The Foreclosure Exposure

The number of residential foreclosures is up as property owners are unable or unwilling to catch up on mortgage payments. Foreclosures on commercial real estate are also increasing. As a result, the property insurance industry is experiencing an influx of claims from mortgage holders for damage to properties with borrowers in default, with foreclosure pending, and with foreclosure completed. The status of the foreclosure will be a determining factor in how the claim proceeds.

Suppose an insured, faced with foreclosure but still living in his home, intentionally damages the structure. The insured has a homeowners policy that lists a mortgagee in the standard mortgage clause. Can the mortgagee recover for this loss?

The answer depends in part on what stage the foreclosure proceedings are in. If foreclosure is pending, meaning there has been no legal conclusion to the foreclosure proceedings, the mortgagee can seek recovery under the standard mortgage clause of the homeowners policy. The mortgagee would have a good argument in favor of recovery. The standard mortgage clause is generally said to protect the mortgagee from act or neglect of the mortgagor. In other words, although the insured cannot recover for his own destruction of the property, the mortgagee can recover. For example, in one often cited case, Jones v. Motorists Mut. Ins. Co., the mortgagee had a right to recover despite the insured’s arson conviction.

The mortgagee generally can recover, but its recovery is limited to the amount of its mortgage lien, not to exceed policy limits. What if, despite the damage to the property, the mortgagee’s security in the property has not been impaired?The majority of courts have held that the mortgagee is entitled to recover for a loss despite the fact that its security in the property has not been impaired by the loss. For example, in Kintzel v. Wheatland Mut. Ins. Assn., the mortgagee recovered insurance proceeds although the property in its damaged state was sufficient to secure the mortgage debt.

Any recovery received by the mortgagee will decrease the balance on the insured’s mortgage debt. So does that mean the insured will benefit by the payment to the mortgagee? The standard mortgage clause is designed to prevent this result. It entitles the insurer to subrogate against the insured or take an assignment of the mortgage, enforceable against the insured. This provision in the standard mortgage clause is an exception to the general rule that an insurer cannot subrogate against its own insured.

The standard mortgage clause protects the mortgagee only against losses under Coverage A and B of the policy. Thus, if the damage in question consists of the insured’s removal of appliances from the home, assuming the appliances are personal property and not fixtures to the realty, the mortgagee would not be entitled to recover for this loss.

What if the mortgagee chooses to complete the pending foreclosure action after the loss, buying the property at the foreclosure sale with a full credit bid? (A full credit bid is a bid equal to the unpaid principal and interest on the mortgage debt plus costs, fees and other expenses of the foreclosure.) In the vast majority of jurisdictions, the mortgagee, having foreclosed with a full credit bid, will not be able to recover. For example, in Countrywide Home Loans v. Allstate Ins. Co., a post-loss foreclosure and sale extinguished the mortgagee bank’s right to recover under the insured’s policy. Courts reason that the foreclosure after loss extinguishes the mortgagee’s interest in the property. Courts’ reasoning in this respect constitutes an exception to the majority rule on collateral sources that an insured’s entitlement to recovery is determined as of the time of loss.

What if there is no full credit bid, but a deficiency judgment is entered at the foreclosure proceeding instead? A deficiency judgment is a judgment against a debtor for the unpaid balance of the debt in the event that a foreclosure sale fails to yield the full amount of the debt due.If a mortgagee forecloses and a deficiency judgment is entered, the mortgagee can recover insurance proceeds up to the amount of the deficiency. For discussion of this general rule, see 495 Corp. v. New Jersey Ins. Underwriting Assn.

Now suppose the insured damaged the property after foreclosure proceedings were complete, at the time the sheriff came to evict him. At this point, the mortgagee had become owner of the property and, in the vast majority of jurisdictions, would be entitled to recover as owner. The majority view is that when a mortgagee forecloses and assumes ownership of a property, it obtains an insurable interest in the entire property. The lien that the mortgagee extinguished through foreclosure no longer limits the amount of its insurable interest. As the New Jersey Supreme Court reasoned in 495 Corp. v. N.J. Ins. Underwriting Assn., “If the property happens to have greater value than the mortgage debt, the mortgagee should be able to retain the benefit gained through the acquisition by receiving insurance proceeds to restore the property to its original condition.”It should be noted that, correspondingly, the mortgagee would have the duties of an owner as well as the rights of an owner. For example, if a mortgagee seeks a replacement cost recovery, it would first have to repair or replace the damaged property.

Foreclosure status is pivotal in determining the ultimate payout to a claimant. If foreclosure is pending, the mortgagee may be able to recover up to the amount of its lien under the standard mortgage clause of the insured’s homeowners policy. If the mortgagee completes the foreclosure after the loss, the mortgagee cannot recover insurance proceeds if it acquires the property with a full credit bid; and if a deficiency judgment is entered, it can recover only up to the amount of the deficiency. If the insured damaged the property at the time of eviction after foreclosure was completed, the mortgagee can likely recover as owner of the property, up to its interest as owner, with the corresponding duties of an owner under the policy.

Sande L. Salstone is counsel and senior research analyst at the Property Loss Research Bureau (PLRB). For a workshop on mortgagee claims and foreclosure, attend the PLRB/LIRB’s Claims Conference March 21-24, 2010, in San Antonio (www.plrb.org).