Latent defects insurance is on the rise

25 January 2018

Lateral thinkers always have the edge in business. And savvy property developers are using a niche form of insurance to make their projects a hotter prospect to banks, financiers, tenants and other stakeholders.

The product in question is latent defects insurance (LDI). LDI is a type of cover that’s normally taken out by property developers who desire first party protection post completion for defects, and /or want to enhance the lease-ability / saleability of the completed building.

Why LDI take-up is increasing

When discussing LDI, the primary driver for most clients (mainly property developers) stems from the fact that the Council of Mortgage Lenders (CML) requires a 10-year warranty or insurance policy before lending money for newly built residential properties.

For commercial developments, it is rarer for lenders to require this cover. Despite this, Building Life Plans (BLP), one of this market’s key insurers, has seen a 575% increase in LDI take-up on commercial developments in the past few years. We are also seeing the wider application of LDI, in particular on international civil projects; more about that in my next blog.

The growth in take-up can be attributed to a number of factors, including:

  • Private rented sector

With LDI not being compulsory on commercial developments, some developers might consider going without it. To deal with any defects post completion, they’ll rely on collateral warranties and rights of recourse against the construction and professional teams.

This is particularly common when there is no desire from the developer to sell the assets or dwellings once complete. We have seen this recently in the private rented sector (PRS).

In this sector, typically, the assets are held long term, and individual units are rented out instead of being sold. That being the case, in LDI terms, this type of development is akin to a commercial risk as opposed to residential however, some developers wish to maintain the option to sell units after a period of private rental creating a requirement for them to have a CML-approved structural warranty or insurance product in place.

Why LDI attracts investors

Despite there being no regulatory requirement, lenders and financiers are keen on the cover being arranged on PRS schemes. This is to protect them should they need to step in within the first 10 years of completion, and sell the individual units.

Having the appropriate form of LDI arranged can allow for a ‘switch option’, meaning they’d be able to evidence the housing warranties and certificates required to sell individual units and release capital.

Some insurance markets have responded to this. They will consider options that allow developers to arrange cover on a commercial basis to begin with, and agree for a switch option should they wish to convert to residential within the first 10 years, and require the CML certificates for sales to go ahead.

  • Not all things are equal: housing warranties vs latent defect insurance

LDI operates in a way where both the developer and the homeowner are afforded first party cover. Should a claim-worthy defect arise during the period of insurance, insurers will indemnify the developer and the homeowner to rectify the damage.

Insurers would then look to be compensated by the professional party that was negligent in causing the defect. The claim is settled regardless of whether a party is found negligent.

Many of the housing warranties operate separately and could end up costing the developer dearly. Should a defect arise during the period of insurance that amounts to a claim, insurers will only indemnify the homeowner. Furthermore there is often a 24-month period where the developers are liable for defects. LDI, however, provides cover from practical completion (with the exception of ingress of water); this cover commences 12 months post practical completion.

Insurers would look to claim back money from both the developers and the professional parties. If the professional party is not found to be negligent, then the developer must cover the costs to the extent of the law.

“For PRS developers looking to protect their rental income flow and to enable the possibility of a future ‘asset flip’, the provision of LDI is undoubtedly something that needs to be considered,” says Chris Loerns, Underwriting Director of BLP insurance.

“Policies will respond to defects causing damage rather than evidencing negligence under contract. This enables prompt repair, which minimises untenanted periods and indemnifies against loss of rental income,”he says.

LDI: What’s in it for me?

Whether their projects are commercial or residential, there are many reasons why developers should consider LDI for their new projects:

Saving time and money

First party cover, in the form of LDI, removes the time delays and legal costs in proving fault / negligence and pursuing the relevant parties of the construction contract in order to remedy any defects. 

In the absence of LDI, the developer would need to pursue the contractor or relevant parties under the construction contract in order to remedy the defect or the cost of doing so. In relying on this route of recourse, the developer risks what is likely to be a litigious process with high costs attached to it.

As developments become more complex (and costly) to build, the need to protect these assets increases.

“More than 250 buildings of more than 20 storeys high are in the pipeline in the UK. Seventy skyscrapers are already under development in London alone,” comments City law firm, Kennedy’s. 

“These developments command a lot of capital. The result of all of this is a growing demand for policies such as bespoke latent defects insurance cover so that developers, tenants and owners have the reassurance that their property is covered should latent defects arise in the future.”

Removes fears of contractor insolvency

LDI is an upfront cost, and is non-renewable; it is not affected by the subsequent insolvency of any member of the construction or professional team. The same can’t be said about the contractor’s collateral warranties, or their professional indemnity (PI) insurance.

That being said, latent defect insurance does not remove the need for collateral warranties or PI. Both remain important parts of the overall risk management strategy.

This is especially true for defects that do not cause damage, as LDI doesn’t cover non-damage events unless damage is imminent (see What does LDI cover? below).

Attractive to tenants

Developers looking to increase their properties’ attractiveness are more likely to offer their tenants full cover for defects in the form of LDI. This cover is becoming almost customary and accounts somewhat for the increase in take up.

Future-proofs your investment

The policy can help smooth the process of future sale / tenancy agreements, as it is freely assignable to future tenants or purchasers.

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LDI: THE FACTS

What is LDI?

Typical latent defects insurance policy periods run between 10 and 12 years from the date of practical completion. They should be sought prior to construction start, however some insurers will consider arranging cover on partially complete and completed structures.

What does LDI cover?

  • Structural defects
  • Ingress of water (all weather-proofing is excluded for first 12 months)
  • Subsidence landslip or heave
  • Threat of imminent collapse requiring remedial works to prevent damage caused by a defect in design, workmanship or materials, but not discovered before inception of cover.

Additional forms of insurance

It is possible to arrange other forms of cover for owners / developers and tenants to work in conjunction with a latent defects policy, including:

  • Loss of rent
  • Loss of gross profit or revenue arising out of a defect
  • Increased cost of working from alternative premises
  • Mechanical and electrical breakdown
  • Premature component failure cover. This cover is one enhancement that is not purely damage-related. It responds to provide cover for premature failure (with reference to pre-agreed life-cycle plans) of non-structural components. These include boilers, electrical wiring, pipework and more. 

Cover operates on a reinstatement basis, and includes professional fees, debris removal, costs to comply with public authority requirements, external walls or roof, and seepage below ground level.

It is important to remember that LDI insurance doesn’t replace the need for collateral warranties and professional indemnity insurance. The insurance is designed to respond to damage, and the aforementioned are still very important for defects that do not cause damage. 

How do I find the most effective LDI policy / coverage at the best price for my business?

Consult a specialist construction broker who can advise on the most effective structure for your project / appetite. Like any form of insurance policies, LDI cover can be structured to suit the need and appetite of policy holders and other stakeholders. Standard terms, conditions and exclusions will apply so it is important to work with your broker to ensure that the coverage meets the needs of your business.

For more information, please contact Naresh Dade, Partner on +44 (0)20 7528 4776, or email naresh_dade@jltgroup.com

This blog is compiled for the benefit of clients and prospective clients of companies of the JLT group of companies (“JLT”). It is not legal advice and is intended only to highlight general issues relating to its subject matter; it does not necessarily deal with every aspect of the topic. Views and opinions expressed in this document are those of JLT unless specifically stated otherwise. Whilst every effort has been made to ensure the accuracy of the content of this document, no JLT entity accepts any responsibility for any error, or omission or deficiency. If you intend to take any action or make any decision on the basis of the content of this document, you should first seek specific professional advice. The information contained within this document may not be reproduced and nothing herein shall be construed as conferring to you by implication or otherwise any licence or right to use any JLT intellectual property.

contact Naresh Dade
Partner, JLT Construction