At first glance, a $500 million blanket limit policy appeared more than sufficient to support the financing of a $200 million mixed-use retail property. However, a deeper look revealed a clause that effectively capped recoverable property coverage at $85 million, leaving the lender exposed to a $115 million gap in collateral protection.
This example highlights a common reality for commercial lenders: adequate insurance coverage does not always translate to adequate loan protection. Insurance that appears sufficient at closing may contain structural limitations, valuation provisions, exclusions, or other features that impact a lender’s ability to recover value following a major loss or default.
Lockton’s Lender Risk Advisory team estimates that it encounters material insurance deficiencies in more than 90 percent of the transactions it reviews, with most of those deals containing between one and five significant issues. Deficiencies can range from catastrophic exposure and inadequately structured property coverage to liability programs that fail to align with the borrower’s operations, transaction structure, or risk profile.
What traditional lending reviews miss
It’s not that commercial lenders ignore insurance due diligence, but rather that insurance review has often been regarded as a checklist item to confirm that coverage has been placed, not necessarily to validate adequacy. As insurance programs become increasingly complex and assets and environments shift, this can lead to insurance gaps that arise in several different ways.
Coverage doesn’t respond as expected
Deficiencies are not always caused by missing coverage. Sometimes, coverage exists but may not perform in the capacity that lenders expect following a significant loss. Policy structures, shared limits, sublimits, and other program features can materially alter the amount available to protect collateral. For example, a general contractor’s liability program may appear sufficient to cover projects where the owner is scheduled as an additional insured. From a lender perspective, however, shared limits across the general contractor’s entire operation leave significant exposure if claims from unrelated projects erode the available limits before the lender needs them. In addition, coverage may not account for claims made throughout the life of the loan, after the project is complete. This would leave the borrower, and, therefore, the lender’s securing asset, exposed if the general contractor became insolvent or ceased operations.
Insurance doesn’t keep pace with asset exposure
In addition, coverage that was adequate at loan origination may become inadequate later due to factors such as shifting property values, construction costs, and economic factors that impact replacement costs.
With significant inventory portfolios, for example, it’s common for asset-based lenders to underwrite loans against the current value of the inventory; however, that value is often crucially different from what it costs to replace the inventory, which any insurance in place must be sufficient to do. Otherwise, lenders can find themselves exposed following a catastrophic loss, as the borrower may be unable to fully restore operations, rebuild the inventory, or generate the cash flow it needs to repay the loan.
This is increasingly important for commercial real estate and construction lending as well, as climate volatility and more severe weather events shift the risk profiles of commercial real estate properties and their insurance markets. Lenders may continue to see higher deductibles, lower catastrophe limits, and more restrictive coverage structures at renewal, which means that insurance protection that aligned with the lender’s risk assumptions at origination may not be sufficient at a certain point during the life of the loan.
Insurance review doesn’t reflect lender objectives
Lastly, even when insurance coverage is scrutinized, it may be viewed through a lens that prioritizes ownership or investment concerns rather than collateral preservation and loan recovery. This is particularly relevant as more lenders participate in sponsor-backed transactions, where comprehensive insurance diligence has been performed on behalf of the borrower, sponsor, or equity investor. Though valuable, diligence performed through that lens does not address the issues that are most relevant to a lender’s recovery position.
For example, a sponsor might simply confirm that business interruption insurance exists, whereas a lender needs to know whether that coverage is sufficient to continue servicing debt following a major disruption or loss. This may include a more detailed look at the length of the indemnity period; coverage of key dependencies or contingent exposures; or sublimits, waiting periods, or policy exclusions that interrupt cash flow.
None of these issues is limited to the closing table. While insurance is most scrutinized at loan origination, diligence is equally important at annual renewals as gaps in coverage can continuously arise and put the entire loan portfolio at risk. This makes insurance diligence an ongoing necessity.
How dedicated insurance risk advisory can help
A good risk advisory team should add depth to insurance review processes that are already in place — standardizing review requirements and embedding them into existing processes without delaying underwriting.
Dedicated risk advisory should look at three phases of the review process:
Protecting the transaction. Pre-close insurance diligence protects the loan at origination, rooting out and addressing potential post-funding problems.
Protecting the portfolio. Without ongoing monitoring, dropped policies, reduced limits, and shifting environments can leave a lender in the dark until a catastrophic loss occurs, which may impact the entire loan portfolio.
Protecting the lender. Ongoing education for internal credit staff helps shore up insurance requirement standards and helps teams become better at protecting their loans.
The value of lender insurance diligence isn’t simply in identifying insurance deficiencies, but also in working through those gaps prior to closing so they don’t cause problems down the road. Having a dedicated team that can conduct diligence from a lender perspective not only ensures that lenders are turning over every stone; it also strengthens internal teams.
For more information about Lender Risk Advisory, contact one of our experts here (opens a new window).