Improvements and Betterments in Commercial Insurance: What Landlords and Tenants Must Know

If you’re a landlord or a tenant in a commercial building, you should be aware of how
improvements and betterments are treated for insurance claim purposes. First of all,
what are improvements and betterments? Improvements and betterments, sometimes
called additions and alterations, are things a tenant permanently attaches to a building
they’re renting. In order to be treated as an improvement, it is a requirement that the
they be installed at the tenant’s expense. If the landlord gives the tenant a credit
towards the rent for the cost of the improvements, then technically the landlord paid for
them, not the tenant. Also, to qualify as an improvement, it must be something added to
the building. Installing a central air conditioning system, in a building that didn’t
previously have one, would be an improvement. However, replacing a worn out air
conditioner with a new one is merely considered maintenance, not an improvement.
Examples of improvements would include things like installing a ceramic tile floor over a
concrete slab, adding wood wall paneling, or adding a partition wall to divide a space. A
refrigerated showcase in a butcher shop, that the butcher intends to remove at the end
of the lease, would not qualify as an improvement. It would be considered a trade
fixture, even if it were secured to the building, because its installation was not intended
to be permanent.

Who insures the improvements, the landlord or the tenant? In order to collect on an
insurance claim for property damage, the claimant must have an “insurable interest” in
the property. Having an insurable interest means that you suffer some financial loss if
the property is damaged or destroyed. Now when a tenant permanently attaches an
improvement to a building, the landlord owns the improvement immediately. Since the
landlord owns it, they suffer a financial loss if the improvement is damaged, thereby
establishing an insurable interest. However, if the improvements are damaged, the
tenant suffers a financial loss as well. This gives the tenant an insurable interest. The
tenant has the right to use the improvement for the term of the lease. If the
improvements are damaged, he’s lost the ability to use them. So while the landlord has
an ownership interest, the tenant has what’s known as a use interest, a completely
separate insurable interest. Since both the landlord and the tenant each have an
insurable interest, who can collect on their claim for damage to the improvements?
The commercial policies state that neither party can collect if the improvements are
replaced at the expense of others. So, if the landlord replaces the improvements, they
can collect for them but the tenant can’t. Similarly, if the tenant replaces the
improvements, they can collect for them but the landlord can’t. What happens if no one
replaces them? In that case, the landlord can collect the “actual cash value” of the
improvements. Actual cash value is usually defined as today’s replacement cost less
depreciation. However, the tenant can also collect because they have a separate and
distinct insurable interest. The tenant can collect a pro-rata share of his original
investment. For example, if a tenant installs improvements on the first day of a ten year
lease and the improvements are destroyed after six years and never replaced, the
tenant has lost 40% of his ability to use the improvements. He would therefore be
entitled to claim 40% of his initial cost. If the lease had an option to renew for an
additional ten years, the tenant could include that period and, for these purposes, treat the lease as a twenty year lease. This would entitle the tenant to claim 14/20ths or 70% of his initial cost.

When a building is damaged by fire or other casualty, most commercial leases require
the landlord to repair the property to the condition it was in at the beginning of the lease.
However, that doesn’t preclude the landlord from doing more than the lease requires.
The landlord can repair the entire building, including the tenant’s improvements, even
though not required by the lease. Since the landlord’s ability to make claim for the
damaged improvements is not contingent of the terms of the lease, the landlord should
include the value of the improvements in the overall value of the building when
purchasing insurance, even if they never intend to replace the improvements.
Here’s why. Many commercial property insurance policies include what’s known as a
“coinsurance clause”. Insurance companies want to collect a premium that’s
proportional to the risk they take on when selling a policy. Insurers don’t want to sell a
$100,000 policy to cover a building valued at $1,000,000. From an insurance
underwriter’s perspective, a $1,000,000 building is like ten $100,000 buildings, making
the risk much greater. So insurance companies give you a discount if you promise to
fully insure the building. Total losses are rare so the most common coinsurance
requirement is 80%, though the percentage can vary between 50% and 100%. When a
policy contains an 80% coinsurance clause, it means that the insured is promising to
insure the building to at least 80% of its value. If you keep your promise, the insurance
company will pay your loss, in full, up to the limit of the policy. But what if you don’t
insure the building to 80% of its value? The insurance company makes the insured their
partner in the loss. The insured becomes a coinsurer. For example, suppose your
building has a value of $1,000,000 but you buy a policy with a $600,000 limit and an
80% coinsurance clause. The coinsurance clause requires that you insure your building
to 80% of its value, which would be $800,000, but you’ve only purchased $600,000 of
coverage. Since you’ve only insured the building for 75% of what was required by the
coinsurance clause, the insurance company will only pay 75% of your loss. If your
damages are $100,000, the carrier will only pay you $75,000.

As was discussed earlier, since the landlord has the right to make claim for the
damaged improvements, even if not required by the lease, the carrier expects the
insured to include them in the overall value of the building, when determining if the
insured has met their coinsurance requirement. The landlord could suffer a coinsurance
penalty even if none of the improvements were damaged and claimed. In other words, a
claim for damage to the roof, which was not part of the tenant’s improvements, could be
penalized by virtue of not including the value of the improvements when insuring the
building.

Sarasohn & Company, Inc. is a 102 year old, family owned public adjusting firm,
specializing in large commercial and residential claims. For a free policy review or to
discuss any claim you have or might have, please feel free to contact us at any time.