Model Insurance Requirements For A Commercial Mortgage Loan James E. Branigan and Joshua Stein Commercial buildings make good collateral for a lender.They make even better collateral when properly insured against damage and destruction. ⅥⅥⅥ REAL ESTATE LOANS START FROM the A fire or other loss affecting the borrower’s fundamental assumption that the borrower’s building can undercut this very fundamental assumption and throw the loan into default building will continue to exist. As long as the rather quickly—unless the borrower has main- building exists, it can produce rental income so tained an appropriate package of insurance cov- the borrower can pay debt service. erage for the mortgaged property. James E. Branigan, President and Chief Executive Officer of Omega Risk Management LLC, has spoken extensively on insurance and risk management for bar associations and major law firms. His firm is a consultancy, which does not sell insurance. He can be reached at (631) 692-9866 or [email protected]. Joshua Stein, a partner in the New York office of Latham & Watkins LLP, is a member of the American College of Real Estate Lawyers, First Vice Chair of the New York State Bar Association Real Property Law Section, and author of New York Commercial Mortgage Transactions (Aspen 2002), A Practical Guide to Real Estate Practice (ALI-ABA 2001), and over 100 articles about commercial real estate law and prac- tice. He can be reached at (212) 906-1342 or [email protected]. An earlier version of this article appeared in The Real Estate Finance Journal 10 (Winter 2004) , and in Joshua Stein’s recent Mortgage Bankers Association book, Lender’s Guide to Structuring and Closing Commercial Mortgage Loans. Copyright © 2004 James E. Branigan and Joshua Stein. 19 20 The Practical Real Estate Lawyer November 2004 Similarly, if the building burns down or suf- ance program must include and whether a par- fers some other damage without appropriate in- ticular set of insurance provisions is adequate or surance coverage, the value of the mortgaged seriously flawed. Any insurance expert can usu- property will probably drop, quite possibly to ally suggest improvements in any insurance re- the point where it will not support repayment quirements or any insurance program. There’s of the principal of the lender’s loan. always something to add. Many such sugges- For those and other reasons, any mortgage tions, whether for modifications or additions, lender will typically regard the borrower’s are often perfectly valid. Differences of opinion obligation to insure the mortgaged property as about insurance reflect the complexity, multiple one of the most fundamental nonmonetary facets, and constantly changing nature of the in- obligations under any set of loan documents. surance market. This article offers a set of standard insurance requirements that any mortgage lender might CONTEXT FOR MODEL INSURANCE LAN- want to use in its loan documents for substan- GUAGE • The provisions offered here reflect tial loans. These requirements are reasonably recent developments in the law, the markets, complete, straightforward, thorough, and lend- and the world of insurance. The authors have er-oriented, without being excessive. They ap- not tailored this model language specifically for proach insurance as a prudent risk manager securitized loans or for any particular transac- would, if that risk manager wanted to protect tion. This language must always be checked the mortgaged property and its cash flow in a against the specific circumstances of the mort- manner consistent with typical expectations in gaged property and the rating agencies’ current commercial real estate. requirements and expectations. Some further Extensive footnotes explain why some of introductory comments: these insurance provisions say what they say, other ways to approach some issues, and gaps Future Changes that may still need filling for some loans. Insurance markets and mortgage lenders’ expectations change over time as the business NONGENERIC INSURANCE REQUIRE- world becomes aware of new risks or of the true MENTS • Beyond the generic insurance re- magnitude of older risks previously thought quirements in the model language offered here, small. These sample insurance provisions seek loan documents for a substantial commercial to respond to the marketplace and lenders’ ex- loan will often require other insurance based pectations at time of writing, but will inevitably on characteristics of a specific building, such as become out of date. The authors intend to main- particular occupancies, construction tech- tain these insurance provisions over time, as a niques, zoning issues, nearby risks, special haz- current benchmark, taking into account ards, and the terms of major leases (particular- changes in markets. The authors will distribute ly on rent loss or business interruption insur- updated copies periodically to their clients and, ance and restoration). A lender’s insurance ad- upon request, to others. visors should identify and tailor these require- ments as appropriate. Policy Boilerplate Expectations about insurance requirements The last few decades have seen the courts can vary widely. Every insurance expert seems create numerous new theories of liability. Enter- to have a different view about what any insur- prising plaintiffs’ lawyers usually fashioned Model Insurance Requirements 21 these theories, sometimes with help from “pub- the matter in question will satisfy the particular lic interest” organizations. A gold rush of claims lender’s requirements. against insurance companies usually followed each new theory. In response to each such gold Best’s Ratings rush, the insurance industry created new or im- This model language requires insurance car- proved exclusions from coverage in subsequent riers to have an A.M. Best rating of at least insurance policies—for example, the “pollution “A:X.” The first letter refers to the company’s exclusion” and more recently new limits on “quality,” as Best measures it, ranging from coverage for “toxic mold” risks. Terrorism cov- A++ (the highest) all the way through F (in liq- erage followed a somewhat similar path, at least uidation) and S (suspended). The second letter until federal legislation made the issue go away, refers to the company’s “financial size catego- at least for now. Some of the latest new policy ry” (“FSC”), again as Best measures it—a com- limitations are buried in the boilerplate of in- bination of the company’s capital, surplus, and surance policies. A lender will often want to un- “conditional reserve.” FSC requirements for earth and understand those limitations as part any loan should take into account a particular of the process of closing a loan. In some cases, company’s potential exposure to loss. FSC rat- the lender can (and may want to) require the ings can range from I ($10 million FSC) to XV borrower to pay an additional premium to (over $2 billion FSC). Typically a lender will re- solve the problem. That entire process falls out- quire a rating of at least A:X (i.e., FSC of at least side the scope of this discussion, but will often $500 million and quality level of “Excellent”), matter a great deal for any particular loan. but may accept a smaller company for a small- er exposure. As an example, earthquake and windstorm coverage are difficult to place and Rating Agency Requirements relatively little coverage can usually be ob- The requirements of the rating agencies for tained. Many lenders would settle for smaller securitized loans change over time. Anyone companies for these risks, but not lower their who closes securitized loans must stay current “quality” standards. with those changes (a comment by no means limited to insurance). For example, on May 1, Construction 2003, based in part on difficulties in the insur- This model language includes very limited ance market, Standard & Poors (“S&P”) low- requirements on builder’s risk insurance—in- ered the required rating for property insurance tended only for incidental additions to build- carriers in AAA-rated transactions to “A,” thus ings, and perhaps limited renovations of exist- matching the requirement for liability insurance ing structures. If a borrower undertakes sub- carriers. At the same time, S&P made other stantial construction, or for any construction changes in its insurance requirements. loan, the construction-related language here will not suffice. Instead, a comprehensive con- References To Rating Agencies struction-related insurance program will usual- Wherever this model language refers to the ly need to be designed, taking into account Rating Agencies, that reference can usually be whatever insurance the contractors and subcon- omitted for portfolio loans, but only after con- tractors bring to the table. Because the borrower firming that some other appropriate require- ultimately pays for all parties’ insurance, the ment is added (or already exists) to assure that borrower will often want to wrap all insurance 22 The Practical Real Estate Lawyer November 2004 for any large project into a single policy, a so- Coverage Levels called controlled insurance program (“CIP”). The minimum coverage requirements of- This will often cost less than many separate but fered here are purely illustrative, reflecting typ- overlapping policies from many separate par- ical requirements of some lenders. Any deter- ties. It can also simplify any claim processing. mination of minimum coverage requirements The insurance process for any construction job requires careful analysis of the risks associated will also often include a coordinated bonding with the particular mortgaged property. program. Again, the topic falls outside the pre- sent discussion. Use Of Model Documents You can use a model legal document, such as “Claims Made” Policies this model insurance language, in two ways. For a while, the insurance industry tried to First, you can use it in a specific transaction with convince its customers to accept “claims made” appropriate modifications. Second, you can use policies, where the carrier covered only any it to compare and contrast against another, sim- claims made against the insured during the life ilar transactional document.