Standard Mortgage Clause
Most commercial property policies contain a clause that protects the rights of mortgage holders (lenders). This provision applies when insured property has been used to secure a mortgage, and that property has been damaged by a covered peril. The clause ensures that the lender will receive payment under the policy to the extent of the remaining debt.
When a business owner purchases a commercial building with a mortgage, the mortgage holder may require the buyer to obtain a property policy that includes the standard mortgage clause.
Here is an example.
Andy owns A-1 Appliances, a company that sells home appliances. Andy's company has just purchased a new warehouse with a mortgage it obtained from Lucky Lending.
The loan A-1 obtained from Lucky Lending is secured by the warehouse. Because the warehouse is serving as collateral for the loan, Lucky Lending has an insurable interest in it. To protect Lucky's interest, the loan agreement requires A-1 to insure the warehouse against damage by fire and other perils under a commercial property policy. The contract states that the policy must include the standard mortgage clause.
In years past, insurers who wrote property insurance were required to use a policy form called the 1943 New York Standard Fire Policy. The latter contained a clause entitled Mortgagee, which addressed the rights of lenders. This clause was referred to as the standard mortgage clause.
Nowadays, the New York form is rarely used, and the ISO commercial property policy is considered the industry standard. The ISO form addresses mortgagees in a clause entitled Mortgageholders. This clause now serves as a standard mortgage clause. It appears in many property policies drafted by individual insurers.
The ISO mortgage clause applies to the mortgage holder named in the declarations. The lender is covered for loss or damage to the building or structure that serves as collateral for the loan.
If multiple lenders are listed in the policy, they are covered in order of precedence. For example, suppose that a policyholder has purchased a building with two mortgages (a first and a second). If the building burns down, the lender listed on the first mortgage will be paid. After the first lender has been compensated, the lender on the second mortgage will receive payment.
The mortgage clause states that lenders will receive payment "as their interests may appear." This means that the amount each lender will receive depends on the extent of damage to the insured building and the unpaid balance (principal and interest) of the loan. For example, a fire destroys A-1 Appliances' warehouse. At the time of the fire, A-1 owes Lucky Lending $750,000 in principal and accrued interest. Lucky Lending receives an insurance payment of $750,000, its interest in the property.
The amount the insurer will pay for a loss is subject to the limit on the policy. For instance, if A-1's warehouse is insured for $1.5 million, the insurer will pay no more than $1.5 million to all covered parties (A-1 Appliances and all lenders).
In some states, lenders secure their loans via deeds of trust rather than mortgages. For this reason, the term mortgage holder in the standard mortgage clause includes a trustee.
The lender's right to recover for a loss under the borrower's property policy is not affected by any foreclosure action the lender has initiated against the property owner prior to the loss. For example, suppose that A-1 Appliances fails to make several mortgage payments, so Lucky Lending issues a notice of default. One month after the notice has been issued, the warehouse is destroyed by a fire. The default notice will not affect Lucky's right to receive payment for the loss under the policy.
Acts of Policyholder
The mortgagee has a right to recover for a loss under the policy even if the policyholder has violated a condition of the insurance contract.
For example, suppose that A-1 Appliances' warehouse is destroyed by a fire. A-1 files a claim with its property insurer for damage to the building and its contents. However, A-1 refuses to let an adjuster onto the property to inspect the damage. The insurer ultimately denies A-1's claim because A-1 has failed to comply with a policy condition.
Lucky Lending's right to recover under the policy will not be affected by A-1's actions as long as the lender fulfills certain conditions. The lender must:
- Pay any outstanding premium due that the policyholder has failed to pay
- Submit a proof of loss (if the policyholder has not done so) within 60 days of receiving a notice that a proof of loss is due
- Notify the insurer if the lender is aware of any change in the building's ownership or occupancy, or if the risk has changed substantially
Once the lender has completed all of these steps, it is eligible to receive a loss payment under A-1's property policy.
Transfer of Rights
The ISO Mortgageholders clause contains a subrogation provision. It states that if the insurer makes a loss payment to the lender but denies payment to the insured, the lender's rights of subrogation are transferred to the insurer to the extent of the payment amount. In the previous example, A-1 Appliances was denied payment under the policy because it failed to comply with the terms of the insurance contract. Suppose that Lucky Lending has received an insurance payment of $700,000 for its interest in the damaged warehouse. The fire was caused by a defect in an electric dryer stored in the building. If Lucky Lending had not received compensation for the damage, the lender could have sued the dryer manufacturer for property damage.
A-1's property insurer has indemnified Lucky Lending for the loss. Thus, the lender's right to sue the manufacturer for compensation is transferred to the insurer. The insurer now has the right to sue the manufacturer to recover the $700,000 it has paid to Lucky Lending.
The insurer may choose to pay the lender the principal amount on the mortgage plus any accrued interest. If any debt remains, the policyholder must pay that amount to the insurer.
Cancellation and Non-renewal
Under the mortgage clause, the insurer must notify the mortgage holder in writing if the insurer cancels the policy or refuses to renew it. If the insured has failed to pay the premium, the insurer must notify the lender 10 days in advance before canceling the policy. If the insurer cancels the policy for any reason other than non-payment of the premium, it must provide 30 days' advance notice to the lender. Should the insurer decide not to renew the policy, it must provide the lender ten days' notice.
These cancellation conditions may be modified by state law. For instance, some states require insurers to notify a lender at least 45 days in advance if a policy is canceled for any reason other than non-payment of premium.