Latent Defects Insurance and its history in the UK
Latent Defects Insurance (LDI) or as it has historically been known, inherent defects insurance has been readily available in the UK market since 1989. It is used for both residential and commercial applications with the former requiring a more stringent need under the requirements of the Council of Mortgage Lenders (CML). Historically speaking it has been more common for parties to rely on Collateral Warranties (“CW’s”) or even the Contracts (Rights of Third Parties) Act 1999 (“the Act”) for redress in the event of damage due to defective design or construction as a result of contractor work. In this article we will discuss the commercial application of LDI and how this method of protection should be utilised in favour of CW’s or potential cover afforded under the Act.
What does the cover provide?
The fundamental concept of how LDI works is crucial in determining whether or not it should be required. The stock standard form provides cover for actual physical damage to the building and is only provided in the event that such physical damage is caused by latent defects that have originated in the structural parts of the building. This would typically include some of the following, but may differ between any individual insurer:
Examples of Types of Claims:
A latent defect is defined as one that existed prior to Practical Completion (“PC”), that remained undiscovered and was observed in the LDI policy period, which can range form 10-12 years.
The policy also provides cover for damage resulting from ingress or egress of water caused by the latent defect in the weather and/or water proofing. This cover is subject to a 12-month exclusion from the date of PC. In most cases, coverage in this period would be picked up in the ‘rectification period’ cover afforded under the contract works policy. Weatherproofing would normally cover elements such as roof coverings, cladding and skylights where waterproofing would cover all elements that were meant to prevent ingress of water below ground level (basements, carparks etc.)
The insured can be any party who has an interest in the property such as the owner or developer, but can also be the funder or prospective tenant who may have an obligation under the lease to repair the property.
How the LDI policy functions
The policy is best procured before any construction and development work has begun. The reason for this is twofold: firstly, the insurer will procure the services of a technical advisor whose job it is to oversee and monitor the construction and ensure all building practices have been complied with. After the technical advisor has been procured, the certificate of approval can be given to insurers at PC confirming the building is sound with no patent defects. Secondly, purchasing the insurance before construction begins eliminates and unnecessary costs of late notice to insurers. The cost of the insurance (usually 1-2% of contract values) can double if procured after construction has begun and the associated policy deductibles can also double. Once the technical advisor is satisfied, and they have liaised with all relevant parties, they will issue a certificate of approval that all building practices have been complied with and post PC the policy will begin to run for a period of 10-12 years.
Advantages of using an LDI policy
The LDI insurance policy provides many advantages when used as a risk management tool on development projects.
Disadvantages of using an LDI policy
Premium and Cover
Premiums will vary by cover and options chosen. The basic product will restrict cover for economic losses that are consequent to the damage. The policy may require an excess (up to 1-1.5% of sum insured) before any cover were to apply.
The cover will typically exclude defects in non-structural elements of the building such as protective coatings and decorative finishes and mechanical and electrical services such as heating/ventilation systems and lifts and electric distribution systems Cover for all of these elements can be purchased back into the policy but premium considerations will be required.
Policies will exclude cover for any inherent defect discovered during the the ‘rectification period’ as this is seen as the contractors’ responsibility under the terms of the building contract.
Examples of Principal Exclusions:
Availability in North America
LDI is available to the North American market through the London markets; however, only one project in the Social Infrastructure space in Long Beach, CA has ever purchased the product. This is likely due to cost and capacity, as most markets cap at $50M to $80M. The pricing could be anywhere from 0.70% to 1.60% of construction value. Another factor likely influencing the placement of this cover in the North American market is the lack of familiarity of the product.
The leading markets that are considered “front runners” for this cover:
It is our understanding that SCOR and Allianz are starting to actively re-introduce LDI into the North American market with a maximum capacity of $100M-$150M.
The LDI insurance policy is not a sole solution for defects discovered post PC but should be considered as a mainstay for protection against issues arising due to contractor negligence in design and construction. Collateral Warranties still have their place within the building contract environment. It is prudent of contracting parties to consider an LDI policy be procured, particularly when the interests of future parties such as owners/tenants and financiers are not protected under the original contracts. LDI insurance can provide a secure and straightforward alternative to relying on the contractual provisions of warranties and building contracts.
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INTECH Risk Management (“INTECH”) is an independent insurance consulting company involved in the analysis, design, development, implementation and management of insurance programs. INTECH does not sell insurance, nor is it affiliated with any insurance company or brokerage. This unique independent position in the marketplace enables our consultants to avoid conflicts of interest and provide our clients with unbiased, expert advice. INTECH has been the 2015 and 2016 winning recipient of the IJGlobal Americas Due Diligence Provider of the Year Award.
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