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Construction Insurance and UK Construction Contracts

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CHAPTER 12

Latent defects insurance

Introduction

 12.1 Latent defects insurance provides cover against defects that appear in a building after it has been completed and that are not discoverable at the time of its completion. The policies operate on the basis that if such a defect appears, the policy will meet the cost of remedying it, without regard to who may have been responsible for the defect in the first place. In theory, therefore, latent defects policies provide the building owners and occupiers with a much simpler method of meeting the costs of putting defects right than enforcing the terms of building contracts, professional appointments and collateral warranties. In practice, because such policies are hedged around with exclusions and limitations, recovering the cost of repairs is not as straightforward as it might first appear. 12.2 There are, essentially, two types of policy, one of which has been around for a very long time and the other is a more recent development. The first are the homeowner’s insurance policies issued by organisations such as the NHBC (National House-Building Council, which has existed since 1936) and Zurich Insurance, which are of a generic nature, issued in a standard form to all those entitled to such a policy. And the second are commercial latent defect insurance policies issued by a relatively small number of underwriters in terms that, although based on the insurer’s standard form, are usually specific to the development in respect of which they are issued. Such policies are issued only in respect of commercial premises.

The purpose of latent defects insurance

 12.3 As indicated above, latent defects insurance enables the insured to recover the costs of making good defects in the building that appear after it has been completed. It is important to emphasise that if the defect existed and was discoverable at the time the building was completed, then it will not be covered by the policy. If it existed but could not be discovered at the time of completion, then it will be covered by the policy. 12.4 The main benefit of such a policy is that, unlike trying to enforce a building contract or professional appointment, there is no need for the insured to have to prove that anyone else is at fault in order to recover his costs of repair. As long as he can demonstrate that there is a defect in the building then the policy, subject to its limitations, will meet that cost. That said, it does not necessarily mean that those who were actually responsible for defects will avoid liability. It is often the

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case that, particularly with commercial policies, the underwriters will retain rights of subrogation so that once they have paid the insured’s claim under the policy, they are subrogated to any claims that the insured might have had against a contractor, the designers or others involved in the project who were responsible for the defects in the first place. However, this is not always the case, and it is important always to read carefully the terms of the particular policy. 12.5 In practice, of course, there can be different disputes over whether a particular defect is covered by the policy or not and there are procedural requirements, particularly under the homeowner’s policies mentioned above, which can create as much difficulty as having to prove fault on the part of those who caused the defect. It will be evident, from what has been said before in this section, that latent defects policies do not always live up to their promise.

Homeowner insurance

 12.6 There are a number of companies and organisations that provide such insurance today, but the two largest are the NHBC and Zurich Insurance who, between them, provide the great majority of this type of insurance. Their schemes (and most others in the marketplace) display many similarities but are not identical. 12.7 First, they issue policies specifically aimed at private homes (whether houses or flats), social housing and self-build. The topic of self-build is too wide for this publication but the principles applying to other types of insurance are similar. 12.8 Generally, the schemes require that the providers of the homes are registered. The NHBC registers developers and builders and either can be the “builder” for the purposes of the policy. If one is registered, it is not necessary for the other to be registered as well. Zurich, on the other hand, requires developers to be registered and that developers should employ a builder that is registered with Zurich. In some cases, of course, the two may be the same organisation. Under the Zurich scheme, it is the developer who is liable rather than the builder, but this distinction does not arise under the NHBC scheme. 12.9 The schemes require that developers and builders demonstrate both their financial credentials and their technical ability. These having been demonstrated, developers and builders must maintain the required standards otherwise they will be de-registered and no longer be allowed to develop or construct properties that benefit from homeowner insurance. The fact that the schemes investigate the financial standing of those registered with them explains the first part of the cover available under these policies set out below. 12.10 The policies usually provide cover in three sections, namely, the period up to completion of the home, the first two years after completion of the home and the period from two to 10 years after completion of the home. The cover available in each period is different:
  • (1) If the home is not completed because of the builder’s insolvency or fraud, the insurer will either pay the losses that the insured has suffered as a result or pay to complete the home. As can be seen, this is not latent defects insurance at all and is an incidental part of these schemes.

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    (2) For the two-year period after completion of the home, where the insured has asked the builder to put right a defect in the home but the builder has failed to do so, the insurer will meet the cost of repairing it. Not all defects are covered and, in very general terms, the policy applies to the structure of the building, its waterproof envelope and the various utility systems in it. There are, nevertheless, distinctions between the schemes that could be important. For example, the NHBC scheme expressly includes retaining walls constructed as part of the development but the Zurich scheme excludes retaining walls unless they form part of or provide support to the building. Similarly, the NHBC scheme covers heating systems but the Zurich scheme covers heat-producing appliances. The latter would therefore include cookers but the former would not. There are many other distinctions and these are merely two examples.
  • (3) Presumably on the assumption that most defects are likely to appear in the first two years, limited cover only is available from the third year to the 10th year. However, the extent of cover provided by the two main schemes is significantly different. The NHBC provides cover for specific elements of the building if they are damaged by a defect. An obvious omission is that if a defect is discovered that has yet to cause damage, the cost of repairing the defect will not be covered by the policy.
12.11 The NHBC also provides additional cover where it carries out the building control function during construction of the home and will meet the cost of putting right any non-compliance with Building Regulations. The Zurich scheme is limited to damage to structural elements and non-compliance with Building Regulations. Both schemes cover claims arising from the removal of contamination from the site of the home but the Zurich scheme will only remove contamination that should have been removed as part of the original development whereas the NHBC scheme will remove any contamination which could lead to the homeowner being required to remove the contamination under current legislation. 12.12 It should also be noted that schemes have financial limits to the amount that they will pay out and, again, there are significant differences. 12.13 Typically, once the site has been registered with the insurer, the insurer will arrange to inspect the development from time to time during the course of the work. Provided that those inspections show that the insurer’s requirements are being complied with, the developer will be provided with a homeowner’s pack for each home, which will include the relevant insurance documents, and which will be handed over to the homeowner when the purchase is completed. Once that has happened, it is up to the homeowner to identify and pursue claims against the developer or builder and the insurer will become involved only if the developer or builder fails to meet its obligations under the scheme. At that point, the homeowner may be expected to carry out any necessary repairs with the insurer simply reimbursing the cost or the insurer may arrange for the necessary repairs itself. 12.14 The terms of the policies set out above are those current at the time of writing and the current policy terms should always be carefully checked.

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Latent defects insurance policies

12.15 These operate differently from homeowner’s policies as there are no standard schemes and latent defects insurance policies are issued by a relatively small number of underwriters. The insurance is only designed to deal with latent defects, i.e. those that existed at the date of practical completion of the development but that were then undiscovered (and, under some policies, were undiscoverable). There is therefore no cover available before completion of the development, unlike homeowner’s policies, as most commercial policies do not provide any cover until the end of the defects liability period under the relevant building contract, on the basis that the contractor is liable to make good any defects that appear during that period. 12.16 Commercial latent defects policies have been around for a couple of decades but have never become widely used. The perception, rightly or wrongly, is that they provide a limited level of cover and, for the cover provided, they are expensive. The judgement as to whether a policy is expensive or not is made in the context of the provision of collateral warranties to those who have an interest in the development, which will be discussed later. 12.17 It is certainly true that the original policies provided limited cover and this was usually confined to the structure of the building and its waterproof envelope. Cover was simply not available for other elements of the building. The position has changed over the intervening years and most policies now provide a wider range of cover. However, some elements of cover that many would regard as essential are available only as optional extras at additional cost. This is particularly true for mechanical and electrical installations, which, for a long time, were excluded from latent defects policies and, while some policies now include them as a matter of course, others require payment of an additional premium if these elements are to be included. 12.18 Cost affects those who are insured under the policy. Typically, a latent defects policy would provide cover for the developer, any subsequent owner or occupier of the building and (where applicable) the bank that provides funding to enable the development to be constructed. There are those in the industry who argue that latent defects policies should operate, in a sense, as “no fault” insurance, providing cover for everybody involved in the development, including the contractor, the designers, other professionals involved and subcontractors. 12.19 Under a policy that provides cover only to those who have a direct financial interest in the development, the underwriters will usually obtain rights of subrogation so that, if a claim is paid under the policy, the insurers can pursue the contractor, the designers and/or the subcontractors, to the extent that they were responsible for the defect the insurer has had to put right. 12.20 If all of these parties are included as insureds under the policy, so that the insurers have no right of subrogation and cannot recover their losses from anybody, it is self-evident that the cost of the policy is going to be substantially higher. On the other hand, if latent defects insurance policies become more popular for commercial developments so that the market grows, it is likely that the cost of such policies will come down and the “no fault” approach may become an economic possibility.

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Latent defects policies in practice

12.21 If it is decided that a latent defects policy is appropriate for a particular development, underwriters will be approached to quote an indicative premium. This premium will be made up of two parts. The first is known as the deposit premium and is a fixed amount. The second part is an indication of what a premium is likely to be if the policy is ultimately issued, on the basis that the facts provided to the insurers all turn out to be accurate. This indicative premium will be based on the limited information provided at that stage and without any detailed technical appraisal of the development. 12.22 If the developer decides that he wishes to proceed, he must then pay the deposit premium. This is usually non-refundable in any circumstances and is intended to meet the cost of the insurers’ technical advisers reviewing the drawings and specifications of the development in order to satisfy the insurer that the development presents no unusual or serious technical risks. 12.23 Clearly, if any such risks are identified, the indicative premium for the policy quoted previously will go up and it may be that the developer will decide not to proceed. If so, the insurer keeps the deposit premium and the developer has nothing. However, assuming that, following the technical appraisal, the premium quoted by the underwriter is acceptable to the developer, the development proceeds. During the course of the development, the insurer’s technical advisers will inspect the building as it goes up and will identify any potential shortcomings in the way that it has been designed or constructed. The technical advisers normally have the right to require that any defects or omissions be put right and, if the developer and his team fail to comply, the policy will not be issued. Assuming that any requirements of the technical advisers are properly complied with then once practical completion of the development has been achieved, the policy will be issued. As indicated above, the policy will not usually be effective until the end of the defects liability period, which will normally be 12 months later. 12.24 Most policies provide cover for a period of 10 or 12 years from practical completion and operate on the basis that the insured simply has to demonstrate that there is a defect in the development which is covered by the terms of the policy. As with homeowner policies, the insurer then has the right either to reimburse the cost of putting the defect right or to arrange to carry out the necessary work itself. However, because of the exclusions of cover under the policy, disputes may arise as to whether a particular defect or damage is covered. For example, internal non-structural elements are usually not covered and external decorative elements are often not covered if they do not perform part of the waterproof envelope. 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. As with homeowner policies, these types of issue mean that policies are not as simple to operate in practice as might appear at first sight.

Latent defects policies in the context of collateral warranties

 12.25 In most commercial developments, the contractor, the design team (and often other professional consultants) and subcontractors with a design responsibility are required to enter into collateral warranties. These are separate contractual

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obligations entered into, usually under seal, in favour of third parties who have an interest in the development. These will typically include the first purchaser, the first tenant, any bank providing finance for the development and other interested parties such as the freeholder if the developer is a tenant. Increasingly, such warranties have written into them express limits on liability but, at least at the time of writing, they do not exclude specific elements of the development. Thus if the beneficiary of a warranty suffers loss because of a defect in the development then, up to the amount of any financial limit in the warranty, he can recover that loss from the party responsible for it, provided, of course, that he has a warranty from that party. 12.26 The major disadvantage is, inevitably, that fault has to be proved as these are simply contracts and in order to recover loss a breach of contract has to be established. The need to prove fault can lead to substantial disputes, particularly where more than one party has contributed to a particular defect. However, despite this shortcoming, the development market generally regards collateral warranties as a preferable solution to the question of latent defects as they are viewed as providing more comprehensive cover at a lesser cost. 12.27 As has been indicated, the cover provided by collateral warranties is not necessarily more comprehensive, given the need to prove fault and the fact that it may not be possible to prove that any particular party was at fault. Similarly, the concept that collateral warranties are available at a lesser cost is not necessarily correct. Simply because the developer or other beneficiary does not have to pay a premium for the provision of warranties does not mean that a cost does not exist. The additional risks that a contractor, consultant or subcontractor takes on under collateral warranties are reflected in the price charged for the task they undertake and there is also a significant cost involved in negotiating the terms of warranties that can take a very long time. However, as the cost of collateral warranties does not form a separate line item in most development budgets, they continue to be perceived as a no cost or low cost option. 12.28 There are many who press the case of latent defects insurance policies as an alternative to collateral warranties and argue that, if properly assessed, they are cheaper and more effective. They point to the example of the French decennial insurance scheme. However, this ignores a number of factors, the first being that the French scheme is a statutory requirement for all developments and this statutory requirement has created the market for such insurance policies in France. As long as the market in the United Kingdom remains voluntary, it is unlikely to develop as it has done in France. Secondly, the extent of cover available under French decennial policies is restricted and many areas that the developers would regard as essential are optional extras at additional cost. Third, insurers under the French decennial scheme retain rights of subrogation and are therefore entitled to seek to recover their losses from those responsible for them. This being the case, from the point of view of a contractor, consultant or subcontractor, the position is no better than it would be had they entered into a collateral warranty. They and their professional indemnity insurance policies remain exposed. Finally, the experience of decennial policies in France has not been good and the number of insurers providing such policies is very limited. As a result, the cost tends to be high and many of those involved in the development market in France regard them as a necessary evil, rather than a positive benefit.

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Way forward

12.29 The sentiment in the development market is currently against the commercial latent defects policy but clearly in favour of the homeowner’s policy. This is largely because the latter is treated as a marketing device by residential developers and builders, whereas the former is more concerned with cost. As a result, the market for commercial policies is relatively immature and cost and coverage will remain issues until it expands. Once it does to a sufficient extent, it may well be that latent defects policies will replace collateral warranties, once such policies are issued on a “no-fault” basis without rights of subrogation as a matter of course. This is an issue for the insurance industry and its ability to convince the development market of the benefits of latent defects policies. For a typical type of latent defects insurance arrangement see and 22.

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