I was recently asked to explain the difference between a mortgagee and a loss payee in one sentence. Here’s the sentence: A loss payee may in fact be a mortgagee, but a mortgagee is probably not a loss payee. Not very helpful, right? Here’s a fuller explanation.

An insurance contract pays the insured in the event of a covered loss. But, sometimes the insured has entered into contractual relationships with other parties. The terms of the outside contract may provide the other party an insurable interest in the subject matter to be insured. For example, the insured may have obtained a loan to purchase real property that is the subject matter of the insurance contract. Or, the insured may have obtained a business loan to fund equipment acquisitions or initial business expenses. In both cases, the lender will have gained an insurable interest in the item or entity being insured.

When a mortgage was used to finance the purchase of real property, the lender (mortgagee) has an insurable interest in the property. Here, the correct term to apply in the insurance contract is “mortgagee”.¬†But, when the insured obtained a loan for purposes other than the finance of real estate, the proper term is “loss payee”.

But, what if the insured obtained a loan, secured by real property and the proceeds were used to finance business operations or acquisitions? Then the proper term would be “loss payee”.

Here’s why it matters. Let’s say you own a building insured for $1 million with a $500,000 mortgage against it. Then, a covered peril completely destroys the building. If the lender is listed as a “mortgagee”, the insurance company will pay the amount of the mortgage ($500,000) to the lender and the balance directly to you. The lender may use the proceeds to pay off the mortgage, or upon negotiations between you and the lender, may release the funds back to you to fund repairing or rebuilding.

Now, let’s say the insurance contract specified the lender as “loss payee”. When “loss payee” is listed, covered losses will be paid to the loss payee. So, the lender will receive the entire $1 million. Under law of equity, the lender will not be entitled to keep more than the balance of the mortgage. However, the delay caused by diverting funds to another entity may result in more expense, and a longer wait before full recovery from the loss.

There are scenarios when it is appropriate for a mortgagee to be listed as a “loss payee”. This occurs most frequently when the borrowed funds are secured by real property¬†and personal property, such as equipment, business property, or receivables.

The lesson for both insureds and brokers is to ask lots of questions. The broker must fully understand the relationship between the insured and other interested parties. This is best achieved when the broker’s business acumen and training are sufficient to recognize and appreciate nuances in the world of business and finance.