Why Do We Ask For Insurance In The First Place?

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To be able to intelligently negotiate the insurance provisions found in leases, mortgages, and other contracts requires some sense as to why one party would ask the other to carry insurance in the first place. This, of course, presumes Ruminations readers aren’t life members of the “my way or the highway” negotiation society. If, when trying to work out a deal, you don’t need a reasonable basis to impose an obligation on someone else, save your time by clicking the “back” arrow on your browser.

Some of what follows restates what was said by us at the just-ended ICSC Shopping Center Law Conference in Orlando. If you have any need to understand retail real estate law, don’t miss the October, 2013 Conference scheduled forSan Diego.

Basically, as Ruminations sees it, you ask the other party to carry insurance because you don’t trust it to have the money needed to respond to an event such insurance would cover. That is to say, insurance is solely a form of credit enhancement. That’s all it is. It doesn’t make any problem go away. It doesn’t protect against a fire or against a slip or fall on ice or snow. It doesn’t settle claims. It doesn’t allocate responsibility between or among the parties. It just (reasonably) assures that a pot of money will be available to “pay” for certain obligations. Perversely, it might even give license to someone to be less careful than that person would otherwise be had she or he not carried the insurance. Basically, it isn’t magic.

Commonly, we insist that the “other” party carry commercial general liability (CGL) insurance of a certain amount, say $2,000,000. We ask that the policy be written by an insurance company we trust to have a “spare” $2,000,000 available on short notice if certain policy conditions are met. So, by way of example, consider the situation where a tenant owes its landlord $1,000,000 by reason of its obligation to indemnify the landlord with respect to a customer’s personal injury claim. With an insurance company on the hook, the landlord will almost certainly receive the $1,000,000 to cover its own obligation to the tenant’s injured customer. In the absence of the liability insurance being carried by its tenant, if the tenant isn’t “good” for the money, the landlord may not “see” this $1,000,000.

Having set out the preceding proposition, we find the following to be pretty funny. The number of instances where landlords call upon their tenants to make an indemnity payment pales by comparison to the number of times landlords get stuck for unpaid rent, sometimes a lot of rent. Yet, landlords don’t very often insist on “credit insurance” to pay the rent of a defaulting tenant. Now, we already expect most readers to shout out: “BUT THAT’S NOT TRUE – for dicey tenants, landlords require large security deposits, personal guarantees or letters of credit.” You are all absolutely correct. You see, we’ve set you up.

All of those “rent security” devices (and others) are forms of credit enhancement. They are pots of money to be readily available if the tenant can’t meet its monetary obligations. [We say monetary obligations because even where they seem to cover the obligation of a tenant to fix something, such as a broken window, the security devices don’t do the fixing. They just pay for the fixing.] If rent were covered by a “surety contract,” you’d all recognize that to be “credit insurance.” So, where you have a small tenant and not a lot of rent, you ask for “security.” Where you have a large tenant and lots and lots of rent, perhaps millions, you don’t,

When a landlord leases space to ExxonMobil (only by way of example), it doesn’t ask for a personal guaranty, a cash security deposit, a surety or a letter of credit. It figures that ExxonMobil is “good for it.” Why then would it ask ExxonMobil, even in the first instance, to carry a $2,000,000 CGL policy? But, landlords and their negotiators almost always ask. And why, when ExxonMobil wants to self-insure, does the landlord want to see a “formal plan of self-insurance”? Ruminations suggests this is because the landlord doesn’t really share our understanding that the tenant’s insurance policy only serves as credit enhancement. Stop and think about this. Does any landlord think that ExxonMobil doesn’t have the funds to cover its indemnification obligations? [Or, to buy an insurance company?]

[If you were at the Law Conference and were fortunate enough to hear Marty Glazer of goulston&storrs explain the implications of a Massachusetts anti-indemnity case, you might be able to articulate why requiring actual insurance and rejecting self-insurance is needed. We think we know how to easily dispose of such a fear, but we’ll save that for our private “bag of tricks.”]

It isn’t just ExxonMobil as a tenant. It isn’t just the federal government as a tenant. There are lots and lots of tenants who have tons and tons of available money to cover their lease or similar obligations. If we were talking about a call for $100,000,000 of liability coverage, we would understand landlords (and more fairly, their attorneys) arguing, arguing, and arguing that all tenants are required to carry insurance and that all leases must have at least two pages of insurance clauses, even if the insurance clauses are just plain wrong in the way they are written. Of course, let’s not forget that we need to spend four phone calls and four hours to argue about those clauses. What Ruminations sees, day in and day out, are leases for tenants with substantial tangible net worth (and even substantial liquid assets) calling for such tenants to carry a piddling amount of CGL coverage. [Let us digress for a moment. We also see a lot of leases, mortgages, and other contracts call for non-existent “public liability insurance” policies or “comprehensive liability” policies, but that’s for another day.] Why insist that a tenant, with the ability to write a $2,000,000 check on an instant’s notice, pay insurance premiums to make sure it can pay $2,000,000? This is just as true where a landlord has “plenty-enough” money.

We’re not just talking about liability insurance policies that essentially provide coverage that overlaps the insurance coverage carried by the “insisting” party. In fact, we also engage in protracted negotiations over whether a particular party must carry insurance to cover loss of its own property. The legitimate reason for this is to make sure that a party is able to replace its own property, whether by use of insurance proceeds or by use of its own assets. That’s so its own business can resume after the loss. This means that a tenant (or a lender) wants to have comfort that its landlord (or borrower) can repair or reconstruct the building, and a landlord wants to be comfortable that its tenant can replace its FF&E and inventory and get back into business and thus be able to resume paying rent.

Our logic with respect to property insurance is no different. We’ve already posited that a party with a ready “pile of cash” should be able to decide for itself if it wants to take the risk of using its own cash to recover from a liability claim or a loss of its property, or make its own decision to pay an insurance premium to “lay off the risk.” By way of the following example, we suggest that some tenants don’t need a lot of spare cash “hangin’ around” to be able to recover from a fire or similar loss. Think about a tenant with 400 locations and three warehouses. Doesn’t such a tenant have enough “fat” in its inventory to replace a store’s merchandise? Doesn’t it have enough fixtures to replace what it has lost? Doesn’t the damaged store represent 1/4 of 1% of the tenant’s inventory and fixtures? Why should it be required to carry insurance on its personal property?

For those who cry, but “we self-insure” and we would bear a loss if the other party can’t honor its indemnification obligation, Ruminations responds that this is mixing apples and horses. The reason someone chooses to self-insure (which usually means – “go naked”) is because it feels that it will make more money by investing “premium money” in its own business than giving the same money to an insurance company to invest for the insurance company’s business. That’s a decision based on ROI. The “self-insurer” has chosen to take that risk in the first place. If it has chosen wisely, its profits will be enhanced by the “self-insurance” decision. If not, it won’t. Either way, the other party in the deal isn’t sharing in the upside or the downside of that “self-insurance” decision.

Similarly annoying is the all too frequent situation where once you persuade the “other side” that making the lease, mortgage or other document into a welfare program for insurance companies just doesn’t make sense, all you’ve done is move to the next plateau. That’s where a simple agreement that the “self-insuring” party need only show that it has the wherewithal to pay this piddling sum leads to the next argument about “formal plans of self-insurance.” These are plans that mimic what an insurance policy would pay. It seems to us that so long as the self-insuring party can show that it meets an agreed-upon financial test, then leave it alone.

Yes, we’ve heard the Enron-type “here today, gone in a flash” stories. We could counter with the “what is the chance of being struck by lightning” argument or reveal the following. Your tenant or landlord or borrower could file for bankruptcy and its former ability to cover its indemnity or rebuilding obligations could go away. With its required insurance in place, you feel comfortable enough to quote Alfred E. Neuman and say “What, me worry?” (originally, “What – me worry?”). Yes; worry. An insurance company might want to get off the hook and a bankruptcy trustee might want cash. So, they might make a deal where the insurance company pays the trustee to allow the policy(ies) to be terminated ab initio (look it up, if you need to) and the claims otherwise covered would be added to the other unsecured claims. You might have some protection if you were actually an additional insured, but not as to required property insurance if you didn’t have an interest in the property and weren’t, in some way, an intended third party beneficiary of the property insurance policy.

On top of all of this, Ruminations all too frequently encounters negotiators who don’t understand insurance policies well enough to know that their intensely detailed insurance provisions calling for at least $2,000,000 in CGL coverage don’t give any comfort that the insurance company will even be obligated to cover the first $2,000,000 of a claim. For an understanding as to why we say this, look HERE.

There are other legitimate reasons (beyond backing up an indemnification obligation) as to why one party might insist that the other party carries insurance, one of which is the interplay with anti-indemnity laws in a small number of jurisdictions. [There are also legitimate reasons why a party might choose to carry insurance even if not required by the terms of any agreement, but that’s not a topic we choose to cover today.]

As long as Ruminations is being didactic, we’ll trot out another one of our mantras. If a party wants to be sure that it has an insurance company to “belly up to the bar” should it face a liability claim or should its property be destroyed by an insurable peril, then it should buy its own insurance. That way, it can control its claim and control the extent of its coverage and whether it is actually in force. In the case of a landlord, its tenant is invariably paying for that coverage anyway. Even where a tenant has put up its own building on leased land, its landlord might be wise to carry the insurance and charge-back the premium to the tenant. Certainly, when a tenant has an absolute net lease for an entire parcel and the landlord’s improvements on that parcel, the landlord should be protecting itself by controlling its own property insurance.

Ruminations suffers no delusions that what we’ve said will change anyone’s practice, even ours. But, intellectual honesty has demanded that all of this be said.

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Comments

  1. My compliments on an easy to understand primer on something that few understand and all take for granted in their lease transactions.

    But there is a related “boilerplate” in many leases (and associated construction projects) that is even more misunderstood: General Contractor Bonds. I’ve heard them frequently characterized by Landlords and Owners as “insurance policies” that will guarantee the completion of a project if the contractor fails or can’t perform. However bonds are definitely not “insurance” and in my opinion in many projects really only guarantee lengthy litigation, certainly not a timely project completion. Bonds are also much more expensive then most Owners realize or know: although a top rated contractor will show a bond fee of less than 1%, what is frequently unseen is the additional 2% bond fee (standard for subs) that most subcontractors also include within their price quotes to the general on bonded projects. That totals a 2% — 3% added cost to a construction project; far in excess of typical PL & PD insurance rates and for a lot less actual coverage. A much better return for an Owner can be found in investing in tight progress payment procedures and verification over the course of the project.

  2. Herb Meyers says:

    You did not mention the litigation defense aspect of liability insurance. While a strong credit tenant may “be good for it,” it may or may not step up to provide a defense for the landlord against a liability claim. This is a significant concern for the landlord, whether or not the claim ultimately is found to have any validity. Defense costs can easily exceed the amount of a claim or any damage award. While the landlord may ultimately recover its defense costs from the tenant by enforcing indemnity or self insurance provisions, the uncertainty, delay and cost of recovery can be considerable.

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