Today, property insurance must be more than just fire insurance, so owners, lenders, and their attorneys must understand the additional coverages needed under current insurance practices to provide the property protections they expect to receive.
Today, property insurance must be more than just fire insurance. A modern business relies on its property insurance to pay for the restoration of its building and equipment and to cover its other business losses, regardless of the type of casualty that causes the damage. But the insurance forms still limit the types of coverage provided. Owners, lenders, and their attorneys need to understand the additional coverages needed under current insurance practices in order to provide the property protections that they expect to receive.
Why Special Coverages?
The base property insurance forms provide coverage only for certain specified property and certain specified causes of loss. Most property owners and their lenders require special coverages for property and causes of loss that are either expressly excluded from, or not described as being covered in, the base policy. Landlords and lenders also require special endorsements to give them rights under the property policies maintained by their tenants and borrowers.
ISO form CP 00 10 10 12 (the Insurance Services Office, Inc., known as ISO, is an organization serving the insurance industry that promulgates standard forms) describes the property covered by a commercial property policy. This property generally includes only (1) real property, including buildings, fixtures, permanently-installed machinery and equipment, and the materials and equipment used to maintain or service the real property, and (2) personal property used in that business, including furniture and fixtures, equipment, and stock. If business losses or rental losses are to be insured, then the owner needs special coverage. If other types of property, such as a tenant’s interest in its improvements, are to be insured or if the owner wishes to overcome an endorsement setting out additional exclusions, then the owner will need other types of special coverage.
Not only is special coverage needed to insure excluded types of property, but also it is needed to insure excluded causes of loss. Three types of forms can be used to describe the basic covered causes of loss: Basic Form, which covers only specified types of casualties; Broad Form, which covers listed additional types of casualties; and Special Form (formerly known as “All Risk”), which covers all direct causes of physical loss except to the extent that the policy expressly excludes or limits the cause or the loss (see ISO CP 10 30 10 12). Of these three forms, a Special Form/Special Causes of Loss policy provides coverage for the widest range of possible risks. For a more detailed discussion, see Marie Antoinette Moore, Windstorms, Tornadoes, and Floods, Oh My!, Property Insurance Basics That Every Lawyer Should Know, Prob. & Prop., Sept./Oct. 2012, at 10. But even a Special Form policy excludes many types of casualties. For this reason, most owners and lenders need special coverage for the risks that are the most important in the area in which the property is located. For example, special coverage is needed if an owner wishes to have coverage for damage caused by flood, terrorism, loss of utility services, and various other events or circumstances.
Lenders and landlords that own buildings but rely on the property insurance maintained by their tenants have additional special coverage needs. Lenders need to be sure that they will receive proceeds sufficient to pay the mortgage. Landlords need to be sure that if there is casualty damage, their tenants’ insurance will provide them with the proceeds to restore the property if the lease stays in effect or to provide recovery for their investment if the tenant terminates the lease.
Special Coverages Adding Insured Property and Costs
Loss of Business Income; Loss of Rental Value
Perhaps the most important special coverage for a business is coverage for loss of business income. A base policy of Special Form Property Insurance (for example, ISO CP 00 10 10 12) does not cover the loss of business income that an owner suffers when its property is damaged. The owner must supplement its property coverage with an endorsement like ISO CP 00 32 10 12 to provide coverage for these business losses.
As stated in ISO endorsement CP 00 32 10 12, a “Loss of Business Income” policy covers (1) the “Net Income”—the gross sales or other gross receipts less the operating expenses of the business—plus (2) the continuing normal operating expenses, including payroll and the rent (if the insured is a tenant and the rent does not abate under the lease). If the business was operating at a loss before the casualty, then it is likely that no business interruption insurance proceeds for loss of net income will be payable for the period after the casualty, though continuing payroll and rent should still be covered. For a discussion of the cases, see Moore, supra, at 14.
“Loss of Rental Value” coverage can be included using the same endorsement, but it is an option that must be selected specifically. Whether a landlord can recover for its rental loss depends on whether the rent abates—loss of rental value insurance covers the rental loss only during periods when the tenant’s rent abates under the lease by reason of the casualty (and then limited by the reasonable restoration period and the coverage limits). If the lease is a net lease under which rent does not abate, then the tenant’s loss of business income insurance is expected to provide the tenant with the funds to pay its rent during the restoration—the landlord’s insurance is not designed to reimburse the landlord if the tenant does not pay when it is obligated to pay. On the other hand, if the lease is a gross lease and provides that the rent abates until restoration is complete, then the landlord should be able to recover this abated rent amount from its loss of rental value coverage. But this normal risk allocation plan in which the landlord expects its loss of rental value coverage to pay its lost rent may be frustrated by a lease clause stating that the tenant’s rent will not abate if the tenant’s negligence caused the damage. This may sound fair, but if the tenant’s negligence did cause the casualty, this provision will give the landlord’s insurer an argument that the landlord should recover the lost rent from the tenant, not from the insurer. If the tenant does not have sufficient assets to pay this rent (through its loss of business income coverage or otherwise), then the landlord might be left with no rent and no coverage for that rent.
Insurers permit an owner to recover only the loss of business income or loss of rental value sustained by reason of the suspension of operations during a “period of restoration”—unless the owner obtains special coverage for an additional period. The ISO CP 00 32 10 12 endorsement defines the “period of restoration” as the period beginning 72 hours after the occurrence of the direct physical loss or damage caused by the covered cause of loss and ending on the earlier of the date on which the property should have been repaired, replaced, or rebuilt with reasonable speed and similar quality, or the date on which the business is re-opened at a permanent location. It does not include delays caused by compliance with building codes or environmental laws. The owner can and should obtain special coverage for these additional periods.
“Extra Expenses” are “necessary expenses” that the owner incurs “that it would not have incurred if there had been no direct physical loss or damage to the property.” See ISO CP 00 30 10 12. A loss of business income policy can be with or without coverage for extra expenses, but loss of business income coverage with extra expenses is the best way to avoid a dispute with the insurer over whether the expenses incurred by the business after the casualty are “continuing normal operating expenses” automatically covered by the loss of business income policy or are extra expenses requiring additional coverage (and limits of coverage).
The coverage under a standard property damage policy does not cover the added cost of demolishing a damaged building when the law requires demolition or for complying with laws and ordinances when the building did not previously comply with these laws (most commonly, because it was grandfathered). For example, if an older building does not comply with current electrical codes or contain sprinklers, the building codes in effect at the time of the restoration may require that the owner spend substantial sums to comply with these requirements as a condition of restoration. A property owner can cover the increased costs of complying with these laws and building codes by obtaining the special coverage known as Building Ordinance or Ordinance and Law coverage through an endorsement like ISO CP 04 05 10 12.
There are three types of building ordinance coverage options: Coverage A, which covers the loss in value of the undamaged portion of a building if the ordinance or law requires the demolition of the undamaged portion as well as the damaged portion; Coverage B, which covers the cost of demolishing and clearing the site if the ordinance or law requires the demolition of the undamaged portion as well as the damaged portion; and Coverage C, which covers the increased cost of construction necessary to comply with current laws and ordinances (for example, by the addition of a sprinkler system). All three types of coverage are valuable. Coverages A and B are important to an owner that must demolish all or part of the improvements to satisfy local codes. Coverage C is important when the owner does rebuild and must include improvements (such as a sprinkler system or electrical work to satisfy electrical codes) required by laws that were not in effect when the building was originally constructed.
Loss of Leasehold Interest
Tenants can obtain a special Loss of Leasehold Interest policy to cover their losses. A Loss of Leasehold Interest endorsement, generally ISO CP 00 60 06 95, states that if the leased property is damaged by one of the selected causes of loss, then the insurer will pay for:
- the “Net Leasehold Interest”—the present value (determined by a schedule) of the (a) monthly rental value of the premises minus (b) the actual monthly rent and other amounts payable by the tenant—plus
- the unamortized portion of the tenant’s improvements, betterments, and prepaid rent (amortized over the original lease term and equal to the portion remaining based on the number of months remaining in the lease).
Increase in Rebuilding Expenses
If a disaster affects the entire area in which the property is located, then it is likely that materials suppliers and contractors will be scarce and will naturally increase their charges. An endorsement like ISO CP 04 09 10 12, entitled “Increase in Rebuilding Expenses Following Disaster (Additional Expense Coverage on Annual Aggregate Basis),” provides coverage for additional expenses up to a specified additional expense percentage when (1) the covered cause of loss results in a declaration of a state of disaster by state or federal officials or occurs in close temporal proximity to a declared disaster, (2) the expenses of labor or materials increase as a result of the disaster and the total cost exceeds the applicable limit of expenses, (3) the insured owner repairs or replaces the damaged building, and (4) the insured owner notifies the insurer within 30 days of completion of any work to the insured building that increased the replacement cost by 5% or more.
Special Coverages Adding Covered Causes That Will Trigger Recovery (Covered Causes of Loss)
Terrorism coverage is not the hot-button issue that it was in late 2014. On January 12, 2015, President Obama signed the Terrorism Risk Insurance Program Reauthorization Act of 2015 (Pub. L. No. 114-1, 129 Stat. 3) (“TRIPRA 2015”), which extended the expiration date of the Terrorism Risk Insurance Program (TRIP) to December 31, 2020. The practical value of terrorism coverage can be debated because the scope of the legislation is extremely limited. For an act to satisfy the definition of covered terrorism, it must be certified as an act of terrorism by the Secretary of the Treasury, it must have caused losses that exceed a high monetary threshold, and it must be designed to coerce the civilian population or influence U.S. foreign policy. Under these criteria, even the Boston Marathon bombing was not classified as an act of terrorism. See Jon C. Cowen & Rosanna Sattler, The Boston Marathon Bombing One Year Later: Insurance Coverage for Business Raises Concerns, 58 Boston B.J., Spring 2014, at 19, 20. This coverage is crucial, however, because mortgage lenders require terrorism coverage. By reason of TRIP, property owners can satisfy these lender requirements.
The property insurance exclusion that has caused property owners the most problems is probably the flood exclusion. This exclusion encompasses not only events we think of as floods, but also surface water, waves, overflow of a body of water, spray from any of these (whether or not wind-driven), mudflow or mudslide, water overflow or backup from a sewer or drain, and underground water seepage. See ISO CP 10 30 10 12.
Property owners obtain coverage for damage caused by flood through policies issued by private commercial insurers. The most readily available coverage is sponsored by the National Flood Insurance Program (NFIP), a FEMA program. At the time of this article, NFIP policies have the following maximum limits: for residential property, a $250,000 limit for a building and a $100,000 limit for its contents; and for commercial property, a $500,000 limit for a building and a $500,000 limit for its contents.
These subsidized policies, however, do not cover loss of business income or rental loss for commercial properties, and only actual cash value (the depreciated cost to rebuild rather than actual replacement cost) is recoverable.
The Biggert-Waters Flood Insurance Reform and Modernization Act of 2012 (the Biggert Act) extended the NFIP’s authority through September 30, 2017 (previously it was subject to frequent reauthorization by Congress). The Biggert Act also made several changes to the existing program, including phasing out certain subsidies for severe repetitive loss properties and allowing greater annual premium increases. It also allows multifamily properties containing five or more residences to purchase flood insurance up to the limits for business properties.
The Biggert Act requires that the premium rates for properties located in areas designated as having special flood hazards be increased to accurately reflect the current risk of flood to those properties. This increase is to be phased in over a five-year period at the rate of 20% per year. Most areas have already experienced premium increases based on the newest flood maps. In response to public comments and complaints about the significant increase in premiums, Congress enacted the Homeowner Flood Insurance Affordability Act of 2014 (H.R. 3370), which delayed implementation of most of the 2012 amendments until 2016.
If the property is not in an A (100-year flood risk) or V (100-year flood risk with additional hazards associated with storm-induced waves) zone, a property owner may be able to get non-NFIP flood insurance for the undepreciated full replacement cost and loss of business income/rental value. The property owner also may be able to obtain coverage for the excess over the NFIP limits, though this coverage may be expensive, and it is likely to have a deductible of at least the NFIP limits (in other words, the owner will need to maintain both the NFIP coverage and the additional coverage).
Earthquake and Volcanic Eruption
In many parts of the country, earthquakes and volcanic eruptions are real risks. The standard Causes of Loss forms exclude earth movement like (1) earthquake, landslide, mine subsidence, and earth sinking (other than sinkhole collapse), but if they result in fire or explosion, the insurer will pay for the damage caused by the fire or explosion, and (2) volcanic eruption, blasts, dust, and lava. See ISO CP 10 30 10 12 (Causes of Loss—Special Form). But an owner can obtain coverage for some of these risks by an endorsement like ISO CP 10 40 10 12 or CP 10 45 10 12.
Coverage for explosion of boilers and other mechanical breakdowns is excluded in the Special Causes of Loss form property damage policy (these breakdowns can include HVAC systems destroyed by a power surge). Coverage for equipment breakdown, however, can be obtained through a separate policy or endorsement like ISO endorsement CP 10 46 10 12, entitled “Equipment Breakdown Cause of Loss.” This policy or endorsement should be obtained as part of the overall policy from the same insurer that insures the rest of the property in order to avoid squabbling between insurers.
Loss of Utility Services
An owner can obtain coverage for loss of or damage to property, including loss of business income, caused by an interruption in utility supply services that originates outside the insured property. ISO endorsement CP 04 17 10 12, Utility Services—Direct Damage, will provide this coverage, but only if the interruption results from direct physical damage by a covered cause of loss (generally excluding flood) to the water supply, communication supply, or power supply equipment. Overhead transmission and distribution lines are not included in the covered utility supply equipment under this ISO form. Although equipment providing communication supply services is part of the covered property, covered property loss does not include loss of or damage to electronic data.
Contingent Business Income (from Dependent Properties)
A property owner also can obtain coverage for loss of business income at the insured property caused by direct physical loss or damage to property other than the insured property. ISO endorsements CP 15 08 10 12 and CP 15 09 10 12 describe this coverage as the actual loss of business income sustained by reason of the necessary suspension of operations at the insured’s property by reason of a direct physical loss or damage to another specified property (the “dependent property”) caused (of course) by a covered cause of loss. Loss of electronic data at the dependent property is not covered, however. The dependent property should be a property whose operation is crucial to the operation of the insured’s business, such as a primary supplier if the insured is a manufacturer, or a shopping center if the insured operates an outparcel.
Coping with Insurer-Added Limitations
Many insurers add an endorsement like ISO CP 04 11 10 12, which requires the insured to maintain certain listed protective devices or services, such as a sprinkler system or fire alarm. This is not “special coverage”; instead, it is a special exclusion from coverage that benefits the insurer (probably explained as justifying a lower premium). This endorsement provides that if a fire occurs while the sprinkler system or other protective device is not working, the insurer may deny coverage (all coverage, not just part of the coverage) unless the insured previously notified the insurer that the sprinkler system was not working and obtained assurance that the property would be covered during this period.
Property damage coverage forms like ISO CP 00 10 10 12 (the Building and Personal Property Coverage Form) provide that if a building has been vacant for longer than a certain period—60 days in ISO CP 00 10 10 12—the insurer will not pay for losses caused by vandalism, sprinkler leakage, building glass breakage, water damage, theft, or attempted theft; and the recovery on all types of covered losses will be reduced, by 15% in ISO CP 00 10 10 12. A building is considered to be vacant under ISO CP 00 10 10 12 unless at least 31% of its total square footage is rented to a tenant and used by the tenant to conduct its customary operations or used by the building owner to conduct customary operations. This percentage can be changed under an endorsement like ISO CP 04 60 10 12 (Vacancy Changes). But if an owner knows that a substantial portion of the property is vacant at the time the policy is issued or if it later becomes vacant, the owner needs to notify its insurer and obtain a vacancy permit.
In Hawaii, Florida, and other coastal areas, insurers are likely to exclude coverage for hurricanes as well as windstorm and hail or to require a higher deductible for those risks. In those areas, an owner should review its policy carefully to be sure it obtains the necessary additional coverage, without the high deductible.
Special Coverages Adding Insured Parties
Additional Insured or Loss Payee Coverage
In a net lease of a stand-alone building, the tenant typically agrees to maintain the property insurance coverage for the building it occupies. This makes sense if the tenant built and owns the building and the landlord just owns the land and if the tenant has the obligation to repair or reconstruct the building. This arrangement makes less sense when the landlord owns the building and must repair or restore it if it is damaged. There are several problems that arise from tenant-maintained insurance in this context. First, the landlord cannot rely on a one-page ACORD Evidence of Insurance form as proof of tenant’s insurance coverage. See W. Rodney Clement Jr., Is a Certificate of Commercial Property Insurance a Worthless Document?, Prob. & Prop., May/June 2010, at 46. Second, the landlord will need to be named on the policy, preferably as both a loss payee and an additional insured. Even then it will not have the rights it would have if it maintained the coverage itself.
What benefits will the owner receive as a loss payee? If the landlord is a loss payee on the building policy maintained by its tenant, then it will probably receive the type of coverage described in ISO endorsement CP 12 18 10 12. In this form, for loss payees that are building owners, the insurer agrees to adjust the losses to the building with the building owner and it will adjust the losses to the tenant’s property and its betterments and improvements with the tenant, unless the lease provides otherwise. The insurer does not agree, however, that the building owner’s rights will not be affected by the tenant’s failure to comply with the policy, and it does not agree to give the building owner a notice of cancellation or modification of the policy. Because the one-page ACORD proof of insurance form no longer provides for notice of cancellation, the building owner also will need to request a separate endorsement in which the insurer agrees to give this notice.
Many national tenants will not make the landlord a loss payee. They insist that the landlord be satisfied with being an additional insured. What benefits will the building owner receive as an additional insured? ISO endorsement CP 12 19 06 07 simply states that the building owner will be a “Named Insured” on the coverage provided for direct physical loss or damage to the building. Consequently, losses will be adjusted with both of the named insureds—the tenant and the building owner—and loss amounts will be paid to both. Again, the insurer is not obligated to give notice of cancellation to the additional insured building owner, and an endorsement providing for notice to the landlord is required.
Additional complications may arise if the tenant is self-insured or if it maintains a blanket policy with a high deductible.
The bottom line is that landlords should try to maintain their own property insurance on their own buildings, if possible, and rely on the tenant’s insurance only if they must (and then only with a great deal of vigilance).
Lender Property Coverage
Lenders are given much better protections than owners in their loss payee endorsements. A mortgagee is generally protected by a lender’s loss payable clause in an endorsement such as ISO CP 12 18 10 12. In the “Lender’s Loss Payable Clause” portion of this endorsement, the insurer agrees to pay the lender loss payees in their order of priority as their interests may appear, even if one of the lender loss payees has started foreclosure. The insurer also agrees that even if the insured borrower has failed to comply with the policy, the lender will have the right to receive payment if it (1) pays the premium at the insurer’s request when the borrower has failed to do so, (2) submits a signed, sworn proof of loss within 60 days after the insurer’s notice of the insured’s failure to submit this proof of loss, and (3) has notified the insurer of any change in ownership, occupancy, or substantial change in risk of which the lender is aware. This form endorsement also requires the insurer to give the lender at least 10 days prior notice of a cancellation for nonpayment of premiums and 30 days prior notice of a cancellation for any other reason and requires the insurer to provide the lender with at least 10 days prior notice of an election not to renew the policies.
The management of property damage is more complicated than it used to be, but a property owner and its lender can nevertheless obtain coverage for the most likely casualty events and the most important property. In addition, if the owner is relying on a tenant’s insurance, the lease can require that the tenant maintain the owner’s desired coverage, and lenders can require the customary lender loss payable endorsements. What is important is knowing what risks and property damage are excluded from typical property insurance policies and how to obtain the necessary special coverages.