Collateral Interests In Insurance: Confusing Territory

Secured lenders often look to the borrower's or guarantor's rights under insurance policies to improve their collateral position. Obtaining a collateral interest in a business interruption insurance policy may protect a lender who is dependent upon the ongoing cash flow of its borrower for debt service. Obtaining an assignment of an interest in a life insurance policy of the borrower's owner or a principal guarantor protects the lender against economic effect of the sudden loss of a member of the borrower's team essential to its success.

Despite its importance to many commercial loan transactions, the law governing lien interests in insurance is non-uniform. Since 1945, matters relating to insurance have been left to each state.1 More importantly, all but two states have excluded liens in insurance policies from Article 9 of the Uniform Commercial Code ("UCC").2 Because of this exclusion, concepts of creation, perfection3 and priority of liens taken by lenders in insurance policies are wholly dependent upon the forum and the terms of the particular insurance policy involved. Nonetheless, in the context of a bankruptcy proceeding, these concepts are essential to determining the extent of a lender's secured claim under section 506 of the United States Bankruptcy Code4 ("Code") and to determining when a lien is perfected under Code section 547(e)(1)(B) for avoidable preference purposes.

How, then, does a lender create and perfect its interest in policies of insurance? Because of the exclusion of insurance from the ambit of the UCC, it is clear that execution and delivery by the debtor of a security agreement covering general intangibles and filing a financing statement will not create an enforceable lien.5 An important first step is to examine the policy to make sure that all of the elements required by the insurer for the creation of a valid lien are complied with.

Case law provides guidance (albeit conflicting) regarding how liens in insurance policies are created. Regarding life insurance, some courts hold that possession of the policy is required to create a lien interest,6 while other courts hold that a policy cannot be pledged by possession.7 In those jurisdictions where possession is not required or with respect to commercial insurance policies, execution and delivery of a collateral assignment of rights under the policy and notice to the insurer will likely be sufficient to create an interest in the policy. Commercial insurers often do...