Liability for latent defects remains a prominent issue in the construction industry. In this article, we set out some of the insurance solutions available to parties and the practical steps required to put such insurances in places.
Latent /Inherent Defects - Overview
The term 'latent' or 'inherent' defect is a term that is commonly used in the construction industry. Both terms are used interchangeably but both are, in effect, a defect arising due to a defect in the design, materials, workmanship or supervision of contractors or site works which existed but was not apparent (or 'patent') on completion of the building works. Protection in relation to such defects is often a key focus for purchasers or investors when purchasing commercial or residential property. Developers and contractors are also keen to understand (and limit) the extent of their liability for latent defects.
This shared concern in relation to liability for latent defects often leads to consideration of the options available to help protect the interested parties in the event that latent defects arise. One such option is insurance, namely Latent Defect Insurance and Homebond.
Latent Defect Insurance
What is Latent Defect Insurance?
Latent Defect Insurance (LDI) is a form of insurance cover against defects that may arise in the design, workmanship or materials used in construction works. LDI can, in theory, be obtained for any kind of development (commercial, residential or mixed use). Given that it is quite an expensive policy, we most often see it in large-scale developments when an institutional investor or purchaser is involved.
Typically, an LDI policy will be for the full reinstatement value of the insured building (calculated at practical completion). This reinstatement value will normally be subject to a percentage per annum indexation, the purpose of which is to offset inflation over the course of the policy period.
In order for an LDI policy to respond to a claim, the defect must have first:
(a) Become apparent in the structure or waterproofing envelope of the insured building;
(b) Only become apparent after the defect liability period for the works has expired; and
(c) Resulted in actual physical loss or damage.
What is the process for obtaining LDI cover?
Typically the process for obtaining an LDI policy is as follows:
- Prior to commencing works, or at a very early stage in the construction process, the owner or developer of the building will approach insurance brokers in order to obtain quotes. Before pricing the policy, brokers will require the relevant technical information and drawings from the future policyholder.
- Once a quote is accepted, the future policyholder will pay a deposit and an inspection fee to the insurers.
- The insurers' technical adviser (ITA) will audit the works for the duration of the construction period with particular attention paid to any construction milestones such as the completion of the laying of foundations or the completion of the waterproofing elements of the building. If the ITA flags any potential defects during the construction period and these are not resolved to their satisfaction prior to practical completion then the insurers will reserve the right to increase the initial quote for the policy.
- Once practical completion is achieved, the ITA will request copies of the certificate of practical completion and the snagging items list. At this point, the ITA will audit the works and the parties will agree the reinstatement value of the building and the associated policy premium to be paid by the insured party. The policy premium is paid at practical completion.
- Although the policy will come into force on practical completion, it will only respond to claims in respect of latent defects that arise after the expiry of the latent defect period set out in the underlying building contract.
Key Features of LDI
- Building owners/developers who require LDI cover must engage with LDI providers as early as possible in the construction process. This is important for the following reasons:
(a) It allows the insurer and their ITA to begin auditing the construction works from an early stage in the process, thereby increasing their level of oversight over the works and, in theory, decreasing the risk of a defect arising. If parties seeking LDI cover fail to engage with insurers at an early stage the cost of obtaining the LDI cover can increase significantly and depending on the complexity of the structure, may not be obtainable at all.
(b) It allows the owner/developer of the building the opportunity to get a clear picture as to the deliverables that are required under the LDI policy. This in turn allows the owner/developer to pass these obligations onto the construction parties under the suite of the construction documents.
- Unlike other forms of construction insurance such as professional indemnity insurance, there is no requirement to prove fault or negligence as a pre-condition to recovering against an LDI policy. As such, LDI policies tend to respond much more quickly to claims as compared to other forms of construction insurance.
- LDI policies are taken out directly by the building owner/developer and as such, do not depend on the solvency of the contractor, consultants and sub-contractors who carry out the works. As such, LDI can be seen as a type of hedge against the risk of insolvency on the part of construction parties.
- LDI policies are typically assignable meaning that they are an attractive feature for funders and future purchasers/tenants who want the additional level of protection afforded to their investment by LDI cover.
- LDI policies are expensive. This expense is likely driven by the advantages of LDI as highlighted above. However this cost is concentrated in large up-front payments (by way of a deposit and inspection fee that is payable when the insurer is first engaged followed by a single lump sum premium that is payable upon practical completion).
- LDI policies only respond to latent defects that arise in the structure or waterproofing envelope of the insured building and therefore will not respond to latent defects that may arise in respect of other aspects of the works.
- The LDI policy will be subject to a monetary cap (being the full reinstatement value of the insured building as calculated at practical completion) and a time limitation, which is typically 12 years from the expiry of the defect liability period for the insured works.
- LDI policies are typically subject to the following exclusions:
(a) Failure to maintain/repair the building;
(b) Structural changes made after practical completion;
(c) Fitout plant and equipment; and
(d) Consequential loss, loss of profit and loss of rent cover (to the extent that the LDI policy covers loss of rent, the ability to recover lost rent is typically time limited and subject to a monetary cap).
Homebond
What is Homebond?
Homebond is a form of insurance against defects that arise following the construction of residential units. Unlike LDI, it is an insurance solution available only to residential development.
In order for Homebond to respond to a claim, the defect must amount to a "material non-compliance" (a term that is unfortunately not defined) with the requirements of the Building Regulations. Note however that failure to follow the guidance documents accompanying the Building Regulations does not amount to a latent defect for the purposes of Homebond if the performance required by the Building Regulations is achieved by some other means.
As with LDI policies, Homebond only responds to latent defects and is subject to a number of exclusions. For example, personal injury claims and claims for consequential loss typically are not recoverable against a Homebond policy. This list includes 24 exclusions with some sub-categories. Before taking out a Homebond policy, these exclusions should always be reviewed thoroughly.
Homebond will audit the works as they are being carried out and will only cover the property if the works are carried out to their auditors' satisfaction.
Key Features of Homebond
Typically, a Homebond policy comprises two separate forms of insurance (defects insurance and structural insurance) with an option to add additional insurances at an additional cost (for example, mechanical and electrical equipment cover). Each of these standard two forms of insurance have different features and respond to different claims.
Defects Insurance:
- This insurance will respond only to latent defects that cause the following:
a) Smoke and water ingress;
b) Certain physical dangers caused by latent defect relating to fire safety; or
c) Damage caused by a latent defect which materially and adversely affects the use of a significant portion of the unit (for example, drainage or pipework).
- The cover remains in place for a 5 year period from the date of final certification (being the date on which Homebond certify the satisfactory structural completion of the insured unit).
- Any claims made against this insurance are subject to either, a monetary cap of €50,000 for any one housing unit or the rectification costs for the housing unit, whichever is less. If the housing unit is part of a continuous structure (for example, an apartment in an apartment complex) then an additional monetary cap of €500,000 will apply for all of the claims made in respect of the housing units in that continuous structure.
Structural Insurance:
- This insurance will respond to latent defects that arise in respect of an element of the structure of the building and which cause major damage.
- The cover remains in place for a 10 year period from the date of final certification (being the date on which Homebond certify the satisfactory structural completion of the insured unit).
- Any claims made against this insurance are subject to either, a monetary cap of €200,000 for any one housing unit or the rectification costs for the housing unit, whichever is less. If the housing unit is part of a continuous structure, then an additional monetary cap of €2,000,000 will apply for all of the claims made in respect of the housing units in that continuous structure.
Conclusion
The most appropriate type of latent defects insurance really depends on the nature of the development, i.e. whether it is commercial, residential, or mixed use. The exit strategy for the finished development is also a key factor; for example, a sale to an institutional purchaser or investor who may have particular concerns and requirements in relation to protection for latent defects. While we hope you find this explanatory note useful, if you are considering your options in relation to latent defect insurance solutions, we strongly encourage you to seek advice from an insurance specialist and determine which solution best suits your requirements.
For further information in relation to this topic or any related matter, please contact Siobhan Kearney Senior Associate, or Paul McNamee, Solicitor or your usual contact on the A&L Goodbody Construction & Engineering team.
