Latent defects insurance: worth having?

Marc Hanson examines the logic behind, and the limitations of, latent defects insurance

Construction disputes relating to latent defects are invariably complex. It is often not clear who is responsible for any particular defect and it may well be that any one defect may be the responsibility of a number of parties. For example, a latent defect caused by poor workmanship may be the responsibility of not only the contractor, but also the sub-contractor who undertook the work and the architect if he failed to notice the defect on his inspection of the works. Lack of clarity in relation to responsibility for latent defects invariably leads to multi-party proceedings which can take a number of years to resolve at significant expense to all involved, including the building owner. The building owner may, even if he is successful in his claim, end up having to bear a significant proportion of his own legal costs. Furthermore, pending the outcome of any legal proceedings, he may have to pay for the repair of the defect out of his own pocket in the hope that he can eventually recover those costs from those responsible for the defect.

In 1998, the National Economic Development Council published the BUILD report - “Building Users’ Insurance against Latent Defects”. The report promoted latent defects insurance derived from the system of decennial insurance introduced by the French Civil Code in 1978.

The perceived advantage of a latent defects insurance policy is that the owner is not obliged to establish who is responsible for any particular defect before being able to obtain funds to rectify that defect. In addition, no expensive court proceedings are necessary in order to obtain funds to put the defect right. Also, as the funds will be paid as soon as a claim is made, this would allow the immediate rectification of the defect without the building owner needing to have recourse to his own funds.

Unfortunately, the latent defects insurance policies initially promoted by the insurance industry did not meet the expectations of building owners. Briefly:

• The policies only covered physical damage and not defects which did not result in damage but which, for example, led to high running costs of the building. In addition, they did not cover purely aesthetic defects, for example discolouration of cladding panels. Most importantly they did not cover poor performance of the building and its components, for example any mechanical and electrical engineering services. This was a significant limitation given that most claims in relation to building services relate to non-compliance with performance requirements.
• Policies only covered newly built buildings, not refurbished buildings.
• Policies only provided cover for ten years from completion and, after only five years from completion, insurers reserved the right to review the cover in relation to water-proofing. These limitations contrast unfavourably with the twelve year limitation period available in relation to a contract executed as a deed.
• Policies did not cover all losses that could be sustained by the building owner. For example, they did not cover business interruption losses such as the cost of alternative rented accommodation, loss of profit and loss of production. Given that such consequential losses could form the lion’s share of the building owner’s losses, this was a significant limitation.
• Policies only covered the structural elements of the building and did not cover mechanical and electrical services. It was rare to find a policy which unequivocally covered all parts of the building.
• Policies frequently did not take effect until after the contractor had complied with his obligations under the defects liability period. Given that most latent defects tend to manifest themselves in a building before the end of the defects liability period, this, again, was a significant limitation.
• Finally, the policies available were considered, given their limitations, very expensive. This was especially the case as the premium needed to be paid “up front” and could not be spread over the lifetime of the policy.

The problems outlined above led to a general lack of take-up in latent defects insurance for much of the 1990’s. Where such insurance was taken out, this was where question marks existed as to the financial covenant of the contractor or consultants who built the building or where such contractor or consultants had become insolvent and were therefore unable to warrant their works. In the latter circumstances, policies were extremely expensive as insurance companies were generally unhappy to provide policies for existing buildings where they had not had a chance of monitoring the construction work.

In recent years, increased competition amongst insurers has led to a general fall in the premiums for latent defects insurance policies. In addition, the cover offered by such policies has, to a limited extent, expanded. It is now possible to buy extensions to latent defects policies to cover defects in mechanical and electrical plant and services and policies are now available to cover refurbishment of existing buildings. Some insurers are also prepared to issue policies that offer cover for twelve years from the date of completion rather than just ten years.

Despite the recent improvements in latent defects insurance noted above, policies currently available in the market place are still unattractive to many building owners. In particular, the lack of cover for poor performance of the building and the lack of clear cover for all parts of the building not just the structure has led to only a modest increase in the take-up of latent defects insurance in recent years. However, take-up can be expected to increase if premiums continue to fall and building owners take out such policies on a belt and braces approach whilst still relying primarily on the contractor and the consultants in relation to any latent defects.