Expert Commentary

Fair Claims versus the Property Insurance Mortgage Clause

It is likely that most home owners are unaware of an important partner in their homeowners insurance policy—a partner that effectively makes the policy a three-party contract involving the insurer, the insured, and the mortgage company/lender. It is called the mortgage clause, and it is a well-settled principle that a borrower's mortgagor is a separate insured in a homeowners policy.


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May 2018

Ordinarily, this arrangement is benign at worst; however, several natural disasters have awakened many home owners to the fact that the mortgage clause can be a stumbling block to timely repairs on a home damaged by catastrophic perils, such as floods for example. By introducing lenders to the claims process, home owners may find themselves wrestling with their mortgage company to ply insurance proceeds from lenders' hands to pay for repairs and comply with the conditions in their insurance policies.

A home owner's difficulties are compounded by the fact that there are well-established rules applicable to claims processing by insurers, but these rules and the regulators that oversee their implementation are generally inapplicable to the mortgage companies. This commentary offers an overview of the mortgage clause in insurance policies, its purpose, and some problems it presents for insureds. A subsequent commentary will suggest ambiguities and possible changes in public policy.

The Mortgage Clause

The mortgage clause appears in Section I Conditions of the standard Insurance Services Office, Inc. (ISO), policy form. Condition K., Mortgage Clause, states:

  1. If a mortgagee is named in this policy, any loss payable under Coverage A or B will be paid to the mortgagee and you, as interests appear. If more than one mortgagee is named, the order of payment will be the same as the order of precedence of the mortgages.
  2. If we deny your claim, that denial will not apply to a valid claim of the mortgagee, if the mortgagee:
    1. Notifies us of any change in ownership, occupancy or substantial change in risk of which the mortgagee is aware;
    2. Pays any premium due under this policy on demand if you have neglected to pay the premium; and
    3. Submits a signed, sworn statement of loss after receiving notice from us of your failure to do so. Paragraph E. Appraisal, G. Suit Against US and I. Loss Payment under Section 1-Conditions also apply to the mortgagee.
  3. If we decide to cancel or not to renew this policy, the mortgagee will be notified at least 10 days before the date cancellation or nonrenewal takes effect.
  4. If we pay the mortgagee for any loss and deny payment to you:
    1. We are subrogated to all the rights of the mortgagee granted under the mortgage on the property; or
    2. At our option, we may pay the mortgagee the whole principal on the mortgage plus any accrued interest. In this event, we will receive a full assignment and transfer of the mortgage and all securities held as collateral to the mortgage debt.
  5. Subrogation will not impair the right of the mortgagee to recover the full amount of the mortgagee's claim.

This language is commonly referred to as the New York Standard Mortgage Clause.

Please note that the clause applies to Coverages A and B, "A" being your dwelling, while "B" coverage represents "Other Structures" such as detached garages or other outbuildings and those attached in some way to the main dwelling. "C" coverages for personal property, furniture, for example, are not included, although it is my experience that some loan documents used at real estate closings may include a check space to include personal property items within a mortgage. Anyone purchasing a new home should watch that carefully and avoid financing personal and real property in the same loan.

The current National Flood Insurance Policy follows the ISO language with two exceptions. The flood policy includes a 30-day notice prior to cancellation or nonrenewal and says that "All the terms of this policy apply to the mortgagee." The American Association of Insurance Services (AAIS) HO 0003 01 06 policy form also includes the following provision under its Mortgage Clause: "All 'terms' of this policy apply to the mortgagee unless changed by this clause." In the AAIS form, "Terms means all provisions, limitations, exclusions, conditions, 'declarations', and definitions used in this policy."

Note that the regular ISO HO-3 policy, as noted above, restricts the mortgager's obligation to only three conditions: Appraisal, Suit against Us (the Insurer), and Loss Payment. Essentially, the flood and AAIS insurance policies hold the mortgagee to the same, complete insurance contract as the home owner. Some possible implications of this arrangement will be discussed in a later commentary.

What the Clause Means

"As interests appear" is often abbreviated as "ATIMA" ("As Their Interests May Appear"). It is language allowing an unnamed party to receive insurance benefits under the policy without being named as an insured. The main purpose of the clause is the protection of the lender's economic interest in the property. Basically, the mortgage clause is a contract within a contract, one being between the insurer and the debtor "home owner" and the other between the insurer and the lender. Under this separate contract, even if a borrower burns or otherwise destroys her own home, thereby negating the possibilities of an insurance recovery, a lender, by complying with policy conditions, can still collect insurance proceeds.

Technically, in many states, the term "mortgage" is a misnomer because the real estate trend is to use a security deed (also known as deed to secure debt, loan deed, or warranty deed to secure debt) and not a standard mortgage in financing real estate. Security deeds are more lender-friendly because they are an outright transfer of a property's title to the lender as security of a debt, whereas, a mortgage merely creates a lien on the property.

Essentially, a security deed splits a deed into two parts, (1) a part granting a lender legal title to secure debt and (2) an equitable right of redemption to the debtor; that is, a right to enjoy the property while redeeming the debt. In effect, just as "mortgage" may be inappropriate language, the same is true of "home owner" since "current occupant" may be a better way of describing the mortgagee-mortgagor relationship.

Security deeds may take precedence over all competing liens except tax liens. Another attractive feature of security deeds from a lender's perspective is that they permit a means of nonjudicial foreclosure by the lender. Note to a borrower: this means a lender does not have to get a court order to foreclose on you.

What the mortgage clause means for a lender is where most discussions of the clause end in our insurance literature. But what about the mortgagee/debtor? Buyers also have rights while enjoying and maintaining the property. While much of the emphasis is upon the lender's ability to get its money, one must not lose sight of the fact that the borrower has a contract that confers upon him or her the availability to repay a loan over an extended period, often 30 years, at a specified interest rate. Without such an arrangement, the American dream of homeownership would be reserved for only a few. The fact that there is a contract at all indicates that the borrower, following scrutiny by the lender, is capable of meeting payment obligations. As will be shown later, courts are very sensitive to this fact in passing judgment on how lenders apply the mortgage provision.

Losses: Where Troubles Begin

The mortgage provision rises from obscurity when the property is damaged and insurance claims are filed. Small claims, those of $10,000 or under, may be handled in routine fashion by most insurers because they rarely imperil a lender's security interest. Not so, however, when fire, flood, wind, or other covered perils inflict significant damage on the property. After such an event, any insurer check issued to cover losses will be a two-party check naming both the lender and the mortgagee as payees.

Most likely, the security deed says something like this Model Security Deed document found on Fannie Mae's website at fanniemae.com.

In the event of loss, Borrower shall give prompt notice to the insurance carrier and Lender. Lender may make proof of loss if not made promptly by Borrower. Unless Lender and Borrower otherwise agree in writing, any insurance proceeds, whether or not the underlying insurance was required by Lender, shall be applied to restoration or repair of the Property, if the restoration or repair is economically feasible and Lender's security is not lessened.

During such repair and restoration period, Lender shall have the right to hold such insurance proceeds until Lender has had an opportunity to inspect such property to ensure the work has been completed to Lender's satisfaction, provided that such inspection shall be undertaken promptly. Lender may disburse proceeds for the repairs and restoration in a single payment or in a series of progress payments as the work is completed….

If the restoration or repair is not economically feasible or Lender's security would be lessened, the insurance proceeds shall be applied to the sums secured by this Security Instrument, whether or not then due, with the excess, if any, paid to Borrower. [NOTE: I have taken the liberty to break the contract into paragraphs for readability purposes.]

The Fannie Mae model prohibits the use of insurance proceeds to pay public adjusters or other third parties hired by the insured. Further, it does not require interest payments to the insured, so the lender has an incentive to sit on the money as long as possible under the Fannie Mae form.

Procedurally, therefore, the insureds sign the check and forward it to the mortgagee for signature. The mortgagee may choose to deposit the check into an escrow account and release it in steps as the work is completed. This process may take a couple of weeks or more. When the check is returned, it will probably be a partial payment from the lender, and the balance will be released in installments. Never mind that contractors may be at work and expect to be paid; never mind that if it is a catastrophic loss (e.g., a hurricane), general contractors are all tied up, skilled workers may be spoken for, and materials may be in short supply. Meanwhile, the insurance contract obligates an insured to mitigate the loss.

While this condition may vary in wording, rest assured that mitigating the loss is a provision a borrower must take seriously. For example, the ISO HO-3 says the insured has a duty to protect the property from further damage. If repairs are required, the insured must make reasonable and necessary repairs to protect the property and, of course, keep accurate records of repair expenses.

So, if the house is flooded, one must get the water out; if a door is missing, a new door must be installed; if windows are blown out, new window coverings are necessary; if the roof or a portion thereof is missing…. Well, the situation speaks for itself.

A hundred dollars here and a hundred dollars there soon add up to a lot of money out of an insured's pocket. In fact, based on knowledge and experience, if a dwelling suffers significant damage, the borrower should be prepared to "front" costs for the insurance company and the lender, a process that converts the insured into a role of lender subsidizing insurers and mortgage servicers.  

Suggestions for Dealing Directly with Lenders

Handling an insurance claim demands the skills of a bookkeeper, carpenter, accountant, lawyer, statistician, interior designer, debater, realtor, building supply owner, electrician, and painter. At the outset, and for illustration purposes only, prepare to deal with an insurer in Miami, a claims adjuster in Mobile, a lender in Cincinnati, a mortgage service company in South Carolina, a local insurance agency, and a call center in isolation somewhere on the globe where no one is known by his or her real name. It would also be helpful to know the dimensions of each room in your house (length, width, and height), the building materials used in each room, the age of everything, and a willingness to suspend your better judgment at times and just get along with pricing data services (e.g., Xactimate). In case you haven't met Xactimate, that is the computer program 95 percent of adjusters depend on to figure what to pay out in settling a claim. Most likely, the first number will be conservative. After all, it is merely an estimate.

I won't bother to mention the laborious and sensitive process of acquiring the appropriately skilled workers to repair damages, nor will I dwell on the insurance adjuster since this article addresses primarily the mortgagee. Here are a few suggestions for insureds in that regard.  

Buy a recorder if one is not already available to support relevant paper trails. Use of a speakerphone will make it easier to maintain a complete record of all conversations. Whether one is obligated to advise the other party or parties that the conversation is being recorded is a matter of state law. Rest assured, a lender or its servicing company will have its own recording and may disclose that fact by declaring that the call may be monitored for quality purposes. "Monitored" is corporate lingo for "We're gonna record this." An insured can advise that, "I will monitor it with you." Remember, a paper trail is essential, but only video captures the inflection or tone of a conversation better than a voice record.

Ask the following questions and following introductions.

  • With whom am I speaking?
  • What is your job title?
  • In what city are you physically located?
  • If I call back, will I speak to you or are the calls randomly answered in such a manner that I get the "next available person"?
  • Does everyone doing your work have access to the records of my claim? Do you have a copy of my security deed? (The person will not know what this is, so the substitute word "mortgage" may be a better term.)
  • Have you read it, and is there a copy in the file or not?
  • Do you have a copy of my insurance policy?
  • Are you a licensed insurance adjuster? Realtor?
  • What is your claims procedure? Is the procedure based on what my deed and insurance policy say?
  • Specifically, what do I have to do to get the money you are holding?

Be prepared to discover that the person who may either facilitate or obstruct your efforts to access money to cover claim costs follows a "one size fits all" procedure, has never read a deed or an insurance policy (and will not resolve to start reading them now), and holds no formal training in either real estate or insurance.

Be aware of SWAMU factors. Most consumers are aware of "fine print" warnings, but not necessarily what I call the SWAMU factors. "SWAMU" is my acronym for "Stuff We Always Make Up." For example, in a claim I know well, consistent with the Model Security Deed document cited above, the security deed confers certain powers on the mortgagor/lender. The mortgagor/lender may hold the money from the insurance company and release it in a series of checks as the repairs are completed and inspect the property after repairs are completed to make sure its security interest in the property has not been compromised. However, the lender's claims procedure requires an estimate from a general contractor, Internal Revenue Service W-9 forms from people working the claim, the "working papers" of the insurance adjuster, and a waiver of lien from all parties that provided labor or materials. One "claims representative" added receipts for all purchases to the list. Incidentally, "working papers" is real estate jargon for the scope of loss, not proof of citizenship. It is a printout from Xactimate that the home owner receives from the insurance adjuster.

I repeat, in this example, the only contractual requirements allowed for the mortgagor/lender are (1) the right to control the insurance proceeds and (2) the right to inspect the work done. That is why it is important to read the deed and insurance policies before speaking with the mortgagor/lender's representatives. Any home owner who does that simple act of reading the loan documents will probably know more than the person or persons at the lender's call centers. Yet, many consumers will acquiesce to the more detailed demands without actually reading their deeds and insurance policies.

It is also possible that some deeds require these details, but the most important point to recognize here is that two contracts govern the mortgagee/borrower relationship—the deed and the insurance policy—and it is the wording of those documents that matters, not the one-size-fits-all procedure devised by a mortgage service company, the effect of which is manufactured delays in processing payments for labor and supplies. In this process, the mortgage company must act reasonably, in good faith, and with fair dealing.

This issue and other matters will be addressed in a future IRMI.com article.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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