The Mortgage Clause: Insurers and adjusters shouldn’t overlook the role of the standard mortgage clause in the property insurance policy

A version of the Standard Mortgage Clause (SMC) is found in virtually every property insurance policy where a mortgage underlies the property ownership. The standard wording of the SMC is:

Breach of Conditions by Mortgagor, Owner or Occupant – this insurance and every documented renewal thereof – AS TO THE INTEREST OF THE MORTGAGEE ONLY THEREIN – is and shall be in force notwithstanding any act, neglect, omission or misrepresentation attributable to the mortgagor, owner or occupant of the property insured.

The potential effect of the SMC is much greater than the brevity of this clause might indicate.

The effect of the SMC was examined by the Supreme Court of Canada in National Bank of Greece (Canada) v. Katsikonouris, (1990) 2 S.C.R. 1029. The Court explained that the SMC allows lenders to “piggy-back” on the insurance purchased by the insured/mortgagor and is akin to an independent contract between the insurer and the mortgagee. Essentially, with no further payment of premium, the mortgagee derives the entire benefit of the insurance policy as if the policy had been issued separately to the mortgagee.

Further, the court found that the insurance coverage of the mortgagee will not be invalidated by any omission or misrepresentation of the insured. Therefore, regardless of egregious conduct by the insured, such as arson, the mortgagee’s insurance cannot be invalidated.

However, the power of the SMC surpasses the insured’s conduct and appears to apply regardless of the mortgagee’s conduct as well. In Royal Bank of Canada v. State Farm Fire and Casualty Co., 2005 SCC 34 (2005), the insurer denied the claim of the insured and the mortgagee arising from a fire loss. The insurer claimed that the dwelling was vacant, which was a material change in risk as to the occupancy of the dwelling, thereby removing coverage. The insurer further claimed that the SMC did not apply because the mortgagee was specifically aware that the dwelling was vacant. In fact, the mortgagee had foreclosed on the home, thereby instigating the vacancy, and had assumed control of the dwelling at the time of the fire.

The insurer argued that Statutory Condition 4, which permits the insurer to void coverage where there is a material change in risk, applied to limit the grant of coverage under the SMC. The Supreme Court of Canada did not agree, finding that to the extent the SMC was in conflict with Statutory Condition 4, the SMC prevailed. As the closing words of the SMC provide that the mortgagee’s coverage shall remain in force despite any act of the mortgagors, the SMC supersedes any conflicting policy provisions.

The fact that the mortgagee’s actions had caused the vacancy had no effect on coverage for the mortgagee. Thus, given that SMC clauses do not generally include any limitations or impose any obligations on the mortgagee, the SMC extends virtually unfettered coverage to the mortgagee regardless of the actions of either the insured or the mortgagee.

An open question in interpreting the SMC is whether the mortgagee can demand payment for the equivalent of replacement cost, or if payment should be made on an ACV basis. Arguably, allowing for replacement cost as opposed to ACV is a potential windfall to the mortgagee whose security in the property is typically limited to the depreciated value of the dwelling (in addition to the land). Further, allowing replacement cost recovery where there has not actually been replacement puts the mortgagee in a better position than the insured would have been in, as the typical replacement cost wording requires that the structure actually be replaced.

The commonly used SMC wording states that the SMC extends “as to the interest of the mortgagee only therein.” One interpretation of this phrase is that the SMC extends the policy only so far as the mortgagee’s interest in the property at issue. As the mortgagee’s security interest in the dwelling is restricted to the depreciated value of the structure, only ACV is available.

On the other hand, it is possible that the phrase simply means that the SMC terms are restricted to the mortgagee and are not for the benefit of the insured. This argument finds some support in the Royal Bank of Canada v. State Farm Fire and Casualty Co. case, as the Court found that a similar phrase, “but only to the interest of the mortgagee,” meant that terms of the policy that conflict with the SMC, including exceptions to the mortgagor’s coverage, do not affect the mortgagee’s coverage.

There is little helpful Canadian case law on this issue. In Voloudakis v. Allstate Insurance Co. of Canada, (1998) O.J. No. 354, the insurer made two payments under the SMC for replacement cost to the mortgagee, although it seems that replacement did not actually took place, and counterclaimed against the Plaintiff for the amount of those payments. Thus, it appears the insurer conceded prior to trial that replacement cost, without actual replacement, was the correct method of valuation pursuant to the SMC and, therefore, the issue was not squarely before the Ontario Superior Court of Justice. However, the court allowed the insurers counterclaim for paying out the replacement cost under the SMC without any consideration of whether this was the correct method of valuation.

A different result arose in Sholidis v. Economical Mutual Insurance Co., O.J. No. 2242, where prior to trial the insurer and mortgagee agreed that ACV was the correct method of valuation. Each retained an appraiser to give an opinion as to the value of the building and the land and arrived at an agreement as to the dwelling value. The insured was not part of this process. The Court noted its, “reluctance about allowing the award under the appraisal methodology used by the insurer and the mortgage company.” However, it did not elaborate whether its reluctance was because the insured was not given the opportunity to obtain his own appraisal, or because ACV was used as opposed to replacement value. Given that the dwelling was never actually replaced, as required by the policy in order to invoke replacement value, it is difficult to imagine how anything other than ACV would have been appropriate.

Thus, it is an open question whether a mortgagee is entitled to replacement cost given that its interest in the property, and its security for the mortgage, is limited to the depreciated value of the dwelling (in addition to the land).

Recently, a more detailed SMC has been seen from some insurers to address issues such as the mortgagee’s obligation to report a material change in the risk, and the insurer’s option to pay out the mortgage in full and take an assignment of the mortgage where the loss under the policy is greater than the mortgage balance. However, the correct method of valuation under the SMC has yet to be defined.