Fair Claims versus the Property Insurance Mortgage Clause

The Mortgage Clause

The mortgage clause appears in Section I Conditions of the standard Insurance Services Office, Inc. (ISO), policy form. Condition K., Mortgage Clause, states:

1. If a mortgagee is named in this policy, any loss payable under Coverage A or B will be paid to the mortgagee and you, as interests appear. If more than one mortgagee is named, the order of payment will be the same as the order of precedence of the mortgages.

2. If we deny your claim, that denial will not apply to a valid claim of the mortgagee, if the mortgagee:

• a. Notifies us of any change in ownership, occupancy or substantial change in risk of which the mortgagee is aware;
• b. Pays any premium due under this policy on demand if you have neglected to pay the premium; and
• c. Submits a signed, sworn statement of loss after receiving notice from us of your failure to do so. Paragraph E. Appraisal, G. Suit Against US and I. Loss Payment under Section 1–Conditions also apply to the mortgagee.

3. If we decide to cancel or not to renew this policy, the mortgagee will be notified at least 10 days before the date cancellation or nonrenewal takes effect.

4. If we pay the mortgagee for any loss and deny payment to you:

• a. We are subrogated to all the rights of the mortgagee granted under the mortgage on the property; or
• b. At our option, we may pay the mortgagee the whole principal on the mortgage plus any accrued interest. In this event, we will receive a full assignment and transfer of the mortgage and all securities held as collateral to the mortgage debt.

5. Subrogation will not impair the right of the mortgagee to recover the full amount of the mortgagee's claim.

This language is commonly referred to as the New York Standard Mortgage Clause.

Please note that the clause applies to Coverages A and B, "A" being your dwelling, while "B" coverage represents "Other Structures" such as detached garages or other outbuildings and those attached in some way to the main dwelling. "C" coverages for personal property, furniture, for example, are not included, although it is my experience that some loan documents used at real estate closings may include a check space to include personal property items within a mortgage. Anyone purchasing a new home should watch that carefully and avoid financing personal and real property in the same loan.

The current National Flood Insurance Policy follows the ISO language with two exceptions. The flood policy includes a 30-day notice prior to cancellation or nonrenewal and says that "All the terms of this policy apply to the mortgagee." The American Association of Insurance Services (AAIS) HO 0003 01 06 policy form also includes the following provision under its Mortgage Clause: "All 'terms' of this policy apply to the mortgagee unless changed by this clause." In the AAIS form, "Terms means all provisions, limitations, exclusions, conditions, 'declarations', and definitions used in this policy."

Note that the regular ISO HO-3 policy, as noted above, restricts the mortgager's obligation to only three conditions: Appraisal, Suit against Us (the Insurer), and Loss Payment. Essentially, the flood and AAIS insurance policies hold the mortgagee to the same, complete insurance contract as the home owner. Some possible implications of this arrangement will be discussed in a later commentary.

What the Clause Means

"As interests appear" is often abbreviated as "ATIMA" ("As Their Interests May Appear"). It is language allowing an unnamed party to receive insurance benefits under the policy without being named as an insured. The main purpose of the clause is the protection of the lender's economic interest in the property. Basically, the mortgage clause is a contract within a contract, one being between the insurer and the debtor "home owner" and the other between the insurer and the lender. Under this separate contract, even if a borrower burns or otherwise destroys her own home, thereby negating the possibilities of an insurance recovery, a lender, by complying with policy conditions, can still collect insurance proceeds.

Technically, in many states, the term "mortgage" is a misnomer because the real estate trend is to use a security deed (also known as deed to secure debt, loan deed, or warranty deed to secure debt) and not a standard mortgage in financing real estate. Security deeds are more lender-friendly because they are an outright transfer of a property's title to the lender as security of a debt, whereas, a mortgage merely creates a lien on the property.

Essentially, a security deed splits a deed into two parts, (1) a part granting a lender legal title to secure debt and (2) an equitable right of redemption to the debtor; that is, a right to enjoy the property while redeeming the debt. In effect, just as "mortgage" may be inappropriate language, the same is true of "home owner" since "current occupant" may be a better way of describing the mortgagee-mortgagor relationship.

Security deeds may take precedence over all competing liens except tax liens. Another attractive feature of security deeds from a lender's perspective is that they permit a means of nonjudicial foreclosure by the lender. Note to a borrower: this means a lender does not have to get a court order to foreclose on you.

What the mortgage clause means for a lender is where most discussions of the clause end in our insurance literature. But what about the mortgagee/debtor? Buyers also have rights while enjoying and maintaining the property. While much of the emphasis is upon the lender's ability to get its money, one must not lose sight of the fact that the borrower has a contract that confers upon him or her the availability to repay a loan over an extended period, often 30 years, at a specified interest rate. Without such an arrangement, the American dream of homeownership would be reserved for only a few. The fact that there is a contract at all indicates that the borrower, following scrutiny by the lender, is capable of meeting payment obligations. As will be shown later, courts are very sensitive to this fact in passing judgment on how lenders apply the mortgage provision.

Losses: Where Troubles Begin

The mortgage provision rises from obscurity when the property is damaged and insurance claims are filed. Small claims, those of $10,000 or under, may be handled in routine fashion by most insurers because they rarely imperil a lender's security interest. Not so, however, when fire, flood, wind, or other covered perils inflict significant damage on the property. After such an event, any insurer check issued to cover losses will be a two-party check naming both the lender and the mortgagee as payees.

Most likely, the security deed says something like this Model Security Deed document found on Fannie Mae's website at fanniemae.com.

In the event of loss, Borrower shall give prompt notice to the insurance carrier and Lender. Lender may make proof of loss if not made promptly by Borrower. Unless Lender and Borrower otherwise agree in writing, any insurance proceeds, whether or not the underlying insurance was required by Lender, shall be applied to restoration or repair of the Property, if the restoration or repair is economically feasible and Lender's security is not lessened.

During such repair and restoration period, Lender shall have the right to hold such insurance proceeds until Lender has had an opportunity to inspect such property to ensure the work has been completed to Lender's satisfaction, provided that such inspection shall be undertaken promptly. Lender may disburse proceeds for the repairs and restoration in a single payment or in a series of progress payments as the work is completed….

If the restoration or repair is not economically feasible or Lender's security would be lessened, the insurance proceeds shall be applied to the sums secured by this Security Instrument, whether or not then due, with the excess, if any, paid to Borrower. [NOTE: I have taken the liberty to break the contract into paragraphs for readability purposes.]

The Fannie Mae model prohibits the use of insurance proceeds to pay public adjusters or other third parties hired by the insured. Further, it does not require interest payments to the insured, so the lender has an incentive to sit on the money as long as possible under the Fannie Mae form.

Procedurally, therefore, the insureds sign the check and forward it to the mortgagee for signature. The mortgagee may choose to deposit the check into an escrow account and release it in steps as the work is completed. This process may take a couple of weeks or more. When the check is returned, it will probably be a partial payment from the lender, and the balance will be released in installments. Never mind that contractors may be at work and expect to be paid; never mind that if it is a catastrophic loss (e.g., a hurricane), general contractors are all tied up, skilled workers may be spoken for, and materials may be in short supply. Meanwhile, the insurance contract obligates an insured to mitigate the loss.

While this condition may vary in wording, rest assured that mitigating the loss is a provision a borrower must take seriously. For example, the ISO HO-3 says the insured has a duty to protect the property from further damage. If repairs are required, the insured must make reasonable and necessary repairs to protect the property and, of course, keep accurate records of repair expenses.

So, if the house is flooded, one must get the water out; if a door is missing, a new door must be installed; if windows are blown out, new window coverings are necessary; if the roof or a portion thereof is missing…. Well, the situation speaks for itself.

A hundred dollars here and a hundred dollars there soon add up to a lot of money out of an insured's pocket. In fact, based on knowledge and experience, if a dwelling suffers significant damage, the borrower should be prepared to "front" costs for the insurance company and the lender, a process that converts the insured into a role of lender subsidizing insurers and mortgage servicers.

Suggestions for Dealing Directly with Lenders

Handling an insurance claim demands the skills of a bookkeeper, carpenter, accountant, lawyer, statistician, interior designer, debater, realtor, building supply owner, electrician, and painter. At the outset, and for illustration purposes only, prepare to deal with an insurer in Miami, a claims adjuster in Mobile, a lender in Cincinnati, a mortgage service company in South Carolina, a local insurance agency, and a call center in isolation somewhere on the globe where no one is known by his or her real name. It would also be helpful to know the dimensions of each room in your house (length, width, and height), the building materials used in each room, the age of everything, and a willingness to suspend your better judgment at times and just get along with pricing data services (e.g., Xactimate). In case you haven't met Xactimate, that is the computer program 95 percent of adjusters depend on to figure what to pay out in settling a claim. Most likely, the first number will be conservative. After all, it is merely an estimate.

I won't bother to mention the laborious and sensitive process of acquiring the appropriately skilled workers to repair damages, nor will I dwell on the insurance adjuster since this article addresses primarily the mortgagee. Here are a few suggestions for insureds in that regard.