Lenders’ Insurance: New Tools for Banks and Borrowers

Your customers are likely to witness this trend firsthand the next time their company applies for a loan, and their bank requires “lenders’ insurance”. The reason this trend is catching on is that environmental insurance is good for both the borrower and the lending financial institution.

Lenders’ insurance is rapidly becoming a standard component of commercial real estate mortgage lending transactions. Essentially a hybrid environmental and credit insurance product, lenders’ insurance helps protect banks against the environmental exposures that may arise from these transactions. Such exposures include:

loss of the loan balance due to the borrower’s default when accompanied by environmental damage of the real estate backing the loan;

loss of the collateral value of the real estate backing the loan; and

liability for third-party environmental claims.

Multiple triggers

Many lenders’ policies are structured with three distinct insuring agreements, all offered in one standard policy form. The most significant of the three from a bank’s perspective is the “loan balance” insuring agreement, which is triggered by a default on the loan and the discovery of environmental damage at the collateral property. It is often referred to as a “dual trigger” because both these events must take place in order for the policy to respond. When the loan balance coverage is triggered, the policy typically pays off the balance due on the loan, plus interest. In such case, the insurance company may elect whether to take over the note and pursue foreclosure.

If there is a loan default and environmental damage at the collateral property and the bank forecloses, a second insuring agreement, “remediation costs” coverage, is triggered. Under this insuring agreement, the bank is reimbursed for the remediation costs necessary to address the environmental condition at the collateral property.

The final insuring agreement that is a standard part of these policy forms provides protection for the bank against liability in third-party claims arising from environmental conditions at the collateral property. These claims could be filed against the bank while it is still only the lender for the property, though they are more likely to be filed against the bank if it forecloses on the collateral property.

“Lesser-of” coverage is also available as a replacement to the “loan balance” coverage in the standard form. When this coverage is selected, the bank will receive – in the event of default and environmental damage – either the outstanding loan balance or the cost of remediation, whichever is less.

Good for banks

With the significant expansion of federal and state environmental regulations in the 1980s, lenders have required environmental assessments for almost all real estate to be used as collateral for a commercial loan. This evaluation process typically involves a “Phase I Assessment” of the property, which requires conducting a site visit and a review of historical and regulatory records.

While lenders historically have relied on Phase I Assessments to mitigate environmental exposures, these assessments have limitations, which can be costly. For instance, a Phase I can raise concerns about a transaction by recommending additional investigation of a property, even though contamination is absent. A Phase I may also indicate that a property is free of environmental concerns when contamination does in fact exist. Either scenario mandates review of the Phase I, and often requires further work and investigation at the property, which can be both expensive and time-consuming.

In addition, a Phase I provides only information about a property. It offers no risk transfer protection. On the other hand, lenders’ insurance helps protect banks against the loss of commercial real estate loan balance, reduction in value of real estate backing the loan, and third-party claims arising from environmental damage.

As an added benefit, lenders’ insurance can also reduce a bank’s operational costs. Lenders typically spend six to 10 hours reviewing environmental issues including a Phase I, compared with the approximately one hour required to disclose the information an insurance company needs to underwrite lenders’ insurance.

Good for borrowers

As its name implies, lenders’ insurance provides protection for financial institutions. But it can also benefit the borrower. Consider the following scenario: A financial services company is negotiating a loan to upgrade the technology infrastructure at one of its offices. Its office building will be used as collateral. Although there are no known environmental conditions at the company’s site, the bank’s lending guidelines require protection from potential environmental issues. The financial services company does not want to extend an environmental indemnity.

In this instance, lenders’ insurance may be substituted for the environmental indemnity. With insurance in place, the bank will be able to adhere to its lending guidelines by securing protection for potential environmental issues, and the financial services company will not have to provide an indemnity. Similarly, the policy can also replace environmental escrows or guarantees that may be required.

Assume another scenario: A real-estate investment trust (REIT) has identified a “hot property” investment lead, a shopping center in a commercially active area that is for sale. The business opportunity just materialized, but the REIT must move quickly to close the deal. But one significant potential obstacle stands in the way. Lenders must have a current environmental assessment report on the property, and the most recent report for this property is more than two years old, and getting a new Phase I will take too long.

In this scenario, lenders’ insurance may be used to supplement stale environmental diligence, or, depending on the type of property used as collateral, may even replace environmental diligence altogether. Obtaining lenders’ insurance also takes significantly less time than a Phase I report, enabling the REIT to close the deal.

Borrowers may also get a preliminary non-bindable quote for lenders’ insurance, which can be presented to the bank during negotiations or when developing final loan terms, potentially expediting the lending process. Because of the many advantages lenders’ insurance provides for both banks and borrowers, one can expect to see rising interest in this coverage. A select group of insurers are the positioned to respond to the increased demand.