Type of insurance
One of the first things to consider when looking at insurance requirements on any transaction is: what does the relevant business do and what are its insurable assets? For example, a manufacturing business is likely to have insurance relating to its premises and its plant and machinery, but these are likely to be less relevant to a services business which leases property and equipment. Likewise, where a borrower owns an investment property, that building's insurance will be key.
The second question is: who is the insurance intended to benefit? Buildings insurance, business interruption cover and insurance relating to plant and machinery should protect the insured against its own losses. These are insurances for which the proceeds can offer valuable security for a lender and which could be paid directly to it if there was a loss of those assets.
On the other hand, there is likely to be a number of insurances, such as professional indemnity cover, occupier's liability cover and product liability cover, which are only intended to benefit third parties who have claims against the insured party. Whilst it is important that these policies are in place to ensure that the borrowing business is not faced with liabilities which would otherwise erode its value, these are generally not insurances for which the proceeds would be payable to a lender.
Common issues for lenders
Cancellation of a policy
A lender needs to know if the insurer cancels any of the borrower’s insurance policies, particularly if it is for the non-payment of insurance premiums. In order to remain protected, a lender will often require that, not only are they notified of any cancellation, but that the policy is not effectively cancelled until the expiry of a notice period. A 14-30 day notice period is fairly common and it gives a lender some time to rectify the breach by bringing the premiums up to date.
An insurer will not agree to this requirement easily and will likely argue that it prejudices its position if the cancellation of the policy is delayed for any period of time.
A prudent lender will often seek comfort from the insurance broker that the non-cancellation wording is contained in the insurance policy at the time of issuing the broker letter.
Effectiveness of a broker letter
A broker letter is a letter from the borrower’s insurance broker which confirms that the borrower has put in place insurance which complies with the terms of the facility agreement or relevant security documentation.
Usually, the letter outlines the policies in place, confirms that premiums are paid and are up-to-date, that a notice period applies before the policy is cancelled for non-payment of premiums, that, where agreed, the lender is listed as co-insured and/or first loss payee and that the insurance is usual for a company carrying on the same business as the borrower.
However, negotiating the specific wording of the undertakings to be given by the broker often takes some time and a broker may not wish to assume additional obligations or have any potential liability to the lender (and may seek to limit its liability accordingly). The requirement for a broker letter is a common condition precedent that often leads to a delay in completion of a transaction. Whilst the LMA’s standard form broker letter for real estate finance transactions has gone some way to creating a 'market' position for REF transactions, those provisions are still not always acceptable to a broker and are often not appropriate for other types of financing. A borrower should be asked to make contact with its broker early on in a transaction to ensure that any issues are identified (and can be resolved) in a timely manner.
Duty of disclosure
Anyone applying for, or renewing, an insurance policy has a duty to make a "fair presentation of the risk" to the insurer. This involves disclosing "every material circumstance" to the insurer. A circumstance is material if it would "influence the judgement of a prudent insurer in determining whether to take the risk and, if so on what terms" (Insurance Act 2015).
There are different types of non-disclosure: "deliberate or reckless" or "neither deliberate nor reckless".
There is some uncertainty as to whether a lender, as co-insured, has a duty to disclose matters to the borrower’s insurers. The duty of disclosure applies to any insured party, but the borrower, not the lender, will be the party who presents the risk to the insurers and will also have much greater knowledge of the risk than the lender. It seems that the lender’s duty of disclosure would, in practical terms, be quite limited. Of course, if the lender becomes aware of a material circumstance which might not have been properly disclosed to the insurers, it should ensure that this is drawn to the attention of the insurers. A good example would be if the sum insured under the policy was known to be too low.
A lender should ensure that it has the protection of a "non-vitiation" clause in the policy, so if the borrower’s cover is vitiated (invalidated) for non-disclosure by the borrower, this will not vitiate the lender’s cover.
Amending a policy
There may be times when an insurance policy needs to be amended. A lender will want to know if any amendments are made, but the question is: how can the lender control this process? The lender has two principal options available to it: Firstly, it could request that the insurer notifies them of any amendments, whether they are material or not. It may even request that no amendments can be made without it giving prior written consent. If this is an important requirement for a lender, it should ensure that the broker letter confirms this condition will be complied with.
Secondly, it may include this obligation in the finance documents, contractually restricting the borrower from requesting any amendments to be made in the first place. This restriction would commonly be found in the representations and covenants contained in the facility agreement or security documents.
Application of proceeds
A lender and a borrower will usually have conflicting interests when it comes to applying any insurance proceeds paid out by an insurer. The LMA Real Estate Finance facility agreement contains insurance provisions which confirm that the lender is happy for any insurance proceeds to be used towards replacing and reinstating any property. On the other hand, the LMA Leveraged Finance facility agreement contains insurance provisions which confirm that insurance proceeds should be used to repay the facility.
Where a borrower is to be able to apply its insurance proceeds in reinstating assets, a lender should also consider requiring the use of a specific blocked ‘holding account’ for those proceeds to be placed into before they are used. This enables the lender to maintain control over them where it is seeking to rely on having fixed charge security over any insurance receivables. In the absence of this, insurance receivables may be regarded as only being subject to a floating charge.
The importance of insurance
In order to achieve the best outcome, a lender should consider its insurance requirements on a transaction by transaction basis. A lender will need to take into account the nature of the borrower’s business and in particular, the nature of its assets. If a borrower has a property portfolio, then replacing and reinstating the property will be relevant but if the borrower’s assets consist of its trading contracts and goodwill, then repaying the facility will likely be the lender’s main priority.
Furthermore, a lender should be aware that a borrower will usually have existing policies in place which they are committed to until they expire. These existing policies may contain provisions contrary to the requirements of the lender, so early due diligence can pay dividends further down the line, especially if a claim is made.
If an existing policy does not satisfy the requirements of a lender from the outset, that lender should consider whether it can make its insurance requirements a condition subsequent to be satisfied either by the borrower taking out a new policy post-completion or on renewal of the existing policy.
Thinking about insurance requirements at the start of a transaction and carrying out early due diligence so that an informed decision can be made as to what insurance provisions need to be included in the documentation will make the negotiation process much easier.
Insurance jargon buster
These terms effectively have the same meaning. Unless the policy provides otherwise, the legal effect of co-insurance is that the rights of each co-insured are separate. So, if one co-insured does something which invalidates (vitiates) its cover under the policy, this does not impact on the cover of the other co-insured.
Property insurance policies commonly contain a ‘non-vitiation’ clause preventing (to a varying extent) the actions of a borrower resulting in the policy being invalidated for the benefit of the lender. These protections are less common where the insurances don't relate to a specific valuable asset (for example, business interruption insurance).
Lenders should seek to negotiate the broadest possible wording of such a clause, particularly where the value of a specific asset is a key component of the lender’s security and credit sanction.
Where the clause is included, a lender should be named as ‘composite insured’ or ‘co-insured’ (as shorthand for 'co-insured on a composite basis'), not as joint insured, to reflect that it is insured only for its own rights and interests.
Although some policies refer to ‘joint insurance’, lenders and borrowers are not true joint insureds because they have different interests insured under the policy.
First loss payee
A first loss payee clause requires an insurer to pay any proceeds to the person named in that particular clause (for example, a lender) in order to ensure that it receives the relevant proceeds of insurance. It is important to note that in order to obtain maximum protection a lender should still request that it is also listed as 'co-insured' (as well as first loss payee). However, including only first loss payee wording is a useful protection, particularly where a lender does not have co-insured status.
It is often assumed that noting a lender’s interest on a policy provides that lender with the right to any insurance proceeds paid out by an insurer when a claim is made. In fact, noting an interest does not make a lender a party to the policy and does not give that lender itself the ability to make a claim or enforce any rights provided by the policy, including the right to receive any proceeds. Furthermore, having an interest noted does not mean that a lender will be automatically notified of any cancellation or alteration in cover – these rights need to be expressly agreed.
So noting a lender on an insurance policy offers little or no protection and ought to be avoided as the sole protection.
An insurer who pays a claim is subrogated to the insured’s rights. This means that the insurer has the right, acting in the insured’s name, to proceed against a third party responsible for causing the loss, in order to recover sums paid out by the insurer to the insured. If an insurer agrees to waive these subrogation rights, it cannot recover its outlay from those responsible for the loss.
Finance documents commonly require that a policy contains a waiver of rights of subrogation against the insured (the borrower), the tenants and the lender (as composite insured). Except in relation to tenants, this requirement is difficult to justify to insurers. Insurers generally cannot sue their own insureds. They do not have subrogation rights against their insureds or composite insureds, so there is strictly nothing to waive against them. However, most insurers can be persuaded to agree to the waiver.
It is important to get a waiver of subrogation rights against tenants if those tenants are not composite insureds under the policy. However, there are circumstances in which the landlord’s insurers have no subrogation rights against the tenant, even where the tenant is not composite insured under the policy.