UK: Terrorism Insurance in Today´s Market

Last Updated: 27 June 2002
Article by Shelagh McKibbin

A standard commercial property insurance policy covers loss or damage to property caused by fire or explosion, but where the cause of that fire or explosion was due to a terrorist act, insurance cover was generally limited to £100,000. However, the insured could purchase extended cover, and since the mid 1990s, the insurance market for terrorism insurance had been bullish and premiums relatively low.

In addition to the market generally, extended cover was available through the Pool Re Scheme. This is a government backed reinsurance scheme which meets the cost of claims over £100,000 occurring as a result of terrorism in Great Britain (ie not Northern Ireland). It was established by legislation in 1993 because the reinsurance industry declined to cover terrorism as a result of escalating IRA attacks - triggered by the St Mary Axe bomb in 1992. If the Pool Re funds are exhausted the government picks up the balance of all claims as reinsurer of last resort.

Authorised insurance companies and Lloyds Syndicates are eligible to be members of Pool Re. The insured pays the premium for the extended cover to the reinsured members of Pool Re; premium rates are set by agreement with the government and are calculated by reference to property valuers and rating zones.

Post 9/11

Even before 9/11 world insurance markets had been jittery because of poor underwriting results and a number of high profile insurance company failures. Insurance companies had already begun to narrow the scope of cover they were willing to provide, and in the US, some companies had withdrawn from the real estate insurance market altogether. Premiums were increasing and greater emphasis was being placed on risk management regimes.

Since that tragedy, UK insurers have begun to exclude loss or damage by terrorist action from new policies or on policy renewals after 1st January 2002, because the re-insurance industry will no longer cover the risk. Property owners, occupiers and mortgagees are therefore considering the wording of insurance policies closely to check whether they are adequately insured against loss or damage caused by an act of terrorism. They are also examining the terms of their leases and security documents to ascertain their position, should their premises be damaged or destroyed by an act of terrorism.

Currently, the only available cover for terrorist risk is through the Pool Re scheme, which has (and always has had) limitations (although at least for the time being it has said it will cover fire and explosion caused by any terrorist act within the definition of terrorism in the 1993 Act which established Pool Re, and hold its rates).

DRAWBACKS OF POOL RE
  • it is available only to insured parties whose insurers are members of Pool Re (although most of the big insurance names are)

  • it covers terrorism damage caused by fire or explosion only, so loss or damage caused by flood, impact (arguably) and chemical attack are not covered;

  • the definition of terrorism in the Re-insurance (Acts of Terrorism) Act 1993 which established Pool Re is limited, and of particular significance, having regard to the events of 9/11, does not cover terrorist activity for religious or ideological purposes;

  • a freeholder or landlord cannot pick and choose which of its buildings to insure; reinsurance cover with Pool Re is available only for the whole of a freeholder/landlord’s property portfolio (although the insured can opt not to take out cover for business interruption, which obviously reduces the premium);

  • if Pool re makes a loss in any year, its insurance company members can be called upon to make an additional payment (of up to 10% of the premium).

The Association of British Insurers, the BPF and other interested parties in the property market are lobbying Government to address these issues, but this will take time since it may well need legislation to correct the deficiencies.

Pending clarification of the situation, many landlord clients now have limited, or even no, terrorism insurance at all, leaving landlords, tenants and funders exposed.

In the medium to long term this will affect relocation and financing decisions, and the widespread absence of insurance cover may make property untradeable. All of this will inevitably impact adversely on the property investment market. Also, there is evidence emerging in the market that the issue of uninsured risks is beginning to be raised in rent review negotiations, giving rise to a concern that a two tier market may emerge in leases which deal with uninsured risks and those which don’t.

Uninsured Risks - Landlord and Tenant Exposure

In most leases, the landlord will not have given an unequivocal covenant to insure against loss or damage caused by an act of terrorism. Older leases are often completely silent on the subject; leases granted more recently generally enable the landlord to exclude from its insurance obligation risks (notably acts of terrorism) which are either not insurable at all or are not insurable at a reasonable cost.

Leases generally require the landlord to reinstate loss or damage caused by an insured risk. There is generally no obligation to reinstate if the loss or damage is caused by an uninsured risk, and furthermore the cesser of rent provisions will not kick in this situation. The drafting of the tenant’s repairing covenant may mean that technically it is obliged to reinstate the premises at its cost as well as continue to pay the rent. A tenant is going to resist this most strenuously. It may seek to claim that the lease is frustrated; this is an evolving area of the law and under present circumstances, the tenant may well succeed in this argument.

There may be a right for the tenant to determine the lease if the landlord has not reinstated the premises (at its cost) by the expiry of the loss of rent period, typically 3 – 5 years depending on the nature of the premises. In this case, whilst the tenant is required to pay the rent for this period, it will then be off the hook and the landlord will be left with damaged or destroyed premises, no insurance proceeds with which to reinstate and no tenant.

Leases generally require the tenant to pay the insurance premium, whatever the cost. Qualifying terms such as “fair and reasonable” will be fairly meaningless since, if the tenant insures with Pool Re, the premium is in effect fixed by the Government. Moreover landlords will be more reluctant than previously to agree such qualifying terms given the recent hikes in insurance premiums generally.

The standard tenant’s unqualified covenant to comply with the insurer’s requirements and recommendations (often objected to or qualified by tenants and their advisers) will now be insisted upon by landlords because failure to do may result in the insurer cancelling or avoiding the policy. It is likely to be strengthened by a requirement to keep the landlord and its insurers advised of the tenant’s risk management procedures.

For structuring reasons, it has become commonplace for landlords and occupiers to be set up as special purpose vehicles (SPVs). However, property owners and funders will be likely to object to this now, at least without adequate security, since SPVs are unlikely to have the means to reinstate uninsured damage.

Negotiated Solutions

There are an increasing number of negotiated solutions to deal with this issue; these depend upon the negotiating strength of the parties, the location of the premises, the importance of the location to the tenant and other relevant factors.

Frequently each of the parties accepts a degree of risk sharing; after all, damage or destruction by an act of terrorism is clearly a no-fault situation. For example, the landlord may have a period in which to decide whether or not to reinstate at its cost. During this time the tenant may pay no rent, or a reduced rent. If the landlord takes the decision to reinstate, the tenant will remain on the hook and depending on the negotiations, pay rent, or a reduced rent, for an agreed period (but this will not usually be the whole of the time it takes the landlord to reinstate).

Increasingly, however, tenants are refusing to accept any risk at all on the basis that they have no capital interest in the land or building; they simply want to walk away if the unthinkable happens, or worse, oblige the landlord to reinstate at its cost. They also want to exclude responsibility to reinstate damage or destruction by an uninsured risk from the scope of their repairing obligations. Moreover tenants may well seek to exclude or limit their liability to pay any additional premium. This position is not going to be acceptable to most landlords, particularly institutions and those funding development.

We have come across a number of recently negotiated compromises.

DRAFTING SUGGESTIONS
  • A tenant may agree to repair minor damage (such as the replacement of windows which have been blown out by an explosion).

  • The whole of damage or destruction by an uninsured risk (as well as insured risks) is excluded from the tenant’s repairing liability, but the tenant is unable to determine the lease if the landlord decides within an agreed period to reinstate at its cost; however, the tenant pays no rent at all, or at best a reduced rent, during the period from the date of damage or destruction until the reinstatement works are completed.

  • The parties agree an obligation on the landlord to reinstate at its cost where the cost of doing so amounts to less than an agreed percentage of the reinstatement value of the premises, with the tenant paying rent, or a proportion of it, for an agreed period, but where the damage or destruction is more substantial, the landlord will have a first right to decide whether or not to reinstate with a mutual break right thereafter.

Lenders and Borrowers

Funders lending against property have a clear concern to protect their security by requiring, in the loan agreement, that the property is comprehensively insured. A failure to insure in accordance with the loan agreement could result in the funder having the right to accelerate the loan without the borrower having the means to repay it.

In the past, the borrower's insurance covenant in favour of funders in respect of terrorism insurance has varied depending on what is negotiated. At one end of the spectrum, funders have required an absolute obligation to take out terrorism insurance – whether or not it is available and whether or not it is obtainable on reasonable commercial terms. The view of funders here is that the availability and cost of terrorism insurance should be at the risk of the borrower; if it is not available (or not obtainable on reasonable commercial terms) the funders want the ability to control the situation; they, therefore, want the right to accelerate the loan (and if necessary enforce their security over the property to repay their loan). Borrowers argue that this is inherently unfair in that they may face their loan being accelerated as a result of circumstances beyond their control. Funders are generally unsympathetic to this argument and require the risk to sit with the borrower.

At the other end of the spectrum, some funders have accepted that the terrorism insurance covenant in the loan agreement should only apply for such time as terrorism insurance is available on reasonable commercial terms in the London insurance market. Even before 11th September, funders’ views on terrorism insurance have been generally hardening and funders are increasingly reluctant to accept this position, insisting on the borrower having an absolute obligation to take out terrorism insurance. Many funders view 11th September as further justification for the hardening of their views.

Subject to the terms of the lease and the insurance policies themselves, funders generally seek to have the right to have insurance proceeds applied in prepayment of the loan. Some funders are willing to agree regimes about reinstatement where it is economically viable to do so. A key point for both landlords and tenants to appreciate is that where funders exercise their security, the funders will have access to the insurance proceeds to repay their debt, since almost invariably the funder will be a composite insured and/or will be named as loss payee. However these clauses overlook the fundamental duty of the property owner to reinstate damage – one owed to tenants and funders alike. The maximum proceeds from an insurance claim will only come from a reinstatement claim. An indemnity settlement – where no repairs are carried out - will generally be for far less. As such, it is unlikely that they will be sufficient to satisfy the funders’ outstanding debt. Far better to reinstate both the building and the income stream.

Funders will insist upon full compliance with the insurers’ requirements in respect of the borrower’s risk management procedures.

What the Future Holds

One thing is clear and that is that the commercial real estate insurance market is not going to revert to the position of a few years ago. In an increasingly volatile political world, terrorism insurance will become more and more expensive and governments are going to have to stand behind the reinsurance market as reinsurers of last resort. Of the European countries, only France has so far set up similar arrangements to the UK but all of the others are considering their position. The ABI and other interested parties are lobbying the Treasury to make up the gap between the total exclusion now being applied and the cover currently available from Pool Re but thus far, its response has been slow and unsatisfactory. Watch this space!

This e-brief was produced in conjunction with Bill Gloyn, Chairman of the Commercial Property Practice Group of AON.

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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