Noting Interest on the Insurance Policies
It is still common practice that the lender simply requires its interest to be "noted" on the policy. Under a previous protocol between the Association of British Insurers and the British Banking Association, it was agreed that, where a lender's interest was "noted" on the policy, the insurer would notify the lender of any cancellation or alteration in the insurance cover. This would give the lender an opportunity to arrange its own insurance if the borrower failed to maintain the level of insurance cover required. This protocol is no longer in force. A lender should therefore obtain a specific confirmation from the insurer that the insurer will notify the lender of the cancellation or alteration in cover. The disadvantage of the lender requiring its interest to be simply "noted" on the policy is that it offers the lender little legal protection. The lender has no rights under the policy itself or to the proceeds. If the borrower invalidates the policy, the lender is left without protection.
Loss Payee Provisions
The lender may require a provision in the insurance policy that it benefits from "loss payee" provisions. Such provisions mean that, in the event of a successful claim on the insurance policy by the borrower, the insurance proceeds are paid to the lender rather than the borrower. The advantage is that the lender is in control of the insurance proceeds. The disadvantages are that the lender is not entitled to make a claim under the insurance policy and is not protected from the borrower invalidating the insurance policy.
It may not be desirable in every case for the proceeds to be paid to the lender. Dealing with insurance proceeds for minor claims may be an administrative burden.
If the proceeds are paid to directly to the lender, the lender may, in its option, be entitled either to use the proceeds to repay the loan or allow the borrower to reinstate the building. If the lender uses the proceeds to repay the loan, then the borrower is left with a damaged building. There may be additional consequences for the borrower. For example, the borrower may hold the property under a long lease and undertaken to the landlord under the long lease to use insurance proceeds to reinstate the property. The borrower will be in breach if the insurance proceeds are used to repay the loan. Similarly, the borrower may lease out the property to occupational tenants and undertaken to them under the leases to use the insurance proceeds to reinstate damage. Again the borrower will be in breach of these undertakings to the tenants if the insurance proceeds are used to repay the loan.
Composite insurance is used where the transaction is of a significant value although it is becoming more common in smaller loan deals. Composite insurance means effectively that the borrower and the lender each have their own separate insurance cover under the insurance policy. The advantage of such insurance is that the lender's insurance cover is not invalidated by the actions of the borrower. The disadvantage from the borrower's point of view is that it may be required to pay an additional premium. In cases where there are occupational tenants, these tenants might object to paying an increased premium, particularly where the lender is introduced after the leases (and current insurance policy) are in force. The disadvantage from the lender's point of view is that, as with all insurance contracts, the insured party is required to act in good faith and make any relevant disclosure to the insurer. The lender may be reluctant to accept this administrative burden on the basis that its interest in the insurance policy is purely financial.
In deals of significant value, the insurance provisions in the loan agreement and the provisions of the insurance policy can be complicated. A lender is sometimes willing to accept a letter from the insurance broker confirming the insurance policy covers the requirements set out in the loan agreement and that the lender's interest is protected. However, the broker is normally acting for the borrower and the extent to which such a letter can be relied on by the lender needs to be checked.
Ongoing monitoring by the lender
At completion, the lender will be satisfied that adequate insurance cover is in place and that its interest is protected. However, insurance policies tend to be renewable annually and lenders should have adequate monitoring procedures in place to ensure that any new insurance policy complies with its requirements and that the lender's interest is adequately protected on the policy.
Whether the lender requires its interest to be "noted" on the policy, or to be paid as "loss payee" or to be separately insured under a "composite" insurance policy needs to be considered carefully by the lender and its advisors and will vary on a case by case basis depending on transaction value and other relevant considerations. Periodically, properties are damaged by fire, storm and flood and it is important that the lender's interest is covered and that monitoring procedures are in place to ensure that its interest is protected throughout the duration of the loan.