Magazine article Journal of Property Management

Allocating and Insuring Risks in Leases

Magazine article Journal of Property Management

Allocating and Insuring Risks in Leases

Article excerpt

One of the primary functions of a lease is to allocate the risks of losses that may occur to people or property. Too often, risks are allocated between the parties in an unclear or contradictory manner. Even worse, the responsibility to bear losses may be assigned to the party without insurance to cover that loss. These errors can have devastating consequences.

While these misallocations sometimes occur because of poor drafting of the lease, they more often take place because the parties do not understand or consider carefully the reasons for assigning risk and the importance of ensuring that insurance coverage follows the risk.

This article will use several examples to analyze the concepts of risk allocation and insurance coverage in leases and to demonstrate how to draft leases that better protect both parties.

Key concepts

It is important to begin by defining some very basic insurance concepts. Property insurance covers damage to property in which you have some insurable interest, or ownership right. You cannot insure something unless you have an insurable interest in it.

Therefore, while a tenant can insure the personal property and fixtures it owns and uses in its own premises, it cannot insure the building itself. Yet, the damage and destruction clauses of many leases force a tenant to pay for the restoration of any damage it caused to the building, especially if the damage was caused by the tenant's negligence or willful misconduct.

In the case of serious damage, where will the tenant get the money to pay for the restoration? Typically, the tenant will turn to its liability insurance to cover this loss. However, most tenants maintain only $1 million or perhaps $3 million in liability coverage. That amount will not go far toward the restoration of any major damage. Trying to force the tenant to pay for the remainder out of its own pocket will certainly involve litigation and probably result in the tenant disappearing or filing bankruptcy.

Tenant improvements

One area in which the lack of a clear definition can cause problems in both risk allocation and insurance coverage is tenant improvements. Leases often require tenants to insure and restore their own, non-standard improvements. But the dividing line between building standard improvements, for which the landlord is responsible, and the tenant's improvements is often left unclear in both the lease and insurance documents.

This vagueness may result in duplicate insurance coverage, as both parties insure the same improvements and pay premiums for that coverage; or it may result in gaps in insurance coverage, resulting from disputes between insurance carriers over which is responsible for paying for damage to the improvements.

Avoiding these problems are easy. All that is required is a clear definition in the lease of which improvements each party must cover. The parties may also want to consider having the landlord insure all the improvements because that may cost less, be more efficient, and will certainly avoid disputes over coverage.

Waiver of subrogation

Many leases have a waiver of subrogation provision, but few people realize how important it is. Subrogation allows one party to "step into the shoes" of another and pursue any legal actions available to that party. Thus, if a tenant's negligence causes $20 million in damage to the property, the landlord will ask its property insurance carrier to pay for the loss.

Without a waiver of subrogation clause, the landlord's insurance carrier will subrogate through the landlord and sue the tenant to recover the $20 million. But the tenant will not have $20 million of insurance to pay for that loss because its liability insurance is unlikely to be that high.

Including a waiver of subrogation in a lease protects the tenant from loss and possible bankruptcy and protects the landlord from the loss of a tenant and lengthy, expensive litigation. …

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