About Co-insured Parties, First Loss Payees and noting a Mortgagee’s Interest on the Policy
As many commercial real estate financings are non-recourse, the mortgaged property provides the main recourse for the financier. This means that a proper building insurance is key and a CREF financier will normally require that the full reinstatement value of the financed property is covered by a building insurance entered into by its borrower with a reliable insurance company on terms that are market consistent and meet the financier’s own credit risk/funding criteria. This blog briefly discusses:
- the differences between a mortgagee’s statutory pledge versus a contractual pledge over insurance receivables;
- the agreement between fire insurers and the Dutch Banking Association of 2009;
- the differences between a financier being noted on a building insurance policy as co-insured, as first loss payee and noting a mortgagee’s security interest (as mortgagee and pledgee) on the policy;
- the use of broker letters; and
current market practice in the Dutch CREF market with respect to carve-outs from a mortgage lender’s right to receive building insurance proceeds
1. Statutory right of pledge vs. contractual right of pledge
Under Dutch law, a right of mortgage includes, by operation of law, a right of pledge on all debt-claims for compensatory damages which can be regarded as a substitution for the mortgaged property. This includes any compensation claims for loss resulting from a depreciation of the value of the property. This is convenient. Nevertheless, most financiers will, in practice, also include a contractual pledge over insurance receivables in their deed of mortgage. The main reason for this is that a contractual right of pledge can, in addition to covering the same insurance claims as a mortgagee's statutory right of pledge thereon, also be made to cover loss of rent and public liability insurance. Loss of rent insurance is arguably not covered by a mortgagee’s statutory pledge because, as such, loss of rent insurance claims do not replace the mortgaged property itself. Where future insurance claims are concerned, however, a statutory pledge over such claims will stick also with respect to insurance claims that only arise after the borrower/mortgagor has become bankrupt. The same does not apply to a contractual pledge. It is therefore worthwhile to obtain both.
2. Agreement between fire insurers and financiers (2009)
In case of damage to a mortgaged property, the financier/mortgagee would require that the insurer pays out directly to it instead of to the borrower/owner/mortgagor of the property. The Dutch Association of Insurers and the Dutch Banking Association (together with several other parties active on the Dutch REF market, such as pension funds and German banks) concluded an agreement to ensure that this is done, whereby parties agreed that insurers would check the land register and on finding that the insured property is mortgaged pay out to the mortgagee in any case where the insurance proceeds are higher than EUR 25,000 per claim. This is useful although not every financier or insurer may be party to this agreement and the same can of course also be accomplished by requiring that the financier's interest is noted on the insurance policy, which has by now very much become the norm. It should also be noted that although (even if its name suggests otherwise) this agreement does cover insurance claims arising from building insurance policies due to causes other than fire (as long as the policy concerned also includes fire insurance), it is limited to insurance claims relating to physical damage to the property. In practice, a borrower and lender may also wish to agree on a different threshold amount than the EUR 25,000 per claim included in this agreement.
3. Noting a mortgage lender's interest on the policy
In practice, there are different ways of protecting a mortgage lender's interest under an insurance policy.
i) Noting the lender's interest as mortgagee of the property/pledgee with respect to the insurance claims on the policy
The effect of this is dependent on the terms of the policy. In practice, the insurer would typically check with the mortgage lender/pledgee if it seeks to make any claim with respect to the insurance proceeds upon having been notified that damage or loss has occurred in respect of which the borrower/owner wants to make a claim under the policy. In this case the mortgage lender/pledgee can, however, only claim and collect such amounts as the insurer may be required to pay out to the borrower/owner under the terms of the insurance.
ii) The mortgage lender as composite insured under the policy.
This effectively results in two separate contracts of insurance insuring each party for its own interest and accordingly its own damage or loss, whereby it will depend on the terms of the policy what would be regarded as the damage or loss suffered by the financier, but this would in any case, if lower, not usually exceed the (in a portfolio, allocated) nominal value of the claims secured by its mortgage where the proceeds are not used to reinstate the mortgaged property. Compared to i) the advantage is that the lender will be less vulnerable where a borrower/owner’s actions would lead to the insurer no longer being under an obligation to pay out to them. However, without further provisions being made, making a lender co-insured could also lead to it owing the same duties as any other insured, including being liable to pay insurance premium, which could be very impractical. Therefore, many lenders would typically seek to exclude those obligations, such as the duty of disclosure and the obligation to pay premium.
iii) The mortgage lender as first loss payee under the policy
A third loss payee clause typically provides that any insurance proceeds are paid out to the party noted on the policy as first loss payee instead of to the owner/insured party, usually subject to a certain threshold per claim made below which proceeds could still be paid out to the borrower/owner of the property, which would usually range from EUR 25,000 to EUR 150,000 depending on the size and risk profile of the relevant mortgage loan. It does not, by itself, say much about what right a lender really has with respect to any insurance proceeds and should therefore be combined with i) or ii) above or both.
In our view it is worth combining (and we would usually combine) i) through iii) for a financier so that maximum comfort is provided.
4. Broker letters
In order to receive a third party professional confirmation that the insurance taken out by a borrower with respect to a mortgaged property financed by them complies with their requirements, mortgage lenders increasingly require to receive a broker letter either from the borrower’s insurance broker of from a broker or insurance advisor instructed by them. On this point, the Dutch CREF market appears to move in the direction of what is usually required by US/UK CREF lenders in their home markets. Usually, a broker letter would quote the insurance covenant from the facility agreement and confirm compliance of the policy with that (usually extensive) covenant on a point by point basis. Where provided by the borrower’s insurance broker it would also usually include a confirmation that any insurance premiums due have been paid. Although we do find that for some Dutch insurance brokers the concept of a broker letter is not something they deal with on a daily basis, our experience is that it is usually possible to obtain such a letter if we provide them with a format they can work with.
In addition to a threshold to the effect that proceeds per claim below a certain amount may still be paid to the borrower/owner, usual carve-outs in the Dutch CREF market to the rule that building insurance proceeds with respect to a mortgaged property should be paid to the mortgage lender closely follow the international LMA standard. Usually, a lender would, as long as the loan is not in default, allow the borrower to put the proceeds on deposit in an account pledged to it for a period of in between 6-12 months depending on the deal (though not beyond the maturity date of the loan) in order to reinvest such proceeds in the mortgaged property, often with an added requirement for the borrower to present an acceptable reinvestment/reinstatement plan to the lender within 3 months from the date on which the damage occurred. Public liability insurance proceeds would be used to pay the relevant third parties and loss of rent insurance proceeds would be required to be paid into the account in which rent would normally be received to mimic rental income.
Finally, it is advisable for borrowers to ensure that where insurance proceeds are held on deposit to be reinvested into the mortgaged property, these are deducted from the loan component for the purpose of calculating financial covenants and that the damage of the property or an insured loss of rent does not just by itself trigger an event of default under another representation or covenant in the facility agreement, whilst a period to remedy and reinvest is still ongoing under the insurance covenant included in the facility agreement.