Leasehold Interest Insurance Court of Appeals: VMM& Sec 240 Decisions Super Bowl & the Weather Outside is Frightful

Leasehold Interest Insurance Court of Appeals: VMM& Sec 240 Decisions Super Bowl & the Weather Outside is Frightful

This month, I want to expand my previous discussion of two problems: leasehold interest insurance and the definition of vandalism and malicious mischief, plus take a look at another NY Court of Appeals case. I’ll wind up with an odd-ball insurance coverage.

Leasehold Interest Insurance

As Rodney Dangerfield might have said, “Leasehold interest insurance don’t get no respect.” It’s misunderstood and overwhelmingly undersold.

The definition on a leading insurance reference website exemplifies the fog surrounding this coverage. It reads:

Leasehold Interest: Property insurance covering the loss suffered by a tenant due to termination of a favorable lease because of damage to the leased premises (emphasis added) by a covered cause. The principal coverage is the net leasehold interest, which is the present value of the difference between the total rent payable over the unexpired portion of the lease and the total estimated rental value of the property during the same period.1

That’s true, as far as it goes, but there are many more aspects to leasehold interest insurance and, most importantly, it’s not limited to damage to the leased premises. Cancellation of a lease by the property owner can be triggered by damage to the rest of the building even if there’s no damage to the premises leased by the insured. The trigger is often damage exceeding 50% of the replacement cost of the entire building, but it can be as little as 25%. It’s sometimes tied to the time it will take to complete the repairs or other criteria. It should be obvious that in many multi-tenant buildings sufficient damage could occur to trigger cancellation of a tenant’s lease even though there’s no damage to the tenant’s premises. A tenant should check what the trigger is in its lease.

They types of leasehold interest losses a tenant might sustain are illustrated by the areas of coverage under the ISO Leasehold Interest form CP 00 60 06 95:2

• Tenants’ Lease Interest, which is the difference between the: (1) rent the insured pays for its premises; and (2) rental value of the described premises. For example: the current rental value of many premises is much higher that the rent negotiated when the lease was originally negotiated. This may be due to changes in the area, changes in business conditions, general inflation, etc. To illustrate this, assume that the insured has 10 years to go on its lease at a rent of $10,000 a month and comparable space now rents for $15,000 a month. Should the landlord terminate the lease when the building is substantially damaged, it will cost the insured $5,000 a month more for the next ten years to rent similar space.3

• Bonus Payments, covers the unamortized4 portion of a cash bonus that will not be refunded to the tenant. A cash bonus is money the insured paid to acquire the lease. It does not include: (1) Rent, whether or not prepaid; or (2) Security.

If the lease permits assignment, one firm may take over another tenant’s lease because the rent called for in the current tenant’s lessee is below market. The current tenant will generally receive a bonus payment in exchange for assigning the lease.

• Improvements and Betterments   The definition of I&B in the Leasehold Interest form is identical to that in the commercial property form that I discussed in the November 11, 2013 issue of the Insurance Advocate:

Improvements and betterments are fixtures, alterations, installations or additions: (1) Made a part of the building or structure you occupy but do not own; and (2) You acquired or made at your expense but cannot legally remove

However, there are some coverage differences. Because the tenant’s interest has ended when Leasehold Interest coverage is triggered— the lease has been cancelled— there’s no need for the tri-partite discussion of what happens when the insured, someone else or no one replaces the I&B.. One troubling difference concerns the valuation of I&B. When the I&B are not replaced, the commercial property form calls for calculating the unamortized portion of the original cost of the I&B over the period of the lease including any lease extension options. The Leasehold Interest form is silent on whether or not to consider lease extension options in determining the length of the lease. When you write leasehold interest insurance, clarify this with the underwriter. Enter the agreed upon lease term in the Leasehold Interest Coverage Schedule (discussed below).

• Prepaid Rent is the unamortized portion of any advance rent the insured has paid that will not be refunded in the event the property owner elects to terminate the lease due to damage to the building.

Coverage for bonus payments, improvements and betterments and prepaid rent are tied to the insured’s monthly leasehold interest. For these three types of coverage, the monthly leasehold interest is calculated on a straight-line basis by dividing the original cost by the number of months left in the lease at the time of the expenditure. For example,

• Original expenditure for Bonus Payments, Improvements and Betterments, or Prepaid Rent was $240,000

• At the time of the expenditure, the lease had 24 months to run

• Monthly leasehold interest is $10,000

The most the insurer will pay for a loss is the insured’s net leasehold interest. Net leasehold interest is the monthly leasehold interest multiplied by the number of months remaining on the lease. The net leasehold interest automatically decreases each month. Using the above example, if, at the time of the loss there are 10 months remaining on the lease, then the maximum the insured can collect for its loss is $100,000; one month later it will be $90,000, etc.

For bonus payments, improvements and betterments, and prepaid rent the time value of money is not considered, however it is a factor for tenant’s lease interest. To reflect the time value of money, an amount to be received in the future is discounted at a chosen interest rate that reflects expected probable interest earnings and inflationary expectations.5 For example, if the chosen interest rate is 5%, then $1,050 due one year from now is equal to $1,000 today since $1,000 today would increase to $1,050 in one year at 5% interest.

When we’re dealing with a lease with monthly payments over a long period of time it would be possible, but very time-consuming, to calculate each month’s amount individually; fortunately a simple arithmetic formula enables solves the problem without complex calculations. It looks fearsome, but it requires only addition, subtraction, multiplication and division. A computer or hand-held calculator can do the calculation in a fraction of a second. However, ISO doesn’t want to include a frightening looking formula or write “take out your calculator,” so the commercial lines manual includes charts showing the factors to use to calculate the present value at various interest rates.

A chart with the factors for up to 400 months (33 1/3 years) is attached to the policy. For example, if the selected interest rate is 6% and the lease has 120 months to run, the chart shows a factor of 90.7243. The gross monthly leasehold interest is multiplied by this factor to find the insurer’s maximum liability at that time. The gross monthly leasehold interest is calculated for Tenants’ Lease Interest by subtracting the rent that the tenant pays under the lease from the monthly rent value at the time the calculation is done. Thus, if the current monthly rental value is $15,000 and the insured’s rent under its lease is $5,000; the gross monthly interest is $10,000. A calculation that ignores the time value of money would make the amount of the loss for the 120 months $1,200,000 (120 x $10,000). Multiplying $1,200,000 by the factor shown in the table, (90.7243), reduces the amount to $1,088,691.60, which would be the amount of insurance. That’s equitable for both the insurer and the insured, since $1,088,691.60 at 6% interest could produce a payment of $10,000 each month for 120 months.

Leasehold Interest Coverage Schedule  The leasehold interest coverage schedule is the “declaration” page that spells out the coverage. (ISO form CP DS 07 10 00) It calls for the following entries: • Inception and expiration dates of lease (As mentioned above, clarify with the underwriter whether the expiration date is to be based on the options to renew, if any, in the lease.)

• Months Remaining at Inception

• The form also contains space to enter interest rate to be used to value tenants’ leasehold interest and the premiums.

• For bonus payments, improvements and betterments and prepaid rent: monthly leasehold interest amount and the net leasehold interest at inception.

• For tenants’ lease interest coverage: the monthly leasehold interest amount and the gross leasehold interest amount. The net leasehold interest for tenants’ lease interest is the monthly leasehold interest amount times the factor shown for the selected interest rate.

An insured might have coverage for bonus payments, improvements and betterments and prepaid rent as well as tenants’ leasehold interest. For example, an insured might pay a bonus to take over an advantageous lease, thus creating the need for tenants’ leasehold interest coverage and bonus coverage. If the insured then renovated the premises by installing expensive improvements and betterments, that would create the need for I&B coverage. The total amount of insurance would be the sum of all the net leasehold interests. The premium for leasehold interest coverage is determined as follows:

1. Determine the average amount of insurance over the policy period by adding the amount of insurance at inception and the amount at expiration and dividing by 2.

2. Multiply the average amount that’s been calculated by the building (not the contents) property insurance rate to determine the premium.

Sources of Coverage Some insurers include coverage for leasehold interest in their enhanced property coverages. The amount of insurance is often quite low, but some insurers include it in a basket of coverages with a maximum total payment for all the items in any one loss of as much as $500,000.

If no amount is provided by the insured’s property policy or if the amount provided is inadequate, discuss leasehold insurance with clients. It can be a very large exposure that’s been overlooked. (Department of full disclosure: The only clients I’ve ever been able to convince to insure leasehold interest are those who purchased a valuable lease. They could see that the leasehold had value—they just paid for it. Others had exactly the same exposure even though they hadn’t paid out of pocket, but I couldn’t get them to see it!)

Two New Court Of Appeals Insurance Decisions

The NY Court of Appeals has weighed on two insurance cases in its new term. One concerned vandalism and the other was a Section 240 Labor Law case.

The vandalism case is Georgitsi Realty, LLC v. Penn-Star Ins. Co.6 The US Court of Appeals for the Second Circuit had certified two questions concerning vandalism to the NY Court of Appeals. The second circuit court asked whether an act performed on adjacent property that causes damage to the [insured’s] property may constitute “vandalism” under the [insured’s] property insurance policy and whether “malicious damage” can result from an act not directed specifically at the insured. The NY Court of Appeals has answered yes to both questions.

Combining this decision with the broad definition New York courts have applied to determine what constitutes vandalism (intentional doing of a wrongful act without legal justification even if there is no malice or ill will involved7) may make vandalism coverage apply to many more acts that damage covered property. The second case, Jose A. Soto v. J. Crew Inc., et al.8, involves a cleaning contractor’s employee, Jose Soto, who was injured when he fell from a ladder while dusting a shelf. Falling from an elevated level is a classic example of a Labor Law Section 240 claim. Section 240 gives the injured employee broad rights to sue the store owner and the building owner for amounts in excess of workers compensation benefits as well as for pain and suffering even though neither the store nor building owner controlled the work. (The sole remedy nature of workers compensation coverage prevents the employee from suing the employer.) One basis for establishing Section 240 liability is that the injured worker was not provided with suitable safety equipment. Soto submitted an engineer’s affidavit stating that Soto was not provided with proper protection because the ladder was not secured, such as being held by another store employee. The insurance companies defending the claim pointed out that there is another leg to establishing such a claim. Section 240 only applies to “the erection, demolition, repairing, altering, painting, cleaning or pointing of a building or structure.9” The insurers argued that “cleaning” in that section refers to cleaning only in connection with construction or demolition work; it doesn’t apply to ordinary cleaning. The Supreme Court (a lower court in NY despite its title) and the Appellate Division of the Supreme Court both agreed with the insurance companies. Nevertheless, Soto took the case to the NY Court of Appeals. That court has now also agreed with the insurance companies. Labor Law cases are extremely fact intensive. Jen Ehman, an attorney with Hurwitz & Fine in Buffalo, points out that there are four key issues with regard to Section 200, 240, and 241 cases:10

• Is this a statutory defendant?

• Is the project “covered” by the statute?

• Is the injured party “protected” by the statute?

• Is the accident an “event” within the contemplation of the statute.

• If any one of the four is missing, then it’s not a labor law case.

Adding a Labor Law provision requiring that the injury be “grave”11 before the employee sue the owners and/or contractors was a partial fix to the onerous application of the law. When the owner or contractor is sued, they in turn sue the injured employee’s employer alleging failure to properly manage the work. This is the so-called “third-party over” lawsuit. In effect the employee is suing his or her employer, something that the exclusive remedy doctrine of workers compensation was supposed to prevent. These cases can be extremely expensive to defend and, when the defense is unsuccessful, the awards can be huge. Originally enacted in 1885, these laws predate workers’ compensation, which didn’t gain traction in New York until the second decade of the 20th century. It made sense when workers had few legal protections; they cry out for further revision today.

Super Bowl May Require Super Insurance— And The Weather Outside (May Be) Frightful

The next Super Bowl game will be played in a northern clime for the first time since 1976. The Farmers Almanac predicts copious wind, rain, and snow around the time of the game.12Who knows? They may be right—the football powers-that-be obviously have a different expectation. If the weather breaks wrong, it’s not just the NFL and its teams that could incur a loss. Think of all the firms that expect profit from showing the game, selling to the fans, etc. Tell them about it. There’s insurance available. Houston Casualty has stepped into the breach. It is offering broad event cancellation insurance that would indemnify the insured for the loss of business income that might result from bad weather. Coverage can be purchased up to two weeks before the game.13  1 “Glossary of Insurance & Risk” Irmi.com . http://www.irmi.com/online/insurance-glossary/terms/l/leasehold-interest.aspx (accessed 11/24/13)

2 An indication of how little attention there is leasehold interest coverage is the date of the form edition, 06 95, that is June, 1995. The more frequently used property forms have been revised many times since then and now bear edition dates of October, 2012.

3 The policy will cover the present value of future rent loss. Present value calculations discount future expected payments to reflect the time lag. The promise to pay $1,000 a month from now is worth more than the promise to pay $1,000 ten years from now. The ISO commercial lines manual contains charts showing the discount for various time periods and rates of interest. This is discussed in more detail below. 4 Amortization refers to the spreading of payments over a period of time. Thus if the insured paid $500,000 to take over a lease that has 50 months to go, straight-line amortization would be $10,000 a month. The unamortized portion would be the portion that has not yet been amortized.

5 The present value of money (also know as the time value) is based on the concept that a given amount of money today has a greater value than the same amount of money in the future. The difference reflects interest earnings and inflation expected during the period. In simple terms, most people would chose to receive $10,000 today rather than $10,000 five years from now. In fact, they might prefer payment today to payment of a larger sum five years from now. I don’t know why it isn’t considered in calculating bonus payments, improvements and betterments and prepaid rent coverage, perhaps it’s because for smaller amounts and short periods, the difference is not great. 6 NY Court of Appeals Slip Op 6731 No. 156 October 17, 2013. I wrote about the original case in the September 9, 2013 issue of the Insurance Advocate

7 Georgitsi Realty, LLC v. Penn-Star Insurance Company U.S. Court of Appeals, 2nd Circuit. 11-4444-cv (12-21-12) 8 NY Court of Appeals Slip Op 06603 No. 162 October 10, 2013

9 N.Y. LABOR LAW § 240 : NY Code – Section 240: Scaffolding and other devices for use of employees – http://codes.lp.findlaw.com/ nycode/LAB/10/240#sthash.WGkowSRi.dpuf (accessed 10/31/13) 10 Jennifer Ehman “New York Labor Law Imposes Liability On Owners And Contractors For The Failure Of The Employer To Provide A Safe Place To Work” Presentation to Westchester-Fairfield CPCU Chapter seminar 11/20/13.

11 The law defines “grave” to mean: Death; permanent and total loss of use or amputation of an arm, leg, hand, or foot; loss of multiple fingers; loss of multiple toes; paraplegia or quadriplegia; total or permanent blindness; total and permanent deafness; loss of nose; loss of car; permanent and severe facial disfigurement; loss of an index finger or an acquired injury to the brain caused by an external physical force resulting in permanent total disability.

12 Ken Belson “Almanacs Foresee a Super Bowl to Test Fans’ Resolve, and Snow Gear” NY Times November 23, 2013 http://www.nytimes.com/2013/11/24/sports/f ootball/almanacs-foresee-a-super-bowl-totest- fans-resolve-and-snow-gear.html?_r=0 (accessed 11/30/13)

13 Anne Freedman “Dewitt Stern Protects Super Bowl Revenue” Risk & Insurance October 1, 2013 http://www.riskandinsurance. com/story.jsp?storyId=533354950 (accessed 11/30/13)