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1.5.2.4 Distribution of Insurance Proceeds

Almost all mortgage loans require borrowers to maintain hazard insurance to protect the lender’s interest in the property. The typical security instrument language gives the lender119 broad discretion to determine what types of insurance are required (fire, flood, earthquake, wind, etc.) and the amount of coverage.120

After a covered loss occurs, the insurance company issues a claim check identifying both the borrower and the mortgage lender or servicer as payee.121 Because the lender or servicer is also a payee, it effectively controls the disbursement of the proceeds to the borrower.

Fannie Mae and Freddie Mac, as well as the FHA, all have general rules governing distribution of insurance proceeds after claims have been made.122 However, there are also special rules regarding insurance proceeds after disasters, discussed below.

The general rule is reflected in the Fannie Mae standard security instrument, which provides that insurance proceeds will be applied to the restoration of the property so long as the restoration and repair123 are “economically feasible” and the lender’s “security is not lessened.” If the repairs do not satisfy both conditions, then the security instrument directs the lender to apply the insurance proceeds to the debt. The term “economically feasible” is not defined in the instrument, and there is no explanation of what it means to lessen the security. Most courts have interpreted it to mean whether the cost of repairs will exceed the insurance proceeds, and whether the value of the repaired home will at least exceed its value prior to loss.124 Like many mortgage servicing issues, the question of who bears the burden of demonstrating economic infeasibility or reduced security may depend on the procedural posture of the case.125

If the proceeds are to be used for restoration and repair, the mortgage servicer may disburse proceeds in a single payment or in a series of progress payments as the work is completed. Typically disbursement schedules call for release of one third of the proceeds up front, the next one third at 50% completion (and after inspection), and the last one third at completion (and after inspection).126

Delays in distributions of funds can wreak havoc with rebuilding efforts, and may give rise to claims of breach of contract or breach of good faith and fair dealing.127 However, courts have held that once the borrower defaults, the lender is under no further obligation to disburse insurance proceeds.128 Lenders generally may not keep insurance proceeds that exceed the outstanding loan balance, and should not keep any funds attributable to loss of personal property.129 The lender is not required to pay interest on undisbursed funds unless “applicable law” so requires.130

Another issue arises as to when the servicer must apply the insurance proceeds, if the repairs do not satisfy the stated conditions. Mortgage servicers have allowed insurance proceeds to languish for years in suspense accounts. Courts have implied a “reasonable time” to perform under this contract provision.131

For a more thorough discussion of the distribution of insurance proceeds after claims, see NCLC’s § 17.2.8.

Footnotes

  • 119 Though the standard security instrument refers to the “lender,” the mortgage servicer is generally responsible for ensuring compliance with the security instrument, including the insurance provisions.

  • 120 See Single Family-Fannie Mae/Freddie Mac Uniform Instrument, ¶ 5 (Jan. 2001).

  • 121 For a description of variations in insurance policy mortgage clauses, see Costanzo v. Property & Casualty Insurance Company of Hartford, 2014 WL 11511717 (D.N.M. Oct. 1, 2014).

  • 122 See, e.g., Fannie Mae Single Family Servicing Guide B-5-01.

  • 123 Courts have construed the terms restoration and repair narrowly at times. See Green Tree Servicing, L.L.C., v. Mann, 2008 WL 793632 (W.D. Ky. Mar. 24, 2008) (replacement of manufactured home did not constitute restoration or repair, therefore lender did not need to disburse insurance proceeds for that purpose); Cox v. Wightman, 2007 WL 708611 (W.D. La. Mar. 5, 2007) (insurance proceeds not required to be used for mold testing, as “testing” was not restoration and repair).

  • 124 See Vongohren v. Citimortgage, Inc., 2016 WL 739070 (D. Md. Feb. 25, 2016); Alvarez-Mejia v. Bellissimo Properties, L.L.C., 208 So. 3d 797 (Fla. Dist. Ct. App. 2016).

  • 125 See Music v. Bank of Am., 2015 WL 8477614 (N.D. Cal. Dec. 9, 2015) (placing burden on borrower-plaintiff to show economic feasibility).

  • 126 For current loans with loss proceeds in excess of $40,000, Fannie Mae requires installment distributions up $40,000 or 10% of unpaid principal balance, whichever is greater. Fannie Mae Single Family Servicing Guide B-5-01, Insured Loss Events (Apr. 12, 2017).

  • 127 Pressler v. Am. Home Mortg. Serv., Inc., 2013 WL 1320462 (N.D. Cal. Apr. 1, 2013) (denying breach of contract and breach of good faith and fair dealing for pre-default conduct).

  • 128 See, e.g., Music v. Bank of Am., 2015 WL 8477614 (N.D. Cal. Dec. 9, 2015); Everidge v. Wells Fargo Bank, 2015 WL 5786738 (M.D. Ga. Sept. 29, 2015) (suggesting that paying over proceeds and delaying foreclosure constituted sufficient impairment of security to justify applying proceeds to debt), aff’d, 654 Fed. Appx. 479 (11th Cir. 2016); Pressler v. Am. Home Mortg. Serv., Inc., 2013 WL 1320462 (N.D. Cal. Apr. 1, 2013). But see Fannie Mae Single Family Servicing Guide B-5-01, Insured Loss Events (Apr. 12, 2017) (requiring release loss proceeds for repair and evaluate the borrower for workout options).

  • 129 See, e.g., Fannie Mae Single Family Servicing Guide B-5-01, Insured Loss Events (Apr. 12, 2017).

  • 130 State law may require payment of interest on insurance proceeds held by the servicer. See, e.g., Cal. Civ. Code § 2954.8 (West); Md. Code Ann., Com. Law § 12-109 (West); Or. Rev. Stat. §§ 86.205.3, 86-245; Utah Code Ann. § 7-17-2 (West); Vt. Stat. Ann. tit. 8, § 10404(b). Some banks have argued that payment of such interest is preempted; however, preemption principles should not apply to the bank’s contractual obligation to pay interest.

  • 131 See, e.g., Vongohren v. Citimortgage, Inc., 2016 WL 739070 (D. Md. Feb. 25, 2016).