08JUNE2015 PRIVATE CIRCULATION
BANK INTEREST CLAUSES ON LOANS/MORTGAGES
Guiding your property owning customers through the maze of bank interest clauses
What are bank interest clauses? Bank interest clauses are the insurance conditions that a bank inserts within a customer’s finance offering. These usually require specific provisions to be put in place, affecting the insurance policy covering the property upon which the loan is secured. Real estate lending has become trickier to secure since the financial crisis. Banks are increasingly attempting to de-risk lending, meaning they are imposing ever stricter conditions on their customers, who are often negatively impacted as a result. The clauses they impose are onerous to both the insured and also the insurer. In reducing their own risk, the banks increase the risk that insurers are writing and remove control from the insured. The specifics of these requests are variable between banks and individual deals, often containing requirements that are incompatible with what an insurer is able to provide. Insurers understand the banking industry’s reasons for including the clauses, but are concerned that many customers do not fully understand the impact that the conditions have on their insurance arrangements and the unfavourable position they may unexpectedly find themselves in as a consequence. Why do banks enforce them and how do they affect customers? Banks have various reasons for enforcing the interest clauses:
1)To ensure that the insurance policy cannot be invalidated where they, the lender, are concerned, regardless of any intervening events (Composite Insured) Allowing the lender to be Composite Insured gives them equal status to the insured customer. This means insurers must accept instructions from the lender as well as the customer, even if this is not in the customer’s best interests. It also allows the lender equal influence over how claims are settled. Being Composite Insured means the lender will also be protected against a customer’s policy being invalidated, to the extent of their interest, or claims not being paid due to an action or omission on the customer’s part. Due to the additional liability presented to insurers by such a clause there can be a requirement for an additional premium to be paid.
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The following scenarios are not exhaustive, but indicate potential issues that may arise for the customer at the time of claim settlement.
Example 1 – Lender retains claim payment
The lender decides to settle a claim on a cash basis and use the funds to offset loan amounts rather than reinstate the property. (Note in such circumstances a Loss of Rent claim will form part of this settlement and will cease upon conclusion of the claim) The potential for such a scenario needs to be considered by the customer to assess: – What position is the customer left in under their lease obligations? – Does the customer have the funds to cover the repairs? – What effect will an on-going and uninsured loss of rent have on the customer’s business? – Is there a clause within the loan agreement to protect the customer from such action being taken?
Example 2 – Repair contract in place but delayed funds the customer appoints a contractor to conduct remedial repairs to the property. The first payment on the contract is due for payment and the customer requests an interim payment from Insurance to cover the customer’s obligations. We would have to make that payment to the lender, or obtain their written permission to pay the customer/the contractor direct. As a minimum there will be a delay whilst authorities are received from the lender to pay the customer/contractor direct, but it is equally possible that the lender will require payment to themselves, at which point we will be unable to influence the speed at which that money is passed on to the customer/contractor.
Example 3 – Lender breaches policy conditions by delaying repair having made payment to the lender, a delay is experienced in passing that money on to complete the reinstatement of the property. Under the policy, the policy holder (which includes the lender as they are Composite Insured) is obliged to mitigate a loss. Any unreasonable delay in the reinstatement following payment would be taken into account in any on-going loss of rent claim, thus introducing a potential shortfall in the loss of rent claim. 2) To ensure that the lender can control claims moneys in the event of a loss (First Loss Payee) where a lender is noted as First Loss Payee they will control payment of any claims moneys that fall within the terms of the arrangement. This means that the insurer has either to pay the lender, or to pay in accordance with their written authorisation. Obtaining the appropriate authorisation will trigger delays and prevent the optimisation of the claims service. Points 1 and 2 combined Most often the lenders require both Composite Insured and First Loss payee to be added in tandem. In these circumstances the consequences are wider reaching and it is important to consider how the two clauses interact, which can be summarised as follows: The First Loss Payee means that in the event of a loss the lender becomes the key decision maker under the policy. As they are also Composite Insured they are free to negotiate settlement of the claim within the terms of the policy coverage. It is therefore now within the remit of the lender to agree settlement of the claim in accordance with their own priorities (which may not always align with the insured company’s).
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Example 4 – Lender insists upon reinstatement
The customer has a property that is damaged, but is performing poorly from an investment perspective. The customer wishes to negotiate a cash settlement and direct the funds to another property. The lender would be able to prevent the customer from exercising this option, instead insisting upon reinstatement of the original asset. How can broker’s best support their customers?
- A major issue for insurers and customers is that customer obligations are highlighted at a late stage in the application process. This means negotiations need to be turned around quickly, often during a very stressful time for customers. It is therefore of utmost importance to inform customers about potential bank interest clauses arising at the very start of any dealings. Brokers should broach the subject as soon as they are aware that a customer is considering finance options
- When considering whether to challenge the clauses, only the insured will know how important their business – and leverage – is to the lender. Yet if customers do decide to challenge the clauses, brokers should be aware of the insurer’s likely position and assist if possible
- Even if customers cannot negotiate successfully, or have no appetite to challenge the clauses, it remains crucial that brokers and insurers ensure customers are aware of the consequences of the requirements
- Ultimately, as a broker you should never underestimate the complexity of bank interest clauses. Always consult insurers if you have any doubts if you have any further queries about bank interest clauses, speak to your usual expert Real Estate contact for more information