The ravages of the recent hurricane season served as a wake-up call to many lenders and their professionals about problems and pitfalls when collateral is not appropriately and necessarily insured as well as when the lenders do not have the necessary rights concerning insurance recoveries. Too often, lenders found that they had not focused on the uniqueness and special needs of certain types of collateral securing loans and that, to their dismay, they were not adequately protected.
Review All Insurance Policies Before Closing a Loan. In too many instances lenders that have collateral insurance requirements in loan documents only require the borrowers to provide certificates of coverage before closing the loan. Not all insurance policies are the same. If collateral securing a loan is to be covered by insurance, the lender and its professionals should review the insurance policies itself before closing the loan and not just the insurance certificate. Additionally, the borrower and the lender should notify the insurance carrier not only of the lender’s collateral interests, but also to require the insurance carrier to inform the lender if any terms in the insurance policies are changed or modified or any of the insurance policies are canceled. The lender should also make sure that the start date of coverage is no later than the date the loan closes and that the insurance carrier meets minimum rating requirements.
Never be an Additional Insured. Most lenders require that their collateralization is protected by requiring the borrower to maintain specified insurance coverage. However, either by design or neglect, the lender is listed as an additional insured on the policy as opposed to being a loss payee. This is a distinction and a major difference. As a loss payee, the lender has rights concerning the adjustment of the casualty loss and the timing and adequacy of the payment by the insurance company for the loss. Being listed as a loss payee also prevents the borrower from unilaterally settling a claim quickly for a lower amount. As an additional insured, the lender abdicates its independent rights and can be subject to the whim of the borrower concerning any insurance settlement and proceeds. Furthermore, in the event of a bankruptcy proceeding involving the borrowers, the rights of the lender are distinctly different and detrimental as an additional insured.
Insist on Necessary Geographic Coverage. Most lenders have standard insurance provisions in their loan documents which usually require what is known as multi-peril casualty coverage which includes fire, theft, etc. However, especially in areas like Florida where there are perils such as windstorms and floods that are geographically unique, it is essential to make sure that the loan agreements require appropriate coverage. Fire, hail, earthquake and hurricane insurance are other types of extra coverage that lenders should require in areas prone to those kinds of disasters. If the borrower is located near a body of water, additional umbrella insurance may be required since flood insurance has a minimum upper limit. Each loan should be individually analyzed to make sure that there is coverage appropriate to the physical geographic location of the collateral.
Insist on Replacement Cost Coverage. In not reviewing insurance policies before closing a loan, or in only requiring minimum limits of coverage, lenders often cheat themselves in the event of a casualty loss. The tangible assets that serve as collateral for commercial loans should be covered to the extent of replacement cost and not some other formula such as a depreciated value. While replacement cost insurance may be more expensive, it is the only way to provide appropriate protection to the lender if the valuable collateral is lost due to a casualty. And the total coverage of the insurance policies should at least equal the loan amount.
Builder’s Risk Policies Are Not All the Same. Whether or not a lender is making a construction loan, if the borrower is doing any construction where the tangible collateral is to be located, the lender and its professionals should require appropriate builder’s risk insurance policies, worker’s compensation policies and policies that protect against the use of defective materials. Otherwise, in the event of a casualty where the borrower is not adequately insured, the loss can create a catastrophic environment which will preclude the borrower from continuing as a going business concern.
Preclude Other Lenders from Being a Loss Payee. While it may seem axiomatic that a lender would take steps to preclude junior liens on collateral too often this occurs without the senior lender’s knowledge. If the senior lender does not have an agreement from the borrower and the insurance carriers that there will be no other loss payees on an insurance policy, in the event of a casualty, an unsuspecting lender can be caught up in time-consuming and expensive litigation as to the parties’ respective rights to the insurance proceeds.
Do More Than List Insurance Proceeds as Part of the Collateral. Many lenders and their professionals believe that listing “all insurance proceeds of the collateral” in the collateral description in a security agreement and financing statement is sufficient. It is not. While this does create a security interest in any insurance proceeds resulting from a casualty of the collateral, in the event of a bankruptcy proceeding of the borrower, the lender’s interest is only as good as the value of the collateral. Therefore, the collateral description should also designate the lender as a loss payee on all insurance policies covering the collateral.
Business Interruption Insurance Proceeds Are Different. Lenders and their professionals too often fail to focus on the fact that the proceeds from business interruption insurance that may be held by a borrower will not be covered by language in security agreements and financing statements covering “proceeds of collateral insurance.” Business interruption insurance does not cover tangible assets subject to a security interest. Thus, it is imperative that a lender adds to its collateral description in loan documents a separate category covering business interruption insurance, and require the lender’s designation as a loss payee on any business interruption insurance policy.
Deductible Limits. Many insurance policies carry a deductible, which is the amount of money that the borrower must pay before the insurer pays on a claim. Borrowers have a financial incentive to obtain insurance policies with higher deductibles since that typically results in a lower premium cost. Lenders should make sure that the deductible doesn’t exceed a threshold percentage of the value of the collateral.
The above is only a summary of some of the problems and pitfalls that can entrap the unsuspecting and unfocused lender. It is imperative that lenders and its professionals be awake and vigilant when structuring, memorializing and overseeing collateralized loans.
Charles M. Tatelbaum is a director and senior attorney in the bankruptcy and creditors rights department at Tripp Scott in Fort Lauderdale. Matthew Zifrony is a director with Tripp Scott and serves as general counsel for several large companies.