Insurance requirements in REF transactions: "mind the gap or read the policy… !"
The background in commercial REF deals
Provisions related to insurance form an important part of all REF transactions, increasingly being the subject of negotiation. Funders will require the funded property, being the primary asset of recourse in a default scenario, to be comprehensively insured and protected from the risk of value erosion, and go to considerable lengths to ensure that borrowers are placed under a comprehensive (insurers would argue 'onerous') set of obligations in respect of the insurance they are required to maintain to achieve this.
What has become clear (as anecdotally evident to the authors over the course of several recent REF transactions) is that real tension has emerged between funders and brokers/insurers when it comes to reconciling funders' expectations of what a borrower's insurance cover should look like, with the practical reality of cover that insurers are prepared to underwrite.
There does not seem to be divergence between funders, insurers and borrowers on what risks the policies should cover, in essence loss or damage to the property, site clearance, damage by sabotage or terrorism, loss of rent of not less than 3 years and third party risk cover.
However, there is a perception amongst some insurers that funders are trying to take steps to make it almost impossible for insurers to void policies by a combination of insisting on being named as composite insured (where funders effectively become a second insured party) and having non-vitiation provisions included in policies (which prevents the actions of another insured party, in this context the borrower, vitiating the policy).
Whilst lenders have for many years insisted on being co-insured and more recently, composite insured, it is only comparatively recently that funders are monitoring and enforcing the non-vitiation requirements. Arguably this change in practice has been driven by two factors. Firstly, we are faced with a REF market; post the GFC, in which funders are increasingly careful to mitigate the risks associated with REF transactions. In the context of insurance, this means looking to insurers to accept more stringent undertakings, which essentially seek to shift the risks associated with a vitiation of policies to the relevant insurer. Secondly the termination, in 2012, of the protocol, between The Association of British Insurers ("ABI") and the British Bankers’ Association ("BBA"), dating from 1992, which was designed to protect funders' interests as mortgagees of property, has left funders feeling increasingly exposed. Under the 1992 protocol insurers were obliged to inform funders of any alteration or cancellation of cover in relation to the subject property, which led to a welcome uniformity of approach across the market against which funders could derive a degree of comfort.
Insurance Broker Letters
The above tensions tend to manifest themselves in the insurance broker confirmation letters required as a CP to funding. It is a common CP (reflected in the LMA suite of standard form REF credit agreements) that borrowers must deliver evidence that the insurance cover in place conforms to the requirements of the funder set out in the facility agreement. Typically, this evidence is required to take the form of an insurance broker's letter, addressed to funders, giving the required confirmation. Insurers are becoming less willing to give a blanket sign off on the pro-forma letters, which could result in liability on the insurance broker placing the cover, in the event that there is a mismatch between the strict requirements of the facility agreement regards non-vitiation, the terms of the policy, and general insurance law..
Practical implications
The practical implication for participants in REF transactions, both professionals and principals, is the need to be aware of the competing interests of funders, borrowers and their insurers and the very real risk that obtaining confirmation of insurance cover is an issue that can often take some weeks to resolve. The core message to all parties has to be to engage early and to appreciate the need for clear lines of communication. Ideally, a direct dialogue between lawyers acting for the borrower and the insurers' in-house legal team should be established at first draft stage. Insurers will seldom actually see the facility agreement which sets-out the requirements they are being asked to meet meaning these should also be clearly articulated at an early stage to avoid a communication gap.
Improving the process
Going forward there is clearly room to improve the process. From the insurers' perspective, it may be time for funders' legal teams to take more responsibility for examining policy documents, fully understanding what cover is provided and being ready to take commercially informed decisions on the requirements to be placed on insurers, rather than relying on blanket confirmations from brokers. However, this solution would no doubt push an additional layer of cost and legal risk into transactions.
Of real benefit would be a move towards establishing a market standard form of insurance brokers' confirmation letter (and attendant reconsideration of the insurance provisions of the LMA documentation suite), possibly being a process best led by the LMA, in conjunction with the ABI and BBA, which reflects the reality of competing pressures faced by insurers and funders and the need to reach a better compromise. Until that point, funders, borrowers and their legal teams need to be aware of, and ready to deal with, the gap that currently exists if completion deadlines are to be achieved without placing undue stress on the relationships between funders, borrowers and their insurers.
For further information and support please contact the authors or your usual Fieldfisher contact.