Insurance Issues Too Important to Ignore
By Robert Machson, RMachson@TotalOccupancySolutions.com
Given the increasing cost of insurance and insured “loss,” this article discusses some of the quickest ways landlords and tenants can save money and avoid disputes.
The typical lease requires the landlord and tenant to purchase “insurance” for property damage and liability claims in and to the shopping center and the common areas. A first stumbling block is what is meant by the term “insurance.” From the layperson’s point of view, insurance means coverage purchased from a rated, commercial insurance company. But what if a party wants to provide coverage through less traditional means, such as self-insurance or a “captive” carrier?
Self insurance is the easier of the two. To begin, “self-insurance” is an oxymoron: one cannot really “self-insure,” because insurance requires a “transfer of risk” from one party to another. Thus, to the degree a lease requires a party to purchase or provide insurance, it should never be allowed to self-insure.
Of course, many leases contain provisions permitting a party to self-insure, generally if they can demonstrate some minimum net worth. While this may present no conflict for the tenant, a landlord’s agreement to self-insure may run afoul of other provisions in the lease, for example, the so-called “exculpatory” provision, in which the landlord’s liability to the tenant is limited to its actual equity in the shopping center. A smart tenant may want to carve out liability claims (at a minimum) from any exculpatory provision, especially if the landlord is seeking to self-insure.
Another trend is the use of “captive” insurance, which in some ways is like self-insurance. A few states -- notably Vermont and a number of non US jurisdictions, for example, Bermuda and the Cayman Islands -- permit companies to insure their parent and affiliates for loss that the company is likely to encounter, for example, workers’ compensation. Because it is a strictly intra-company transaction, the use of a captive permits them to take advantage of a number of accounting, tax and regulatory benefits, which might not otherwise be available.
There may be a number of concerns to using a captive to satisfy insurance obligations, only a few of which can be addressed here. One is whether “captive insurance” is “insurance” at all within the meaning of a traditional shopping center lease. At least one federal district court has held that it is not, ruling that the word “insurance” means a policy purchased from a third-party, commercial carrier.
Another issue that arises with the use of a captive is how the landlord would calculate the premium to be charged to the tenant. The reason for this is that the cost (“premium”) of the captive coverage between affiliates is not governed either by regulators or the commercial market. Not surprisingly, the tenant might wonder whether it is being charged the same or less than it would pay to a commercial carrier.
How would a tenant know if a landlord is using a captive and whether the premium is a fair? First, most leases require the landlord (and tenant) to provide a certificate of insurance. The name of the carrier will be on the certificate. Look it up on the Internet; you should know quickly enough whether it’s a captive. (One tip: if the landlord is a public company, the captive will be listed as a subsidiary in its public filings.)
Determining whether the captive premium is a fair, market rate is far more difficult (which is one reason tenants may want to preclude landlords from billing for captive coverage). For that, the landlord will have to disclose how it came up with the premium, meaning it would have to show how it allocated the risk and matched that to competitive market rates.
Another thorny issue is deductibles, both how high they should be, and who should pay them. It is important to note that a deductible, like “self-insurance,” is not insurance at all. Therefore, a lease that requires the tenant to reimburse the landlord only for the “cost of insurance” may not require the tenant to pay any share of the deductible. Nevertheless, the deductible is too important to leave to chance.
There are two issues. The first is the amount of the deductible; the second, who pays. A commercially reasonable deductible depends upon a number of factors that cannot be covered here. Suffice to say that a deductible of $50,000 at all but the smallest center seems reasonable to most experts. Deductibles at larger centers may be as high as $250,000.
A deductible that is too low may be a costly mistake. As anyone who buys insurance for personal property knows, the lower the deductible, the higher the premium. Thus, a tenant who demands too low a deductible is simply asking to pay too high a premium. At this far end of the spectrum, an insured that buys a policy with little or no deductible (the “zero dollar” policy), is simply paying a premium for expected loss -- in other words, an exchange of money at a very high cost.
For that reason, the zero dollar policy should be avoided. Of course, the reason the zero dollar policy may be popular is the unwillingness of landlords and tenants to address the issue of deductibles. For some landlords, the simple solution is to have no deductible at all (zero deductible policies are generally available to cover liability, but may not be sold for all risk -- though one can buy a very low deductible all risk policy as well) and simply pass the cost of the expensive premium on to the tenant.
The smart solution is to agree upon the right balance of premium and deductible, and then agree on how the deductible will be allocated. In order to avoid unexpected spikes in expenses, the parties may agree to cap costs, or provide for cumulative carry-overs for a period of years.