Improve and Better Improvements & Betterments Coverage

Improvements and Betterments (I&B) coverage in commercial property insurance policies is something you studied when preparing for the broker’s exam and probably haven’t paid much attention to since. That can be a big mistake. I&B can involve millions of dollars. In one high profile loss, a restaurant’s I&B claim was over $17,000,000. Even a moderate- size firm with fewer than 50 employees and just functional furnishings in its office, spent close to $1,000,000 on the build-out of the space. You ignore I&B at your client’s peril—and perhaps yours.

Standard practice in the metropolitan New York area is for commercial tenants to lease raw space and build it out to suit their needs by installing interior walls, doors, and decoration at their own expense. That’s why I&B are so important.

Let’s start by looking at the definition of I&B in the ISO commercial property:

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

A tenant does not own the I&B. By definition they are a part of the building that the insured occupies as a tenant and that it cannot legally remove.

Once they are installed, they become the building owner’s property. The value is automatically added to the insurable value of the building and the building owner can collect on its insurance for the damage to them by an insurable peril. The tenant’s business personal property coverage does not cover I&B per se; it covers the tenant’s use interest in the I&B. The amount that each varies with the exact circumstances:

1. Nothing, if another party pays for the repairs or replacement. (This avoids duplicate payments to both the landlord and the tenant.)

2. The actual cash value of the I&B if the tenant-insured does the repairs. If the tenant carries replacement cost coverage, it can collect the replacement cost for the I&B when it repairs or replaces them. (I strongly recommend replacement cost, if the tenant intends to restore the premises after a loss.)

3. If the I&B are not repaired or restored, the tenant-insured can collect remaining value of the cost to originally install the I&B. The remaining value is calculated by multiplying the original cost by the time remaining from the date of the loss until the expiration of the lease and dividing by the time from the installation of the I&B until the expiration of the lease. If the lease contains an option to renew—and many do—the expiration date of the last extension is the date used for the expiration of the lease, even if the insured has not yet exercised that option. And, since the policy doesn’t say otherwise, even if the insured will most likely not renew.

An example may make this clearer. Legal Eagles (LE), a fictitious law firm, leased its current offices on July 1, 2005. This lease runs for ten years and contains an option to renew for another ten years. On July 1, 2010, LE reconfigured and remodeled the interior of the office at a cost of $500,000. It also purchased $700,000 of new desks, chairs, tables, etc.

On July 1, 2013, a fire totally destroyed the office. The lease provided that if the building damage amounted to more than 50%, the building owner could terminate the lease. Because rents in the area had increased, the building owner exercised its option to end the lease. Therefore, the I&B installed by LE were not replaced.

The building owner can collect for the actual cash value of the I&B under its policy— I&B become part of the building as soon as they are installed. It could collect replacement cost if it replaced the I&B.

The tenant can collect the actual cash value of the desks, chairs and tables as part its business personal property loss. (It could collect replacement cost if they were replaced even at another location.) But if the I&B are not replaced, the tenant can only collect a portion of the value of the I&B. As stated above, that would be calculated by multiplying the original cost ($500,000) by the length time from the date of the loss (7/1/13) until the expiration of the lease renewal option (7/1/25), that is 12 years, and divided by the length of time from the date of the installation of the I&B (7/1/10) until the expiration of the lease renewal option (7/1/25), that is 15 years. To put it in insurance terms, the tenant can collect for the “unexpired” portion of its use interest in the I&B. The total expected time of use was 15 years and the tenant had use of the I&B for three years, so 12/15th of the original cost is unexpired. The insured can collect $400,000; that’s 12/15th of the original cost of $500,000.

Setting the Right Amount of Insurance for I&B is Vital

If the tenant carries replacement cost coverage2 and expects to repair any damage to the I&B, the amount of insurance should be the replacement cost of the I&B. If the policy is written on an actual cash basis, it’s more complicated. A tenant that expects to repair the damage and whose coverage is written ACV, needs at least an amount of insurance equal to the ACV of cost to replace all the I&B. However the “unexpired” portion of the I&B might exceed the ACV in the case of a long-term lease. Since extensive damage might result in the termination of the lease, you should compare the “unexpired” portion of the I&B with the ACV of the I&B and select an amount of insurance equal to the higher.3

Coinsurance provisions and seasonalincrease additional coverage provide other reasons to select the correct amount of insurance. If the policy is subject to coinsurance, the value of the I&B is included in the total value on which coinsurance is based, whether or not the I&B are damaged. This can result in substantial coinsurance penalty. If the policy contains a seasonal increase provision, and most BOPs do, improvement and betterments are included in the total values to determine if the seasonal increase, generally 25%, will apply.

Many insureds have learned to their dismay that the amount they can collect for damage is reduced by the operation of the coinsurance provision because they neglected to include I&B values when determining the amount of insurance needed to satisfy the coinsurance formula.

Although many BOPs do not contain coinsurance provisions, the seasonal increase provision, common in BOPs, is triggered only if the amount of insurance equals 100% of the average value of the preceding twelve months values. A large New York City bookstore on Columbus Circle was destroyed by fire. The amount of insurance carried was inadequate to cover the loss. The public adjuster told the insured not to worry, the seasonal increase provision would provide an additional 25% in coverage. Not so fast replied the insurer. The value of I&B are part of the business personal property values. When they were added in, the amount of insurance did not come close to 100% of the values for the preceding 12 months. The insured did not get the benefit of the 25% increase in insurance. Some Items are Not I & B

Often a commercial lease will make the tenant responsible to repair building components such as plate glass windows, HVAC equipment, etc. That doesn’t make them I&B. They are part of the building that the tenant leased. They should be covered as building items. Because making the tenant responsible for plate class windows is so common, ISO and some other insurers have provided coverage as part of business personal property in some policies.

The ISO BOP policy reads:

Covered Property

Exterior building glass, if you are a tenant and no Limit of Insurance is shown in the Declarations for Building property. The glass must be owned by you or in your care, custody or control (emphasis added).4 The ISO commercial property form doesn’t include this provision, but there is an endorsement, Building Glass – Tenant’s Policy CP 14 70 06 07 that can be used to add similar coverage.

What if the Building Owner Paid to Install the I&B?

It often happens that the building owner pays for the I&B as an inducement to the potential tenant5. The lease, however, will often obligate the building owner to repair or replace only structural items, not the I&B. Can the tenant collect under its insurance if it replaces the damaged I&B?

This was a serious problem in many of the World Trade Center 9/11 losses. The $17,000,000 loss mentioned at the beginning was one of those losses. The insurance company originally took the position that there was no coverage for the I&B because they were not made at the insured’s expense. The insured’s attorney responded with a long letter, the gist of which was that if the building owner had not reimbursed the tenant for the cost of the I&B, the tenant would have demanded a lower rental. Therefore, he asserted, the tenant had effectively paid for the I&B. The case settled so we don’t have the benefit of a court’s opinion.

Diana Reitz, CPCU, an editor for the FC&S Online bulletin doesn’t agree. In discussing questions she and her staff receive about I&B paid for by the owner she writes:

…I maintain that “acquired or made” means that the tenant must have actually paid for them, had them installed, or personally installed them. But often subscribers counter that the term should encompass a tenant paying a higher rent because the property was built-out by the owner.

I don’t think that qualifies. After all, how can we prove that the additional rent actually subsidized the build-out? How much of the rent should be allocated to the basic real property and how much to the fixtures and alterations that made the space suitable for the tenant’s use?6

I don’t agree. The policy doesn’t say that the insured must have paid the full value of the I&B, only that they were made at its expense. The I&B had value and the insured would almost certainly have received some reduction in rent if it had paid for the I&B; even if it weren’t dollar for dollar. That, in my opinion, satisfies the requirement for “made at the insured’s expense.”

But when you’re arranging insurance for a client, don’t rely on “opinions.” Find out the facts regarding payment for the I&B, spell them out for the underwriter and get his or her agreement as to coverage. If the underwriter won’t cover them as I&B, then cover them as a building item. The tenant is often obligated to do the repairs and, in any event, has a use interest in the I&B until the expiration of the lease. That’s more than sufficient to give the tenant an insurable interest.

What if the Lease is Cancelled, but I&B aren’t Damaged?

There’s yet another facet to the I&B riddle. What if lease is cancelled due to damage to the building, but insured’s I&B aren’t damaged? That might result in cancellation of the tenant’s lease if there’s sufficient damage to the building it occupies, even though there’s little or no damage to the insured’s I&B. Can the insured suffer a financial loss loss? Of course it can. Cancellation of the lease means the loss of the use value of the I&B. Can the insured collect under its business personal property coverage for this loss? Of course not. To paraphrase the basketball concept of no harm, no foul—no damage, no insurance coverage. Can we close the gap? Yes, leasehold interest coverage.

Leasehold interest insurance is even less common than proper I&B coverage. I&B coverage is part of the standard forms, so it’s a question of setting the correct amount of insurance and determining what’s covered as I&B versus what requires building coverage. Few policies contain coverage for leasehold interest; some add a limited amont for it in a coverage enhancement endorsement, but most don’t even do that.

In brief, leasehold interest insurance covers the loss an insured sustains when a lease is cancelled due to damage to the premises by a covered cause of loss. (It can cover more situations than the loss of the use value of I&B, including tenants’ lease interest, bonus payments, and prepaid rent.) It’s a complicated topic. I’ll discuss it in detail next month.

1 Form # CP 00 10 10 12 © Insurance Services Office, Inc., 2011. Just to keep us on our toes, this definition is not included in the definition section of the form, but in the “Your Covered Business Personal Property” in the coverage section.

2 When the replacement cost option is selected, ISO forms specifically provide replacement cost coverage for I&B. Not every form does. This is often the case with businessowners policies and surplus lines policies. Check the form to be sure.

3 If the current replacement cost of the I&B is less than the original cost, the same type of discrepancy can occur with replacement cost coverage.

5 Building owners are more willing to pay for I&B than to reduce the rent even when the net amount to be received by the building owner is effectively the same. The reason is that the appraised value of a building is in part determined as a multiple of its rent roll, which increases the amount of mortgage the owner can obtain as well as increasing the selling price. Furthermore, future percentage increases in rent will be based on the higher rental if the owner paid for the I&B rather than reducing the rent.

6 Diana B. Reitz, CPCU “Coverage For Tenant Improvements And Betterments” February 28, 2011 http://www.propertycasualty360.com/2011/02/28/coveragefor- tenant-improvements-and-betterments (accessed 10/30/13)

Improve and Better Improvements & Betterments Coverage

Jerry Trupin