Uninsured risks – whose responsibility? Landlord or tenant?

An issue which is now frequently being raised in lease negotiations (particularly in relation to lettings to major tenants) is how the risk of damage caused to a building by an uninsured risk should be apportioned between a landlord and a tenant.

The debate has in part been reopened as a result of the events of 11th September and also insurers' attitudes towards exclusions for terrorist activity from insurance policies in recent renewals.

In addition, the new edition of the Code of Practice for Commercial Leases has encouraged the debate further. Recommendation 8 of the Code states that "If the premises are so damaged by an uninsured risk as to prevent occupation, the tenant should be allowed to terminate the lease unless the landlord agrees to rebuild at his own cost".

So what are the issues and how can they be dealt with fairly in lease negotiations?

In the vast majority of cases, the landlord will be responsible for insuring the building (whether the building is let to a single occupier or a number of occupiers). Although the landlord will covenant in a lease with the tenant to arrange buildings insurance against a number of specified insured risks, the landlord cannot guarantee that such insurance will always be available. Normally there is some qualification on the landlord's obligations so that the landlord's obligation only applies where, for example, such insurance is available in the UK insurance market at reasonable commercial rates or on reasonable terms.

In addition, the landlord's obligation to rebuild or reinstate only arises where damage is caused by an insured risk. If the damage is caused by an uninsured risk then the landlord will not be obliged to reinstate. Instead a tenant may well find in the case of a single let building, that it is responsible for the rebuilding of the building at its own cost. In the case of a multi let building, the tenant will probably be liable to pay the cost of rebuilding under the service charge. The tenant's position is made worse by the fact that any rent abatement clause is, normally limited to damage by insured risks so the tenant will also have to continue paying rent for premises which it may not be able to occupy or which are inaccessible through no fault of its own.

In practice what are likely to be uninsured risks?

The most obvious example is damage caused by terrorist activity. The issue of who bears responsibility for damage by an uninsured is not a new topic. It is an issue which tenants frequently raised in lease negotiations in the early 1990s before the introduction of Pool Re. Since then, because of the Pool Re reinsurance, the issue has been far less controversial for landlords and tenants – in addition major occupiers in some cases had access to the global insurance market and could therefore arrange separate terrorist cover for buildings which they occupied even where the landlord could not do so.

However, in the relation to terrorist activity, Pool Re is no longer a complete answer (even if it was before). There are two reasons for this. The first is that in the case of policies renewed with effect from 1st January this year, wider exclusions of terrorist damage have been included by a number of insurers and these do not mirror the additional cover provided by Pool Re. As an example, some insurers are now starting to use the definition of "terrorism" contained in The Terrorism Act 2000 which extends to the advancing of political religious or ideological causes. In addition, the Government has not been persuaded to extend Pool Re to cover incidental damage caused by terrorist activity (the most often quoted example is damage flooding if caused by a terrorist explosion were to destroy the Thames Barrier). The events of 11th September also refocused attention on this issue.

The other most likely uninsured risk is subsidence. The code of practice refers to "insured risk" generally and not just to terrorist activity. By and large lease negotiations have in the past focused on terrorist activity only, but a tenant should consider including protection against uninsured risks generally.

Should the risk be shared and, if so, how?

There are two separate issues. Firstly who should rebuild? Secondly, should rent be payable by the tenant in the interim?

In terms of rebuilding, the fairest solution is for the landlord to rebuild. However, a landlord will not want to be responsible for repairing minor damage caused by an uninsured risk. Any provisions relating to uninsured risks should be qualified by references to the fact that they only apply where the premises are as a result of the damage, not capable of occupation or use, or alternatively, only where there is substantial damage. If there is any minor damage, the tenant should be liable to deal with this under its repairing obligation. However, no landlord will want to commit to re-building in the event of damage by an uninsured risk. The normal compromise is to allow the landlord a period to decide whether or not to rebuild at its own cost or, alternatively, to determine the lease. If the lease is determined then the tenant no longer has any liability and the landlord is free to deal with the site in whatever way it thinks fit.

If the landlord is prepared to rebuild, then it should be on the same terms as if the damage had been caused by an insured risk (for example the obligation should be conditional on the landlord obtaining all necessary planning consents which the landlord should use all reasonable endeavours to obtain).

How long does a landlord need to decide whether or not to rebuild? This needs to be assessed separately for each individual building. In some cases it may be relatively easy decision. With other more high profile buildings it may take longer (particularly in conservation areas or for listed buildings). A tenant may not be overly concerned about the length of time the landlord has to elect (although that the tenant will not want this to be left open indefinitely as to whether or not the premises is to be reinstated – the tenant will need to relocate in the meantime). What the tenant will not want do to is pay rent for a substantial period whilst the landlord is making its mind up. As a matter of law, there is no reason why the parties cannot agree that the landlord has, say, an 18 month period to decide but the tenant is only responsible for paying rent for say, 9 months out of this period. This is entirely a matter for negotiation between the parties.

In terms of payment of rent whilst the premises are being rebuilt or made accessible, (assuming the landlord elects to rebuilt) then again this depends very much on the negotiating position of the parties. To achieve a proper sharing of the risk, it may well be appropriate that the tenant should continue to pay rent whilst the landlord is rebuilding at its own cost.

In any event either the landlord or the tenant should have an ability to determine the lease if the landlord does not rebuild within, say, three years of the damage or destruction by an on insured risk – as would also normally be the case following damage by an insured risk.

Additional Premium

A landlord with a substantial property portfolio may want to consider charging the tenant a "premium" in addition to the normal insurance premium to compensate the landlord for the fact that it is assuming part or the whole of the risk of damage caused by an uninsured risk. The landlord could then use the total premiums collected from its various tenants to offset rebuilding costs where the landlord actually has to carry out works subsequently on any building.

Redevelopment

The other issue which a tenant may want to consider is whether the landlord should be prevented from electing to determine the lease if the landlord does actually intend to reinstate the building in substantially its previous form but it has decided to determine the lease instead because it believes it can achieve a greater return by granting a new lease to a third party at a higher rent than the rent payable under the existing lease. Although it may be fair that the landlord should accept that it cannot determine in these circumstances, the landlord will need to ensure that specific criteria/timetables are included (for example the provision should only apply where the landlord redevelops within, say, one year of the damage).

So where does that leave the parties?

The crucial point is that any tenant who wants protection against damage by uninsured risk needs to deal with this issue as part of the initial lease negotiations. It is not an issue which can be left until damage actually occurs. Only time will tell whether provisions relating to sharing uninsured risks become the norm. At the moment, generally, it is only leases of fairly high rental value buildings where the issue is addressed in detail.

For further information please contact Mark Heighton at mark.heighton@cms-cmck.com or on +44 (0)20 7367 2177.

This article was first published in Property Week.