American Bar Association
Business Law Section Mid-Year Meeting
Loan Documentation Subcommittee of the
Commercial Law Committee
Insurance: Make It a Post-Closing Item?
In lending transactions, insurance is generally used
to mitigate known or unknown risk
•
What is risk?
–
Risk is the uncertainty, possibility or chance of loss.
A chance occurrence that results in monetary losses
making the profit predictions of an organization
unreliable. Taken a step further, such chance
occurrences may expose the organization to a loss or
series of losses of a magnitude that could compromise
its financial stability and ability to survive.
What is the role of insurance in managing risk?
– Insurance is a component of risk management, not a
substitute for it.
In exchange for the payment of a known loss (the
premium), insurance transfers the financial
consequences of covered loss exposures from the
insured to the insurance company. The most
common and frequently used method of handling risk
is the purchase of insurance to cover loss exposures
•
Speculative Risk:
– Speculative risk has two possible outcomes, the chance of gain or the chance of loss.
• When a business commences operations, it will experience only two possible outcomes over a period of time.
• It may be successful and make money or it may lose money because income does not cover expenses.
• Organizations deal with this type of risk by choice, actually seeking or exposing themselves to certain risks with the hope of taking advantage of opportunities.
• Speculative risk includes consideration of opportunity costs and what might be lost by not taking a chance on a potentially profitable venture.
• Risk managers involved with this type of risk must be able to evaluate business, credit and commodity risks, hedging exposures and investment risks.
Two types of risk: speculative risk and pure
risk
•
Pure Risk:
– Pure risk also offers two possible outcomes: loss or no loss.
Examples of this type of risk include loss to property by fire, wind, or theft; third party liability claims for damages; or the interruption or reduction of income from loss of power, strikes or fire.
With pure risk, the most favorable outcome is to have no loss. The only other possibility is that a loss will occur. This is why risks and exposures need to be identified and analyzed to determine the effect that the risk or loss exposure will have on continuing business operations. Whether
identification and analysis takes place or not, the only two outcomes with pure risk situations are loss or no loss. Risk managers involved with this type of risk, must be knowledgeable and experienced with insurance,
various risk transfer clauses in operating contracts, loss control and safety and accident prevention.
Pure Risk (continued)
Pure Risk exposures involve a number of broad and diverse classes of risk.
They include:
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Economic
•
Legal
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Political
•
Social
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Physical
•
Judicial
Why is insurance important to lenders?
• Lenders’ concerns tend to focus on a borrower’s ability to mitigate Pure Risk • Assets taken as collateral may be impaired or destroyed either by natural
or man-made occurrence
– Loss of market value of collateral – Loss of cash flow
• Key personnel may die or leave the company
– Strategic and/or operational disruption
• Employees or customers may be injured as a result of borrower negligence
– Damages assessed against the borrower may impact borrower survival
• Collateral may be detained in a foreign jurisdiction
– Inability to replenish inventory may disrupt sales
• Lender’s lien or lien position may be impaired
– Reduced or complete inability to satisfy loan through liquidation of collateral
• Borrower may not have insurable interest in the collateral
Types of Insurance to mitigate Pure Risks:
•
Casualty coverage
– Protection from physical destruction of real or personal property:
• Buildings
• Movable machinery and equipment • Office equipment
• Computer hardware and software • Inventory
• Goods transported over water or land (in-transit goods) • Fixtures
• Fine arts
• Business interruption (loss of income) • Valuable papers
• Other personal property stored offsite • Office collateral
• Aircraft • Boats
•
General liability
– Protection from lawsuit damages
:
• Bodily injuries that occur to customers, employees, vendors or visitors to the borrower’s premises
• Personal injuries sustained as a result of the actions or negligence of borrowers’ employees
• Property damage caused by borrowers’ employees
• Advertising injury (damage from slander or false advertising) • Product recall and product failure
• Liquor liability
• Professional liability • Environmental liability
•
Credit Insurance
– Extension of credit to borrowers’ customer
• Protects borrowers’ receivables against non-payment
• Mitigates risk that a borrower will incur a large unexpected credit loss as a result of customer financial difficulties or political risk impeding transfer of funds from foreign jurisdictions including war, cancellation of buyer permits or other
•
Life Insurance
– Key employee coverage
• May be required if one or more key employees are critical to strategic or operational functions of the borrower
• Policy is generally owned by the business and proceeds may be used to reduce financial loss to the company
• Policy may be assigned to a lender so proceeds may be applied to outstanding loan balance
•
Title Insurance
– Protection from:
• Defects in title or other encumbrances on collateralized real property • Invalidity or unenforceability of liens on real property
• Errors relating to title searches on real property
– A policy may protect property owners, lenders or both – Title insurance exists for real property, aircraft and vessels
•
UCC Insurance
– Similar to title insurance, but relates to personal property – Provides lender protection as a result of:
• Defects in attachment or perfection resulting in invalidation of a security interest • Other filing related issues resulting in loss of insured lien priority
Specialty Insurance
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Flood
– Commercial coverage
– Federally backed coverage under the National Flood Insurance Program
•
Earthquake
– Coverage for collateral located in earthquake-prone locations
•
Environmental
– Coverage for pollution releases – Clean-up cost coverage
– Storage tank liability
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Protecting the lenders’ interest in insurance proceeds
– Generally cannot obtain an interest in any type of insurance under
Article 9 of the UCC (see 9-109(d)(8)) except for certain
healthcare-related insurance receivables
– To the extent that payment of an insurance claim occurs on a policy
covering destruction or damage to a lender’s collateral where a
lender has perfected an Article 9 security interest in the collateral,
Article 9 will apply with respect to proceeds of the insurance (see
9-315) and priorities in proceeds of the insurance (see 9-322);
insurance proceeds are generally treated as identifiable cash
proceeds for Article 9 purposes
•
Most lender protection, especially with respect to casualty and general
liability insurance will arise through a contractual relationship with the
insurer
•
What is the nature of the lender’s interest in a casualty or general
liability insurance?
– Additional Insured, Mortgagee, Loss Payee, Assignees?
– These are all methods for a lender to obtain an interest in policy proceeds or the policy itself
– Method will vary depending upon the type of policy and the lender interest to be protected
•
Liability insurance protects insured against third party claims
– Lender requires protection for third party claims in connection with its lending activity to borrower
– Lender is a potential target of third party claims
– Generally, only the owner of the policy is the “insured”
– Lender should seek to be named as an “additional insured” via specific language in the policy covering certain classes of parties or via specific endorsement to the policy
Property and Casualty Insurance protects against damage or destruction
•
Lender as Loss-Payee (personal property)
– Lender does not obtain interest in the policy, but rather directs payment of claim proceeds to the lender
– If borrower, as insured, is not covered by virtue of its own acts or omissions, lender as loss-payee may not assert its own rights under the policy; lender’s interest in derivative of borrower’s interest
– Personal property lender may seek enhanced coverage similar to mortgagee coverage through specific endorsements
•
Lender as Mortgagee (real property)
– While similar to loss-payee status, lender will gain rights independent of borrowers through industry standard mortgagee endorsements; lender may be entitled to payment even if acts or omissions of the borrower preclude payment of the claim
•
Key-Man Life Insurance
– Lender usually obtains an assignment of the proceeds through
execution of assignment document supplied by and then
acknowledged by the insured
– Unlike loss-payee interest when payment of proceeds is made jointly
to the insured and the loss-payee, payment is made solely to the
assignee
– Life insurers generally are deemed to have no notice of the
assignment and therefore no obligation to pay the assignee if the
insurer has not acknowledged in writing the assignment document
filed with the insurer.
•
Insurance Documents provided at Closing
– Language in Loan Agreements, Security Agreements, Mortgage or other security documents; and
– Certificate; or – Binder; or – Policy
•
Insurance industry is notoriously bad when it comes to producing new or
revised policies after coverage is bound
– Lag time can be anywhere from 30 days to 6 months
– Insurance industry organizational called The Association for Cooperative Operations Research (“ACORD”) establishes basic document templates for agents and insurers nationwide for use in attesting to existing insurance coverage: i.e., ACORD 25, ACORD 27, ACORD 28
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Should ACORD certificates be relied upon at closing?
– The answer depends upon what the lender requires
– The ACORD certificate does little more than provide information about existing coverages
– Real concern voiced by Standard & Poor’s, FreddieMac and the Mortgage Bankers Association as to the value of the ACORD 28 certificate in its 2006/2007 revised form
– ACORD 28 certificate (2003/2004) stated that “commercial property insurance has been issued, is in force, and conveys all the rights and privileges afforded under the policy “and provides a timeframe that the
insurer would provide notice to the “interest named below” (the mortgagee or mortgage servicer) of termination or cancellation
– ACORD 28 certificate (2006/2007) now states that the certificate is provided as “a matter of information only and confers no rights” for the “additional interest” (the mortgagee or mortgage servicer) names on the certificate and further indicates that the insurer has no obligation to notify the “additional interest of cancellation or termination
– FreddieMac will require the ACORD 28 (2003/2004) or the ACORD 75
insurance binder or an insurance policy or duplicate original insurance policy as evidence of insurance and its interest as mortgagee or servicer. See
National Lenders Insurance Council, News and Events at
http://www.nlic.org/news/index.html
– Standard & Poor’s recommends that ACORD should re-adopt the language from ACORD 28 (2003/2004) or institute a new certificate that sufficiently attests to the existence of current insurance and contains appropriate notice provisions. See Standard & Poor’s For Commercial Loan Servicers,
Evidence of Insurance is Essential,
http://www2.standardpoors./portal/site/sp/en/us/page.article/2,1,1,0,11484423 54422.html?region=us&lang=en#ID69
– The relationship between ACORD and the Mortgage Bankers Association has apparently chilled somewhat on this issue since their joint press releases on the rollout of the ACORD 28 (2003/2004). See Press Release ACORD and
MBA Announce Joint Release of Evidence of Commercial Insurance Form,
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What is a lender to do to protect its interest as a lender
– Start the insurance review process as early in the transaction as
possible
– If the transaction is significant, engage an insurance expert to assist
– Make sure the borrower and its counsel understand that in the first
instance ACORD certificates will not be acceptable at closing; at
minimum, binder containing the appropriate interest as loss payee,
mortgagee or as an additional insured shall be required
– If only certificates are available, provide for post-closing conditions
for delivery of the binder and endorsements or the actual policy with
endorsements within 30 days (note that the lender may have exposure
during the period until the insurer actual recognizes the lender’s
– Provide notice to the borrower 60-90 days prior to insurance
expiration that evidence of renewal is required prior to the renewal
date
– Should insist on receipt of actual renewal declarations page, not just an
ACORD certificate
– Although dated, the following article provides some perspective on the
relative worth of certificates:
• Joseph, Alfred S. Pape, Arthur E., Certificates of Insurance: The Illusion
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Loan Agreement Provisions
– Short and general – See Exhibit A
• Leaves adequacy determination of scope and coverage amounts to the sole or reasonable discretion of the lender
– Generally more typical for non-real estate transactions
– Specific requirements – See Exhibit B
• Borrower is directed to maintain specific types of insurance and coverage amounts
– Generally more typical of loans where significant real property is part of the collateral package
– The size and complexity of the transaction may also drive the amount
of specificity drafted into the loan documents
– In addition to coverage and scope and amount, loan documents may also detail requirements for the nature of the lender’s interest to be incorporated in the policy or in endorsements
