This document provides an overview of common mistakes that lenders make regarding insurance. It discusses the importance of understanding insurance contracts and coverage details. Key points include: defining covered losses and determining how insurance proceeds will be used; ensuring sufficient coverage amounts and resolving valuation issues; avoiding assumptions that insurance proceeds substitute for lost collateral; and properly structuring additional insured endorsements and bonds. The document emphasizes the need for lenders to thoroughly read policies and endorsements to fully understand risk allocation and obligations.

1. Insurance Mistakes that Lenders
Make
Kevin J. Connolly

2. Preliminary
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RTFP: Read the Fine Policy
Insurance is a contract
That pays money or money’s worth
Upon the occurrence of a fortuitous event
In which the policyholder has an insurable
interest
• In the property-casualty world, keep the
difference between First and Third Party coverage
clear

3. Why Insure the Collateral?
• Tangible property is subject to loss or damage
through casualty.
• Failure to preserve the security for the loan
might seem to be a lapse in care.
• Insuring the property against casualty loss just
makes sense.
But then…when there is a loss…what do you—
the lender—intend to do with the insurance
proceeds?

4. Whither the Insurance Proceeds?
• There is more than one way to secure the
proceeds for the lender
– Loss Payee
– Mortgagee
• Options
– Keep the money and pay down the indebtedness
– Apply the money to repair or replace the lost property
– Keep the money until the borrower repairs or replaces
the collateral

5. How MUCH Proceeds?
• The amount paid is not directly tied to the size
of the mortgage debt.
• The size of the debt stands as a limit on the
amount that the mortgagee can intercept
(sometimes) but the amount paid depends on
many factors.
• First of all, the loss has to be “covered.”

6. Covered?
• The loss has to be to property
• At the site described in the Declarations
• Damaged or destroyed by or as a result of a
covered cause of loss
• Many things are not covered property
(underground, DEMCABS)
• Many causes of loss are not covered, or
require special policies (e.g., “boiler &
machinery”)

7. Exclusions
Building & Realty
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♦ Land,
♦ Water,
♦ Bridges,
♦ Roadways, walks, patios, and other
paved surfaces.
♦ Retaining walls that are not part of a
building.
♦ Bulkheads, pilings, piers, wharves,
and docks.
♦ The cost of excavations, grading, back
filling, or filling.
♦ Foundations below the lowest
basement floor or, if there is no
basement, the surface of the ground.
♦ Underground pipes, flues, and drains.
Plants and Outdoor Property
exclusions:
♦ Outdoor grain, hay, straw, and other crops.
♦ Outdoor trees, shrubs, and plants (unluss they are the insured’s
merchandise).
♦ Outdoor radio or television antennas, including satellite dishes,
their lead-in wiring, masts, and towers.
♦ Outdoor signs, other than signs attached to buildings.
♦ Outdoor fences.
DEMCABS
♦ Deeds,
♦ Evidences of debt,
♦ Money – including food stamps,
♦ Currency,
♦ Accounts,
♦ Bills,
♦ Securities –lottery tickets are not securities.
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And then there are excluded causes of
loss…

8. Causes of Loss
• The insuring clauses promises to pay for losses
“caused by or resulting from a covered cause of
loss”
• A separate schedule is usually attached to
identify which causes of loss are covered
• Open Peril forms, such as the ISO CP 10 30
Special Causes of Loss form, cover all perils
except those that are excluded
• Named Peril forms, such as the ISO CP 10 20
Broad Form, cover only the perils that are listed

9. Causes of Loss
• We could spend a whole hour discussing
causes of loss.
• Here are just a few significant points.
– Even the most liberal coverage is going to exclude
some causes of loss, such as war, nuclear release,
and government activity.
– Some excluded causes have corresponding special
coverage
• Mechanical Breakdown Exclusion::Boiler& Machinery
• Flood Exclusion::Flood Insurance

10. Value
• The property can be valued on the basis of the
cost to replace it with new or like-new
property.
• This is “replacement cost” valuation.
• The primary alternative is “Actual Cash Value.”
• ACV = Replacement Cost minus depreciation.
• This is not depreciation in the ACRS sense, but
a simple valuation reflective of age, condition,
etc.

11. Valuation
• Under a Replacement Cost policy, the full value is not
paid unless the property is replaced or rebuilt.
• Most insurance companies will pay only the ACV until
the policyholder proves that the property has been
replaced or repaired.
– The difference can be substantial.
– Delayed release of the insurance proceeds can undermine
the payment amount.
– Lender liability claims have been seen with slimmer bases
than this.
• Access to the insurance proceeds to pay for the repair
is frequently negotiated…but if it isn’t…

12. Show Me the Money
• In some States (e.g. Texas), the mortgagee has no duty
to make insurance proceeds available to pay for the
repairs.
• In others (e.g., NY) the mortgagee has to reimburse the
cost of repairs (up to the insurance proceeds) but no
duty to advance money during the repairs.
• California takes a approach that appears to be
unique—so far. The obligation of good faith and fair
dealing mandates making the insurance available
unless the security is inadequate or the loan is nonperforming.

13. How Much Money?
• Insurance Company has options:
– Pay the “value” of the property
– Pay the cost to repair or replace with like-kind and
condition property
– Perform the repair or replacement with like-kind
and condition property
– Take the property and pay an agreed value or
value set by an appraisal proceeding
• They will of course minimize the payment

14. How Much Money II?
• Coinsurance
– Most occurrences result in partial losses
– Policyholder might realize substantial premium savings by
under-insuring the property
– Insurance requires the policyholder to refrain from underinsuring the property
– Most policies require the policyholder to insure the
property for at least 80% of its insurable value
• Blanket coverage usually requires 90% coverage
• Builders Risk usually requires 100% coverage
– Payment for partial losses is pro-rated if the policyholder
fails to purchase the required amount of the insurance

15. How Much Money III
• Co-insurance can be daunting if the building is a
legacy structure, e.g., masonry block building,
that would be very expensive to rebuild
– Unless the building is landmarked, the usual solution
is “functional valuation” based on the cost of
reconstructing a building that is functionally
equivalent
– Co-insurance can be sidestepped with an Agreed
Value Endorsement
• Insurance company does not agree to pay the Agreed Value
• This applies solely to satisfying the required amount of
insurance

16. How Much Money IV
• Deductible
– This is a portion of the loss that is not paid by
insurance
– Usually stated as a fixed dollar amount
• The “basic” deductible amount is $500 per occurrence
• Higher deductibles lower the premium/lower deductibles
increase the premium
– Some policies have a special deductible, e.g., for
Named Storms: the deductible is a percentage of the
loss or, in some cases, a percentage of the limits

17. Insurance Proceeds ≠ Substitute
Collateral
• Payment is based on cost to repair/replace
covered property
• Lots of things are not covered, or are covered for
limited amounts
• There may be legal mandates on how you apply
the funds. Demolition and Debris Removal can
use up the insurance
• Valuation issues are always present
• Maybe insurance proceeds are a
poor substitute for the collateral

18. Sundry Property-Casualty Mistakes
• Nomenclature
– “All Risk” insurance does not cover all risks
• Call for Special Causes of Loss or equivalent
• “Fire, Lightning, extended coverage, vandalism and malicious
mischief” is swallowed by the current forms
– Current insurance forms refer to Commercial Property
Insurance, not Comprehensive Public Liability
– CGL insurance should be comprehensive—covering
everything that is not excluded—but more and more
insurance companies will endorse coverage down with
“Classification Limitation Endorsements” that often
eliminate all or nearly all coverage

19. TRIA, Terror and Humbug
• September 11, 2001 changed many
perceptions
• Insurance companies reacted to 9-11 in the
traditional insurance way: they sought to
eliminate coverage.
• What coverage could be had was prohibitively
expensive.

20. TRIA, Terror & Humbug
• Congress enacted the Terrorism Risk Insurance
Act.
• Once the insurance industry as a whole has
incurred $10B in annual losses, those insurance
companies that have satisfied their own
deductibles are eligible to receive a federal of up
to 85% of the losses
• No event has been certified as meeting the
criteria for being designated as an event of terror,
and the bar is pretty high.

21. TRIA
• Caveat: Some insurance companies have expanded the terrorism
exclusion far beyond the narrow definition in the statute
• “the use or threatened use of force or violence against person or
property, or commission of an act dangerous to human life or
property, or commission of an act that interferes with or disrupts an
electronic or communication system, undertaken by any person or
group, whether or not acting on behalf of or in connection with any
organization, government, power, authority or military force, when
the effect is to intimidate, coerce or harm a government, the
civilian population or any segment thereof, or to disrupt any
segment of the economy.”
• The “occupy” movement would fit under this definition, as might
sit-ins, teach-ins, and similar civil disobedience.
• These things are essentially nuisances; but to discover that you
have no insurance coverage is just an unnecessary complication.

22. Additional Insured
• This is a liability insurance concept
• You CAN name an additional insured in a property
policy, but it’s a mistake
• Under the standard commercial property conditions,
misconduct or concealment by any insured (during the
underwriting of the policy or the presentation of a
claim) will vitiate the whole policy
• Mortgagees who are covered by the standard
mortgage clause are immune to this because the policy
is construed as if the mortgagee had its very own
policy.

23. Additional Insured
• This is a method of using someone else’s insurance to
pay for your losses
• An additional insured on a liability policy should have
the same coverage as the named insured parties…but
many insurance companies have written AI coverage
down to limit it to vicarious liability for the acts and
omissions of the Named Insured…or to eliminate
coverage for the active negligence of the additional
insured party
• AI parties MUST be named as such by an endorsement
to the policy
• RTFP

24. Additional Insured
• Why does a lender care?
– Use the borrower’s insurance to pay for losses and
loss adjustment expenses
– Even without liability, lenders get sued anyway
– Receivership
– Foreclosure
• Other transitional issues

25. Additional Insured Endorsements
• The gold standard in construction is the ISO’s CG 20 10,
which makes the Additional Insured into an insured party
for liability arising out of the continuing operations of the
named insured
• Subcontractors can’t cover the owner this way (see CG 20
28 04 13)
• Coverage for completed operations requires a different
endorsement
• Certificates of Insurance are inadequate as evidence of
coverage
• You need to see the whole policy because coverage also
depends on the “other insurance” clause in the policy

26. Additional Insured
• Loss Runs are the only way you can be sure that
the coverage has not been used up
• There is no substitute for seeing the policy
• The availability of AI coverage varies from State to
State
• AIs do not get notice of cancellation/non-renewal
(Mortgagee coverage under property insurance is
different.) It takes more (much more) than a note
on the Certificate of Insurance to change this.

27. Texas Anti-Indemnity Law
• Indemnity is subject to the usual limits, but this law also prohibits
requiring constructors to cover anyone else as an Additional Insured
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Wraps
Breach of Warranty
Required by loan/financing document
Required by Sureties as a condition of executing the bond
Rights pursuant to the Workers’ Compensation Laws
Oilfields (which have their own statute)
Pertaining to governmental immunities
License agreements with railroads
Copyright infringement
Construction of residential property and public works
Joint defense agreements once executed
• The insurance industry is spending lots of money to get similar laws
enacted nationwide.

28. Bonding
• Surety bond provides a guarantee from a solvent third
party. We use archaic language
– Bonds are “conditioned for” the desired result
– Sureties and principals are not discharged by performance: they
are “exonerated”
• The form of a bond is a formal acknowledgement of an
indebtedness with a condition that, if performed, the
parties to the bondareexonerated.
• In construction, the usual bonds are Payment Bonds and
Performance Bonds
• Payment Bonds are conditioned for the payment of
amounts due to subcontractors, laborers and material
suppliers for labor, services and materials

29. Bonding
• Performance Bonds are conditioned for the
performance of the work
• Construction Bonds are typically exonerated by
an Owner Default
• If you want coverage for an owner default then
you want a Completion Bond
– Very expensive
– Very hard to get
– Usually replaced by personal guarantees and/or
standbys

30. Bonding
• Lenders like to have “dual obligee” bonds
• This has disadvantages
– Any obligee can compromise the bond
– Lender should demand terms that require Owner to
notify Lender of any Notice of Intent to Terminate and
Demand for Conference with Surety
– Put this in the Construction Contract and it will be
binding on the surety
– Remember you can draft to require Lender’s assent
without making Lender take control of bond proceeds

31. Bonding
• Better approach for Lenders
– Include the bond and proceeds in the collateral
– Reserve the right to name a new beneficiary of the
performance bond
– Do not take control of the proceeds unless you are
prepared to be accountable for them as a trustee
– Require notice to Lender of Owner’s intent to
terminate and call for surety conference
– Surety should recognize Lender’s rights
– Include these terms in the contract so that surety is
bound to them