Analyzing the lease exposure

WHEN my daughter went away to college, she and two of her friends decided to rent an apartment. She brought the apartment lease to me because the property owner required a parent's signature. After reading the lease, I was convinced that if I signed it, I would have to hold the property owner and management company harmless for almost anything. They could get into a bar fight on Friday night, and I would have to pay for their defense and any judgment or settlement.

I took my concerns to the property manager, who admitted he had never actually read the lease. When I showed him some sections I had highlighted, he admitted that he wouldn't sign the lease for his own children. Fortunately, he agreed to modify some sections before I signed. However, I imagine that many other parents signed the lease "as is" for their children, not fully realizing what they were agreeing to. This experience led me to begin researching property leases.

Too often, I hear agents and brokers describe a similar situation. Many of their clients sign property leases without reading them, much less understanding them. The leases can have important insurance implications, but many agents don't ask to see them before writing an insurance policy. This can lead to uninsured exposures for clients and E&O exposures for agents.

Let me be clear: I don't suggest that agents get involved in negotiating their clients' leases. But they should check them for some basic provisions that may affect the insurance policies. In this article, I'll discuss some typical lease provisions that lead to insurance exposures and suggest different ways of dealing with them.

Insuring leased buildings

Who does the lease say is responsible for maintaining and insuring the building? Some leases require the tenant to purchase insurance on the building for the benefit of the landlord. This is not the best arrangement. Even if the tenant provides a certificate of insurance, there's always the chance that coverage will be inadequate at the time of a loss, or that the landlord won't be notified of a cancellation.

Transferring the cost of insurance may be safer than transferring the responsibility to insure a building. One of the more common leases used today is referred to as a "triple net" lease. This arrangement allows the property owner to pass on to the tenant(s) the cost of insurance, property taxes and maintenance, but allows the owner to control the insurance.

Other common leases require the landlord to insure the building, the tenant to insure his or her own personal property, and the tenant to maintain his portion of the building as if he owned it. If a client has signed such a lease, there are several steps you should investigate to avoid an insurance problem later on.

Consider the following scenario: Your client is leasing space in a building. A storm causes the roof of your client's space to collapse, damaging his property. The landlord's insurance company pays $50,000 for damage to the roof, your client's insurer pays for the damage to his personal property, and everyone is happy. A few months later, your client gets a letter from the landlord's insurer: "We have determined that the collapse of the roof was a result of water back-up caused by your failure to clean the gutters, as required by your lease. Our subrogation department is enclosing a bill in the amount of $50,000. Please pay at your earliest convenience."

Your client's first call may be to you. You have not written coverage for the building, only your client's personal property, as required by the lease. Your client next takes the letter to his landlord, who is just as upset about it as your client is-the landlord doesn't want to lose a valuable tenant over the issue. He promises to do what he can about this. The they not seek recovery from the tenant.

Not only might the tenant be out of luck (and $50,000), but the landlord also may now be on shaky ground with his own insurer. The Commercial Property Conditions Form (CP 00 90 07 88) transfers to the insurer the right, to the extent of its payment to the insured, to seek recovery from a third party. The form says the insured "must do everything necessary to secure our rights and must do nothing after loss to impair them." By attempting to prevent subrogation, the insured might be construed by his insurer as impairing the insurer's right of recovery.

The conditions form allows the landlord to waive his right of recovery, but only in certain situations. He may waive his right after a loss to a tenant; however, after the landlord has received payment for his loss, his rights are transferred to his insurer, and thus are no longer his to waive.

The landlord may also waive his right of recovery in writing, if he does so before a loss. Such a waiver, called a mutual waiver of subrogation, might read something like this: "..to the maximum extent permitted by insurance policies which may be owned by Lessor or Lessee, for the benefit of each other, waive any and all rights of subrogation which might otherwise exist."

In the absence of such a waiver, agents should look for a way to insure that part of the building that is in their clients' care, custody or control. One possibility is the Legal Liability Coverage Form. This is a property form, but its insuring agreement states, "We will pay those sums that you become legally obligated to pay as damages because of direct physical loss or damage, including loss of use." Thus it might be said that it's a property form that functions as a liability form. The mutual waiver of subrogation frees the tenant from liability; absent a waiver, the legal liability coverage form can provide coverage for the exposure.

Improvements and betterments

Tenants' improvements and betterments are one of the most complex parts of a property lease to insure. Agents need to ensure not just that they write the proper coverage, but that their clients understand exactly what is being covered.

Consider a client who gets a great rate on a 10-year lease in a strip mall because he installed $250,000 worth of improvements and betterments on the first day of the lease. They are a permanent part of the building and cannot be removed at the termination of the lease. Naturally, the client wants his investment protected for the duration of the lease. Agents should help such clients understand the following issues:

o Who should insure the improvements and betterments, and how are they insured? The Building and Personal Property Coverage Form includes in the definition of business personal property, "Your use interest as tenant in improvements and betterments (emphasis mine)." (You should explain to your clients the difference between insuring the cost to repair or replace improvements and insuring the use interest in the improvements.) This becomes important when you consider valuation.

The improvements are also "completed additions," and as such are listed as part of the "Building" earlier on page 1 of the coverage form. This means that the landlord can insure improvements as well, and could be asking for trouble if he doesn't. Adjusters I have worked with tell me that in about half the cases in which they impose a coinsurance penalty, they do so because a landlord failed to report the increased building value resulting from tenants' improvements and betterments. If the lease does not address this issue, it may be necessary for both the landlord and tenant to insure improvements and betterments.

o What valuation method is used to pay claims? Remember that a tenant's BPP insures the "use interest" in the improvements, not the improvements themselves. This distinction, and the circumstances of a loss, dictate how much a client is paid. In the example above, assume the building was completely destroyed by a fire, five years into the client's 10-year lease. What happens next depends largely on the landlord's decision:

-If the landlord decides to rebuild, the tenant's policy will pay actual cash value for the improvements and betterments, and the tenant can select a replacement-cost option for an additional premium. The decision to rebuild (or not to rebuild) is the landlord's, not the tenant's.

-If the landlord does not rebuild, the BPP gives the tenant "proportionate value" for the improvements and betterments. The formula for determining proportionate value uses the number of days since the improvements and betterments were installed. In our scenario, halfway through a 10-year lease, the tenant would get half the value of $250,000, or $125,000. A replacement cost option is not available to a tenant if a landlord does not rebuild. Even if replacement cost is selected, the tenant gets only proportionate value if the landlord does not rebuild. I don't know many clients who will be happy with this loss settlement. If they paid a premium for $250,000 of insurance and it is a total loss, they expect a check for $250,000. That is why explaining "use interest" is important.

If the landlord files a claim for the improvements (we've already noted that they're also part of the building), the valuation section of the BPP says that the insurer will pay the insured tenant "nothing if others pay for repairs or replacement." If you think a client might be upset to receive only $125,000 for his improvements, imagine how he will feel to discover that he has been paying for coverage that will pay him nothing-or that he may thus think he didn't need! It can be especially important here to help clients understand the wisdom of insuring the exposure, even if they may later believe they didn't need the coverage. A worse situation would be to rely on the landlord to cover improvements and find out too late that the landlord had failed to purchase coverage or that the policy had been cancelled.

The best way to protect a client's improvements and betterments combines lease terms and insurance. The tenant can request a reduced lease rate in exchange for the improvements. He can also ask the property owner to insure the improvements, and in the event of a loss to either rebuild or pay the tenant a proportionate value for them. If the landlord doesn't agree to do this, a tenant's safest choice is to insure his use interest.

Leasehold interest

Building damage may be limited to a part of a building not occupied by a tenant. Contemplating this possibility, many leases give the tenant and/or the landlord the right to terminate a lease (known as an "abatement clause") even if a tenant's space is not damaged, if repairs to other parts of the building will take longer than a specified time (such as 60 days). A tenant thus loses use of the improvements and betterments he has installed, but there has been no loss to them-so coverage does not apply under the BPP. Worse, the client may have received a great lease rate in return for the improvements and betterments. When he relocates, he may now have to pay a much higher rate.

The leasehold interest form can protect clients against this risk. The form pays tenants if one of four conditions exists: loss of a favorable lease, loss of pre-paid rent, loss of bonuses paid to acquire a lease, and loss of use interest in a tenant's improvements and betterments.

The amount paid for loss of a favorable lease depends on when a loss occurs. Suppose a tenant signs a 10-year lease on a 5,000 square-foot space, receiving a discounted rate of $10 per square foot (or $50,000 per month) in return for making improvements and betterments. The lease is terminated in the first year, and the tenant must pay $17 per square foot-or $85,000 per month-after relocating. This increase of $35,000 per month translates to $350,000 over the life of the lease, so the tenant gets a check for approximately $350,000 (present-value discounts would be applied.) The amount of payment is reduced proportionately if the lease is terminated in succeeding years. The same concept would apply to tenants' improvements and betterments.

Leased personal property

Many clients lease personal property in their businesses, such as computers, copiers and office furniture. Insuring these items isn't as complex as insuring improvements and betterments, but I've seen agents and brokers write incorrect coverage more with leased personal property than with any other type of lease.

The BPP lists three classes of covered property: the building, "Your Business Personal Property" and "Personal Property of Others." If no specific limit is indicated on the declarations page for "Personal Property of Others," a limit of $2,500 is provided automatically.

The mistake many agents make is putting leased personal property in the wrong category of the BPP, because they do not read the policy form and the leases carefully enough. The BPP includes the following in its definition of Your Business Personal Property: "(7) Leased personal property for which you have a contractual responsibility to insure." Many leases contain wording such as, "The renter shall during the rental term keep and maintain the property in good working condition and repair and shall be responsible for any loss, casualty damage or destruction to said property." I've seen agents read this type of lease, include property in the Your Business Personal Property category and indicate no limit under Personal Property of Others.

Consider a client with $40,000 worth of leased computers. Following the above reasoning, the agent includes the computers under Your Business Personal Property. After a loss, the adjuster requests a copy of the computer lease. Though it holds the lessee responsible for any damage or loss to the equipment, it does not require the lessee to insure the equipment. Since it thus is not considered Your Business Personal Property, the adjuster writes a check for the automatic $2,500 provided under Personal Property of Others. We can hope adjusters would not be this uncompromising, but if they "live by the letter of the contract," they might.

When you're insuring leased business personal property, make sure the property leases specifically require the lessee to insure the equipment. If the lease doesn't require insurance, include the equipment in the (increased) limit under Personal Property of Others.

If an insured's lease requires him or her to insure leased property for a specific amount, (say, $50,000), consider the "leased property" endorsement, which has an agreed-value option.

Glass Insurance

The 2000 property form (CP 00 10 00) withdrew the glass coverage form. We now insure glass just like we insure bricks and mortar, which requires agents to pay special attention to the mention of glass in a property lease. Tenants leasing space in buildings that have huge plate-glass windows may be required to insure the glass, with the property owner insuring the rest of the building. Most agents I've talked to say they have handled the responsibility simply by purchasing building insurance, limited to the amount needed for the glass, as the form allows; for instance, buying $150,000 of building insurance on glass in a $1 million building. The problem with this approach is the application of the coinsurance requirement; the policy makes no provision for writing coverage only for glass.

Some agents I've spoken with address this problem by selecting the agreed value option when insuring glass, which eliminates the coinsurance requirement. The glass could be insured on an inland marine form. Some carriers may be using a separate glass coverage form. But until insurance companies think of a better way, I think using the agreed-value approach with the current BPP is the quickest, cleanest way to do it. Agents should check with their underwriters to discuss how they want to handle situations in which an insured is required to insure only the glass.

Terry L. Tadlock, CPCU, CIC, is president of Florida Insurance Educators and a former independent insurance agent. He can be reached at ttadlock@fisce.com.

This article was derived from Mr. Tadlock's presentation at the AAMGA University Weekend, which was held in August in Scottsdale, Ariz