Understanding the Leasehold Interest Policy's Remaining Provisions

Christopher J. Boggs, CPCU, ARM, ALCM
January 29, 2010

A discussion of the leasehold interest coverage form's loss calculations and its vacancy provisions complete this three-part series on this highly undersold coverage. Prior posts detailed the expenditures covered by the form and the necessary coverage calculations. This post rounds out the discussion on this unique protection.

Loss Calculation

Although the amount of coverage listed on the Leasehold Interest Coverage Schedule (CP DS 07) is based on both definitions of net leasehold interest (NLI), the amount of loss payment is based on the number of months left in the lease at the time of the loss. The policy specifically states that the coverage amount decreases as each month passes.

Calculating Net Leasehold Interest Loss for Tenants' Lease Interest (TLI)

At the inception date of the previously used example policy, there were 18 months left in the lease. Multiplying the "gross leasehold interest" (GLI) by the 5 percent leasehold interest factor found in the applicable endorsement (CP 60 05) produced a TLI net leasehold interest of $144,342.60.

Assume that six months into the policy period, the building suffered major damage and the insured tenant lost its favorable lease. Only 12 months remain on the canceled lease at the time of the loss.

Because the insured tenant benefited from the favorable lease for the first six months of the policy, paying a leasehold interest loss for that period would violate the principle of indemnification. To uphold indemnification, the TLI net leasehold interest is recalculated at the time of the loss. The new (and recoverable) TLI net leasehold interest is calculated by multiplying the previously developed GLI ($8,333) by the 12-month interest rate factor found in the endorsement used at inception – 5 percent in this example.

Applying the relevant information and forms to this example, the recoverable TLI is $97,397.77 ($8,333 x 11.6882). However, this is the maximum the insured can receive. If the landlord cancels the lease due to the direct property loss but renegotiates the lease with the tenant, still at lower than "market rates," the insured will get the lesser of the recoverable TLI or the difference between the old lease and new lease for the remainder of the prior lease's term.

Market value in our series-wide example is $15 per square foot; the tenant pays only $10 per square foot. In the aftermath of the direct property loss, the property owner cancels the lease, but renegotiates a new one with the tenant at $12.50 per square foot. The tenant does suffer increased operational cost, but not to the amount anticipated.

At $10 per square foot, the tenant's monthly lease payment was $16,666.67. Under the renegotiated lease ($12.50 per square foot), the tenant's monthly payment is $20,833.33 – a monthly difference of $4,166.66. Because there were 12 months left in the lease at the time of the loss, the insured tenant receives $49,999.92 (really should be rounded up to $50,000) for his TLI loss (the lesser of the two calculations, as per the policy form).

Calculating Net Leasehold Interest Loss for All Other Leasehold Interest Exposures

Essentially, the same provisions applicable to a tenant's lease interest (TLI) loss settlement apply to the remaining three leasehold interest exposures. The amount of coverage is reduced monthly during the policy period, and the amount of coverage calculated at the date of loss is the maximum the insured tenant receives.

In the loss presented above, the insured has enjoyed use of the premises for six months, thus the amount subject to loss, and payable, is reduced from $199,998 to $133,332 ($11,111 x 12 months remaining in the lease). But again, this is the maximum the insured can receive. Should the landlord agree to allow the tenant to continue using the premises by renegotiating the lease or through some other arrangement, the leasehold interest policy states that the insured shall receive the lesser of the loss sustained or the "net leasehold interest" at the time of the loss.

Calculating the "loss sustained" may be complicated by the presence of insurance on the improvements and betterments or the landlord's crediting of the "bonus payment" towards the new $12.50 per square foot lease (rather than the $15 per square foot market value). Providing a simplified actual loss sustained example for these expenditures is difficult. Agents just need to be aware of this provision.

One key point concerning both of these loss calculations is that the policy pays for the entire time remaining in the lease, not the policy. If there are 30 months left in the lease, yet only six in the policy period, this coverage pays for the 30 month loss.

Vacancy Provisions

Simply, if the tenant insured under this coverage form vacates the building for more than 60 consecutive days, and the building meets the definition of "vacant," there is NO coverage if a lease-cancelling property loss occurs. The only exception is if a sublease agreement is in place.

With a sublease in place, the vacancy provision in this form matches the commercial property form's stating:

(1) We will not pay for any loss or damage caused by any of the following even if they are Covered Causes of Loss:

(a) Vandalism;

(b) Sprinkler leakage, unless you have protected the system against freezing;

(c) Building glass breakage;

(d) Water damage;

(e) Theft; or

(f) Attempted theft.

(2) With respect to a Covered Cause of Loss not listed in (1)(a) through (1)(f) above, we will reduce the amount we would otherwise pay for the loss or damage by 15%.

"Vacant" means there is nothing in the building. "Unoccupied" generally connotes that there is not enough equipment or furniture to conduct normal operations. It does not simply mean "empty." Placing a desk and chair in a building insured as a manufacturing operation does not negate the fact that it is unoccupied.

Conclusion

There is no better way for an agent to set himself (or herself) apart than to note and present exposures the insured has never considered or been apprised of. Leasehold interest coverage likely meets one of these conditions. First, agents must understand the coverage (hopefully this series has provided the necessary understanding), then they must be able to explain the coverage to the insured.

As seen in the examples provided in this series, the amount of exposure can be rather high; certainly the insured should be willing to protect such investments. And the current market conditions may increase the exposure and need for this coverage when the commercial real estate market rebounds.