When entering into a lease of commercial property the subject of buildings insurance must be carefully considered. From a landlord’s point of view, its primary concerns will be to protect the capital value of its investment and to ensure that adequate funds are readily available to reinstate the property in the event of damage or destruction, with minimal loss to its rental stream. From a tenant’s perspective, it wants the comfort that it will not be responsible for remedying insurable damage and that it will not be required to pay rent for a property it cannot use.
There are many points to consider when negotiating the insurance provisions in a lease. This article will discuss the main issues for both parties and how they are dealt with in a typical commercial lease.
Who will insure?
In a market rent commercial lease, the landlord will almost always insure, being the party with the capital value in the building and generally best placed to arrange the cover. This is even more likely to be the case if there are multiple tenants in the building, as it would be complicated and unwieldy for each tenant to insure their own part. The landlord will be keen to retain control over the policy, ensuring premiums are paid on time and all insurer's requirements are complied with. The landlord will want sole conduct of making any claims and applying the monies received in repairing and reinstating the building. For these reasons there will usually be a prohibition in the lease on the tenant taking out its own policy.
As the policy taken out by the landlord won't be in the tenant's name, it is common practice for the tenant’s interest in the property to be "noted" on the policy and tenants often insist on this. This should result in the tenant being notified by the insurer if any claims are made on the policy or there are any changes affecting the cover or status of the policy. This does not mean that the tenant is joint insured or will have any say in negotiating a claim. Tenants often also try to negotiate an obligation on the landlord to procure that the insurer agrees to waive its rights of "subrogation" against the tenant. If an insurer waives these rights the effect is that they cannot step into the shoes of the landlord and pursue the tenant if any of the damage was caused by the tenant's negligence.
What should be insured?
Generally the landlord will arrange cover in respect of the building/s, public liability (if there are common parts) and loss of rent. The lease needs to clearly specify what property the landlord is obliged to insure. This could be a single standalone building or a whole shopping centre. A tenant will be keen to ensure that the policy not only covers its premises but also any other parts of the landlord’s estate with which the premises are interdependent, for example common parts of a building, an access road or a car park.
Landlords also invariably insure for loss of rent because in most leases, the rent will be suspended following damage to the property, unless and to the extent that insurance monies are withheld as a result of an act or omission of the tenant. The loss of rent cover ensures that there is no gap in the landlord’s income stream.
The landlord will be obliged to insure the property with a reputable insurer for the full reinstatement cost against an agreed list of risks (called "insured risks"). Definitions of insured risks are relatively market standard (at least in modern leases) but can vary slightly between leases depending on the characteristics or the location of the building and the availability of cover. Usually there is wording to allow the landlord to insure against any other risks which it reasonably considers prudent to insure against.
There will be certain agreed exceptions to the landlord’s obligation to insure. Typically the landlord will not be in breach if the tenant does anything to invalidate the policy or where the policy itself limits cover, for example flood risk may not be available in an area highly susceptible to flooding. Tenants should be wary of "excluded insurance items", which are parts of the property the landlord could insure against but has excepted from their obligation to, typically tenant's fixtures and sometimes also plate glass.
First and foremost the tenant will be required to reimburse the landlord for its share of the cost of the buildings insurance policy. In a lease of a whole building this may be the whole cost, or in a multi-let building a fixed percentage or fair proportion will be recovered from each tenant. The tenant will also be liable for the full cost of the loss of rent insurance. These sums are normally called “insurance rent”. In addition to the insurance rent the tenant will also be expected to meet its share of any excess and to reimburse the landlord for any insurance proceeds withheld by the insurer as a result of any wilful act or omission of the tenant.
The tenant will be obliged to comply with all the terms and conditions of the insurance policy and therefore it is crucial that this information is made readily accessible. A breach of this obligation may result in the tenant being required to meet a shortfall in insurance proceeds if the insurers refuse to pay out as a result of the breach. For this reason the tenant will want the landlord to be obliged to supply a copy of the policy and to notify it of any changes in policy requirements or terms of cover during the lease term.
What happens in the event of damage?
If the property is damaged by an insured risk the landlord will be obliged to make a claim under the policy and to spend the insurance money received in reinstatement. A tenant should be wary of wording which only requires the landlord to use the insurance proceeds received in reinstatement, as this may cause an issue if the proceeds aren’t enough. A tenant should, therefore, insist on a provision requiring the landlord to make up any shortfall out of its own funds. The landlord should be obliged to obtain all necessary consents from third parties (for example the local planning authority or a mortgagee). The landlord will want to be relieved of the obligation to reinstate if it is not possible to do so for any reason outside of its reasonable control.
Following damage to the property rendering it unusable or inaccessible, the rent will be suspended for the shorter of the time it takes the landlord to reinstate or the length of the loss of rent cover (typically two or three years). If the property has not been reinstated within the loss of rent period, there is usually a right for either party to terminate the lease. In such circumstances the landlord will be entitled to retain the insurance monies, on account of its capital interest in the property.
What about damage by an uninsured risk?
The property may be damaged by a risk against which the landlord has not insured or had no obligation to insure against. This could be because it was not an insured risk or cover was not reasonably available in the market. Historically leases tended not to deal with such damage, which effectively placed the risk on the tenant, but provisions dealing with uninsured risks are now considered market standard.
In the event of uninsured damage, typically the landlord will be allowed a certain period of time to elect whether it wants to reinstate (at its own cost) or terminate the lease. If the landlord elects to reinstate but doesn't do so after a prescribed period, that will usually trigger a right for the tenant to break the lease. As with damage by insured risks, the rent is likely to be suspended until the property has been reinstated, but unlike in the case of insured damage, there will be no insurance in place to compensate the landlord for the lost rent.
What other types of insurance should the tenant consider?
Tenants will need to separately insure their contents as such items will not be covered by the landlord's policy. Tenants may also want (or be obliged to) insure any parts of the property excluded from the landlord's insurance obligation, such as tenant's fixtures or plate glass. Tenants should also consider business interruption insurance, particularly after the experience of the pandemic, and indemnity insurance, if their lawyer's investigation of title revealed potential risks or irredeemable title defects. There may be others depending on the nature of the property and tenant.
Insurance provisions in a lease are a complex area and vitally important for both landlords and tenants. The above is just an overview of the main considerations in a typical commercial lease. We strongly recommend that legal advice is sought to ensure that all relevant issues are considered at the point of drafting.