This article summarises what latent defects insurance and collateral warranties are, their respective advantages and disadvantages and concludes with whether latent defects insurance is a suitable alternative or useful back-up to collateral warranties from the construction team. What is latent defects insurance (LDI)?
LDI typically provides protection for building owners and other interested parties, such as tenants and funders, against damage to buildings arising from a defect in the design, workmanship or materials which occurs during the f rst 10-12 years following practical completion.
To claim, an insured party does not need to prove negligence. Therefore, if an insured defect arises in the building after practical completion, the policy should cover the cost of correcting the defect.
Advantages and disadvantages of LDI
The cost of obtaining an LDI policy has reduced over recent years and it can be a useful way of providing long-term protection because:
- Defects may be corrected even where the contractor or consultant becomes insolvent, which is a signif cant risk in current times
- It can be amended to suit the requirements of most commercial, residential or mixed-use developments and the Council of Mortgage Lenders will accept LDI as an alternative to NHBC cover on residential buildings
However, the signif cant drawbacks of LDI include:
- LDI adds between 1% and 3% to construction cost, for example to fund technical audits required by the insurer throughout the construction phase
- Defects which do not result in physical damage to property are often not covered by LDI
- There is often a total exclusion for consequential and economic losses (eg loss of rent or loss of prof t)
- The policy is limited to a maximum sum insured and any claim will be subject to a deductible or excess. Further, insurers may refuse to respond to a claim where there has been a non-disclosure, misrepresentation or where the policy wording gives rise to an ambiguity over whether a claim is covered
Put simply, a collateral warranty is a contract under which a professional consultant or contractor warrants to a third party benef ciary (eg the developer, purchaser, tenant or bank) that it has carried out services or works in accordance with a specif ed standard of skill and care. Consequently, if a defect arises for which the warrantor is responsible, the third party will have a contractual right to recover damages.
By way of example, the diagram below shows the collateral warranties which may be granted on a typical project. On a large project with multiple benef ciaries, a high number of collateral warranties will be executed.
A carefully and clearly drafted collateral warranty will ultimately put the third party in a more certain and perhaps a stronger position than it would otherwise have had under a LDI policy.
However, collateral warranties also have their drawbacks:
- They often contain limitations or exclusions of liability, which may signif cantly affect the benef ciary’s ability to recover damages
- The benef ciary must prove the warrantor was in breach ofits contractual duties
- The insolvency of a warrantor liable for a defect may preclude recovery (however, the warrantor’s professional indemnity insurance may resolve this to a degree)
LDI or collateral warranties?
It is clear that neither LDI nor collateral warranties can offer benef ciaries the perfect solution. The threat of contractor or consultant insolvency remains a signif cant risk in the current economic climate and LDI may provide a useful layer of protection where collateral warranties are unavailable. Although LDI is not particularly popular in the UK, it is compulsory in some European countries.
However, LDI is unlikely to be an effective substitute for a collateral warranty package which is well drafted and robust. From a bank’s perspective, in addition to affording a right of action against the construction team, a collateral warranty may also provide a right of step-in if the developer defaults under its loan agreement prior to completion of the works.
It would therefore be prudent for those considering developing or investing in new commercial property to investigate both options fully before making an informed choice; or, for the seriously risk averse, to ask for both!