August 2009

What's the point of taking out insurance upon exchange of contracts as solicitors always advise you to do?

Our panel of experts answers property investment questions from API readers. For more Q&As, see this month’s API magazine.

Insurance dilemma

Q I was surprised - and rather dismayed - to read the story in "My Property Nightmare" in the June 2009 edition of API. If insurance companies reject claims for damage prior to settlement because the property is not yet in the name of the buyer, what's the point of taking out insurance upon exchange of contracts as solicitors always advise you to do?

A The law relating to insurance in the context of vendor and purchaser transactions is complex and encompasses numerous common law rules, modified by state legislation (each state is slightly different), and further modified by Commonwealth legislation. The outcome can also depend on the terms of the contract for sale, the terms of the insurance policy and what the vendor and purchaser choose to do following an insured event. So keeping this complexity in mind, it's difficult to comment on the specifics of the unfortunate experiences of Georges Achram as reported in the June issue of Australian Property Investor. Instead, I'll address the question of why finance advisers and solicitors always advise their clients to take out insurance from exchange.

There's a well-established general principal of insurance law that no policy is valid unless it's taken out by a person who has an 'insurable interest' (a legal or equitable interest) in the subject matter of the policy. Historically, the rule served to discourage gambling in the form of insurance (i.e. betting someone else's property is damaged), which could in turn increase the risk of fraud (i.e. someone intentionally causing damage to win their bet). Insurance is about protecting your assets, so the intention of the rule is that you must be able to obtain benefit from the safety insurance offers and be prejudiced by the loss of the underlying asset.

However, the strict application of this common law principal of an having to have an insurable interest is modified by sections 16 and 17 of the federal Insurance Contracts Act 1984 (ICA), with the effect that an 'insurable interest' is no longer strictly required, provided the insured can demonstrate a 'pecuniary or economic loss'.

In practice, a purchaser under a valid contract for sale of real property often has both an 'insurable interest' (derived from the risk passing to the purchaser on exchange or the purchaser taking possession) and an ability to demonstrate 'economic or pecuniary loss' under the ICA (by reason of damage or destruction of the property that the purchaser has agreed to buy). In either case, the purchaser can normally effect insurance to cover the purchaser's risks, and can, generally speaking, validly claim under that insurance (even where the property is not in the purchaser's name).

Accepting that the purchaser can effect insurance, question arises as to whether the purchaser should effect insurance, where the vendor already has insurance over the property. Under general law principals, a purchaser is not privy to the vendor's insurance policy and thus cannot claim under the vendor's insurance. However, section 50 of the Insurance Contracts Act gives the purchaser a right to benefit from the vendor's insurance until the earlier of completion of the contract, the purchaser entering into possession, the purchaser effecting its own insurance or the termination of the sale contract.

While this law can give a purchaser access to the vendor's insurance, solicitors and finance providers still generally recommend that a purchaser effect their own insurance from exchange. This is because a vendor's insurance may be ineffective, defective, inadequate, or even non-existent - for example, the vendor may have made fraudulent non-disclosures, fallen behind in pay-by-the-month instalments, underinsured the property or breached a term of the insurance (such as failure to notify the insurer that the property has been left vacant).

Often the case is that both the vendor and the purchaser have insurance over the property, which begs the question as to which insurer pays out?

The answer often depends on the sale contract and the intention of the purchaser and vendor following an insured event. Where the purchaser cannot or does not want to terminate the sale contract, the convention is that the purchaser's insurer covers the loss. This is because the purchaser will, at completion, own the property and, therefore, will bear the loss. It would make no sense in this situation for the vendor's insurer to pay, because where the vendor is entitled to receive the full purchase price, the vendor has suffered no loss from completion (although the vendor could claim for its loss before completion, after completion the insurer would seek to claw back the claim payment, since the vendor would have obtained a windfall).

On the other hand, the sale contract may entitle the purchaser to terminate the contract following an insured event and the purchaser may elect to do so. In these circumstances, the purchaser loses its interest in the property from termination, meaning that the purchaser cannot claim on its insurance from that point – if a purchaser claimed before completion, and then terminated, the insurer would claw back any payment made to the purchaser as this would otherwise be a windfall for the purchaser. So generally, where the purchaser can and intends to terminate, the vendor's insurer will cover the loss as the loss stays with the vendor from termination.

As a consequence of the complexities and risks surrounding insurance in the context of purchaser and vendor transactions, solicitors and finance providers will generally recommend both parties obtain insurance. Home and contents insurance is usually not hugely expensive, especially not four to six weeks' worth (the normal completion period), thus a prudent person would effect insurance anyway, at worst paying for four to six weeks that they may not need.

As illustrated by the circumstances of Mr Achram's vendor, it's very important that you fully understand the terms and conditions of every insurance policy you buy. This is particularly important for investment properties, as some policies will exclude damage caused by or due to the property being tenanted. Look for a policy that provides cover for accidental and malicious damage caused by tenants.

The other important consideration is your duty of disclosure. Insurance policies can be voided if you fail to provide the insurer with all of the information they request to decide whether or not to insure your risk. If you purchase an investment property that's between tenancies, ensure you advise your insurer. Likewise, if the property is likely to be vacant for an extended period of time; you may have some special conditions added to the policy, but you will also have peace of mind should an insurable loss occur. Carolyn Majda

Salary sacrifice confusion

Q Last year I read that I could salary sacrifice 100 per cent of our rental property loan interest even though I own the property 50-50 with my wife. Am I still able to do this or have they changed the legislation? I've got different answers from different accountants.

A You could say they were both right. In the May 2008 budget the government announced it would change legislation to remove this tax benefit. Because the arrangement was perfectly legal it allowed people who had already entered in the salary sacrifice to continue to do so until March 31, 2009 but no one could enter into a new arrangement from budget night. It's now over a year later and the law hasn't yet been changed. So at law you can still do this but be warned the government has announced it will eventually change the legislation retrospectively so it isn't advisable to go ahead. Julia Hartman

For more Q&As, see API magazine.

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