In the first part of the series “The Mortgage Servicer’s Role in Navigating Insurance Claims,” we covered assessing the damage in the wake of a natural disaster and applying the proceeds when complying with the terms of mortgage agreements to protect against liability. In part two, we will look into protecting the mortgagee’s rights under a property policy.

Part II: Protecting the Mortgagee’s Rights under a Property Policy

Payment of insurance proceeds to a mortgagee are determined by policy specific language, interpretation of which can vary from one jurisdiction to another. In order to protect the mortgagee’s rights to insurer proceeds, it is important for the servicer to take appropriate steps to ensure those rights are not forfeited.

Property, or hazard, insurance policies are based on the concept of providing protection for an “insurable interest,” which is the insured’s financial interest in the value of the subject of insurance. A property owner has an insurable interest in the insured property, and secured creditors who have loaned money to the property owner also have an insurable interest in the covered property. Most mortgages or deeds of trust require the owner or mortgagor to insure the property and to provide coverage under the property policy to the mortgagee.

A typical mortgagee clause provides as follows: “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.” The “as interests appear” language refers to the mortgagee’s “insurable interest” in the insured property and is generally limited to the amount of the debt secured by the property. The scope of that interest is not specified in the policy. The extent to which the mortgagee is protected by the policy depends on the type of mortgage clause in the policy. Property insurance policies generally contain one of two types of mortgage clauses – an “open mortgage clause,” also called a simple clause, or a “standard mortgage clause,” also called a union clause or New York clause.

Under the open or simple mortgage clause, the mortgagee’s right of recovery under the policy is determined by the acts or negligence of the mortgagor. In essence, under an open mortgage clause, the mortgagee is simply a payee whose right of recovery is no greater than the right of the insured – that is, if the mortgagor is entitled to proceeds under the policy, then the mortgagee is also entitled to proceeds to the extent of its interest. If the mortgagor is not entitled to proceeds (such as in cases of fraud, arson, or vacancy), then the policy is also void as to the mortgagee.

A standard mortgage clause, on the other hand, creates a separate insurance policy between the insurer and the mortgagee so that even if the mortgagor breaches the terms of the policy, that breach will not automatically preclude the mortgagee from recovery under the policy. Since the insurer and mortgagee have a separate policy, the acts of the mortgagor will not automatically determine coverage as to the mortgagee. Because the mortgagee is deemed to have a separate policy with the insurer, however, it is necessary for the mortgagee to satisfy, independently, the conditions of the policy, such as notification regarding changes in ownership or risk. Failure to provide the notice required may void the policy.

One of the conditions of any policy is that the mortgagee take steps to notify the insurer if there is a change in the risk associated with the insured property. Some courts have found that an insurer properly denied coverage under a borrower policy where a foreclosing mortgagee did not provide notice to the insurer of a “change in ownership” or “substantial change in risk.” Some courts have found that foreclosure constitutes a substantial change in risk and have held that provisions voiding a policy for foreclosure or the commencement of foreclosure proceedings are enforceable.

It is also important for a servicer to protect rights to insurance proceeds at the time of the foreclosure sale itself. A lender’s right to recovery under a borrower’s property policy is determined as of the date of the loss and is generally limited to the amount of the unpaid mortgage debt. Because the rights of a mortgagee are determined as of the time of the loss, extinguishment of a mortgage or deed of trust by foreclosure that extinguish the entirety of the debt can result in forfeiture of the mortgagee’s rights to insurance proceeds. Courts appear unanimous across jurisdictions in holding that where the mortgagee bids the full amount of the debt at the foreclosure sale, the mortgagee forfeits any right to the insurance proceeds.

Servicers of loans in default should take the following steps to ensure proper application of these funds:

1. Advise the insurer when the loan is referred to foreclosure. In order to protect the mortgagee’s rights to potential insurance proceeds in the event of a loss, servicers should advise insurers when the property is referred to foreclosure.
2. Closely monitor properties scheduled for foreclosure. Aside from regulatory concerns of foreclosure, servicers should ensure that they are protecting the mortgagee’s rights to recovery of insurance proceeds. This may require postponing foreclosure sales if the servicer has reason to believe that there is damage or loss to the property.
3. Reduce foreclosure bid by the amount of available proceeds. Once a foreclosure sale is scheduled for a property that has sustained an insurable loss, bid instructions should reflect the amount of available insurance proceeds and should deduct those proceeds for the bid amount at sale to protect the mortgagee’s rights to such proceeds.