John’s Italian Restaurant recently signed a lease with Landlord LLC to occupy a portion of their building. John’s spent several weeks transforming the once bland storefront into an upscale authentic Italian restaurant. Luxurious lighting, expensive carpeting, wallpaper, new interior wall partitions, and other building improvements were made at a cost of $100,000.
John’s grand opening was a huge success and his business was booming. He attributed it to not only his excellent menu, but to the money he spent improving his rented location. The improvements, though costly, were money well spent.
One night after the restaurant closed, John’s dream restaurant suffered an extensive fire, which consumed John’s portion of the building. He was understandably distraught, but at least he had adequate limits of insurance to cover his restaurant’s contents. He was sure the limits were correct because he had just purchased all of his contents brand new, and their costs matched his insurance limits. John assumed the improvements to the building would be replaced by Landlord LLC, since the improvements were part of the building. He was very surprised when the landlord refused to cover them.
An improvement and betterment is anything installed by a tenant that cannot be taken with them when they leave, such as wallpaper, light fixtures, interior walls, etc. Whether an insured, either the landlord or tenant, has a business owner’s policy or commercial property policy, in most instances there is automatic coverage for improvements and betterments. The questions that comes into play are who pays for the damage to the improvements (tenant or landlord), and are adequate insurance limits in place to cover the losses.
As a tenant, coverage for improvements and betterments is found in the contents limit of the policy. In the case illustrated above, John did not figure the cost of his improvements into his insurance policy’s contents limit and therefore his coverage fell $100,000 short of making him whole again.
As a landlord, coverage for improvements and betterments is found in the building limit of the policy. Landlords need to be cautious when valuing their leased buildings for insurance purposes. As previously stated, improvements and betterments are automatically included in most policies. That being said, all building values should be updated to reflect any improvements and betterments made by tenants.
A landlord’s building value will be adjusted to include all tenant improvements and betterments at the time of loss. If the policy’s building limits are no updated to include these items before a loss, a coinsurance penalty may be applied to the claim. For example, let’s say Landlord LLC insured the building in the above example for $300,000. By failing to include the $100,000 in improvements made by the tenant, the policy’s building limit is understated by 25% (it should have been increased to $400,000 to reflect the improvements). At the time of loss, an adjuster will include the $100,000 in the building’s value, which totals $400,000. As a result, a coinsurance penalty may be applied ( see our prior blog post about coinsurance by clicking here).
In this case, using a policy with a 90% coinsurance clause and $250,000 in building damage, Landlord LLC would only receive a check for $208,333, minus any policy deductible.
In the event the landlord does not want to cover tenant improvements, an endorsement excluding tenant improvements and betterments must be added to the policy to prevent a possible coinsurance penalty. The same holds true for a tenant. Unless a tenant excludes coverage for improvements and betterments, a coinsurance penalty could apply if the value of improvements is not included in their contents limit. It costs nothing for the landlord or tenant to add these exclusions to their policies.
To summarize, landlords and tenants should have a firm understanding of who is responsible for improvements and betterments. They should keep in mind that regardless of what the lease says, both a tenant’s and landlord’s insurance policy includes coverage for them. Improper coverage limits on either party’s policy may result in an unintended and unfortunate result if a claim occurs.
In any scenario, make sure to speak to an insurance agent on this often overlooked an misunderstood coverage.