Insurable Interests and Interests Insured in Property Insurance

Exposure Identification

This is the cornerstone of the risk management process. A flaw in this first step of the property risk management process can result in mistakes on how to appropriately manage the risk through risk control or risk transfer including the use of insurance. Direct damage exposure analysis must begin with what can happen but must include, as equally important, who can it happen to.

When the "who" of a direct damage exposure is understood, then the analysis of indirect damage (i.e., loss of business income and increased operational expense) can be conducted. Sometimes, the "who" may not be obvious to the risk management professional when damage or destruction is thought of only in limited terms of that which is owned, as in building and contents. More than one insured interest may occur from the same exposure unit-item subject to a loss event by insured peril.

Property insurance—whether building or contents, fixed location, or mobile/in transit—begins with insurable interest. An individual or entity may need to demonstrate insurable interest at either application of coverage or at time of loss to receive the benefit of property insurance. "Insurable interest" as defined in Blacks' Law Dictionary, 7th Edition means:

A legal interest in the protection of property from injury, loss, destruction, or pecuniary damage. To take out an insurance policy, a potential insured must have an insurable interest. If a policy does not have an insurable interest as its basis, it will usually be considered a form of wagering and thus be held unenforceable.³

Insurable Interest—by Ownership

John Doe and three partners purchased a building for $100,000. Each partner had an equal $25,000 ownership. Mr. Doe took out a property policy to cover the building for damage by "all-risk perils," and his name appeared as sole named insured. No other interests were identified in the policy. The building burns, fire is an insured peril, and the loss is considered total.

The insurance adjuster agrees the actual cash value of the loss is $100,000. Mr. Doe receives a $25,000 settlement check from the insurer. Has Doe received an equitable settlement from the insurer? Yes, as his insurable interest in the building was $25,000: 25 percent of $100,000.

In this example, we assume the insurer confirmed insurable interest during loss settlement. While this type of investigation does not always take place, it can. Most likely it will occur when a loss event is suspicious, such as a potential arson.

But if the investigation does occur during loss settlement, then the insurer will likely not pay Mr. Doe more than $25,000, as any payment greater than this amount to him is greater than his insurable interest in the building, which results in over-indemnification to him, which is against public policy as already noted above. Even though he purchased the policy and paid for the $100,000 limit, his loss settlement cannot be greater than his insurable interest. If he was paid more than $25,000, he would be indemnified for an amount greater than he was legally entitled to receive.

Indemnification greater than one's insurable interest can't be condoned as this practice introduces a moral hazard into the purchase of insurance and a potential for intentional acts, such as arson. Can Mr. Doe simply inform the insurer that he is not the sole owner of the building so that there is no over-indemnification? Maybe, as long as the insurer cuts checks to each other owner for an equal $25,000.

Mr. Doe and his partners will likely need legal assistance to gain total $100,000 loss settlement from the building insurer. Getting the insurer to reform the policy may be an expensive and time-consuming process; it is better to understand the "who" at the time of application than to learn of a major coverage issue after a loss.

Mr. Doe could have executed a pre-loss written agreement with his three partners that spelled out that he was solely responsible to purchase a property insurance policy on the jointly owned building for $100,000. This agreement would create an insurable interest to enable Mr. Doe to procure a $100,000 policy on the building since the named insured would include Mr. Doe and the three partners. But the issue that remains is if he is the only named insured in the property insurance policy as he forgot to consider the "who" when obtaining the insurance policy.

Even though Mr. Doe has a contractual insurable exposure as a single named insured, he is still only entitled to his insurable interest of $25,000 at the time of loss settlement. The named insured used for the property policy must follow what the written agreement requires Mr. Doe to satisfy in terms of his administrative duties for insurance procurement.

Insurable Interest—by Contract or Common Law

Insurable interest can be established by contract for a person or entity who does not actually own an object but is required to insure the item for mutual benefit of the nonowner and owner. Or, when damage to a nonowned item in the custody of the nonowner can have financial implications to the nonowner as to repair or replace the item. Typical exposures include the following.

A copier owned by ACME Copier Service is leased to NE Bank and kept on the bank's premises. In its lease with NE Bank, ACME requires that NE Bank insure the copier for ACME.
Owner of building leases 100 percent of its building to a single tenant. The owner believes the tenant has better access to property insurance in terms of coverage, limits, and cost. The landlord signs a lease with the tenant, which is required to insure the building for the owner.
When a person or entity ("bailee"⁴) does not own an object but is responsible for damage to or destruction of the object while it is in the bailee's custody. While a written contract between the parties is a best practice, its absence will still recognize the bailee's insurable exposure while it holds items that are owned by the bailor. Common bailment⁵ situations include a dry cleaner, repair shop, or an outside processor used by an unrelated manufacturer.
While an insured is typically thought of in terms of being sole owner of an object, it can include a person or entity that does not own the object but is legally responsible for it, such as found in many tenant/landlord leases (i.e., net lease where tenant is required by lease with the owner/landlord to insure the building for each party's interest). The lease creates an insurable interest for the tenant.
Supply chain exposures create insurable interest when damage to or destruction of nonowned objects will cause consequential financial damages to a person or entity. This consequential/contingent exposure is often found in situations such as a manufacturer that purchases critical components from an unrelated supplier: the manufacturer's assembly process will stop if the supplier is unable to ship components that are critical to final assembly of the manufacturer's product.

If insured perils⁶ (i.e., fire, windstorm, or flood) cause physical damage as described above, then the interruption of incoming supplies to the manufacturer will result in a business interruption loss to the manufacturer even though it did not suffer any direct damage to its own building or contents. The manufacturer has suffered a contingent business interruption loss, but the triggering event for the manufacturer as a named insured in its own property insurance policy is the direct damage event. A business interruption loss (i.e., loss of income and/or extra expense), contingent or otherwise, does not begin unless there is first direct damage.

Property Insurance "Insured"—Named and Additional

When insurable interest is established for a person or entity, then the next step is how to identify that insurance interest in the property insurance policy.

Can a property insurance policy treat differently a "named insured," "additional named insured," and "additional insured"? Yes, but one has to read the policy to determine if the difference is in coverage, in administration of the policy, or both. Let's look to Insurance Services Office, Inc. (ISO), Common Policy Conditions (IL 00 17 11 98) form to answer this question. Similar verbiage may be used by other insurers when their property policy is not an ISO-filed form.

The policy conditions in IL 00 17 11 98 state that the insurer makes the first named insured agent for all other insureds for policy administrative issues: cancellation, policy changes, and premiums. The first named insured can cancel the policy and make any coverage change to the policy with only the consent of the insurer. While the named insured may have a contractual responsibility to procure a minimum level of coverage for any policy insured, this contract is only between these two parties—it does not create an obligation for the insurer.

The Common Policy Conditions form is only between the insurer and named insured. The Common Policy Conditions form allows the first named insured great latitude in its actions for administration of the policy that can affect coverage for all other insureds in the policy. There is clearly an advantage to being the first named insured. Each insured in the policy must make sure that its interests are correctly identified and that it is included for insurer actions such as advance written notice of cancellation. When in doubt as to the extent of coverage, any insured can seek confirmation of coverage through a certificate of insurance or by a certified copy of the actual insurance policy. A best practice is for any property policy insured to seek confirmation of coverage at all times.

"Named Insured"

The named insured is the primary or sole insured in the policy and typically is the designated agent for any other insured whether designated as additional named insured or additional insured in the policy. Is a named insured and an additional insured the same thing? Essentially, one must read the policy to determine if either term is actually defined in the policy. A "named insured" is the person or entity identified as such in the policy declarations or supplemental declarations if there is more than one named insured. A named insured will have the broadest insurable interest in the covered property as the person or entity that purchases the policy and pays the premium.

"Additional Named Insured"

This usually occurs when a first named insured, such as a corporation, has subsidiary entities. Each of the subentities can be included as an additional named insured.

"Additional Insured"

This is a person or entity with an insurable interest in its owned object, but the object is in possession and/or control of a named insured who is an unrelated party to the additional insured. The actual owner can seek coverage under the property insurance of the holder of that property, as in the example of ACME Copier Service leasing a copier to NE Bank or as a landlord/owner in a net lease with a tenant. A named insured and additional insured will have insurable interests in the same object—but for different reasons.

"Loss Payee"

An additional insured can be designated in a property insurance policy as a loss payee to demonstrate its insurable interest in an object insured by the named insured's policy. Even without being specified as a loss payee, it is understood that the additional insured has this status if an object of its insurable interest is damaged or destroyed. The additional insured can require that not only will its identity be added to the policy as an "additional insured," but its status as a loss payee will be best demonstrated through an endorsement, such as the ISO Loss Payable Provisions (CP 12 18 06 95) form.

This form provides certain rights to the loss payee that may not have been provided if its interest was simply identified as an additional insured. The loss payee needs to protect its rights for settlement and payment of the claim to continue coverage for its interests if the policy is void at the time of loss due to an act of the named insured (arson) and to receive advance written notice of the insurer's intent of policy cancellation.

But, even with the use of this endorsement, the additional insured may not have the same rights as the named insured. The named insured can still elect to cancel the policy or make changes in coverage, and the insurer is not obligated to provide advance notice to the loss payee of either the impending cancellation or change in coverage. The additional insured must require advance written notice of a cancellation or a change in coverage in its contract with the named insured and then follow up to ensure that the named insured has had the insurer make the proper amendments to the actual insurance policy.

The named insured obtains a benefit as well when the additional insured defines its specific insurable interest in the policy. By specifying the extent and location of the insurable interest, the named insured limits the potential for the loss payee to be added as a party to all claims settlements no matter what caused the loss event or even if the object insured for the loss payee is part of the loss settlement. Sometimes, an additional insured is added to a property insurance policy, and the interest is shown simply "as their interests may appear." This approach may lead to a situation where, in a total loss, the additional insured appears on the overall claims settlement while its interest is simply a piece of insured contents, such as a photocopy machine.

A more efficient claims settlement process for the named insured and additional insured is to have one check made out to these two parties strictly for the cost of the copier and not everything that is damaged or destroyed. The named insured must review its policy at least annually and remove any additional insured that no longer has an insurable interest in any objects that remain insured in the named insured's policy. This type of policy due diligence will limit the possibility of erroneous insureds being considered during the claims settlement process.

"Mortgagee"

When a building is used as collateral for a loan, the mortgagee as holder of the mortgage (i.e., the bank or other financial services firm) has an insurable interest in the building. This insurable interest should be obvious: damage to or destruction of the building will cause a decrease in the value of the collateral. It is normal to have a property policy endorsed to identify a mortgagee and protect its rights through an appropriate mortgagee endorsement.

Sometimes, a mortgagee will seek loss payee status not only with respect to the building pledged as collateral but also with respect to the business income coverage. This is a puzzling request as it is not clear that a mortgagee has an insurable interest beyond the building itself and may not be entitled to be a loss payee for business income coverage. This position is best summarized by a statement attributed to Robert J. Brennan and Laura C. Company in Business Income Insurance Coverage, 32-SUM Brief 65, 66 (2003):

A claimant seeking business interruption coverage must have an insurable interest in the business in question. Merely possessing an interest in the property, such as that possessed by a mortgagee, is insufficient to create an insurable interest in the business for which coverage is sought.

Claims settlement can become problematic since the mortgagee will appear as a payee on all business income settlement checks. Any request by a mortgagee to be included as a loss payee for business income coverage should be reviewed by appropriate legal counsel prior to loan closing.

Omnibus Clause

Many risk management professionals seek to broaden the named insureds in a property policy through an omnibus clause as a means to safeguard overlooking an entity that should be included for coverage. The omnibus clause, when properly structured, is an acceptable way of extending policy coverage to many insureds without identifying each by a specific name. However, coverage for each insured within the omnibus clause will only apply to the extent that other terms and conditions of coverage apply to such a person or entity.

A broadly worded omnibus clause will not help provide coverage if a location is overlooked and not scheduled in the policy. It is equally important that when the "who" is considered, then the "where" is considered as well.

Many insurers add broadening endorsements to their property policies that sometimes include an omnibus clause. These clauses still need to be properly vetted to ensure the breadth of coverage is as broad as needed. Often, insurer-written omnibus clauses are limited to only entities that the named insured owns more than 50 percent of the entity. This restriction will impair coverage if the named insured, as an example, is part owner of an entity in which it owns less than a 40 percent interest but has a written agreement with other owners that this named insured is responsible to insure the subsidiary for the benefit of all its owners. Since the 40 percent ownership interest is less than the more than 50 percent condition, the clause fails for the named insured as well as the other owners.

If the omnibus clause is not properly amended, you will have a Mr. Doe situation as discussed above under "Insurable Interest—by Ownership." The devil is in the details.