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This content is independent of any content coming from insurance brokers, insurers, or any insurance lobbyists. Commercial insurance is rarely taught in schools, and when it is, it’s mostly done through the lens of brokers or insurers. There are many misconceptions around inherent defects insurance or latent defects insurance, like many other topics in commercial insurance, due to bad habits acquired through the over reliance on brokers, insurers, and information providers who are lobbied by them. It is also important to note that inherent defects insurance, aka latent defects insurance, has both an operational aspect and a legal aspect, on which we put weights of 95% and 5% respectively in terms of importance to protecting a business and its investors (the point is that going to court to enforce coverage defeats the purpose of buying insurance, so you want to make sure that whatever insurance you buy protects your business right, based on operational data, and pays out fast on large losses).
What Is Inherent Defects Insurance?
Inherent Defects Insurance (IDI), also known as Latent Defects Insurance (LDI), protects against the cost of repairing, restoring, strengthening, and fixing the insured building or project if the structure suffers damage due to inherent structural defects as part of construction risks. Developers and Investors can make use of this Inherent Defects Insurance, also known as Latent Defects Insurance, to provide first-party protection post-completion for the structural defects (meaning there does not have to be a liability risk incident for the insurance to pay out, it can pay out directly upon the notification of a structural defect and related loss). This insurance enhances the value of the project and makes it more sellable or leasable, while also providing balance sheet protection.
Let’s run a scenario that will help elaborate what inherent defects are and how inherent defects insurance or latent defects insurance can come in handy. Contractors are obligated to stick to code when constructing a building or project. Between consultations with architects, developers, and civil engineers, there are hundreds of quality checks that a structure undergoes before it is considered finished. Human error must always be accounted for, even in cases where the quality assurance is airtight. No matter how careful contractors are with a project, there will always be the risk of inherent structural defects present in the project that can be harmful and leading to substantial losses. That’s where inherent defects insurance comes in. Inherent structural defects are defects that existed before the date of handing over the project or part of the project by the builder to the owner. These defects remained latent or undiscovered. These defects can include flaws in the design, material defects, and errors in workmanship.
Why Inherent Defects Insurance?
Inherent defects can be traced back to faults in plans, materials, designs, specifications, and workmanship during the planning and construction of a structure. These can only be discovered after a certain amount of wear and tear or after the structure has come into use over time. If such a defect affects a load-bearing structure, it could result in a loss of lives, and property damage, and make it impossible to further utilize the building.
Inherent defects insurance covers the cost of repairing an asset if an inherent defect in the structure causes damage or threat of collapse for 10-12 years, on average, following the completion of construction. You have to keep in mind that IDI or LDI are only granted after a thorough audit and vetting process that considers the design, the materials, and the nature of the work done on the site. A Contractor's All Risks insurance policy, aka Construction All Risks, is typically purchased before an inherent defects insurance policy.
Benefits of Inherent Defects Insurance
Benefits of inherent defects insurance include:
1. Balance sheet protection;
2. Project is more marketable, which can enhance developer pricing;
3. Insurance protection to repair and replace damaged property even if the contractors aren’t trading any longer;
4. The technical audit process identifies defects before the completion of the project, allowing these defects to be fixed before the owner takes over the responsibility for the project. If management chooses to undergo an independent audit, that will protect the project by ensuring the quality as well as the compliance with codes, plans, and specifications;
5. The insurance policy is assignable to future owners and tenants of the project;
6. The insured can call upon the insurance relatively faster than other policies when a building suffers from physical loss or damage;
7. There’s no requirement on the policyholder to establish fault, negligence, or liability of the parties to the construction contract.
Cost of Inherent Defects Insurance
The rule of thumb is that it costs around 1% of project value. This is only a rule of thumb and pricing differs on the details of the project. The cost can be amortized of the length of the insurance period from an accounting standpoint. The cost can also be passed through the owners or tenants of the project.