Are Lenders Entitled to Insurance Proceeds when Foreclosing?
A lender’s right to insurance proceeds after foreclosure depends on the type of loss payable clause contained in the insurance policy and the timing of the loss. Lenders should be mindful of these issues when seeking insurance proceeds in the context of foreclosure and should consider the following:
• Require borrowers to covenant in the mortgage that the lender is entitled to the insurance proceeds.
• Obtain an insurance policy with a loss payable clause, preferably a “standard” clause.
• Collect insurance proceeds prior to foreclosing if the loss occurs prior to foreclosure.
• Remember (a) the lender’s interest in the insurance proceeds is terminated if the full debt amount is satisfied following foreclosure; and (b) the lender’s recovery is limited to the deficiency amount if the foreclosure bid is less than the full debt.
• When the loss occurs after foreclosure, some courts have permitted the lender to recover the insurance proceeds.
• Obtain insurance following a foreclosure sale or confirm with the insurer that the coverage will continue.
In addition to requiring a borrower to covenant that it will maintain casualty insurance for lender’s benefit, it is best practice for a lender also to require the borrower to obtain an insurance policy with a loss payable clause in lender’s favor. In the context of foreclosure, a lender’s right to insurance proceeds depends on the type of clause.
In an “open” or simple loss payable clause the lender’s recovery right is derivative of the borrower’s interest and, thus, the lender is subject to all defenses the insurer may have against the insured borrower, such as failure to pay premiums. No new contract is created between the insurer and the lender. If the loss occurs after foreclosure when there is an open loss payable clause, the borrower is entitled to the insurance proceeds during the redemption period.
The “standard” or New York loss payable clause is more favorable to lenders. This clause provides that the proceeds are payable to the lender as its interests may appear, but eliminates the defenses the insurer may assert resulting from the borrower’s actions and provides full lender protection during foreclosure.
Time of Loss
Loss Before Foreclosure
If a loss occurs before foreclosure, the lender is only entitled to the proceeds amounting to a deficiency after foreclosure, and the borrower is entitled to the remainder. The lender’s bid represents the damaged property’s value and, therefore, once the debt is satisfied, the lender would be unjustly enriched by the additional recovery of proceeds representing undamaged property.
With an open loss payable clause, if the purchase price at the foreclosure sale was equal to the full debt amount, the debt would be satisfied and the insurer’s liability to the lender would be discharged. However, if the purchase price did not equal the full debt amount, the insurer is liable to the lender for the difference.
With a standard loss payable clause, the lender is simply the owner’s creditor at the time of loss. The lender may elect to satisfy the debt either by payment from the insurer or by foreclosing on the property. If foreclosure is pursued, and a deficiency remains, the lender may recover the deficiency from the insurer. However, once the debt is fully satisfied through the foreclosure sale, the lender’s interest in the policy proceeds is terminated. Accordingly, it is best practice for lenders to collect insurance proceeds before the foreclosure sale.
Loss After Foreclosure
If a loss occurs after the foreclosure sale and before the redemption period expires, and there is an open loss payable clause, then post-foreclosure losses are not covered because the lender has an interest in the policy only as security for its debt. There is no longer a creditor relationship after the debt has been discharged. If the policy contained a “standard” clause, a lender may recover post-foreclosure losses. In this situation, the foreclosure occurs when the insured property was undamaged and the lender is considered the property owner at the time of loss and thus entitled to recover the full amount of the covered loss. This result is based on the idea that there is an independent contract between the lender and insurer. Some authority suggests the standard mortgage clause should cover the lender only as its status as lender and not after the lender becomes the property owner.