In the UK, ‘defects liability’ typically lasts for six or twelve years. But what happens when the contractor is insolvent and no longer in a position to discharge its post completion obligations? This has always been a risk for owners and developers but has been in sharper focus in recent years following the collapse of Carillion, one of the UK’s largest contractors, in January 2018. Here we discuss how latent defects insurance (LDI) is becoming an increasingly popular alternative form of protection.

Upon completion of any building, the owner or tenant has limited recourse in the event that the structure is damaged as a result of defects arising from its construction. Traditionally, these remedies are against the contractor responsible for the building project as it is commonplace for the responsibility for both design and construction to be passed on to the contractor, even where the architects and engineers were originally engaged by the employer. The level of responsibility will differ depending on the contract and the way it is executed.  

So what happens in the event of the contractor becoming insolvent?

One might argue that the subcontractor that delivered the defective work should be held responsible for the owner’s losses. However, the courts view of this situation has evolved over time.  

The leading case was decided in 1991 when the House of Lords issued its judgement in the case of Murphy v Brentwood District Council. The decision created the precedent that claims for defective work, pursued in tort, are considered as pure economic loss and therefore not recoverable from the responsible party.

This decision catalysed the development of the collateral warranty, an extra-contractual relationship between key subcontractors and the employer, under which rights could be exercised in the event of main contractor insolvency. It is worth noting that these collateral warranties could also be assigned by the employer to subsequent building owners.
This is still not a watertight solution, however.  The warranty provider should only be liable to the beneficiary to the same extent that it was under its original contract.  In addition, given that the subcontractor market is generally considered to be more volatile than that of main contractors, there is always the chance that the warrantor may also be insolvent when the time comes to claim.

Is there any protection under the main or subcontractors’ insurance?

Defective design liabilities are normally covered under professional indemnity (PI) insurance.  However, making a claim against an insolvent contractor’s PI insurance is fraught with difficulty.  PI insurance is provided on a ‘claims made’ basis, meaning there has to be cover in place at the time the claim is made, not when the error occurred. As policies are normally cancelled by insolvency practitioners to realise unearned premium, there is seldom a policy to claim against.  In addition, any policy breach by the now insolvent insured will be exploited by the insurer to avoid liability to the claimant.

Is there any cover under permanent property insurance for damage arising from building defects?

This damage is normally excluded under a property policy, in which case there is no opportunity to cover the business interruption losses that arise as a consequence.

Are there any other insurance options available to owners?

Latent defects insurance (LDI) is an option that is becoming increasingly popular with property owners and developers embarking on new projects. This will indemnify the building owner (or possibly tenant) for damage (actual or imminent) to the structure or building envelope arising from construction defects.  LDI policies are normally arranged for a ten or twelve year period following practical completion, so can match or even supplement the protection period available under the defects liability provisions of the contract.  Cover can be extended to mechanical and electrical works and also business interruption losses arising from covered damage.

How are the policies underwritten by insurers?

Underwriters will issue a quote prior to commencement of construction following receipt of technical information from the insured.  A deposit premium and a due diligence fee is paid to the insurer and the construction project is then monitored with technical audits carried out to identify any potential defects in design, workmanship or materials. Any defects or concerns must be dealt with during the construction period.  On completion, once the works are signed off by the technical auditor, the policy becomes active and the balance of the premium for the risk becomes due.

What are the main benefits of LDI?

  • LDI is a “first party” insurance product that is procured by and protects the building owner.  This is in contrast to enforcing rights against another independent party through either the building contract or a collateral warranty.  Claims will be settled faster and provide the capital to reinstate damage as opposed to pursuing a lengthy claim through arbitration or litigation to secure reimbursement.
  • LDI provides a backup in cases where the contractors or subcontractors are insolvent.  Without this protection the employer retains significant additional risk which can manifestly affect the value of the property.  In fact, the LDI policy can be assigned to future building owners or tenants that have full repairing responsibility.
  • The technical audit undertaken during the construction phase provides another independent check on design and quality which should assist in delivery of a successful project.
  • Coverage can be extended beyond damage to the building structure and envelope to include mechanical and electrical systems as well as business interruption costs arising from the damage.

For more information and to discuss how LDI could apply to your active or upcoming construction projects, do not hesitate to get in touch.

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