A General Discussion

Summary: A standard mortgage clause is commonly incorporated into property policies covering both personal and commercial buildings. The clause protects the interests of the holder of the mortgage (the lender) and controls the disposition of insurance proceeds between the insured and mortgagor. The provision is generally regarded as a separate agreement between the lender and the insurer, independent of the borrower. This discussion describes the nature and purposes of the standard mortgage clause and reviews various issues and court decisions regarding its interpretation.

Topics covered:
Nature and purpose
Rights and conditions
Court interpretations
Subrogation
Other policy terms

Nature and Purpose

A mortgagee wishing to protect its financial interest in property that is the subject of a mortgage has two options. The first is to purchase insurance covering its interest. This type of insurance provides protection only for the mortgagee's interest in the property, which is usually limited to the balance of the outstanding debt at the time of loss. The mortgagee would have the responsibility of paying the premiums and maintaining the coverage in force. This coverage is discussed inMortgage Holder's Errors and Omissions Form.

Mortgagee protection errors and omissions insurance provides coverage of direct damage to property in which a lending institution has an interest when the damage occurs as a result of the institution's error or mistake. It also protects the insured institution against liability from failing to insure the mortgagor's property when this is required and the mortgagor suffers property damage loss. However, only losses covered under the insurance that should have been in force are covered under this contract.

The second option and the one more commonly chosen is to require that the mortgagor obtain insurance. Thus, the expense and responsibility of acquiring coverage and seeing that it does not lapse rests with the mortgagor. At one time, several different methods were used to protect the interest of the mortgagee on the mortgagor's policy: 1. The mortgagee could be added as an insured under the policy; 2. The mortgagee could also request an assignment of the proceeds of the insurance policy; and 3. The mortgagee could be named in a standard mortgage clause, which is usually considered the best method for protecting the mortgagee's interest for the reasons noted below.

The standard mortgage clause is commonly incorporated in forms applicable to dwelling property, such as homeowners and dwellings forms. It is also incorporated in policies covering business property such as the commercial building and personal property form. See ISO Homeowners Section I Conditions. The Commercial Property section contains an analysis of the mortgage clause from the commercial property coverage form; see Building and Personal Property Coverage Form. The homeowners policy calls the clause the “mortgage clause,” while the commercial property form calls it the “mortgage holders” clause.

Couch on Insurance 4 Couch on Ins. § 65:8 states that the standard mortgage clause is simply an agreement between the insurer and the parties as to the disposition to be made of the proceeds of the policy. Thus, the purpose of this clause is to protect the mortgagee's interest in the property which continues until the mortgage is paid. Naming the mortgagee on the dec page or by endorsement has the effect of activating the mortgage clause.

Rights and Conditions

The mortgagee's interest is not affected by foreclosure proceedings or similar action. The mortgage clause further provides that the mortgagee is to receive payment for covered loss of or damage to buildings or structures subject, of course, to its interest and the limits of the policy. The clause specifies that the mortgageholder will receive written notice from the insurer if the policy is nonrenewed or cancelled.

The mortgageholder also has a right to receive loss payment, but such a right is based on some conditions. If the insurer denies the named insured's claim, the mortgageholder has the right to receive loss payment if these duties are met: the mortgagee is required pay any premium due under the coverage part at the request of the insurer (if the named insured has failed to do so); must submit a signed, sworn statement of loss within 60 days after receiving a notice from the insurer of the failure of the named insured to do so; and must notify the insurer of any change in ownership, occupancy, or substantial change in risk known to the mortgageholder.

Note that the standard mortgage clause does not actually impose an obligation upon the mortgagee to pay the premium should the insured fail to do so. The stipulation that the mortgageholder pay any premium due is a requirement only if the mortgageholder wants to receive a loss payment. So, basically, this stipulation is construed as a condition only and not as a covenant. If the provision were viewed as a covenant, it would be interpreted as an absolute promise to pay on the part of the mortgagee rather than merely a condition precedent to securing the benefit of the insurance contract.

Finally, if the insurer pays the mortgageholder for any loss or damage and denies payment to the named insured for whatever reason, the mortgageholder's rights under the mortgage are transferred to the insurer; if the insurer pays the whole principal on the mortgage plus any accrued interest, the mortgage and note is transferred to the insurer.

Court Interpretations

Over the years courts have interpreted the standard mortgage clause as a separate contract. It is as if the insurer entered into an agreement to provide insurance coverage on the mortgagee's interest entirely independent of the mortgagor. The effect, in other words is to issue two policies, one to the mortgagor for the difference between the mortgage debt and the amount of the policy and the other to the mortgagee to the extent of its interest in the property.

There is, however, an important distinction to be made in considering the mortgage clause an independent contract. That is, the policy terms themselves are not nullified by the standard mortgage clause. Rather, this new contract that is made with the mortgagee contains all the provisions of the insurance policy covering the property. The point is that this new contract is subject only to the mortgagee's breaches.

Just as well established are the principles that a policy containing the standard mortgage clause in certain circumstances entitles the mortgagee to the proceeds of the policy and that the mortgagee's rights are not invalidated by the acts or negligence of the mortgagor. Thus, in Aetna Life & Casualty Co. v. Charles S. Martin Distributing Co., 169 S.E.2d 695 (1969), the court held that the mortgagee could indeed collect for the loss, even though the insured had set the fire. Likewise, a federal district court in J.B. Kramer Grocery Co. v. Glens Falls Ins. Co., 497 F.2d 709 (1974) held that the defense of the owner's arson was not available to the insurer in an action by the mortgagee.

The cancellation provisions in the mortgagee clause require that the mortgagee receive ten days notice of cancellation for nonpayment of premium or nonrenewal (a state law requiring a longer notice period would, of course, apply for mortgageholders also). Thus, the courts have held that where no notice was ever given by or on behalf of the insurer to the mortgagee, as required by the terms of the policy, no effective cancellation took place. Furthermore, the request of the mortgagor for cancellation was held not to be effective as to the mortgagee where the mortgagee did not receive notice. The form of notice is also important. The fifth circuit court of appeals held that oral notice to the mortgagee was insufficient to effect cancellation in Standard Fire Insurance Co. v. U.S., 407 F.2d 1295 (1969).

The mortgagee, as pointed out earlier in this discussion, does have certain obligations if it wants to retain the right to receive loss payment. Specifically, the mortgagee must notify the insurer of any change the mortgagee is aware of in ownership or occupancy of the premises and substantial change in risk. However, since the definition of “change” is not spelled out in the mortgage holders clause, how “change” affects the mortgage holder's position is subject to court interpretation.

Thus, the Georgia Supreme Court, in reversing a court of appeals, held in Hanover Insurance Company v. Federal National Mortgage Association, 257 S.E.2d 388 (1979) that the purchase of an insured building by the mortgagee was not a change in ownership of the property that would require notice of the change to the insurer. Rather the court stated, “the result of such proceedings is an enlargement or increase of the mortgagee's interest….”

In Frisby v. Central Mutual Ins. Co., 119 So. 2d 382 (1960), the insured premises were described in the policy as being occupied as a grocery. In fact, the premises were intended to be used and were used as a night club where illegal whiskey and gambling operations were conducted. The court found that because such facts were known to the mortgagee named in the policy and it did not notify the insurer nor pay the premium for the increased hazard, the policy was void and no recovery could be had by the mortgagee.

However, the failure of the mortgagee to inform the insurer of a change in conditions or increase in hazard will not always bar recovery. In Kinchen v. Lexington Ins. Co., 301 F.2d 301 (1962), the mortgagee of certain premises was informed approximately 10 days prior to a fire of the discontinuance of watchman service. The mortgagee did not in turn notify the insurer. The court held, however, that the failure of the mortgagee to notify the insurer of such discontinuance did not preclude the mortgagee from recovering because the notice could not have been in time for the insurer to have canceled the policy before the loss occurred. The court said that the mortgagee has a reasonable time in which to notify the insurer and the fire occurred before it expired.

It has been noted that the premium payment provision in the mortgage clause is a condition and not a covenant. Of course, the insurer must notify the mortgage holder that the mortgagor has not paid the premium to give the mortgage holder a chance to pay the premium that is due. If the mortgagor declines to pay, after receiving the notice, the insurance company may cancel as provided in the policy. If the insurance company does nothing after the mortgagor refuses to pay, it cannot recover the premium from the mortgagee if the policy runs on and no loss occurs. If a loss occurs, the insurance company may be forced to pay the mortgagee, but it then may deduct the premium for the settlement. General Credit Corp. v. Imperial Casualty & Indemnity Co., 95 N.W.2d 145 (1959) contains a comprehensive review of court decisions and the legal literature on this point.

Subrogation

Another area to note is the subrogation part of the mortgage clause. The insurer states that if it pays the mortgage holder for any loss or damage and denies payment to the named insured, the mortgage holder's rights under the mortgage are transferred to the insurer; that is, the right of subrogation against the mortgagor has passed to the insurer.

However, if the insurer is under an obligation to the mortgagor as well as the mortgagee, it is not entitled to subrogation to the mortgagee's claim as against the mortgagor until it has discharged its obligation to the mortgagor as well. As held in Southern Tier Cooperative Ins. Co. v. Coon, 385 NYS2d 830 (1976), the right of an insurer to subrogate to rights of the mortgagee upon payment to the mortgagee of a loss under a fire policy could take effect only upon a valid and well founded claim of nonliability to the mortgagor; the right to subrogation under a standard mortgage clause arises only if the insurer's payment to the mortgagee also discharges its obligation to the mortgagor under the policy.

One final point regarding the subrogation rights of an insurer. Often when a mortgagor has defaulted in the payment of his or her mortgage debt, the mortgagee will seek to recover its investment through a foreclosure sale. However, the fact that there has been a foreclosure sale does not alter the necessity that the mortgagee be fully indemnified before the insurer has subrogation rights. Furthermore, the mortgagee is covered under the standard mortgage clause to the full extent of the loss.

Other Policy Terms

Although the standard mortgage clause operates as an independent agreement for the purposes of protecting the mortgagee's interests against acts or omissions of the insured, it usually does not affect in any way the applicability of the other policy terms. A lot depends on the wording used in the other clauses of the policy.

For example, it was held in Mortgagee Affiliates Corp. v. Commercial Union Ins. Co., 276 NYS2d 404 (1967), that a mortgagee is required to meet the requirements after loss as to examination under oath and production of accounts, bills and other vouchers. On the other hand, in United States Fidelity and Guaranty v. Annunziata and Maresca, 492 N.E.2d 1206 (1986), the court ruled that the standard mortgage clause does not “[obligate] the mortgagee to comply with the provisions of the policy requiring the named insured to submit to an examination under oath. When the policy is construed as required by giving the words their plain meaning, there is no question that only the named insured—not the mortgagee—is required to submit to an examination under oath.”

These cases simply reflect the “named insured” versus “any insured” wording found on insurance policies that distinguishes between the two classes of insureds. Such a distinction applies to the mortgage holder.