The Basics of Insurance in Leases
As published in Probate & Property.
Reprinted with permission from Probate & Property
November/December (American Bar Association).
Copyright© 2000 American Bar Association
I. INTRODUCTION
Insurance impacts many aspects of the landlord-tenant relationship, including not only lease provisions prescribing specific insurance coverages, but also lease provisions relating to indemnity, restoration of the premises following a casualty, waivers of subrogation, self-insurance and even provisions relating to when abatement of rent occurs. A properly negotiated lease will treat all of these areas in a consistent manner, allocating risk in accordance with available insurance. What makes this area difficult for lawyers is the interface between legal liability and the technical aspects of insurance terminology and coverages. To further the problem, the insurance industry periodically revises its terminology and coverages, so the lease clause that was fine five years ago may be filled with incorrect or outmoded language. This article will outline the basic coverages that arise in the leasing context, discuss applicable insurance industry terminology, and conclude with a limited discussion of how an attorney ought to coordinate lease provisions.
II. FORMS OF COVERAGE
There are two basic types of insurance that impact leases: property insurance and liability insurance. Most policies are written on Insurance Services Offices ("ISO") forms, although special coverages can be negotiated and underwritten.
A. Property Insurance.
Property insurance generally covers loss arising from damage to real or personal property owned by the insured. The typical example would be a fire, where the building owner's property insurance policy would pay to repair the damage. Leases often contain the misnomer "casualty insurance" when property insurance is intended. In the insurance industry, "casualty insurance" means liability insurance, which is discussed in Section II(B), below. Property insurance can be written in several forms of ever broader coverage, the three most basic of which are as follows:
1. "Basic Form"
The ISO "Basic Form" covers the following specified causes of loss:
Fire
Lightning
Explosion
Smoke
Windstorm
Hail
Riot
Civil Commotion
Aircraft
Vehicles
Vandalism
Sprinkler Leakage
Sinkhole Collapse
Volcano Eruption
Leases that call for "fire and extended coverage," policies refer to this type of coverage. If the loss is caused by a peril that does not appear on the foregoing list, the policy does not cover the loss. Fire and extended coverage insurance is not as comprehensive as the other types of coverage discussed below, and is not currently industry standard for leases.
2. "Broad Form"
The ISO "Broad Form" policy covers five causes of loss in addition to the perils insured under the Basic Form: glass breakage, falling objects, weight of snow, ice, or sleet, water damage (for sudden leaks but not seepage), and collapse from certain, specified causes. This form is also not industry standard for leases.
3. "Special Form"
Unlike Basic Form and Broad Form policies, which only cover specific perils, the ISO "Special Form" policy takes a different approach, covering losses from all causes unless they are specifically excluded. Most appropriately referred to as "Causes of Loss-Special Form" this is the standard property insurance landlords and tenants should expect. When a lease refers to "all risk" coverage, it is using an outdated term for this type of coverage. The specified exclusions from Special Form coverage are the following perils:
Ordinance or Law
Earth Movement
Governmental Action
Nuclear Hazard
Utility Services
War and Military Action
Water (flood, surface water, waves, tides, mudslide or mudflow, sewer, drain or sump backup, underground water)
Boiler and Machinery Failure
Wear and Tear or Lack of Maintenance
Continuous Seepage or Leakage
Dishonest Acts
Pollutants
Faculty Design or Workmanship
Many of these perils can be covered by supplemental policies, such as ordinance or law coverage (which covers extra costs incurred to meet current codes), earthquake, flood, boiler and machinery, and environmental insurance policies.
4. Endorsements
Property insurance policies cover direct physical loss. However, a casualty that disables a property and thus disrupts business operations will create broader losses. Certain endorsements to the property policy can protect against these ancillary losses:
A "Business Income" endorsement covers loss of income that results from loss of use of a property damaged by a covered cause of loss, up to a specified amount of time. E.g., if a lease does not permit an abatement of rent in the event of a casualty that renders the premises untenantable, the tenant should carry business income insurance to cover its obligation to pay rent.
"Rents insurance" (also known as rental value or loss of rents) can be a part of the Business Income endorsement, and reimburses the owner of a building for loss of rents. Thus, if the lease provides that rent abates in the event of a casualty that renders the premises untenantable, the landlord should carry rents insurance.
A "Utility Services - Time Element" endorsement covers loss due to disruption of utilities services, such as electrical, water or telecommunications incurred in connection with a covered cause of loss to property of the utility away from the insured’s premises. Depending on whether the lease entitles the tenant to an abatement of rent on account of an interruption in utility service, either the landlord or the tenant should consider this type of coverage.
5. Amount of Coverage
Often leases will require a party to carry property insurance at "full replacement cost", which means that the policy will pay the full cost of replacing the damaged property, with certain limitations (e.g., if the property cannot be restored to its former condition due to a change in law, the added costs would not be covered unless there was also ordinance and law coverage). In order to receive full replacement cost coverage, the property must be restored. If, instead, the property is demolished and not replaced, the insured can only recover the actual cash value.
"Actual cash value" is generally the value of the property at the time of the loss, determined based on the replacement cost, less depreciation, calculated over the useful life of the property.
If a lease does not require full replacement cost coverage, it should at least require the insuring party to carry sufficient property insurance to avoid "coinsurance." Normally, in the event of partial damage, after the insured pays the deductible, an insurance policy will cover the balance of the loss. However, if the insured carries too little insurance, e.g., less than 80% or 90% (depending on the policy) of the value of the insured property, and there is a partial loss, the insurance company will require the insured to participate in paying for the restoration. This is co-insurance. For instance, suppose there is a loss of $5,000 to a $100,000 property. The policy has a $1,000 deductible, but the insured only carried insurance with a limit of $50,000 (50% coinsurance). The insured will pay the $1,000 deductible, plus 50% of the $4,000 balance of the loss ($2,000), for a total of $3,000. If the insured had instead carried full replacement cost insurance, he would only pay the $1,000 deductible.
B. Liability Insurance.
1. Items of Coverage
Liability policies cover bodily injury and property damage to third parties. The industry standard form for leases is known as "Commercial General Liability" Coverage, often referred to as the "CGL". Older lease forms often refer to "Comprehensive General Liability", but the ISO replaced this with CGL in 1986. CGL covers liability claims arising out of:
Premises and operations
Products and completed operations
Advertising and personal injury
Contractual liability (assumption of liability under an "insured contract", which includes a lease)
CGL generally covers bodily injury and property damage occurring as the result of the negligence of the insured. The contractual liability coverage extends to the indemnity section of the lease and provides coverage for the assumed liability for bodily injury and property damage. It is no longer necessary to require a "contractual liability endorsement," which older lease forms often require.
2. Coverage Period
Liability policies only cover losses during a specified period of coverage. They may be written either on an "occurrence" or "claims made" basis.
"Occurrence" policies cover incidents that occur during the policy period, even if the claim is filed after the policy expires.
"Claims made" policies cover claims filed while the policy is in force for any incidents that occurred during the policy period. Thus if an accident happens on the last day of the policy period and the claim is filed a week later, the loss would not be covered. To avoid this harsh result, claims-made policyholders usually purchase "nose" coverage, which extends a claims-made policy back to a specified date prior to the current policy, or "tail" coverage, which provides an extended reporting period for incidents that occurred during the policy period but which were not reported until after the policy period.
3. Limits of Coverage
CGL policies are now written with a "combined single limit" per occurrence for bodily injury and property damage. Older policies used to distinguish between bodily injury and property damage, e.g., "$3,000,000 with respect to bodily injury or death, and $500,000 with respect to property damage." If this language is in a lease, it is no longer correct. A properly worded lease would now require the insured to carry "$3,000,000 combined single limit per occurrence."
III. TERMINOLOGY
Many other common insurance terms arise in the leasing context. The following is a short list of definitions:
A. Limit.
The maximum amount the insurance company will pay on a claim.
B. Deductible.
The amount of loss the insured must pay before the insurance coverage begins. By increasing a deductible an insured can reduce the insurance premium. In a lease where the cost of insurance is passed through to the tenant, it is appropriate for the landlord to pass through the deductible if there is a loss, as long as the deductible is reasonable. The deductible inures to the benefit of the tenant by reducing the insurance premium.
C. Blanket Policy.
When an insured own multiple properties, a blanket coverage insures all of them under one policy.
D. Umbrella Coverage.
Umbrella coverage is excess liability coverage. For instance, a party might purchase primary liability coverage with a limit of $3,000,000, but an additional umbrella policy for the next $10,000,000 of loss. Since the umbrella carrier knows that the first $3,000,000 of any loss will be borne by the primary liability carrier (in essence, a very high deductible), umbrella policies have significantly lower premiums than primary policies. Often the underwriter of the umbrella coverage will not have the same rating as the primary carrier, so one should be careful of language in the lease requiring the insurer to have a minimum rating.
E. A. M. Best Rating.
A.M. Best rates the overall financial stability and management of an insurance carrier using letters (A, B or C, plus or minus), and the carrier's net worth using roman numerals (XV to I). Generally a safe bet is an insurer with a rating of A-, X.
F. Waiver of Subrogation.
Where the negligence of a party damages the property of the other and the insurance company pays the cost of repair, the insurance policy gives the insurance company a contractual right to assume (i.e., become subrogated to) the injured party’s right to collect from the negligent party. However, property policies now generally provide that the insured may waive this right of subrogation against the negligent party. The rationale behind this is that the insurance company has already been compensated for assuming the risk of loss by charging the policy premium. Consequently, well crafted leases avert possible subrogation claims by providing that the landlord and tenant agree not to pursue each other for claims that are covered by property insurance. A standard clause would read as follows:
Anything in this Lease to the contrary notwithstanding, Landlord and Tenant each hereby waives any and all rights of recovery, claim, action or cause of action against the other for any loss or damage that may occur to the Premises or any improvements thereto, or any personal property of Landlord or Tenant, arising from any cause that (a) would be insured against under the terms of any property insurance required to be carried hereunder; or (b) is insured against under the terms of any property insurance actually carried, regardless of whether the same is required hereunder. The foregoing waiver shall apply regardless of the cause or origin of such claim, including but not limited to the negligence of a party, or such party's agents, officers, employees or contractors. The foregoing waiver shall not apply if it would have the effect, but only to the extent of such effect, of invalidating any insurance coverage of Landlord or Tenant.
Older form leases may require a party to obtain an endorsement to the property insurance policy effectuating the waiver of subrogation, but this is no longer necessary. It is entirely appropriate for the waiver of subrogation to be mutual, since it is readily available at little or no cost.
G. Parties.
"Named Insured." The named insured is the party that pays the premium for the property or liability policy. The insurance company underwrites the policy and the premium based on the claims history and risk posed by the named insured. Subsidiaries of the named insured may be added as "additional named insureds." It is not appropriate for a lease to require the landlord or the tenant to be a "named insured" or "additional named insured" on the other's policy.
The landlord or the tenant can be added to the other's property policy as an "additional insured" or "loss payee." The added party can only recover if it has an insurable interest in the property of the insured. For instance, in the case of a ground lease, the landlord has an insurable interest in the building erected by the tenant, since it will revert to the landlord at the expiration of the lease. On the other hand, if a tenant in turn key space carried property insurance on its movable trade fixtures, the landlord would have very little, if any, insurable interest under the tenant's property insurance on the trade fixtures.
The landlord or the tenant can be added to the other's liability policy in as an "additional insured." The landlord or the tenant can be added to the other's property or liability policy as an additional insured only by an endorsement. When a party is added as an additional insured the negligent actions of the insured party will not defeat coverage of the additional insured under the policy. The additional insured has the independent right (regardless of the actions of the primary insured) to a defense under the insured's policy, which can supplement the indirect indemnification provisions under the lease. Further, if the lease does not contain a waiver of subrogation, being added as an additional insured prevents the insurance company from pursuing the additional insured for losses that it may have caused. If the additional party requires an endorsement making the insured's policy the "primary coverage", the insured's policy will pay any claims and must be exhausted prior to any claims under the liability policy carried by the additional insured.
The landlord or the tenant can be added to the other's property policy as a loss payee, which results in a mutual claim to the insurance proceeds. Being a loss payee is not as desirable as being an additional insured because the loss payee is subject to all defenses the insurer may have against the primary insured, and is only entitled to the insurance proceeds if the primary insured decides to pursue a claim.
III. CERTIFICATES OF INSURANCE
To ensure that a party is carrying the appropriate insurance under a lease, the lease should require either a copy of the policy (which may not be practical, since for large companies the policy can be voluminous) or a certificate of insurance. Certificates of insurance are standard forms published by an industry group called ACORD. The certificate itself does not provide coverage, and for added assurance of appropriate coverage (such as assurance that a party has been added as an additional insured), the lease may require copies of specified endorsements.
IV. LEASE CONSIDERATIONS
Where a lease is silent, the common law governs the landlord tenant relationship. At common law, damage to the premises is irrelevant. Neither party is required to repair the damage, and the rent does not abate. This does not necessarily reflect the expectations of the parties. Therefore, one of the main purposes of a written lease is to allocate risk in a consistent, predictable and expected manner. The following are the main areas where this arises:
A. Casualty.
The lease will usually allocate responsibility for repair in the event of a casualty. The repair obligations should be consistent with the availability of insurance. E.g., if the landlord is carrying the property insurance on the building, the lease should obligate the landlord either to repair the damage, or to make the insurance proceeds available to the tenant for repair.
B. Abatement of Rent.
Abatement of rent is an issue in two main areas - damage to the premises, and loss of utilities do to an off-site casualty. The provisions relating to whether an abatement occurs should parallel the insurance carried by the parties. See the discussion in Sections II(A)(4), above.
C. Indemnity.
A lease will attempt to allocate liability for bodily injury and property damage between the landlord and tenant. This may be achieved based on location, e.g., the landlord is liable for incidents in the common area, and the tenant is liable for incidents in the premises. Alternatively, the lease may allocate liability based on fault. In either case, the indemnity provisions of the lease are a form of insurable contractual liability under a commercial general liability policy, at least for bodily injury and property damage. (See Section II(B)(1), above)
D. Waiver of Subrogation.
As discussed in Section III(F) above, a lease should always contain a mutual waiver of subrogation.
E. Self-insurance.
Where the landlord or the tenant has a substantial net worth, it may elect to self-insure for some or all of its losses. This means that, rather than paying an insurance company to take the risk, the party underwrites the risk on its own behalf. Self-insurance arises in many forms, including the following:
High deductible or self insured retention
Low policy limits
Co-insurance
Coverage for limited perils
The main analysis to apply where a party requests the right to self-insure is as follows:
Stipulate a minimum net worth to ensure the party can pay the self-insured loss.
Monitor the net worth of the self-insuring party.
Provide that provisions of the lease relating to indemnity, costs of repair, rent abatement and waiver of subrogation apply as if the party had insurance in place.
Keep the basic insurance provisions in the lease, so that if the self-insuring party has a decline in net worth, or later subleases or assigns the lease, the standard of coverage is specified.
V. CONCLUSION
By remaining aware of the interaction between various lease provisions and available insurance, an attorney can ensure that losses are allocated in accordance with the expectations of the parties. In the regard, it is important to have an ongoing dialogue with the client's insurance agent, to ensure both that the client's insurance reflects the obligations imposed under the lease, and that the lease reflects current insurance industry standards