Plan an insurance strategy in writing a property lease

Note: This article, originally published in the Feb. 1 and 8, 1982, issues of Business Insurance, has been updated.

It was a spectacular fire; the debris had not been cleared, and the landlord was on the phone with his "former" tenant asking when reconstruction would begin.

The tenant responded that his agent told him that reconstruction couldn't begin until the financing for the uncollectible part of the loss, the depreciation, could be established. The tenant said he wasn't willing to take out a mortgage for the uninsured depreciation and expected the landlord to pay the difference.

The landlord adamantly said, "Why isn't the insurance adequate to pay the full reconstruction cost? The lease requires you to carry an amount of insurance equal to the full insurable value."

The tenant replied, "I did cover the full insurable value, but my insurance agent said full insurable value means 100% of the normal insurable value, and normal insurable value is actual cash value, which means replacement costs less depreciation."

Now you've got the picture; the final decision will be made by a judge.

Most leases favor the building owner—not the tenant. Advance planning in writing insurance clauses in leases can save much time, cost and many headaches in the event of an insurance claim. The landlord and the tenant need not be adversaries. In most cases, landlords will accept clauses proposed by the tenant, if properly explained, as the clauses are good for both parties.

The following are some key lease provisions related to insurance. For brevity, we are reviewing only the most significant areas.

1. The area of property insurance in leases is the one in which the most confusion exists. If the lessor is carrying its own coverage, there is no need to deal with the subject in the lease. However, on a net/net lease, where the tenant is required to provide property insurance for the benefit of the lessor, great care must be exercised. Details must be spelled out for subjects such as insured perils, amount of insurance, valuation basis, ownership of improvements and betterments, and repair or restoration requirements.

2. As lessor, you don't want a coinsurance clause in the tenant's policy if you can avoid it. It can only hurt you. It requires the tenant to carry a certain amount of insurance in relation to value, and if he or she doesn't, there's a penalty. You'd like to avoid the possibility of a penalty, so if you can avoid coinsurance, that's advantageous.

3. If the tenant makes improvements to the building, they usually are considered owned by the lessor at the lease expiration. It is usually best to broaden the policy terms so that the improvements and betterments, when made, become a part of the building. The building owner will collect for the value of the improvements as part of the building. Ownership should also be indicated in the lease. Provisions can be made to protect the lessee.

4. A lessee would like the lease to include a release-of-subrogation clause. In the event of claim, the lessee wants to avoid the lessor's insurance company charging him with the cost of repairing damage paid by the lessor's insurance company. So a waiver of subrogation, if approved by the insurance company, would be in the interest of the lessee, and of no consequence to the lessor. Such a release can be turned to a mutual release of subrogation, benefiting both parties, without objection by insurer, as such a release is usually allowed in the policy.

5. Many leases contain a rent abatement clause. While this is equitable, its relationship to the insurance contract should not be ignored. If rental expense continues, it is covered by business interruption insurance, which most businesses carry. There is no benefit to the tenant by abating rent—merely a benefit to the tenant's insurance company. You could therefore safely delete the rent abatement clause.

All insurance policies required in the lease should contain certain provisions protecting the lessor. It is important that the lessor be included as a named insured or additional named insured in respect to the property, and that the lessor be advised in advance of any policy changes, such as cancellation or reduction in coverage. There are also specific rights that need to be protected in regard to payment of insurance proceeds.

Howard C. Alper is president of Chicago-based Alper Services L.L.C., an insurance cost reduction consulting and risk management firm he founded in 1966.