These days, banks are finding themselves unexpectedly—and unwillingly—thrust into the real estate business. In fact, bank officers are often managing disparate collections of real estate holdings, in addition to focusing on their core competencies of underwriting, originating and servicing loans and customer accounts. Throw insurance coverage into that mix, and it's no surprise that we hear this common refrain: "I simply don't see how adding insurance to my list of worries will help us marshal our unintended real estate holdings—now worth far less than the amounts due on the related mortgage loans—and dispose of them for as much value as possible while minimizing additional losses."

This is an understandable concern, but failing to address it significantly increases risk. Creditors, particularly when taking possession of real property as a remedy for defaulted loans, should never underestimate the importance of prudent insurance practices as a risk management tool. In fact, good insurance management in connection with an "accidental" property portfolio can help creditors (1) monitor the financial health of borrowers, as well as the value and upkeep of secured properties; (2) marshal and oversee property holdings; (3) keep potential additional losses or liabilities to a minimum; (4) provide a backstop for breaches of responsibility or indemnification obligations on the part of retained management professionals; and (5) make the potential liabilities associated with lending practices more manageable.

Don't Forget Insurance Coverage

It is easy to take insurance coverage for granted in the day-to-day crush of business. Far too often, insureds do not become aware of gaps or limitations in their coverage until it is too late. The following hypothetical examples illustrate some of the risks that can be addressed through prudent and proactive insurance management.

• A community bank that provided a residential mortgage loan was identified as the loss payee on the homeowners' property insurance policy. When the homeowners began experiencing serious financial difficulties, they allowed their insurance coverage to lapse and eventually walked away from the house. The bank received notice of the lapse, but did nothing because the homeowners were already six months behind on their mortgage payments. Shortly after the homeowners abandoned the residence, there was a catastrophic fire. Because the policy had lapsed, the bank's status as a loss payee became much less valuable.
   
• The property policy insuring an older suburban mall excludes coverage if the insured property is less than 25 percent leased. The owner is trying to reposition the mall, but its occupancy rate has dipped to only 20 percent. As a result, the bank's status as a loss payee on the property policy likely will be of little help if the mall is badly damaged in a windstorm.
   
• A community bank has been forced to repossess more properties in the last year than it did in the prior 50 years. The properties—some vacant and others wholly or partially occupied by tenants—are in widely varying states of repair and some are proving difficult for the bank to unload. Although the insurance covering certain properties has lapsed, the coverage that remains in effect was issued by more than 20 different companies, creating a confusing jumble of inconsistent terms. For example, some policies cover the full replacement cost for property damage, but others cover only the property's actual cash value. Keeping track of disparate policy conditions and expiration dates while also trying to dispose of the relevant properties is an administrative headache.
   
• A small regional bank is sued in a putative class action by residential mortgagors who allege that the lender fraudulently steered them into loans with unfavorable variable interest rates, knowingly used inflated appraisals prepared by a company owned by a close relative of a loan officer, and was negligent in its loan servicing. The bank adamantly denies these allegations, but it still has to defend the lawsuit. During the recent renewal process, however, the bank did not notice that its professional liability/lender liability insurance policy has new terms that exclude coverage for lender liability claims when there is any allegation of fraud, when there is an alleged conflict of interest involving any employee, and when the claims concern residential mortgages.
   
• A community bank hires a local real estate broker to manage the residential properties on which it has foreclosed, including a half-finished, eight-unit apartment building that is enclosed and secured while the bank tries to sell it to a new developer. The broker is overwhelmed with its greatly expanded property management duties and does little more than a cursory weekly drive-by of the unfinished building. Unbeknownst to the broker, squatters move in and illegally obtain electricity by diverting it from a nearby utility tower. Eventually, there is an electrical fire that destroys the building. The bank believes that the broker was negligent in its management. When the broker looks at its errors and omissions policy, which includes property management as a covered activity, it is surprised to learn that it was required to inform the insurer if it undertook the management of more than a specified number of residential units—a threshold that has been exceeded. In addition, coverage is excluded for the management of vacant and/or unfinished properties.

Lessons Learned

The big-picture lesson from these examples is that managing the risks associated with a portfolio of troubled real estate mortgages requires the following: (1) advance planning and familiarity with the terms of the relevant loan conditions regarding insurance; (2) the effective enforcement of those insurance conditions; (3) understanding and accounting for the legal effect of relevant insurance policy terms; and (4) the effective coordination of insurance programs to account for changing risk and liability exposures.

Mortgage agreements almost always require that the borrower maintain (throughout the period of the loan) homeowners' or property insurance that identifies the lender as a loss payee and/or an insured under the policy. As the above examples show, however, these requirements provide little value or protection if they are not enforced or if the extension of loss payee status is too narrow. While protecting your interests can be as simple as maintaining and keeping track of the relevant proofs of insurance, it is also important to act quickly if you receive a notice of termination or cancellation for nonpayment of premiums. Lapsed insurance only magnifies risks and reduces the value of the mortgaged property should there be a loss.

Creditors should also know the legal consequences of the terms of their own insurance coverage, as well as the coverage of the of the parties with whom they contract, whether mortgagors or consultants. Does your insurance adequately respond to foreseeable risks or to changing conditions? The terms of the coverage offered to many financial institutions have changed as insurers have identified risks associated with the economic downturn. So-called "regulatory exclusions," limitations on the coverage provided to individual directors and officers for claims brought by receivers, expanded conflict-of-interest exclusions and exclusions to lender liability coverage for mortgage-related claims are among the limitations that insurers have attempted to impose in recent renewals.

Further, it is not enough to insist that a mortgagor or consultant have in place a particular dollar limit for the applicable coverage and identify your institution as a loss payee or an additional insured. The terms under which coverage is extended make a very real difference. For example, a creditor's ability to recover from property managers and other service providers may be compromised if their insurance coverage is limited regarding the services they provide, as in the case of the realtor that had limited errors and omissions coverage for property management services. Likewise, an occupancy threshold as a coverage condition in a commercial mortgagor's property insurance policy may not seem important in a thriving economy. But if the commercial rental market takes a turn for the worse, that provision may have significant economic consequences.

Finally, if you find yourself burdened with an ever-changing array of repossessed properties, do not treat them as a haphazard portfolio for which there are as many different insurance policies as there are properties. As with any collection of assets, it is possible to group them together into clusters and structure appropriate coverage programs based on their character and risk profile.

Although creditors never enter into mortgages hoping to acquire properties through foreclosure, recent economic conditions have made that scenario unavoidable. Therefore, it is critical that these "accidental" property owners understand the value of insurance coverage as an essential risk management too