The Tenant's Improvements and the Subrogation Trap
A restaurant tenant signs a 10-year lease for a downtown Toronto space and spends $250,000 on leasehold improvements, kitchen equipment, and a ventilation system. The lease requires the landlord to insure the building and the tenant to insure its own improvements, and it contains a mutual waiver of subrogation. The tenant buys a commercial property policy covering the improvements and equipment for $300,000, but the broker never adds the landlord as an additional insured or loss payee. Six months later, a fire starts in the tenant's deep fryer and spreads, causing $600,000 damage: $400,000 to the building and $200,000 to the tenant's improvements. The landlord's insurer pays the landlord and then demands $400,000 from the tenant. The tenant's insurer says the claim is covered, but the landlord's insurer says the waiver in the lease does not bind it because it was not a party to the lease.
1. Does the tenant have an insurable interest in the leasehold improvements and the landlord's building? Explain how insurable interest and indemnity apply to each loss.
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Insurable interest. The tenant has an insurable interest in the leasehold improvements, equipment, and ventilation system it paid for and uses; it would suffer economic loss if they were destroyed. Its interest in the building is limited to its leasehold interest (the value of the remaining lease and any obligation to restore), not the landlord's fee. The landlord has an insurable interest in the building. Insurance cannot create a profit: the tenant's recovery is capped at its actual loss, less deductible, and it cannot recover for the landlord's building beyond its leasehold interest.
Indemnity. The tenant's policy should respond to the $200,000 damage to its improvements. The $400,000 building loss belongs to the landlord's policy; the tenant's policy should not pay it merely because the tenant caused the fire. If the tenant's policy included the landlord as loss payee or additional insured, the result might differ, but that was not done.
2. Explain how subrogation works here and whether the landlord's insurer can recover $400,000 from the tenant, considering the lease waiver.
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Subrogation lets an insurer that has paid its insured stand in the insured's shoes and pursue the party legally responsible. The landlord's insurer paid the landlord for the building damage and therefore may sue the tenant in negligence. The lease's mutual waiver of subrogation is a contractual defence: if the landlord agreed not to sue the tenant for fire loss, the landlord's insurer, which takes only the landlord's rights, is generally bound by that waiver, especially where the insurer insured the risk with knowledge of the lease. The insurer may argue it never agreed to the waiver, but the modern approach is that a waiver in a lease is enforceable against the insurer if the policy was issued with the lease in hand. The tenant's own insurer should defend and raise the waiver. If the waiver is upheld, the landlord's insurer bears the $400,000; if not, the tenant's policy may respond to the judgment, subject to its limit and exclusions.
3. What should the broker have done differently at placement?
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The broker should have obtained and read the lease at placement, confirmed the mutual waiver of subrogation, and added a waiver-of-subrogation endorsement to both the tenant's and landlord's policies. The broker should also have added the landlord as an additional insured or loss payee if the lease required it, and confirmed that the tenant's limit was adequate for both improvements and any contractual restoration obligation. The broker should document the client's instructions and the lease requirements. Failing to do so creates an errors-and-omissions exposure if the tenant is sued and the waiver is held unenforceable.