Avoid 4 Costly Pitfalls When Allocating Lease Insurance Duties

One of the few positives to emerge from the pandemic for commercial leasing was how it got landlords and tenants to set aside historical mistrust and work together for their mutual welfare and survival. While the pressing issue at the height of the COVID-19 crisis was restructuring rent obligations, there are lots of other leasing issues where this approach could do both sides a world of good. Among these are lease provisions addressing insurance and responsibility for fire and other losses to the rental property. Instead of seeking to shift risks onto each other, landlords and tenants can and should work together to shift them to the insurance companies. The starting point is to recognize and take steps to avoid four common lease pitfalls that can expose one or both sides to massive losses.

1. Failure to Cover Full Rebuilding Costs

Pitfall: Commercial leases typically require the landlord and/or tenant to get property insurance covering the building against fires and other natural and manmade hazards. The problem is that the protection leases require may not be adequate.

A common example is a lease clause that requires insurance for the property’s “full insurable value.” While the phrase is omnipresent in leases and contracts, it has no fixed or universal meaning within the insurance business. Accordingly, there’s a tendency for whichever side that pays for the insurance (or its insurance agent) to interpret the language as requiring coverage only for “actual cash value.” The problem is that, technically, actual cash value is the cost of repairing or replacing the building, minus the value of the building’s “physical depreciation” up to the time of the fire or other catastrophe that caused the loss. Consequently, insuring a building for its actual cash value may not provide enough insurance money to rebuild after a catastrophic event occurs.

Solution: How you navigate the pitfall depends on who’s responsible for insurance. If it’s the tenant, require the tenant to get insurance based on the building’s “replacement value”—that is, the amount it would take to repair or replace the building with one of like kind and quality. Attorneys we spoke to recommend requiring insurance for 100 percent of the replacement value, but also suggest that 90 percent might be acceptable depending on the financial situation and bargaining leverage.

2. Assuming that Requiring Tenant to Pay for Covered Losses Will Protect You

Pitfall: Tenants should pay for the building damage and destruction they cause. While completely reasonable as a general principle, this approach that landlords commonly take isn’t always effective as a risk management strategy. So, leasing obligations based on the principle can have unforeseen costs and consequences.  

The first problem is that tenants may be in no position to cover your losses even if they want to. Saddling the tenant with liability for losses can also backfire even when you have your own insurance. Example: Consider the scenario where the landlord does have property insurance covering the building, including the cost of repairing damage or destruction resulting from a tenant’s negligence. A lease clause requiring the tenant to cover the costs of the loss could then put the landlord’s insurer in the position of forcing the tenant to reimburse it for what it pays on the landlord’s claims. The result could be to force the tenant into bankruptcy or out of business. And that could be highly disruptive to your own operations, especially if the tenant is a key tenant.

Solution: Ensure your lease includes a comprehensive “waiver provision” that protects both you and the tenant. Also make sure that the waiver provision works with your and the tenant’s current insurance policy. Because it’s hard to know in advance exactly what a landlord or tenant’s particular insurance policy will be, attorneys recommend using a broad waiver provision. A broad waiver will also protect you and the tenant if either of your respective policies are revised or replaced during the lease term.

Our Model Lease Clause: Include Comprehensive Insurance Waiver also includes a limited waiver of claims by both the landlord and tenant against each other. In other words, the landlord waives the right to sue the tenant and the tenant waives the right to sue the landlord for any claims that are covered by insurance, as long as the waiver doesn’t conflict with the insurance policy of the party granting the waiver. Such clause may or may not also be enough to protect the landlord or tenant from being sued by the insurer for negligence, depending on the laws of the particular state.

A waiver of subrogation can be useful where a landlord can’t give up its right to sue. Example: A landlord files a claim with its insurer after a tenant negligently burns down the building. Normally, by paying the landlord’s claim, the insurer, in effect, acquires any right that the landlord holds to sue the tenant for the costs of rebuilding. However, the insurer will have given up its right to sue if the insurance policy includes a waiver of subrogation.

Under our Model Lease Clause, each party must request a waiver of subrogation in all insurance policies required by the lease unless the policy expressly allows a waiver of claims.

The clause also addresses a third possibility. Because some insurance policies allow a landlord or tenant to grant a waiver of subrogation on the insurance company’s behalf, the Model Lease Clause includes a broad waiver of subrogation by both the landlord and tenant.

It’s fairly standard for landlords to require a tenant to seek a waiver of subrogation in its insurance policy. But landlords frequently refuse to seek waivers of subrogation from their own insurer on the tenant’s behalf. Typically, the reluctance stems from not wanting to exert the extra effort or pay the extra premiums required to get such a clause in the policy.

That’s a mistake, attorneys caution. Waivers of subrogation in insurance policies are often available for little to no additional cost. Moreover, like many landlords, you may be in a position to pass on your added costs to the tenants, paying only for the part of the expense that’s proportional to the amount of space in the building that’s vacant. More significantly, any slight increase in premiums that you do end up having to pay is likely to be trivial compared to the financial losses you might incur if a tenant was saddled with the costs of a big loss.

Practical Strategy: Once you’ve signed a lease with requirements applying to the other party’s insurance, be sure to follow up by ensuring that the insurance actually does meet those requirements. It’s not uncommon for leases to require tenants to furnish landlords copies of insurance policies once they’re issued but for landlords not to actually ask for those policies. In fact, you should request copies of the tenant’s insurance policies even if the lease doesn’t expressly give you the right to ask for them.

3. Claim Made After Lease Ends Not Covered

Pitfall: Liability insurance policies may be written on either a “claims-made” or “occurrence” basis. Policies written on a claims-made basis cover only claims filed while the policy is actually in force. As a result, they won’t protect you if a claim is made after the policy expires, even if the event that caused the loss happened while the policy was still in effect. By contrast, a policy written on an occurrence basis will cover a loss that occurs while the policy is in effect even if the claim is made after it expires.

Solution: Make sure your lease requires that tenants’ liability insurance be written on an occurrence, rather than claims-made, basis.

Example: In 2022, a tenant’s client is robbed at gunpoint inside the tenant’s office suite. The tenant has a commercial general liability policy written that expires in 2023 when the lease ends and the tenant moves. In 2024, the robbery victim sues both the tenant and landlord for negligence stemming from the 2022 attack:

• If the tenant’s insurance policy was written on a claims-made basis, the tenant would have no insurance to cover the losses caused by the victim’s negligence claims;
• If the policy was written on an occurrence basis, the insurance would cover the claims made in 2024 after the policy expired since the robbery occurred in 2022 while it was still in effect.

4. Inadequate Coverage for Multiple Claims

Pitfall: Insurance clauses in some leases specify only the minimum amount of liability insurance coverage “per occurrence” that’s required. For example, the clause may require a tenant to carry commercial general liability insurance with a combined limit of not less than $1 million per occurrence. Result: Coverage is provided for a claim of up to $1 million for personal injury and/or property damage.

In addition to a per-claim limit, insurance policies may also include a “general aggregate” limit on the total amount that will be paid out under the policy. Unfortunately, lease insurance clauses may fail to take general aggregate limits into account. And that can have disastrous financial consequences.

Example: Three separate claims of $1 million are made against a tenant that has a $1 million “combined limits” insurance policy. If the policy has no general aggregate limit, all three of the claims would be covered. The same would be true if the policy has a general aggregate limit of $3 million or above. However, if the policy is subject to a $2.5 million general aggregate limit, the insurance would cover only the first two and half of the third $1 million claims, leaving the tenant—and perhaps also the landlord—with $500,000 in uncovered losses.   

Solution: Make sure your lease requires the tenant to maintain liability insurance with a per-occurrence and general aggregate limit that are both adequate to cover any foreseeable loss or injury. If a tenant leases more than one location, it’s more likely to have more than one claim pending at a time. So, require it to have combined per-occurrence and general aggregate limits that are sufficient to protect against foreseeable losses.