Builders’ Risk and Other Special Coverages that the Owner

and LenderNeed in a Construction Project.

Introduction--

Sophisticated real estate attorneys, representing their respective sophisticated landowner and developer clients in the negotiation of a ground lease under which the ground lease tenant would construct an office building and lease the building to a subtenant, recently agreed that the ground lease tenant would be required to provide the following insurance coverages during construction of the office building on the landlord’s property:

INSURANCE

1.1Tenant’s Insurance. Tenant shall, at its expense, keep in full force and effect the following insurance policies during the Term and any extension thereof.

(a)Property. Commercial property insurance, insuring: (a) one hundred percent (100%) of the full replacement cost of the Leased Site Improvements (exclusive of foundations, footings and excavations), as well as Alterations made at Tenant’s expense or direction, and all other property owned or used by Tenant and located in the Premises; and (b) against all “special perils”.

(b)Liability. Commercial general liability (“CGL”) insurance and, if necessary, commercial umbrella insurance, with limits of at least Three Million Dollars ($3,000,000.00) per occurrence and Three Million Dollars ($3,000,000.00) in the aggregate. CGL insurance shall cover liability arising from premises, operations, independent contractors, products-completed operations, personal injury and advertising injury, and liability assumed under an insured contract, including without limitation this Lease.

(c)During Construction. During the construction of the Improvements and the performance of all Alterations, Tenant shall maintain or, at its option, cause Tenant’s contractor or subcontractor, as appropriate, performing such Alteration to maintain:

(i)Completed Value Builders Risk insurance which shall, at a minimum, cover “special perils” related to the Alteration and materials related thereto;

(ii)Automobile liability and, if necessary, commercial umbrella liability insurance with a limit of not less than One Million Dollars ($1,000,000) each accident covering liability arising out of any auto (including owned, hired, and non-owned autos) used in connection with such Alteration;

(iii)CGL insurance described above; and

(iv)Workers compensation and employers liability insurance with employers liability limits of not less than One Million Dollars ($1,000,000) each accident for bodily injury by accident or One Million Dollars ($1,000,000) each employee for bodily injury by disease.

(text bolded for emphasis).

These authors ask, and this article explores, the questions (i) whether the negotiators in the above transaction have adequately protected their respective clients’ interests in the event a casualty should occur during or as a result of construction of the building improvements; (ii) whether the respective clients’ lenders’ interests are protected in the event a casualty should occur during or as a result of construction of the building improvements; and (iii) if the clients’ or their lenders’ interests are not adequately protected here, what additional—or different—steps should the negotiators have taken to adequately protect those interests?

What IS Builder’s Risk Insurance?

Builder’s Risk Insurance is specifically designed to address a broad group of risks that can arise due to the nature of construction—the number of different contractors and subcontractors typically involved in the construction; the acquisition, on- and offsite staging and ultimate use of materials in the construction; the numerous different acts performed which collectively comprise the construction; the fluidity with which all these people, events, and materials come together in the construction of improvements; and the changing nature of the risks to the improvements and the participants as the construction proceeds toward the completed project.[1]

Builder’s Risk Insurance, sometimes also known as “course of construction” insurance, covers real property improvements as they are being constructed.

Builder’s Risk Insurance will usually also coverdamage to (i) materials onsite, waiting to be incorporated into the constructed improvements, (ii) materials while in transit to the site to be incorporated into the constructed improvements, (iii) materials offsite waiting to be transferred to the site for incorporation into the constructed improvements.

Builder’s Risk Insurance mayalso provide coverage for damage to equipment used in the construction project though that’s not usually the case unless you specifically acquire that coverage through a Contractor’s Equipment endorsement.

Itmay also provide coverage to the insured’s contractors, subcontractors and lenders.

There are important limitations to Builder’s Risk Insurance. It is usually applicable for onlya short time after the improvements are completed. The length of that time can be negotiated, as can the definition of “completed construction”—but you must remember that the Builder’s Risk Insurance coverage WILL expire shortly after construction is completed (however that term is defined through negotiation) and that the insured parties must be insured after that, if at all, under a more traditional ISO type commercial property insurance policy.

Builder’s Risk Insurance may—or may not—cover or exclude a whole host of additional risks, conditions and circumstances depending on what you’ve included—or failed or forgotten to include—during your negotiation of the policy terms. Builder’s Risk Insurance is PROPERTY insurance—not liability insurance—though many coverages operate more like liability insurance. And the party seeking to recover under the Builder’s Risk Insurance policy must have an insurable interest in the property that has suffered the physical damage.

How is Builder’s Risk Insurance different from commercialproperty insurance?

Builder’s Risk Insurance and CommercialProperty Insurance address fundamentally different, though overlapping, kinds of risk.

CommercialProperty Insuranceusually provides protection to the named insureds and additional insureds from casualty events in situations where the property improvements have already been constructed, the casualty events impact the physical condition of the improvements, and the universe of expected risks remains fairly constant.

The insurance industry strives for uniformity and consistency. In the pursuit of this uniformity and consistency, Insurance Services Office, Inc. (ISO), a trade organization that services and advises the insurance industry, has prepared and promotes the use of a number of ISO Liability and Property Insurance Forms. Unlike the ISO’s liability insurance forms, which are “recognized nationally as ‘the industry standard’”, the ISO’s property insurance forms have not gained industry standard recognition. They are widely used, but some insurers write Commercial Property Insurance on forms different from the ISO forms.[2]

There is no equivalent uniformity and consistency regarding Builder’s Risk Insurance policies.

Though Builder’s Risk Insurance can be written on ISO Liability and Property Insurance policy forms, most Builder’s Risk Insurance today is written on “Inland Marine Insurance” forms.

This kind of insurance originally developed to provide coverage for goods lost or damaged while in ocean transit. It later evolved to provide coverage for goods lost or damaged while in transit across inland waterways and, later still, overland by train, truck, or plane.

One key distinction between this form of insurance and traditional property insurance is that Inland Marine Insurance follows the goods as they move rather than following the fixed site real estate.

Another important distinction is that while traditional property insurance insures against a fairly constant universe of risks, Inland Marine Insurance policies have historically insured risks that are based on frequently changing conditions.

Finally, it is typical that the Builder’s Risk Insurance policy will name several parties—the owner, the contractor, major subcontractors and suppliers, the lenders of one or more of these parties, possibly the tenant—as insureds under the policy to reflect the fact that in a construction context numerous parties have insurable interests in and risks related to the materials and the way they are incorporated into the construction.

“Inland Marine Insurance”, today, is a misnomer. It is simply the historic name that underwriters who provided this coverage, and who competed for insurance dollars with insurers who were issuing insurance based on damage to fixed site real estate improvements, began using to highlight—market—the fact that their insurance moved, or “floated”, with the goods as they moved from site to site prior to incorporation into the fixed site real estate improvements.[3]

Today, Inland Marine Insurance is used to insure a number of different risks. One risk, of course, is builder’s risk. Inland Marine Insurance can be obtained to cover, among other things, risks associated with (i) the improvements being constructed,(ii)transporting the goods that will be incorporated into the improvements, (iii)materials installation; (iv) contractor’s equipment, (v) preparing concrete forms and other support structures, and (vi) rigging, i.e. scaffolding, the building in order to construct improvements or renovate existing improvements, all related to the constructionof the fixed site real estate improvements.

Representative Documentation.

ISO offers a Commercial Inland Marine insurance program. ISO has developed an Inland Marine Handbook which includes forms, endorsements, declarations, and suggestions for managing risk and calculating rates for a broad range of business insurance.

The American Association of Insurance Services, Inc. (AAIS) is, like ISO, a trade organization that services and advises the insurance industry. AAISalso prepares Builder’s Risk insurance forms that are used by many insurers. However, there aren’t a lot of standardized forms, and the forms that do exist are generally used as templates—starting points, really—for the individualized Builder’s Risk Insurance policies that usually must be negotiated to address the circumstances, conditions and risks that are unique to each construction project.[4]

You should be aware that AAIS hasfiled inland marine insurance forms for some previously unfiled classes of insurance business in a number of states. You will want to check to see if any inland marine insurance forms have been filed in your state.

AAIS has granted permission to include as exhibits to this Article the following representative documents:

  • Builders’ Risk Coverage, Scheduled Jobsite Form, Comprehensive Form--

AAIS IM 7050 08 12 (Attachment 1);

  • Schedule of Coverages, Builders’ Risk Comprehensive Form--

AAIS IM 7055 01 12 (Attachment 2);

  • Builders’ Risk Coverage, Rehabilitation and Renovation Form--

AAIS IM 7054 08 12 (Attachment 3);

  • Schedule of Coverages, Builders’ Risk—Rehabilitation and Renovation Form—

AAIS IM 7059 01 12 (Attachment 4);

  • Delay in Completion Coverage Part Form—

AAIS IM 7061 09 11 (Attachment 5);

  • Delay in Completion Schedule Form—

AAIS IM 7062 01 12 (Attachment 6);

  • Builders’ Risk Forms Comparison document (Attachment 7): and
  • AAIS Authorization to use forms (Attachment 8).

These forms are not freely available to the public or to practitioners.

What does a Builder’s Risk Insurance policy generally cover? Exclude?

Builder’s Risk insurance “coverage is usually written on an all risks basis and typically applies not only to property at the construction site, but also to property at off-site storage locations and in transit. Builder’s Risk Insurance can be written on either a completed value or a reporting form basis; in either case, the estimated completed value of the project is used as the limit of insurance.”[5] AAIS representatives have advised me that they prefer the term “open perils” or “named perils” in general parlance, as opposed to “all risks”, and so if you deal with an AAIS representative or with AAIS forms you may see “open perils” or “named perils” language instead of “all risks” language.

As with all insurance policies, “the big print giveth and the small print taketh away”. This is an awfully broad and somewhat unfair characterization, considering that there is both market pressure and case law pressure on trade organizations to make their policies readable and to display their policy restrictions prominently. Even so, Builder’s Risk Insurance policies, like most insurance policies, start by providing broad coverage and then limit that broad coverage by exclusions. Consequently, it is important that you read and understand the terms of the proposed Builder’s Risk Insurance policy.

Since Builder’s Risk Insurance, to be most effective, should be tailored to the specific circumstances of your construction project, it is also important that you think through the project events, from your buyer/borrower/lender/contractor client’s perspective.

Finally, and in these authors’ opinions, it is most important that you work with a trusted insurance professional to negotiate the terms of the Builder’s Risk coverage at the same time that you negotiate the terms of the Construction Agreement or the Construction Loan documents. You should pay close attention to make sure that the insurance and indemnity provisions in these agreements “sync up” with the terms of the Builder’s Risk Insurance. And if the project risks are large enough, or unusual enough, you may even want to consider hiring an insurance consultant to advise you during your negotiations with the insurance broker.

During those negotiations, you should ask AT LEAST the following questions:

  • Can you use Inland Marine Builder’s Risk Insurance to cover your project? Or must you insure using an ISO or similar Commercial Property insurance policy?
  • Some states that enforce the Nationwide Marine Definition may not allow you to insure losses related to retrofitting, or the construction of interior improvements in or renovations to, an already completed building using Inland Marine coverage. In those states, you may have no choice but to use ISO Commercial Property insurance policy.[6]
  • What property is to be covered?[7]
  • The existing improvements?
  • Foundations, walls, sidewalks, parking lots, landscaping, signage, or utilities wires, cables, sewer or water lines?
  • Does it matter in your state whether the work is purely renovation work to an already existing structure instead of new construction?
  • Is your client constructing a “building” (generally considered improvements that will be occupied), or a “structure”? Do the Builder’s Risk Insurance policy and the endorsements refer properly to your client’s kind of improvements throughout the documents? And if they don’t, then do you have a potential gap in coverage?
  • Initial site work?
  • The materials that will be incorporated into the existing improvements as part of the construction work?
  • Does that material have to be onsite?
  • Or is it covered while offsite, in transit, or waiting to be put in transit?
  • Does the material have to belong to the policy holder?
  • What if it belongs to the contractor, who is not an insured under the Builder’s Risk Insurance policy?
  • Does that analysis change if the third party owner of the materials is an insured under the Builder’s Risk Insurance policy?
  • Based on the work that’s to be done, should that third party be an insured under the Builder’s Risk Insurance policy?
  • The contractor’s equipment?
  • If so, is this under the Builder’s Risk Insurance policy? Or an endorsement? And are there any equipment exclusions in the governing document?
  • Has the contractor provided a schedule of and values for the equipment which the contractor or the contractor’s employees will use on site?
  • Are office trailers, cranes, contractor work vehicles, scaffolding, fencing, concrete forms or other temporary structures designed to aid the construction, building blueprints and other valuable project papers covered?
  • Is debris removal to be covered?
  • Have you included an endorsement to expedite repairs?
  • Have you adequately identified the real and personal property elements which will be insured? For example, if the policy insures contractor’s materials or equipment under an “equipment floater”, you need to accurately identify the kind, quantity, and value of the equipment being insured. Ask whether you are buying coverage based on the replacement value or the depreciated value of the equipment, and make sure your statement of equipment value properly denotes whether the value is the replacement value or the then depreciated value of the equipment. If you overstate the value of the equipment (for example, by listing replacement value when the policy insures up to the depreciated value), you’ll wind up paying premiums based on those values but, in the event of a loss, will be insured up to only the actual value of the equipment. And what happens if the damage or loss occurs to new, unscheduled equipment that the contractor has brought onto the site?[8]
  • What property is covered and whatis your client’sinsurable interest in that property under a Builder’s Risk Insurance policy?[9]
  • For example, if the Builder’s Risk Insurance policy covers contractors, you may not need to negotiate a separate contractors’ “installation floater” endorsement. But remember that the policy covers only those parties with an insurable interest. The real estate owner does not have an insurable interest in materials owned by a contractor before those materials are installed into the improvements; nor does she have an insurable interest in the equipment owned and used by the contractor to construct the improvements. The parties should take care to make sure those insurable interests are protected. You also need to see whether the policy covers tools/equipment provided by the contractor’s employees. Does the policy cover the contractor’s liability if equipment rented by the contractor to do the construction is damaged or lost? The contractor may need to obtain a separate installation floater policy to cover some of these issues.
  • Are there separate limits for losses involving materials stored offsite, in transit, or stored onsite?
  • Are the limits different based on whether the policy holder or some other insured owns the materials at the time of the loss?
  • Are there different limits for losses due to earthquake or flood? If so, are the limits acceptable?
  • What parties are covered?
  • Owner, buyer, tenant, builder, general contractor, subcontractors, lender.
  • How are their interests alike?
  • Where do their interests differ?
  • Have you properly identified the AMOUNT of insurance coverage?[10]
  • Did you exclude the value of the land?
  • Did you include—
  • The expected completed value of the constructed improvements;
  • Does that value include excavation and landscaping work, and architect’s fees?
  • Does that value include the insureds’ overhead and profit? If not, was is the omission intentional? And if it is, are you sure that the omission won’t lower the insurance/project value ratio to the point where coinsurance concepts begin to apply?
  • Did you build in a mechanism in the Builder’s Risk Insurance policy allowing you to increase the coverage amount if cost overruns or change orders increase the cost of the improvements?
  • Is there any reason why you wouldn’t or can’t structure the Builder’s Risk Insurance as an Owner Controlled Insurance Program (OCIP) or Contractor Controlled Insurance Program (CCIP)
  • If not, then between the two is there any reason why you wouldn’t opt for the OCIP over the CCIP?
  • How does the decision to acquire an OCIP instead of a CCIP affect coverage for materials and fixtures that start out belonging to the contractor? When does ownership of those materials transfer to the owner? And if there IS a coverage gap, can you address it by having the contractor obtain a separate installation floater?
  • Remember that you probably have the same potential problem, in reverse, if the parties decide to acquire a CCIP, but the property owner rather than the contractor owns the materials.
  • AGAIN--WHO HAS THE INSURABLE INTEREST? DOES THAT INTEREST TRANSFER FROM ONE PARTY TO ANOTHER DURING THE LIFE OF THE CONSTRUCTION PROJECT? IF SO, WHEN? AND HOW DOES THE OCIP OR THE CCIP ADDRESS THAT CHANGE IN INSURABLE INTEREST??
  • Is the policy an “all risks” policy? Or does it offer more limited initial coverage?
  • What risks are excluded by the policy?
  • Losses due to flood or earthquake? You can usually obtain endorsement coverage against these risks by paying an additional premium.
  • Collapse of the improvements during construction? Look carefully at your Builder’s Risk Insurance policy.