Recovering the cost of latent defects – contractual claims vs latent defects insurance

How best to protect against latent defects in construction projects has long been a thorny problem.

While developers may have direct contractual claims against contractors and design professionals and may extend those claims by collateral warranties to purchasers, funders, and tenants, as the market has become increasingly sophisticated a greater awareness exists as to the potential shortcomings in relying solely on contractual claims. This has resulted in increased market demand for additional protections against latent defects.

Latent defects: What are they?

The term “latent”, sometimes called “inherent” defects, refers to defects arising due to a defect in the design, materials, workmanship, or supervision of contractors or site works which existed on completion of the works but were not apparent at that time.

To fund rectification of such defects and consequent losses, recourse to parties responsible for them will often be sought through actions for breach of the contracts put in place for the design and construction of the property concerned. In addition to such claims, those with an interest in property can take out latent defects insurance (LDI). LDI policies are becoming increasingly popular for all types of developments despite the additional costs involved.

Contractual claims and collateral warranties: How do they provide protection in the event of latent defects arising?

Contractual claims (under building contracts, design appointments, collateral warranties, and related agreements) are the obvious first avenue of recourse in the event of latent defects arising post completion of building work. These claims rely on the underlying contractual terms agreed with the relevant contractor or design team members concerned. Such claims will only be available to immediate counterparties to the contracts or their permitted assignees (and not to subsequent purchasers, funders, etc.). The ability to effectively impose liability and recover against responsible parties for latent defects will depend on:

• the availability of contractual rights against those parties;
• the ability to prove a breach of the relevant contract (rights of recovery under a contract would usually be “fault based”);
• the precise contractual terms of the relevant contract and any exclusions or limitations of liability under those contracts;
• whether time to prosecute a claim is still running (under the Statute of Limitations, 1957 a cause of action for breach in this context would usually commence from the date of completion of the works for a builder or the date of issue of defective design by a designer and run for 6 years under an ordinary contract or 12 years for contracts under seal); and
• the availability of funds to meet the claim (either from the responsible party’s balance sheet or via then current professional indemnity insurance cover).

In relation to the latter point, the availability of professional indemnity insurance is often relevant in the context of latent defects. Such cover will not always be available at contractually required levels when prosecuting claims for latent defects which may come many years after works are completed. Professional indemnity insurance is written on a “claims-made” basis whereby cover extends only as far as the indemnity limit established under the policy at the time a claim is made (and not the cover in place when any relevant negligence or breach actually occurred). In Ireland, the market for such insurance has recently seen some turmoil with many insured parties not being able to secure cover renewals at traditionally sought levels.

“Developers who require LDI cover must engage with LDI insurers at an early stage of development to allow the insurer and its nominated assessor to begin assessing the scheme and monitoring the construction works from an early stage ensuring increased oversight during the course of the works and clarity for the insurer regarding the underlying risk and ultimate premium.”

LDI: How does it work?

LDI is insurance cover against loss or damage arising due to identified categories of defects becoming apparent in the design, workmanship, or materials used in a construction project. Recovery is typically limited to damage to the structure or waterproofing membrane of the insured development which becomes apparent after the contractor’s defects liability period. Unlike contractual claims they are not “fault based” so it is not necessary to prove the cause of the defect or to pursue the contractor or design team to recover under the policy.

Developers who require LDI cover must engage with LDI insurers at an early stage of development to allow the insurer and its nominated assessor to begin assessing the scheme and monitoring the construction works from an early stage ensuring increased oversight during the course of the works and clarity for the insurer regarding the underlying risk and ultimate premium. A delay in engaging with the insurer may lead to an increased or loaded premium or indeed, the insurer may be unwilling to provide the insurance at all if it is not involved at a sufficiently early stage.

• An LDI policy has the following advantages over purely contractual claims:
• LDI policies are not “fault based” so a claimant is not required to prove a breach of contract or other legal duty prior to recovering under the policy;
• LDI policies are issued by a suitably rated insurer and, therefore, the financial strength of the contractor or design team is not relevant to a claimant;
• LDI policies typically run with the development for the duration of the cover and are therefore, not limited to a certain number of permitted assignments; and
• LDI policies are a common feature in most other jurisdictions and will give comfort to foreign institutional purchasers, tenants and funders.
• Claims under LDI policies (at least the LDI policies commonly available in Ireland) do, however, have certain disadvantages when compared with contractual claims, including:
• LDI policies are expensive and the cost/benefit analysis for a developer incurring those costs is not always immediately clear. As purchasers, funders and tenants are, however, increasingly more sophisticated and global, an LDI policy is often viewed as a “must have” rather than a “nice to have” when offering a development for sale/letting, particularly for mixed use or commercial developments;
• LDI policies cover latent defects that arise in the structure or waterproofing membrane only and not latent defects that arise in other parts of the development such as fit-outs, plant, machinery and equipment (although policy extensions can sometimes be purchased for an additional premium);
• LDI policies generally are written with extensive lists of indemnity exclusions which must be carefully considered; and
• LDI policies generally do not cover certain categories of loss such as loss of rent, loss of profit or other consequential loss or otherwise will have indemnity limits on such loss and other types of claim.

Conclusion

Latent defects are an unfortunate reality in property development. The turbulence of the property market over the last two decades has shown how contractual claims against contractors and designers can be fraught with difficulties either due to insolvencies in the sector, complexity of claims or changes in the professional indemnity insurance market. LDI policies while adding to the cost of delivering a project can be important in terms of maximising the success of the scheme, whether in terms of delivering the best funding option or the most advantageous purchaser/tenant. When considering the appropriate form of insurance on any project specialist insurance advice should be taken and the detailed terms of any policy interrogated to ensure that whatever route is taken delivers the best results in terms of value for money and risk cover.

Maitiú Ó Dónaill
Partner, Commercial Real Estate
T: +353 (0)1 4180600
E: ­m.odonaill@beauchamps.ie

Richard Stowe
Partner, Construction
T: +353 (0)1 4180600
E: r.stowe@beauchamps.ie