In this hazard insurance primer, learn to identify a lender’s ability to apply the proceeds from a hazard insurance claim to the balance due on the loan or release the proceeds from a hazard insurance claim to the owner to rebuild improvements.
The right to rebuild vs. loan impairment
A hazard insurance provision is a mortgage provision granting a lender the option to:
- retain and apply any insurance proceeds to the mortgage balance; or
- release the proceeds to the owner of the building to reconstruct the damaged improvements.
This is true even if the damaged structure does not diminish the property’s value to the extent it impairs the lender’s security interest in the property.
Consider a homeowner who owes $300,000 on a mortgage on their home. The home is valued at $500,000. A well-constructed aviary is attached to the home.
As a required condition of the mortgage, the owner maintains a fire insurance policy on the real estate, listing the lender as an additional named insured.
In the event of a fire, the mortgage also contains a hazard insurance provision granting the lender the option to:
- retain any fire insurance proceeds and apply them to the mortgage; or
- release the proceeds to the owner for rebuilding. [See first tuesday Form 450 §2.2]
A fire destroys the aviary, a $5,000 loss for the homeowner. However, the fire does not damage the home. Thus, after the fire, the value of the real estate is $495,000.
The homeowner decides not to replace the aviary.
To cover the loss from the fire, the homeowner’s insurance carrier issues a check payable to the homeowner and the lender as called for in their policy. The owner informs the lender of their intention not to rebuild, and requests the check be endorsed to the owner.
The lender refuses, demanding the insurance proceeds be applied:
- to the outstanding balance of the debt; or
- to reconstruct the damaged structure.
The owner claims they are entitled to the proceeds since the debt owed to the lender is adequately secured by the dollar value of the remaining property.
May the lender apply the insurance proceeds to the balance due on the mortgage?
Yes! The lender has full control over the proceeds since:
- the owner elected not to restore the improvements after the fire; and
- the mortgage contains a provision stating the lender is entitled to apply the insurance proceeds to the loan balance. [Calif. Financial Code §§1448, 7462]
Good faith cooperation implied
Since a mortgage is a contract, a mortgage is subject to an implied promise on the part of both the owner and the lender to act in good faith and deal fairly with one another. [Milstein v. Security Pacific National Bank (1972) 27 CA3d 482]
The lender and the owner, as the contracting parties to a mortgage, need to:
- refrain from conduct which interferes with each other’s performance of the mortgage provisions; and
- perform all acts contemplated in the mortgage to accomplish the objectives served by the mortgage – lender security from loss.
For instance, a lender may not automatically refuse to release the proceeds to an owner who intends to reconstruct the destroyed improvements and restore the property to its value before it was damaged.
Election to rebuild when funds exist
An owner has the option to rebuild when there are sufficient funds to do so, despite the lender’s wish to apply the funds to the mortgage balance.
Consider an owner’s real estate that is valued at $500,000, with $450,000 owed on a mortgage secured by a first trust deed on the property.
Mortgage provisions require the owner to maintain a fire insurance policy which also lists the lender as a named insured.
Again, the mortgage further provides the lender may either:
- apply any fire insurance proceeds to the mortgage; or
- release the proceeds to the owner for rebuilding the improvements.
A fire totally destroys the improvements.
The value of the remaining real estate is $200,000. The total rebuilding costs are $300,000.
The policy provides sufficient coverage to fund the replacement of the destroyed improvements.
The owner decides to rebuild, but the lender exercises its option to apply the insurance proceeds to the mortgage balance.
The lender refuses to release the proceeds to the owner, claiming the owner may not receive the funds and rebuild since the mortgage states the lender has the option to apply the proceeds directly to the mortgage balance.
However, the lender is required to allow the owner to rebuild, unless the lender can show its security will be impaired by the reconstruction of the improvements as proposed by the owner. [Schoolcraft v. Ross (1978) 81 CA3d 75]
If the insurance proceeds are sufficient to fully rebuild and replace the destroyed improvements, the lender’s security interest will not be impaired. Thus, the lender’s mortgage will be restored on completion of construction to the loan-to-value (LTV) ratio it had before the loss caused by the fire. [People v. Redwood Baseline, Ltd. (1978) 84 CA3d 662]
Failure to release the proceeds constitutes a breach of the lender’s obligation to act in good faith and fair dealing. [Schoolcraft, supra]
While the lender may not refuse to allow the owner to rebuild when the security interest will be unimpaired by rebuilding the destroyed improvements, the lender may demand assurance from the owner they will use the proceeds to complete the reconstruction.
If the fire damage was substantial, the lender may reasonably require the owner to:
- submit the reconstruction plans to the lender for approval;
- hire a licensed contractor; and
- obtain a building permit.
In addition, the lender might require the contractor to provide the lender with a performance bond to ensure completion of the reconstruction.
During reconstruction, the lender may require the insurance proceeds be disbursed in progress payments. As each phase of reconstruction is completed, the lender releases payment to the contractor incrementally for the work performed.
If the lender determines the reconstruction plans are deficient, the lender has a good faith obligation to inform the owner why the plans are considered deficient, and allow the owner time to correct the deficiencies.
Failure to provide adequate insurance
A lender may require an owner to carry fire insurance up to the replacement cost of the improvements, even if the costs exceed the mortgage amount or the current fair market value (FMV) of the property. [Calif. Civil Code §2955.5]
Consider an owner of real estate that is encumbered by a mortgage containing an insurance provision The owner fails to maintain adequate fire insurance to recover the replacement costs of the improvements on the property.
However, the prudent lender is likely to rely on another mortgage provision allowing the lender to advance payment for fire insurance premiums when the owner fails to maintain adequate insurance, called a future advances clause, since the security is in danger of impairment. [See first tuesday Form 450 §2.5]
Under the future advances clause, an owner who fails to maintain a fire insurance policy as required by the mortgage authorizes the lender to:
- take out an insurance policy;
- pay the premiums;
- add the premiums to the loan balance; and
- demand immediate reimbursement of the premium advanced. [Calif. Insurance Code §171]
If the owner fails to tender the amounts advanced on the lender’s demand for reimbursement, the lender may call the mortgage due. Further, if the mortgage is unpaid when called, the lender may initiate foreclosure proceedings. [Calif. Finance Code §§1487, 7461]
Covered for value, not replacement
Now consider an owner of real estate whose hazard insurance coverage is limited to the current FMV of the real estate. However, the home’s replacement cost exceeds the current FMV of the land and improvements due to:
- declining real estate values in the area surrounding the property; or
- replacement costs that have risen faster than real estate values.
A substantial portion of the improvements covered by the policy are destroyed. The owner intends to rebuild the destroyed improvements, but the insurance proceeds are insufficient to cover the costs of reconstructing the same improvements.
Further, the owner is unable to contribute funds to cover the shortage between the full replacement cost of the destroyed improvements and the insurance proceeds.
Since the insurance proceeds alone will not cover the costs of replacing the destroyed improvements with comparably valued improvements, the (LTV) ratio will not be restored. Thus, the lender’s security interest is impaired as a result of the destruction and inadequate insurance coverage.
The lender has two remedies when the insurance proceeds are inadequate to restore the lender’s LTV ratio:
- apply the insurance proceeds to the mortgage balance; or
- call the mortgage due since the owner failed to maintain adequate coverage.
If the lender calls the mortgage due, the lender needs to underbid at the foreclosure sale by the amount of the coverage. If not, the lender will be unable to collect the insurance proceeds.
A full-credit bid at the trustee’s sale satisfies the entire debt, leaving the lender with no loss on the mortgage to recover. This is despite any potential losses to be incurred by the lender on a later resale of the real estate for a price less than the amount bid. [Altus Bank v. State Farm Fire and Casualty Company (1991) 758 F. Supp. 567]
Failure to require insurance
Consider an owner of real estate who maintains a hazard insurance policy as required by the mortgage encumbering the property.
The hazard insurance provision in the mortgage does not require the owner to maintain earthquake insurance. However, the owner purchases an earthquake insurance policy. Without the owner’s consent, the insurer includes the lender as a beneficiary of the earthquake policy.
An earthquake seriously damages the property and the owner defaults on the mortgage. To cover the earthquake damage, the insurer issues a check payable to the lender and the owner.
The owner requests the lender to endorse the check to the owner. The lender refuses, claiming it has the right to either apply the proceeds toward the repair of the property or to the unpaid loan balance.
The owner claims the lender needs to endorse the check to the owner since the hazard insurance provision in the mortgage did not require the owner to maintain earthquake insurance for the benefit of the lender.
The lender claims it is entitled to the insurance proceeds under the waste provision in the mortgage since the lender’s security for the mortgage was destroyed by the earthquake.
Is the lender entitled to the insurance proceeds?
No! The lender is not entitled to the insurance proceeds since:
- the hazard insurance provision did not require the owner to maintain earthquake insurance; and
- the lender was named as a beneficiary of the earthquake insurance policy in error. [Ziello v. Superior Court (1995) 36 CA4th 321]
Further, the waste provision in the mortgage only allowed the lender to sue the owner if the lender’s security interest becomes impaired due to the owner’s action of committing waste.
To ensure the lender is covered for property damage due to hazards such as fires and earthquakes, the hazard insurance provision in the mortgage must state each type of hazard which must be covered. [Ziello, supra]