General Practice, Solo & Small Firm DivisionMagazine
American Bar Association
General Practice, Solo, and Small Firm Division The Compleat Lawyer
Spring 1997 copyright American Bar Association. All rights reserved.
Real Property Insurance
Are Your Clients Covered?
BY JULIE ANN STULCE WILLIAMSON
Julie Ann Stulce Williamson is Of Counsel in the real estate division of the Miami office of Greenberg Traurig. This article is adapted from materials presented by Patrick J. Morgan, Arthur E. Pape, Alfred S. Joseph III, and the author at the September 1995 meeting of the American College of Real Estate Lawyers.
You're a lawyer, not an insurance advisor, but you may be called upon to advise a client on how to reduce the risk of not being properly protected by insurance. Lawyers need to be alert to issues that commonly arise when claims are made on property insurance and business interruption insurance, so they can work in tandem with an insurance advisor and draft documents that will meet the client's needs.
Most lenders and other insureds rely on a certificate of insurance as evidence that insurance is in effect. A certificate of insurance is a document that proves the existence of an insurance policy. But it is not the policy itself, and does not confer benefits beyond those in the policy.
A Bear of a Tale
Several years ago, a dancing bear show operator who was presenting live bear entertainment at a mall obtained liability insurance covering "Bears in Cages, Display Bear Acts and Photos with Bear Cubs." The insurance agent issued a certificate of insurance that indicated coverage for "Animal Display, Photos, etc...." The main attraction was Fluffy, a seven-year-old dancing bear. During a photo session, Fluffy injured some mall visitors, and the subsequently-sued shopping center owner made a claim on the policy. The insurer denied coverage based in part on the policy coverage, which only included photos with baby bears. The court held that the policy did not cover photo opportunities with adult bears such as Fluffy, notwithstanding the apparent coverage in the language of the certificate of insurance ( H.E. Insurance Co. v. Naghtin, 916 F.2d 1082 (6th Cir. 1990)).
Although the result seems harsh in the dancing bear case, the court may have been correct. Many certificates of insurance state that the language of the certificate does not change the terms of the policy. Many states only allow insurance that has been authorized by their respective Departments of Insurance or equivalent regulatory bodies. Because a certificate of insurance is not an approved, regulated form, these states may not recognize coverage shown in the certificate but not included in the approved policy.
All About Certificates of Insurance
Most certificates of insurance are issued on forms promulgated by ACORD, a nonprofit insurance association. The most common forms are the ACORD 25-S, ACORD 27, and ACORD 24. The ACORD 25-S "Certificate of Liability Insurance" relates to liability insurance, confers no rights upon the recipient, and does not obligate the insurer to notify certificate holders if the insurance is canceled or amended. The instructions on the form state that the certificate is to be issued only when the holder is to have no interest in the underlying policy (as a named insured, loss payee, or mortgagee). Common practice, however, appears to ignore the language and the instructions, and many people accept the certificate as binding evidence of the coverage stated on it. Fluffy's dancing, and injuries to spectators, would not have been covered based on the language in a Form 25-S.
The concept of subrogation applies to property, not casualty, insurance. Subrogation is the substitution of a party in place of a lawful claimant in regard to a claim or right; the subrogee succeeds to the rights of the subrogor in relationship to the claim or debt. The subrogee has no rights other than those that the subrogor had. In insurance law, the insured company is substituted or subrogated to the insured's rights. In leases, subrogation applies when the property of the landlord or tenant is damaged; the insurer who pays the claim inherits the rights that its insured may have had against the person who caused the damage. Usually, the parties do not want such claims against them and request that the other party obtain a waiver of its insurer's subrogation rights.
Leases usually include a standard form of subrogation language; each party shall cause any insurance policy obtained by it to provide that the insurance underwriter waives all right of recovery by way of subrogation against the other party. This mutuality of waiver of subrogation is usually the preferred provision. Most policies expressly permit such a waiver of subrogation, but this should always be verified. If an insurer refuses to provide a waiver, another insurer should be consulted.
Some landlords do not provide for mutual subrogation. However, if the landlord's insurer elects to sue the tenant for the tenant's malfeasance, the tenant may spend all of his or her money on legal fees and payment on the judgment, and have no remaining money for rent or other payments to the landlord. - J.A.S.W. The ACORD-27 "Evidence of Property Insurance" relates specifically to property insurance, conveys all rights afforded under the underlying policy, has no statement that it does not amend coverage offered by the policy (but also no statement that it does give such amended coverage), obligates the insurer to give the certificate holder notice of cancellation of the underlying policy, and is designed to be delivered to a party having an interest in the policy (e.g., a lender or additional insured). The ACORD instructions indicate that this form is not to be used for liability insurance, but many insurers and insurance agents do adapt the certificate to liability policies. Fluffy's acts and misdeeds might have been covered if the mall owner had received a modified Form 27.
The ACORD-24 "Certificate of Property Insurance," which was introduced in 1995, adapts the Form 25-S to property insurance, and the instructions again state that the certificate is to be issued only when the holder is to have no interest in the underlying policy; again, this instruction is often ignored. The certificate, however, contains the limitations of a Form 25-S.
A lawyer should insist on an ACORD-27 form for property insurance, and should be alert to problems in coverage if either the ACORD 25-S or ACORD-24 form is used. Many insurers and insurance agents disagree about the possibility of modifying the ACORD-27 form, and may refuse to issue it for liability policies. Nevertheless, the wording on the face of the certificate indicates that a lawyer should consider requesting and fighting for this coverage. The lawyer, or the insured, should consider a letter to the issuing insurance agent describing the coverage requested, and the insured's reliance on the agent to issue a policy that affords such coverage. (For copies of the forms of certificate of insurance, see "Certificates of Insurance: The Illusion of Protection," by Alfred S. Joseph III and Arthur E. Pape, Probate & Property, January/February 1995 (American Bar Association).)
Business Interruption Insurance
Property insurance protects against direct losses to real property and the improvements on it. Its first cousin, Business Interruption Insurance (now often called Business Income Coverage), provides coverage for indirect losses that result from property damage, such as additional business expenses and loss of business income. Businesses can obtain Extra Expense Coverage, which may be an endorsement or part of the primary policy, to cover additional business expenses, including the cost of moving to temporary space, the cost of mitigating damages, extra rent payable at a new site, notification to clients and vendors of the new site, new stationery, and lost employee work hours.
Many businesses have commercial lines of credit, and their lenders require them to carry some form of business interruption insurance so the borrower has a continuing income stream with which to pay off its loans. In addition, landlords often require tenants to carry such insurance so the tenants can pay their rent. Such requirements often dictate the form and content of the insurance.
Because the business interruption is caused by some form of property damage, and business interruption insurance is a form of property insurance, the bases for and exclusions from coverage are very much the same as those for property insurance: There must be a covered peril that causes the loss. Excepted perils may include war, sinkholes, and earthquakes; and causes such as water or windstorm may have different coverage limitations. Potential coverage exceptions also include off-premises service interruption (such as when a hurricane damages an off-site water pump station, not the building's internal pipelines) and civil disturbances (which can also be off-site if, for example, the riot that keeps employees away is several blocks from the building where they are employed). In addition, policies usually require actual physical damage to the insured property. Fires and floods and snowstorms may prevent a business from opening and workers from getting to work, or customers from getting to the point of sale, but they do not come under the purview of most unendorsed business interruption policies unless they also cause direct damage to the insured building.
Business interruption insurance may also require that the covered physical peril actually or predominantly caused the loss. In an "all-risks" policy, the burden of proof for determining whether certain physical damage to certain property is covered under a particular policy is generally on the insured; the burden shifts to the insurer to prove that the loss was caused by an excluded peril. In a "specified peril" policy, the insured generally has the burden of proving that the damage was caused by a peril specified in the policy.
Once the physical damage and causation have been established both to exist and to be covered by a policy, one must show that business operations have actually been interrupted and that there has been an actual loss of income. The amount of the loss is primarily a matter of accounting procedures and proof, and the lawyer takes a secondary place to that of the accountant.
Rent insurance is a generic term applied to the business losses of both a landlord and tenant. Evolving terminology now usually designates the tenant's rent insurance Business Interruption Insurance, and indeed the need to pay rent when one cannot use the premises one is renting is very much a business loss. Rent (or Rental) Insurance usually refers to a landlord's coverage and may apply to an actual rent loss if a building has been leased or to a projected rent loss if a building is leasable but is not yet fully leased. Rental Value Insurance refers to the special situation where a landlord utilizes its own rental property; it covers the costs the insured landlord has avoided by using space in its own facility, and thus protects cash flow rather than gross income.
Rent insurance is intended to cover the amount of rent that either (1) must be paid by a tenant when its leased property is not usable, or (2) is lost to the landlord because the tenant is not required to pay rent because of a specified casualty or event. Landlords and tenants both need rent insurance; they should both be cognizant of the possible exclusions from coverage for business interruption insurance. Many hotly contested lease negotiations could be significantly shortened if the lawyers for both sides understood how rent insurance works.
Volume shopping. The landlord's cost of insurance is almost always passed on to tenants, either through a net rent provision in which the tenant pays its share of all operating expenses, including insurance, or through a gross rent provision in which the tenant pays a base rent that includes base costs of all operating expenses, plus a share of increases in those expenses over a base year. The landlord and tenant have a shared interest in seeing that there is as little overlapping coverage as possible, and in having the insurance purchased by the entity who can get the lowest cost. If a landlord obtains insurance for the cost of rebuilding all of a building's leased premises, the insurance cost is based on the probability that damage will only occur to a portion of the building; the premium is therefore much less than the total premiums would be for each individual tenant for each individual space, which are priced, cumulatively, on the probability that damage will occur to each and every leased premises in the building.
Rent abatement. Every lease provides for some rent abatement in the event of damage to the building or premises. Some leases also allow for rent abatement in other "loss of use" situations, such as lack of utilities. The landlord may lose its claim for rent income insurance in these situations in two ways that are directly controlled by the lease provisions. First, if a lease does not provide for rent abatement in a given situation, but the tenant stops paying rent, the landlord cannot collect insurance for the unpaid rent; the insurance underwriter is not a collection agency.
Therefore, for small tenants who cannot pay rent if they do not have proper insurance, the landlord should either carefully monitor the tenant's insurance coverage, or delete any rent abatement provisions from the lease. Second, if a lease provides that a tenant may cancel or suspend a lease in certain circumstances, and the tenant does so, the landlord's insurer will not need to pay for lost rent under a no-longer-existing lease; a landlord should investigate getting coverage for this alternate form of "business loss."
Small tenants, particularly, have difficulty negotiating any rent abatements short of destruction of the premises or building. Even if a tenant obtains rent abatements for loss of use, such as failure of elevators or electricity, the abatement may not begin for many days. The tenant should evaluate the costs of obtaining business interruption insurance that will cover the costs of rent payments that the tenant is obligated to pay even when its business is interrupted. (If rent is abated pursuant to lease provisions, the insurer is of course not obligated to pay the tenant for rent that the tenant/insured is not obligated to pay; a tenant should verify that it is not paying for such unnecessary coverage.)
In situations where no rent is due but the lease is terminated, Leasehold Interest Coverage could protect against financial loss suffered by a tenant when a very tenant-favorable lease is canceled before expiration because of loss or damage to the building by an insured casualty. In addition, an "Extra Expense" form might pay for out-of-the-ordinary tenant expenses to stay in business on an emergency basis, without limiting payment to the difficult-to-calculate amount of the business interruption loss that the expenditures have prevented; an example might be the cost of obtaining special generators and water treatment equipment.
No-fault lease remedies. Some leases provide that rent is not abated if the cause of damage to the building or premises results from the act or negligence of the tenant or its agents. This provision seems to be a clever landlord drafting technique, but might backfire; if the rent is not abated, the landlord cannot collect on an insurance claim for lost income. The tenant, on the other hand, may not have the wherewithal to pay. The landlord, then, cannot collect from either the tenant or the landlord's insurer.
Potential underinsurance. Whoever carries insurance - landlord or tenant - must determine the correct amount of coverage, and should reevaluate the amount at least annually. Many calculate the base rent for the first lease year; the base rent usually goes up, however, whether in specified steps or through a CPI provision. In addition, percentage rent and additional rent, including the tenants' share of taxes, operating expenses, insurance, common area charges, and similar matters, are a real income stream to the landlord, and a real cost to the tenant, and should be calculated and included in the insurance coverage. Not only could failure to include such amounts result in substantial underinsurance and thus underpayment to the insured, but also the underwriter might construe the underinsurance as a coinsurance factor and therefore only pay 80 percent of the total coverage (which is already below the actual losses).
Rebuilding. Whatever insurance one has - rent, business interruption, property - it includes provisions related to the time it takes to rebuild. In leases, the rent abatement may be tied to a set period of time, which may begin at time of casualty or time of receipt of proceeds. There is a big difference. Most policies have an outside time limit for which business interruption insurance will be paid, and this time runs from the date of damage, not the date of resolution of coverage disputes or beginning of construction. Most rent insurance currently covers a period of one year.
A large shopping center, however, may take years to rebuild. If the coverage is from time of damage, and the damage results from an area-wide calamity such as a hurricane, the insurance underwriter's consultant could take almost a year to reach an agreement with the insured. In addition, there might be a lack of qualified contractors available, further slowing work.
Conversely, the owner of a small strip center might not want to pay the premium for a full year of rebuilding time when there is little chance that any damage will take more than a few months to correct. If the rebuilding and rental insurance companies are the same, there is hope that sufficient agreement will be reached as to construction so that there will be few delays; the business interruption insurance carrier wants the problems over quickly.
Business interruption insurance usually provides coverage for as long as the building repairs should take. This theoretical time described in a policy will usually supersede the actual time of rebuilding. The time it takes to negotiate what repairs will be covered, the limit of dollar coverage, and the length of time that rent payments and similar benefits will be available may use up a part of the period for which rent insurance is applicable. Lengthy negotiations may cost more in the long run even if favorable terms are obtained.
"As was" coverage. Policies generally cover restoration to "as was" condition; upgrades to current code or current desires are not covered. Coverage may be obtained, however, for rebuilding and upgrading to code as it exists at time of damage. Recently, insurance has become available for both the increased cost of construction as well as the extended time required for compliance with such codes. One might also investigate getting coverage for building to code as it exists at a reasonable time after damage, as many building codes are quickly modified after disasters. (For further discussion of rent insurance, see "Rent Insurance: Are You Covered?" by Patrick J. Morgan and Julie Ann Stulce Williamson, Probate & Property, July/August 1996 (American Bar Association).)