Latent Defects Insurance in the UK & North America

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:

• Foundations and support beams
• External walls and cladding
• Roof structures and other load bearing external and internal elements
• External doors, windows and stairs and floors

Examples of Types of Claims:

• Inadequate basement/underground lining allowing seepage
• Defective Roofing
• Defectively designed, or defective installation, of floor slabs which can cause movement and/or cracking

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.

• The policy can be used as a single point through which recovery can be achieved;
• Alternative to complex legal disputes between parties;
• Cover is always arranged on a first-party basis and negligence and fault of any given party does not have to be proved ensuring issues are rectified in a prompt fashion. Unlike CW’s or cover under the Act where the beneficiary would need to establish that a breach of contract or act of negligence has occurred. This could involve bringing actions against several contracting parties for which no remedy will be guaranteed. In the case of the claimant being a financier or tenant they may not have received collateral warranties from the contractor or have the benefit of third party rights under the Act so without the benefit of LDI insurance, they would have little to no remedy at all;
• It is common of insurers to waive subrogation rights under the policy. This means there will be no need later for the insurer to recoup any losses paid out to the beneficiary which acts to preserve the relationship between all parties;
• The policy is also non-cancellable and will remain in force for the period of 10-12 years, affording protection to the beneficiary during all phases of post PC. CW’s require that the contractors hold valid and in force professional indemnity policies which would provide remedy and these must be renewed annually. In the event the contractor were to become insolvent, the PI policy would be cancelled and there would be no avenue for redress;
• The LDI policy is fully transferable and as such is often used as a value add when it comes time to sell or lease the newly constructed buildings as it affords protection even to those who were not contractually aligned with the original contractor. These include financiers and owners’/tenants who may be using or have interest in the newly constructed building. The LDI policy will also most often be required by financiers under the loan agreement and having this is place also satisfies this contractual requirement.

Disadvantages of using an LDI policy

• If the procurement of the policy is not planned well in advance of construction commencement it can be cost prohibitive and premium loadings can be doubled;
• Premiums for the basic cover range from 1-1.5% of the contract price and on larger more complex projects this can be a huge cost to hold.

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:

• Defects known or discovered prior to inception
• Abnormal use or overloading
• Inadequate maintenance or wear and tear
• Non-approved alterations or modifications
• Change in colour and ageing process.

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:

• Allianz
• Aviva (UK only)
• Munich Re
• RSA (UK only)
• SCOR
• Swiss Re

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.

Conclusion

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.

For more information on this topic, please contact:

SARAH ROBERTS
President
sroberts@intechrisk.com

About INTECH

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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