Lenders Have an Affirmative Duty to Notify an Insurer of Foreclosure Proceedings

The Tennessee Court of Appeals recently issued an opinion on the case of U.S. Bank v. Tennessee Farmers Mutual Ins. Co. addressing when a lender has a duty to notify an insurer of foreclosure proceedings against the homeowner. The main proposition to be taken from the case is that an insurer is not responsible for covering a loss if the lender failed to notify an insurer of foreclosure proceeding against a homeowner where the standard mortgage clauses requires notice of an increase in hazard.

In U.S. Bank, the homeowner purchased a home, securing her mortgage through plaintiff- lender U.S. Bank. She was required to obtain a fire insurance policy, which was from defendant-insurer, Tennessee Farmers Mutual Insurance Company. The policy contained a standard mortgage clause requiring the lender to notify the insurer of any increases in hazard. After the homeowner fell behind on her mortgage payments, the lender initiated foreclosure proceedings. The lender did not notify the insurer of the foreclosure proceedings. Before the foreclosure process was complete, a fire destroyed the house. The insurer denied the lender’s claim under the insurance policy.

In response to the lender’s lawsuit, the insurer asserted that the foreclosure proceeding constituted an increase in hazard, and the lender’s failure to notify the insurer of the increase in hazard constituted a breach of the mortgage clause in the fire insurance policy. The Tennessee Court of Appeals agreed and held that the commencement of foreclosure proceedings constituted an increase in hazard under the both standard mortgage clause in the insurance policy and Tennessee state law. The court determined that the likelihood of foreclosure increases the risk to the insured due to a “moral hazard” that the homeowner will be tempted to destroy the property in order to obtain the insurance proceeds. This moral hazard is brought about by commencing foreclosure and the “risk begins with the initiation of foreclosure proceedings and ends with the foreclosure process is complete” because “it is not a new phenomenon for a property owner” to cause damage to his property for the insurance money. Thus, the Tennessee Court of Appeals has created an affirmative duty for lenders to notify an insurer of the commencement of foreclosure proceedings because it falls within the zone of increased hazards. In ruling, the Tennessee Court of Appeals specifically distinguished mortgage clauses that required notice of a “substantial” change in risk because while commencement of a foreclosure proceeding is risk, it is not necessarily a substantial change of risk.

While this case was a Tennessee state law, lenders everywhere should take note of its holding. Other state courts will be asked to decide this issue. Lenders should not assume that the few jurisdictions that have expressed doubt as to whether foreclosure constitutes an increase of hazard intended in mortgages clauses will continue to do so; those decisions are decades old, some over a century. Additionally, in many states – including Ohio – the question of whether something is an “increased hazard” is one for the jury to decide. Therefore, it is possible that courts will let the issue of whether the commencement of foreclosure procedures is an increased hazard go to the jury. Thus, regardless of their location, lenders should be diligent to carefully read insurers’ standard mortgage clauses to see whether the clauses require notice of a “substantial” change of risk or just any change of risk. If the latter, lenders should make sure to immediately inform insurers when foreclosure proceedings are instituted.

If you would like a full copy of the opinion, or if you have any other questions related to matters of property insurance coverage or Finance and Creditor Rights and Liabilities, please feel free to contact one of our practice area leaders.