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Commercial latent defects insurance: benefits and drawbacks

For organisations behind major real estate projects, taking out commercial latent defects insurance can be an attractive alternative to putting in place collateral warranties. Nevertheless, there are advantages and disadvantages to both approaches.

A latent defect is one which appears in a building after it has been completed and that is not discoverable at the time of its completion.

In a construction context, employers can, in their building contracts and consultancy appointments, require contractors and consultants to provide collateral warranties to interested third parties in order to protect those third parties against the risk that a latent defect will arise and the costs associated with remedying those defects. Alternatively, it is open to employers to take out latent defects insurance to mitigate those risks.

How a latent defect policy operates 

The policy is written for the benefit of the property rather than an individual party. If there is a valid claim under the policy, the insurer will respond without fault i.e. without having to prove which of the contractor and/or consultant(s) was responsible for the defect. Depending on the type of policy purchased, the insurer may waive subrogation rights against the contractor and consultants who have caused the loss. Generally, policies with this waiver are more expensive.

The policy will pay up to the total sum insured against the cost of repairing, replacing or strengthening the premises as a consequence of an inherent defect. Inherent defects are normally defined as any defect in the structure or building envelope arising from a defect in design, workmanship or materials or subsidence, heave or landslip upon the site which was undiscovered at the date of inception. 

Some policies work in partnership with the Local Authority Building Control (LABC). The LABC inspectors visit site during the course of the works and monitor the construction of the structural elements ensuring that they are undertaken in a proper manner. This gives the comfort of an independent inspection of the contractor's methods. 

The scope of coverage 

Latent defects insurance policies typically only deal with the load bearing structure and building envelope. Therefore, electrical wiring and connections, pipework, mechanical and electrical works, finishing trades and decorations and items of plant are not covered although some insurers will cover mechanical and electrical services or building components for an additional premium.

In addition, the policy provider will not pay out if the defect existed and was discoverable at the time building works were completed.

The benefits of latent defects insurance

Employers can derive benefits from taking out and making a claim under their latent defects insurance policy as opposed to bringing a claim under collateral warranties.

Typically, the insurance policy is written for the benefit of the project and is assignable. It is often a condition of the policy particularly where subrogation has not been waived that the building contract needs to be assigned to a subsequent owner as well as the policy. If subrogation is waived, the insured will be the employer under the building contract, contractor and any party with an interest in the property. This compares with professional indemnity insurance which is primarily for the benefit of the contractor and consultant. If collateral warranties are granted, there is generally a restriction on the number of assignments.

Typically latent defect policies provide 10 years cover with the payment of the initial premium.  There is no need for annual renewal of the cover.

One of the difficulties of professional indemnity insurance is that claims are made on a claims-made basis. If there is a latent defect discovered and a claim is made on a professional indemnity policy, it is the policy in force at the time the claim is made rather than at the time of the breach of contract. There is always the potential for one or more of the contractor, consultants and design subcontractors to become insolvent. If a party who has become insolvent caused the loss then their insurance is unlikely to respond leaving gaps in the ability to recover losses.

If you have a claim under the latent defect policy, the policy will respond without the need to establish fault on behalf of the contractor or professional team. This is because the policy is for the benefit of the property rather than the various insured.

In contrast, if you make a claim against professional indemnity insurance, it may be necessary to bring proceedings against one or more of the contractor and consultants to establish the loss. This would have the following effects:

  • money would not be available to immediately put right the defect, leading to a cash flow disadvantage;
  • there would be legal costs in pursuing the actions;
  • there would be the "litigation risk" of not achieving the correct decision;
  • there may be reasons why the professional indemnity insurance has been avoided such as late notification of the claim; and
  • either subrogation is waived or it is the insurer's risk of bringing proceedings to attempt recovery after it has paid the claim.

 Generally policies have some annual indexation of the sum insured. If construction costs increase then the sum insured will increase accordingly. Under professional indemnity policies, the constraint is the amount insured on an annual basis. In current market conditions, the contractor and sub-contractors may have annual aggregate insurance (as opposed to cover on an 'each and every' basis) and if there is more than one claim, this may be insufficient to cover the full extent of the client's losses.

With the move to alliancing and no claims provisions in contracts, which prevent the parties from bringing proceedings against each other, a latent defect insurance policy is essential to guard against latent defects which would leave the employer or building owner with a substantial bill for repairing a latent defect. The Government Construction Strategy (2016-2020), approved the Integrated Project Insurance procurement model. This contained both a target cost structure with both elements of cost overrun and latent defects insured. The model has been successfully trialled at Dudley College.

The disadvantages

Latent defects insurance can be expensive to put in place and there are restrictions on what the policy will apply for, as described above.

Under the traditional route of obtaining collateral warranties, it is likely that some or all of these exclusions such as non- structural elements would be warranted by, in the first instance, the main contractor and secondly by the relevant consultant or sub-contractor.

The policy responds solely in relation to the cost of repair and replacement of the defective works together with strengthening of any affected areas. The policy does not cover any consequential losses such as loss of profit.

Due to the exclusions of cover under the policy, disputes may arise as to whether a particular defect or damage is covered. In addition, issues may arise as to who is liable for the cost of repairing elements of the building that are not covered by the policy but that have been damaged by a defect in an element that is covered by the policy. These types of issue mean that policies are not as simple to operate in practice as might appear at first sight.

Additionally, if defects were present at the date of date of inception or practical completion, then they are not 'inherent defects'. In that regard, if LABC has issued a reservation to the insurer, then the items covered by the reservation will be excluded unless they have been subsequently been rectified.

Use in practice

For the major structural elements of the project and, if included, mechanical and electrical services, latent defect insurance provides an acceptable alternative to obtaining collateral warranties backed by professional indemnity insurance. In particular, the ability to obtain immediate payment without establishing breach of contract or negligence is attractive in the current market where there is the potential for insolvency within the professional team and supply chain.