Latent defects insurance

Latent Defects Insurance ("LDI") may be offered to a tenant as a "carrot" for taking on full repairing obligations, or it may be proposed as a required insurance in a PFI project. But what does it do, and what should you bear in mind before you decide to buy it?

What is the purpose of LDI?

LDI is intended to provide first party insurance cover for defects in a building which exist at practical completion, but do not become manifest until later. It came into being as a response to the difficulties of recovering the cost of rectifying a defect from the person responsible for the defect. The difficulties include:

• The cost of repairing a defect is deemed to be an economic loss, which in general terms is not recoverable in tort. Unless a tenant or subsequent purchaser of a building has obtained collateral warranties from the contractor and all of the design team, they will be limited to an action in tort. Even where there is a collateral warranty, it may not offer particularly wide protection, especially where the tenant/purchaser was not involved in negotiating the wording.
• Even if there is a right of recovery against the contractor or design team, that right is worthless if the party in default has become insolvent. The designer's professional indemnity insurance is unlikely to help here as it has to be renewed annually (which it cannot be if the designer is insolvent). Furthermore, even if the designer is solvent, he may have done something to vitiate his professional indemnity insurance, or he may have insufficient cover, which again can mean that there is no money to recover.
• Finally, even when there is a right of recourse and a fund of money to go against, the difficulties and vagaries of the litigation, or arbitration, process still need to be faced. Even with a strong case, recompense is likely to be considerably deferred simply because of the way the system functions.

LDI is intended to provide a (relatively) simple and rapid means of recovering the cost of repairing a defect, avoiding these pitfalls. LDI does, however, have its own pitfalls and is by no means a complete solution to the problems of recoverability.

What is (and is not) covered by LDI?

The principal cover provided by LDI is for damage or imminent collapse due to a defect existing at practical completion, but not obvious until later. It is generally limited to defects in the structural elements of the building, although this is frequently extended to cover waterproofing/weatherproofing, and may, at a price, be extended to cover defects in mechanical and electrical installations. The cover is usually for a 10 year period after practical completion, is paid for by a single initial premium and is non-cancellable (subject to compliance with policy terms and conditions).

It is important to bear in mind that LDI policies usually do not cover:

• Consequential losses (although some insurers may provide a loss of rent extension);
• Defects which are not causing damage, including pure failures to meet a performance specification;
• Defects manifesting during the defects liability period which the contractor has an obligation to repair;
• Defects in non-structural elements of the building (eg. defects in the floor finishes).

This range of exclusions means that the issues of recoverability will still remain in the areas not covered by the policy.

Practical points to bear in mind

There are a number of practical issues which should be borne in mind when deciding whether to procure LDI:

• LDI premiums can be quite high in relation to the cost of the project and so it may not be cost effective to procure LDI for low-value projects. One way to reduce premiums is to agree a large deductible: caution should be exercised here as this effectively reduces the recourse to insurers (which will be unattractive to a tenant which has only taken on a full repairing covenant because LDI is in place). The hardening of the insurance market in the last 12 months means that premiums generally are on the increase.
• Insurers will usually require a technical audit agent to be involved in checking the design during the design and construction phases. Consequently, the decision to procure LDI needs to be made at a very early stage: although LDI can be procured after the design phase, the premiums are significantly greater. The involvement of a technical audit agent also creates issues for those drafting the contracts as to how any comments or requirements are to be dealt with and who bears the risk of delays caused by the technical audit agent.
• Consideration needs to be given to who will be insured under the LDI. Recovery can only be made under insurance if there is a loss, so it is important to ensure that the party which is responsible for repairing the defects is insured under the policy, remembering that this may be the owner when the building is untenanted. The usual position is for the owner/developer and the tenant each to be a named Insured, each for its separate rights and interests. If it is intended that the LDI will be extended to subsequent tenants, this should be raised with insurers when the LDI is procured as it may impact on the premium and the terms of cover. Being a named Insured will protect the tenant against subrogation by Insurers, which would otherwise be a risk if the tenant has repairing obligations and the owner makes a claim.
• Care should be taken to ensure that the building is only used for the purposes for which it was designed and that it is not loaded beyond its design loading as this may vitiate the LDI cover: the tenant’s obligations should reflect this.
• The limitations of the scope of LDI cover mean that it is essential to maintain rights of recourse against the contractor and design team. LDI is not a substitute for the usual property material damage and business interruption insurances and the normal consideration should be given to these.

LDI is not a solution for all of the risks faced by owners/developers and tenants: nonetheless, on high value projects and especially perhaps in times of economic uncertainty, it can provide a valuable means of managing some of those risks.

For further information please contact Sarah Thomas at [email protected] or on +44 (0)20 7367 2094