March 17, 2010
Written by The National Insurance Coverage Group of NLdH
This article is an interpretation of current law and is offered for informational purposes only. This material is not legal advice and should not be construed or used as a substitute for the advice of an attorney.
The current mortgage crisis has affected every aspect of the economy, and the insurance industry is no exception. With the increase in home loan defaults and a declining economy, another alarming trend has emerged - a rise in so-called "economic arson" or "arson for profit," which is defined as the intentional burning of a dwelling by its owner for economic gain through an insurance claim. Studies have shown that arson activity increases when homeowners are faced with financial stress and also when homes are insured for larger amounts. Notably, a study conducted by Allstate Insurance Company reports that the typical motives for arson are: (1) to stop or minimize financial losses, or (2) to make a profit. Allstate Insurance Company: Residential Arson Fraud Claims Study, 2006. Similarly, a study conducted at Baylor University showed strong evidence that arson is positively related to the amount of insurance held on a property. Green, Steven L. and J. Allen Steward, The Economics of Residential Arson: Theory and Evidence from a Panel of Cities. 2004. In the wake of steadily declining home values over the past few years, more borrowers have found themselves unable to meet their mortgage obligations. For a desperate few, arson is perceived as a means of escaping certain default and loss of a home or business property.
Insurance policies almost universally contain exclusions for "intentional losses" that are intended to prevent a carrier from having to pay an insured for a fire loss from arson, assuming the insurer can meet its burden of proving the intentional nature of the loss. However, these exclusions are not the end of the story. Even if a carrier can deny a claim made by an arsonist, it may still be liable to a lender who holds a mortgage on the property - the "mortgagee". The carrier's liability to a mortgagee depends, in large part, on the language of the insurance policy at issue and the timing of the loss. Where the loss to the property has been intentionally caused by the insured, either to avert financial disaster or to profit from his or her fraudulent acts, insurance coverage disputes are likely to arise between the insurer and mortgagee.
Kinds of Mortgagee Clauses
First party property insurance policies contain one of two types of mortgagee clauses. The first is called an "open" or "simple" loss payable clause, which provides that the loss shall be payable to the mortgagee as his interest appears. This kind of clause does not create any separate contract with the mortgagee and it does not nullify any condition or obligation of the policy. Farmers & Merchants Savings Bank v. Farm Bureau Mutual Ins. Co., 405 N.W.2d 834, 836 (Iowa 1987). It merely designates the mortgagee as the party who will receive the insurance proceeds in the event of a loss. The mortgagee's right to recover can never rise higher than the right of the mortgagor. Wholesale Sports Warehouse Co. v. Pekin Ins. Co., 587 F. Supp. 916, 919-20 (S.D. Iowa 1984). This means that the mortgagee's right to recover is based on the homeowner's compliance with all policy conditions and obligations; if the insurer can assert a defense against the insured, it can assert that same defense against the lienholder. Cardwell v. Chrysler Financial Corp., 804 A.2d 18, 24 (Pa. Super. 2002). Therefore, the mortgagee may not have an independent right to recover against the carrier in situations where the homeowner has committed arson or fraud.
The second is referred to as a "New York" or "standard" loss payable clause. It also provides that the loss is payable to the mortgagee as his interest may appear, but goes on to state that the mortgagee's interest cannot be invalidated by any act or omission of the insured. This clause creates a separate contract between the insurer and the mortgagee. Couch on Insurance 3d §65:8 (1996). Therefore, under this type of clause, a mortgagee is entitled to payment for a loss to the extent of its interest at the time of the loss, regardless of whether the insured homeowner has complied with all of its policy obligations. Farmers, 405 N.W. 2d at 836. Acts or omissions of the named insured cannot affect the mortgagee's right to recover. As such, even if the homeowner has committed an act of arson or fraud, the carrier may still be liable to the mortgagee to the extent of its interest in the property.
Even with the protection afforded by these clauses, issues still arise as to the fact and extent of a carrier's liability to the mortgagee for losses occurring at properties in various states of foreclosure. For example, the extent of the mortgagee's interest may potentially be measured by the amount owing on the mortgage or the entire value of the property. Additionally, if the mortgagee purchases the subject property at a foreclosure sale, such purchase may affect the mortgagee's ability or right to recover proceeds under the mortgagor's insurance policy. How these issues will be resolved depends upon (1) the kind of mortgagee clause in the subject policy of insurance, (2) the timing of the loss, and (3) the jurisdiction interpreting the policy.
Does the Mortgagee have an Insurable Interest?
For any party to recover under an insurance contract, it must have an insurable interest in the property that is the subject of the policy, at both the time of the contract and the time of the loss. DeWitt v. American Family Mut. Ins. Co., 667 S.W. 2d 700, 704 (Mo. 1984). Fire insurance policies protect an entity's interest in the subject property, not the property itself. Mutual Benefit Ins. Co. v. Goschenhoppen Mutual Ins. Co., 572 A.2d 1275, 1277 (Pa. Super. 1990). Generally, any party who derives pecuniary benefit or advantage from the continued existence of the property or will suffer pecuniary loss from its destruction has an insurable interest in that property. DeWitt, 667 S.W. 2d at 705.
Generally speaking, a mortgagee has an insurable interest in mortgaged property to the extent of the mortgage debt. Ins. Co. v. Assurance Co., 131 S.E. 2d 36 (N.C. 1963). This interest in the property continues until the mortgage debt is extinguished or satisfied. Wilson v. Glancy, 913 P.2d 286 (Okla. 1995). Of course, the question then arises: what events constitute extinguishment or satisfaction of the debt? In situations involving a simple loss payable clause, courts are in agreement that if the mortgagee takes title to the property at a foreclosure sale, its insurable interest in the property has been extinguished. Aetna Ins. Co. v. O.E. Woods Lumber Co., 76 P.2d 273 (Okla. 1938). This is because the purchase extinguishes the debt, and also because it violates the policy clause forbidding a sale or change of ownership in the subject property. 19 A.L.R. 4th 778. Under simple loss payable clauses, any act that would avoid the policy in the hands of the mortgagor also allows avoidance of the policy as to the mortgagee. Id.
However, where the policy has a standard mortgage clause, many courts have held that the mortgagee's acquisition of title does not extinguish its insurable interest in the property because it does not violate any change in ownership clause in the policy. Travers v. Universal Fire & Casualty Ins. Co., 34 S.W. 3d 156 (Mo. Ct. App. 2000); Continental Ins. Co. of New York v. Rotholz, 133 So. 587 (Ala. 1931).This is because the standard clause constitutes separate and independent insurance of the mortgagee's interest, and the insurance must follow the property. In fact, a mortgagee's acquisition of title actually increases its interest in the property because it no longer merely represents security for a debt. Id. As owner of the property, the mortgagee has an insurable interest in protecting its property from loss by fire.
What is the extent of the Mortgagee's Insurable Interest?
If a mortgagee is held to have an insurable interest despite foreclosure, the question remains as to how much of the insurance proceeds it is entitled to recover. The answer to this question depends on the timing of the loss. Countrywide Home Loans v. Allstate Ins. Co., 246 S.W.3d 515 (Mo. Ct. App. 2007); Western Employers Insurance v. Bank of Ravenswood, 512 N.E. 2d 9, 10 (Ill. App. 3d 1987). A majority of courts considering the issue have held that where the loss occurs before the mortgagee has acquired the property in foreclosure, the mortgagee is entitled to recover only the amount of debt outstanding on the mortgage. Id. However, if the loss occurs after the mortgagee becomes the owner, it may be entitled to recover more than the mortgage amount. Tech Land Development, Inc. v. South Carolina Ins. Co., 291 S.E.2d 821 (N.C. App. 1982).
A mortgagee's right to recover under an insurance policy is fixed as of the time of loss. Builders Affiliates, Inc. v. North River Ins. Co., 91 A.D.2d 360, 362 (N.Y.A.D. 1983). Therefore, its entitlement to insurance proceeds is based on its status relative to the property at the time of loss because that determines the extent of its insurable interest. If the mortgagee does not own the property at the time of the loss, its insurable interest is only that of a creditor and is not really represented by the property, but rather in the debt owed by the debtor. Farmers, 405 N.W. 2d at 835-36. Therefore, a mortgagee is entitled only to the amount of the proceeds that fully satisfies the debt owed to it by the mortgagor because full payment relieves it of its status as creditor. Nationwide Mut. Fire Ins. Co. v. Wilborn, 279 So. 2d 460, 463 (Ala. 1971).
Courts disagree as to when the debt should be considered fully satisfied. The majority view is that a mortgagee who bids the full amount of the secured debt at the foreclosure sale is not entitled to recover any insurance proceeds because the taking of title constitutes a satisfaction of the debt. Whitestone Savings & Loan Ass'n v. Allstate Ins. Co., 28 N.Y. 2d 332 (N.Y. Ct. App. 1971). The only time the mortgagee retains an insurable interest is if it purchases the property at foreclosure for less than the amount of the mortgage debt. Prudential Ins. Co. of America v. German Mut. Fire Ins. Assn. of Lohman, 105 S.W. 2d 1001, 1005 (Mo. App. 1937). However, at least one court has found that a mortgagee's post-fire acquisition of property does not extinguish its insurable interest, and that it is entitled to the amount of insurance proceeds representing the difference between its foreclosure bid and the value of the damaged property. Georgia Farm Bureau Mut. Ins. Co. v. Brewer, 413 S.E. 2d 770 (Ga. Ct. App. 1991).
On the other hand, if the loss occurs after the mortgagee has taken title through a foreclosure sale, the general rule is that the mortgagee now has an insurable interest as owner of property, which interest is in protecting its property from loss due to fire. As such, its coverage under an insurance policy increases beyond its security interest in the property. 495 Corp. v. N.J. Ins. Underwriting Ass'n., 430 A.2d 203 (N.J. 1981). In addition, the foreclosure has occurred in the context of the insured property existing in its undamaged condition and the satisfaction of the mortgagor's debt takes into account the value of such property in its undamaged state. Lenart v. OCWEN Financial Corp., 869 So.2d 588, 590 (Fla. 3d DCA 2004) (citing Wilborn, 279 So. 2d at 464). Therefore, the mortgagee may recover for the losses it incurred after acquiring title without regard to the amount of outstanding debt owed by the mortgagor at the time of acquisition or the value of the property in its damaged state. Id. It can recover for the full value of the undamaged property, up to the limits of the insurance policy, because if the property happens to have greater value than the mortgage debt, the mortgagee should be able to retain the benefit gained through acquisition by receiving the insurance proceeds to restore the property to its original condition. Secured Realty Investment Fund, Ltd. v. Highlands Ins. Co., 678 So. 2d 852 (Fla. 3d DCA 1996); Laurel Natl. Bank v. Mut. Benefit Ins. Co., 444 A.2d 130 (Pa. Super. 1982); 495 Corp., 430 A.2d at 207.
Can Rescission as to the Mortgagor Affect Recovery by the Mortgagee?
Certain policies not only preclude recovery for a policyholder's intentional acts, but also permit a carrier to void the policy in the event of fraud. Carriers may also seek to rescind the policy because of material misrepresentations in the application for insurance. An issue then arises as to whether the carrier can avoid its obligations to the mortgagee because, in essence, where a policy is rescinded, it is as if the insurance contract never existed. Therefore, arguably, even under standard mortgage clauses, an independent contract could not have been created between an insurer and mortgagee because the underlying contract never existed.
Most courts considering this issue in the context of standard mortgagee clauses have held that a carrier cannot avoid its obligations to the mortgagee by declaring the policy void as to the named insured. Mattice v. Minnesota Property Ins. Placement, 655 N.W. 2d 336, 340 (Ct. App. Minn. 2002); Lavin v. Fireman's Ins. Co. of Newark, 1993 WL 436028 (E.D. Pa. October 25, 1993). This holding is premised on the language of the standard mortgagee clauses, which specify that the insurance as to the mortgagee cannot be invalidated by the mortgagor's intentional acts. Therefore, the validity and existence of the contract between the insurer and the mortgagor has no bearing on the validity of the separate contract between the insurer and the mortgagee, which is created by the standard mortgagee clause. Mattice, 655 N.W. 2d at 341. However, if the insurance policy at issue contains a simple loss payable clause, an insured's fraud on its insurance application voids the policy as to all parties, because the right of the mortgagee can never rise higher than that of the mortgagor. 24 A.L.R. 3d 435.
In Conclusion
When evaluating a claim made by a mortgagee for proceeds under a mortgagor's policy, the most important consideration should be the specific language of the insurance policy, as courts use this as a benchmark for the parties' rights and obligations. In addition to the type of mortgagee clause contained in the subject policy, however, it is important to consider the timing of the loss, as courts have often considered both variables as determinative of a mortgagee's right to recover for a loss caused by an intentional act of the named insured.
