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For Closing The Gap

Denials on mortgage claims can nosedive in the cracks left by policy wording.

March 04, 2011 Photo
A lender, or mortgagee, is bestowed with certain rights under a homeowners insurance policy by virtue of the wording in the insurance contract. But questions relating to the rights and obligations of mortgagees under the mortgage clause have arisen, especially as the foreclosure crisis has become a chronic condition. What's come to light is the imprecise wording of most homeowners policies with regard to lenders. A handful of claims have resulted in lawsuits that give some guidance as to how the courts see matters.

Foreclosure Notifications
When a notice of foreclosure is issued by a mortgagee, many insurers don't learn about it until after the property is destroyed by fire. Why? Most property policies state that a lender is required to notify the insurer of any change in ownership, occupancy, a substantial change in risk or an increase in hazard of which the mortgagee is aware.

The problem lies in the clarity of policy wording. Courts have reached differing opinions regarding whether a foreclosure amounts to an increase in hazard or risk and have generally based their decisions on whether or not the insurance policy at issue was clear regarding the mortgage company's obligations.

For example, in U.S. Bank v. Tennessee Farmers Mutual Insurance Co., an insured fell behind on her monthly mortgage payments, and the mortgagee, U.S. Bank, initiated foreclosure. The bank sent a letter to the homeowner stating that it had initiated a foreclosure, but it failed to notify the insurer that a notice of foreclosure was issued. Before the foreclosure process was completed, the homeowner and her husband filed for bankruptcy, which stayed the foreclosure proceedings. Shortly thereafter, the house was destroyed by a fire.

U.S. Bank sought coverage from Tennessee Farmers for the fire loss, but the insurer denied the claim, saying the bank's failure to provide notice of foreclosure was a breach of the policy's mortgage clause. The clause stated that Tennessee Farmers would "protect the mortgagee's interest in the insured building. This protection will not be invalidated by any…increase in hazard, change of ownership, or foreclosure if the mortgagee has no knowledge of these conditions [emphasis added]."
The case eventually found its way to the Tennessee Supreme Court, which held that the bank's commencement of foreclosure proceedings was not an increase in hazard requiring notification to the insurance company. The court offered the following as part of its reasoning:

...we decline to read into this policy an obligation to notify the insurer of the commencement of foreclosure. In our view, the insurer is essentially asking us to write a new contract for the parties in accordance with its idea of what the policy should have said [emphasis added]. This we decline to do, as our duty is to construe and enforce the policy as written, not make a new contract for the parties on different terms.

In other words, in order for the court to find in favor of the insurer on this issue, the policy must specifically require the disclosure of any foreclosure proceedings as a precondition to coverage.

Note, however, that the court's reasoning may provide an argument that notice of an increase in hazard is required if, during foreclosure proceedings, the mortgagee finds red flags that indicate that the mortgage loan it made was the result of fraud on the borrower's part.

Does Rescission Nullify Mortgagee Coverage?
The mortgage clause contained in most property policies does not address the impact of rescission on a mortgagee. Theoretically, a rescission would wipe away the entire policy, and the insurer wouldn't owe any contractual duties to anyone—not the insured or the mortgagee. It would be as if the policy never existed. However, the issue has not been unanimously resolved by the various states.

In Fayetteville Building & Loan Ass'n. v. Mutual Fire Ins. Co. of West Virginia, the court refused to bar the mortgagee's insurance claim on a damaged property even though the mortgagor's application for insurance contained fraudulent representations about its geographical location and proximity to a fire hydrant. The insurer argued that the material misrepresentations voided the policy from its inception and, therefore, the mortgagee should have no rights under the policy.

The court rejected the insurer's arguments and held that it had to show evidence that the mortgagee had prior knowledge of the fraud. The court quoted the reasoning in Germania Fire Insurance Co. v. Bally as support for its conclusion.
As is well known, many insurance policies are issued, primarily, to protect mortgagees. In fact, it is made a condition of the mortgage, as in this case, that the insurance shall be carried by the owner of the property to protect the interests of the mortgagee. This exaction by the mortgagee is well known to the insurance companies, and they are only too glad to take the risk. The insurer issues the policy to the mortgagor. It is a contract between the mortgagor and the insurance company. The mortgagee is not interested in the contract in its inception, and only becomes interested after its execution, when the mortgage clause is attached to the policy for his protection. We think the mortgagee, when a policy is presented to him with a standard mortgage clause attached thereto in his favor, is justified in assuming that the insurance company has satisfied itself that the policy is valid and free from impeachment for any conduct or act of the assured at its inception or prior to the attachment of the mortgage clause.

Conversely, the court in Young Men's Lyceum v. National Ben Franklin Fire Insurance Co. reached the opposite conclusion. In that case, the policy contained a warranty that the insured property was located within 500 feet of a fire hydrant, and the accuracy of the warranty was a condition precedent to coverage. Again, the issue was whether the insured's false statement voided coverage for the mortgagee. The court held that it did, in fact, void the mortgagee's coverage.

The court reasoned that, if the insured makes a false representation regarding a material fact that affects the risk and that would affect the insurer's decision to issue the policy or the premium it charges, that false statement could be the basis for rescinding the policy as to both the insured and the mortgagee.

In light of the conflicting opinions regarding the insurer's right to rescind coverage to a mortgagee when the insured commits fraud in the application for insurance, it would seem advisable for insurers to clarify their rights regarding this issue in their policies of insurance and within the related mortgage clause. Otherwise, claims outcomes are at the discretion of the court.

Mortgagee Deadlines for Filing Claims and Lawsuits
Another area of dispute is the time period for filing suit by a mortgagee. In Howe v. Mill Owners' Mutual Fire Ins. Co. of Iowa, the insurer sought to dismiss the mortgagee's lawsuit because of its failure to file suit within the contractual limitations period. The policy in that case stated, "No suit or action on this policy, for the recovery of any claim, shall be sustainable in any court of law or equity unless all the requirements of this policy shall have been complied with, nor unless commenced within twelve months."

The court upheld the insurer's claim because it found the policy to be clear and unambiguous as well as broad in scope as far as the rights of the plaintiff-mortgagee were concerned. Therefore, the court denied the mortgagee's claim because of its failure to bring suit within the contract period.
However, in a more recent case, U.S. of America (Small Business Administration), the Vermont National Bank, Plaintiffs v. Commercial Union Ins. Companies, Vermont National, as a mortgagee, filed suit against Commercial Union seeking coverage for loss to its collateral. The insurer filed an affirmative defense based upon its policy provision that stated, "No suit shall be brought on this policy unless the insured has complied with all policy provisions and has commenced the suit within one year after the loss occurs." The trial court construed the policy in favor of the insurer, but the mortgagee appealed.

The appellate court found that a standard mortgage clause is intended to protect the interests of a mortgagee from any acts or omissions amounting to a default by the insured. Citing Satchell v. Insurance Placement Facility of Pennsylvania, the Vermont court ruled that the mortgage clause operates as a separate contract between the mortgagee and the insurer; i.e., "The indemnity of the mortgagee is not placed at the whim of his debtor, and is subject only to breaches of which the mortgagee is, himself, guilty…and gives the mortgagee an insured interest that the insured does not have."

Therefore, the question that controls this case is whether the contract terms reasonably informed the mortgagee that the one-year period that bound the insured also bound the mortgagee. As stated in the policy wording, the time limitation in Commercial Union's policy imposed its one-year restriction on "the insured." Therefore, the court reversed the trial court's ruling and found in favor of the mortgagee:

It is a fundamental rule that a policy of insurance must be construed liberally in respect to the person insured and strictly with respect to the insurer. Stonewall Ins. Co., 130 Vt. at 566, 298 A.2d 826 (quoting Valente v. Commercial Ins. Co., 126 Vt. 455, 459, 236 A.2d 241 (1967)). "'We believe the general rule, that conditions in insurance policies inserted for the benefit of the company should be strictly construed against it, to be a sound one.'" Mosley v. Vermont Mutual Fire Ins. Co., 55 Vt. 142, 147 (1883) (quoting Turner v. Meriden Fire Ins. Co., 16 F. 454, 458 (D.R.I.1883)).

In the cases that have been discussed, the essential element in the courts' rulings on mortgagee rights and obligations vis-à-vis an insurer is whether the policy of insurance is clear and unambiguous on the matter involved in the claim. For three essential elements—foreclosure notifications, rescissions and filing deadlines—imprecise language has led to the reversal of claim denials.

As a point of advocacy, the claims units at insurance companies might be well served by taking control of the "bus," or at least providing the driver some navigational assistance. Mortgagee claims don't have to be such a bumpy ride, and they certainly don't have to end in a legal morass. It just takes closing the policy language gap.
Rick Hammond (hammondr@jbltd.com) is a shareholder with Chicago-based lawfirm Johnson & Bell, Ltd., He can be reached at (312) 984-3425 or visit www.InsuranceFraudLaw.com.
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