When a business owner purchases a commercial building with a mortgage, the mortgage holder (lender) will likely require the buyer to insure the building under a commercial property policy that includes a standard mortgage clause. This clause protects the mortgage holder's right to obtain compensation for a loss even if the policyholder has violated terms of the policy.
Many commercial property policies contain a mortgage clause similar to the one found in the ISO property policy. Entitled Mortgageholders, this clause is located under the heading Additional Conditions. It outlines the obligations the insurer must fulfill if mortgaged property is damaged or destroyed.
Who Is Covered?
The ISO mortgage clause applies to the mortgage holder named in the commercial property declarations. The declarations should list the name and mailing address of each mortgage holder as well as a description of the mortgaged property.
If multiple lenders are included in the policy, they are covered in order of precedence. For example, suppose a policyholder has purchased a building with both a first and a second mortgage. If the building burns down, the lender listed on the first mortgage will be paid. The lender on the second mortgage will be paid after the first lender has been compensated.
In some states, lenders secure their loans via deeds of trust rather than mortgages. For this reason, the term mortgage holder includes a trustee.
The mortgage clause covers each lender listed in the policy for loss or damage to the building or structure in which the lender has an interest. A lender has an insurable interest in mortgaged property because the building serves as collateral for the loan. Lenders receive payment "as their interests may appear." This means that the amount paid to each lender depends on the extent of damage to the insured building and the unpaid balance (principal and interest) of the loan.
For example, suppose a fire has destroyed your warehouse. When the fire broke out you owed Lucky Lending $750,000 in principal and accrued interest. Lucky's interest in the property is $750,000 so your insurer sends it a check for that amount.
The limit that applies to your damaged property is the most your insurer will pay for loss or damage in any one occurrence regardless of the number of insured parties. If the building limit on the policy covering your warehouse is $750,000, your insurer will not pay more than that amount to all covered parties combined (your company and all lenders).
The limit that applies to your damaged property is the most your insurer will pay for loss or damage in any one occurrence regardless of the number of insured parties.
Protections for the Lender
The ISO mortgage clause contains several important safeguards for lenders.
If the lender initiates a foreclosure action against the property owner before a loss occurs, that action will not affect the lender's right to recover for the loss under the borrower's property policy. For example, suppose Lucky Lending issues a notice of default against your firm after you miss several mortgage payments. One month later, your warehouse is destroyed by a fire. The default notice will not affect Lucky's right to receive compensation for the loss under your policy.
Acts of Policyholder
The mortgagee (lender) 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 your warehouse is destroyed by a fire. You file a claim with your property insurer for damage to the building and its contents. Your insurer dispatches an adjuster to inspect the damage but you refuse to let him on your premises. Your insurer ultimately denies your claim because you wouldn't allow it to inspect the damaged property (a policy condition).
The policyholder's breach of the insurance contract will not affect the lender's rights of recovery if the lender fulfills all of the following conditions:
- Pays any outstanding premium the policyholder has failed to pay
- Submits 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
- Notifies the insurer if the lender becomes aware of any change in the building's ownership, occupancy or risk
Cancellation and Non-renewal
The mortgage clause requires the insurer to 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. If the insurer decides to non-renew the policy, it must provide the lender ten days' notice.
The cancellation conditions in the ISO form may be modified by state law. For instance, some states require insurers to provide lenders at least 45 days prior notice if the policy is canceled for any reason other than non-payment of premium.
Transfer of Rights
The Mortgageholders clause contains a separate subrogation provision that applies when the insurer has made a loss payment to the lender but has denied payment to the insured. In this event, the lender's rights of subrogation are transferred to the insurer to the extent of the insurer's payment.
For example, suppose that your warehouse burns down and your insurer pays Lucky Lending $750,000, the lender's interest in the property. Your claim is denied because of your refusal to comply with the policy's inspection condition. The fire was caused by a defect in an electric fan installed in your warehouse. If Lucky Lending was not compensated for the damage by your insurer, it would have the right to seek recovery for the loss by suing the dryer manufacturer for property damage.
Because your property insurer has indemnified Lucky Lending for the loss, the lender's right to sue the manufacturer is transferred to your insurer. The insurer now has the right to sue the manufacturer to recover the $750,000 it has paid to Lucky Lending.
The insurer may pay the lender the principal amount on the mortgage plus any accrued interest. In this case, the insured's mortgage and note will be transferred to the insurer. The insured must pay any remaining debt to the insurer.