As set out above, this is the most robust protection for the lender and potentially the most burdensome for insurers. In our experience, lenders often insist on being a composite insured in transactions worth over £10 million.

In composite insurance cases, each of the borrower and the lender has an independent right to make a claim for its own loss. The interests of the lender are completely separate from those of the borrower, so the lender's right to claim is unaffected if the borrower does anything to invalidate the cover - even if the borrower breaches the duty of utmost good faith, and the insurer avoids the borrower's policy altogether.

Because the lender is an insured under the policy in its own right, it will have the same duties under the policy as any other insured: to disclose material facts, to comply with policy conditions etc. This is often impractical for lenders as they do not always have access to all the information about the risk, and so lenders will often look to exclude the duty of disclosure as well as any obligation to pay a premium.

What are the implications for insurers?

As there are two separate insureds in composite cases, insurers will have two separate contracts to manage. Unlike the other examples given above, avoidance against one insured will not affect the insurer's obligations to the other. Although insurers may well be able to charge an additional premium for this, there are potentially serious implications for the insurer because it could lose its right to avoid against the lender, even where the borrower is guilty of non-disclosure or misrepresentation, assuming the lender has insisted on a non-invalidation clause and excluded the duty of disclosure.

The insistence by most lenders to exclude the duty of disclosure also gives rise to practical problems, as the absence of this duty conflicts with the standard terms of most commercial property insurance policies.

If there is composite insurance but no first loss payee or assignment clause, insurers need to ensure that any money paid out is paid to all insureds, in accordance with their respective interests. This can be difficult to do. It is therefore in the insurer's interests for the bank to be appointed as the first loss payee or assignee as well as being a composite policyholder, so that the insurer need only pay out to one party.

Endorsements or letters?

As an alternative to endorsing the insurance policy, lenders can seek to confirm any of the arrangements entered into above through standard form letters, provided to the lender by the insurer or broker.

Letters can be used to provide assurances to the lender, including confirmation that:

  • the insurances are in full force and effect;
  • premiums are all paid up to date;
  • the insurance arrangements are in accordance with the facility agreement;
  • the interest of the lender is as co-insured and/or first loss payee/assignee;
  • the insurance provides property owner's cover, terrorism cover, loss of rent or other lender requirements;
  • the policy contains a provision to the effect that the insurance shall not be invalidated against the lender for non-payment of premium without the insurer giving the lender written notice;
  • the policy contains a standard mortgagee protection clause, waiver of subrogation against lender or no disclosure obligations on the lender.

However, letters such as these can impose new obligations on insurers: for example, to review the facility agreement to ensure compliance, or to give written notice to the lender in certain circumstances over and above those contained in the policy.

Rebecca Ransome-Lewis is an insurance law expert at Pinsent Masons, the law firm behind Out-Law.com.