Construction Insurance and UK Construction Contracts

Marshall Levine and Roger ter Haar KC

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CHAPTER 15 Property insurance (under higher tier property documents)

General

15.1 Above the relationship between client and its builder/contractor and design team are the relationships that allow the development projects to be commissioned and funded. The general contractual relationship between a developer, a funding institution, a tenant and the developer’s design team and main contractor can be seen diagramatically in . Although this diagram may initially seem complicated, the relationships reflect normal “day-to-day” contractual relationships between the main players, and in reality they only reflect the network of contractual duties and liabilities owed in a typical UK building project, involving a funding institution, typically a bank or consortium of banks, or pension fund, insurance fund, equity fund, a property developer, and a tenant or tenants. 15.2 Each of the agreements between these parties will usually contain principal contractual and indemnity clauses: first, in relation to the liability for the carrying out and completion of the works; and secondly, liabilities to third parties, and thirdly a possible loss of rent incurred by the landlord if the tenant fails to pay, whether under a lease or an agreement for lease. 15.3 In addition, the reader should not be confused by a reference to the possibility of the agreement for lease involving the client/developer, the fund and the tenant. The structure is best explained using the diagram in . In normal circumstances the lease would be granted pursuant to an agreement for lease, under which the tenant is promised his lease at or immediately after practical completion of the development, when the building becomes available. This may therefore require a tripartite agreement between the developer who is building the property as new, or refurbishing existing property, e.g. converting a shell (often described as a refurbishment, or renovation project), secondly the fund that is proceeding to forward purchase it at or after practical completion and that eventually becomes the landlord, and thirdly, the tenant or tenants. Such agreements may be signed on a pre-letting basis, or possibly signed after the main development agreement between the developer and fund is signed, in which case it is possible that the developer will have signed agreements for lease with a tenant or tenants before the fund has come onto the scene. 15.4 The contractual lines beneath the developer, with the design team on the one hand and the contractors on the other, are merely reflective of the traditional contract method, which is described in , whereas the dotted warranty lines reflect separate collateral obligations owed between the design team and the fund or

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tenant, as appropriate on the one hand, and the contractors on the other hand, owed again to the fund or tenant as appropriate. The shaded but phased warranty lines are described as “hopeful” because in normal circumstances (though there may be exceptions) subcontractors would not give collateral warranties directly to tenants and funds, because within a complex contractual framework this would be too cumbersome to administer. Possibly what would happen would be that the warranties owed by subcontractors and even suppliers to the developer, would be passed on in favour of perhaps the fund or tenant by way of a declaration of trust by the developer in favour of the beneficiary of whatever warranties it has received. Alternatively there could be an agreement to enforce such rights for and on behalf of the beneficiaries of warranties, if such rights have a prospect of success in the courts, but not beyond such obligation.

Development agreement between the developer and the fund

15.5 The development agreement between the developer and the fund will usually include the following obligations for the developer:

(1) to covenant to build the development in a good and workmanlike manner, in accordance with good building practice and, depending upon the extent of the obligations, to secure that such building works are fit for the purposes intended;
(2) to insure such works until practical completion under the building contract, which is the date when the architect certifies, under normal building contracts, that the building works are practically complete, save any snagging works.

15.6 After practical completion under the building contract, the funding institution, as ultimate landlord of the building, will usually assume the comprehensive insurance obligations through direct obligations back to the developer. The insurance obligations include the following features:

(1) that the insurance is in the joint names of the funding institution, the developer and the contractor. (See Mark Rowlands Ltd v Berni Inns Ltd,1 and see .)

15.7 Alternatively, although not advisable from the point of view of the funding institution, the funding institution’s interest may be merely noted on the policy effected by the developer or the contractor. Noting usually used to have three key effects: (a) it preserved the legality of the policy under section 2 of the Life Assurance Act 1774, which requires all interested parties to be identified; (b) it prevented the exercise of subrogation rights by the insurer (see Mark Rowlands); and (c) it allowed the party whose interest was noted to effect an application under section 83 of the Fires Prevention (Metropolis) Act 1774. 15.8 Following the Mark Rowlands decision it is now clear that the Life Assurance Act 1774 does not apply to policies on buildings, and the insurers have no

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subrogation rights, irrespective of noting, in the case where it is a tenant’s interest that is noted on a landlord’s policy. The same principle should apply to any party having an interest in the premises, just being noted on the policy in any event. Occasionally the developer agrees with the funding institution that the CAR insurance policy, taken out by the contractor in the joint names of the funding institution, the developer and contractor, is sufficient for the purposes of compliance with the developer’s immediate insurance obligations to insure the works directly. It is important that the risks itemised in the insurance obligations correspond with the contractor’s risks under the building contract. The insured is under an obligation to apply the insurance proceeds in the event of a risk event occurring with all possible speed in the full cost of reinstatement of the building (see the meaning given to “reinstatement” in Camden Theatre Ltd v London Scottish Properties Ltd;2 and Vural Ltd v Security Archives Ltd 3) (very rarely are these policies valued policies). The full cost of reinstatement would be construed as covering the cost that might properly be expected to be incurred at the time when reinstatement takes place, as opposed to the date on which each annual insurance premium was paid (see Gleniffer Finance Corporation Ltd v Bamar Wood and Products Ltd 4). The reinstatement obligations usually deal with reinstatement in accordance with “the development documents”, being the documents relating to the original development. However, strict compliance with such obligations may not be possible. A provision is included confirming that the insurance monies paid out in advance of reinstatement should be held in a separate account in the funding institution’s name for reinstatement purposes. This is to avoid a developer’s receiver or liquidator taking the insurance proceeds and claiming a proportion of it, in the event of the developer’s receivership or liquidation. There is usually an indemnity in favour of the funding institution given by the developer in relation to any claims and demands arising from the development’s construction, accident or injury caused thereby to third parties, or in relation to any other similar claims whatsoever. An insurance covenant in a mortgage may in certain circumstances give the mortgagee an equitable interest in the proceeds of an insurance effected by a mortgagor where the mortgagee’s interest has been “noted”.5 A failure on the part of the landlord to have a tenant’s interest noted on a policy required by a lease does not necessarily discharge the tenant from paying an insurance charge under a lease.6 15.9 There are several important points to note:

(1) First, there should be no conflict between the development agreement and the building contract (between the developer and the contractor), because in reality the contractor’s insurance policy will cover the insurance of the works.
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(2) Secondly, if the contractor’s insurance policy is the relevant policy, a note of the fund’s interest should be endorsed on the policy as a matter of priority and an acknowledgement that this has been done should be given by the developer, before the development agreement is signed up.
(3) Thirdly, the contractor’s policy should be generally reviewed, when acting for the funding institution, and should be provided by the developer, in readiness for a request by the fund’s advisers to review the policy. The fund’s advisers should not rely on general front sheet information produced by the developer or the contractor but should look to investigate any special exclusions, special endorsements and the ambit of the cover. In addition they should perhaps require the developer or the contractor, depending upon who carries the insurance responsibility, to procure from the insurer a statement that at the date of the development agreement no events have taken place of which the insurer is aware, which could render the policy to be declared void for nondisclosure or in breach of normal insurance rules.

15.10 If the developer, in a building contract between the developer and the contractor, agrees to insure the works in the joint names of the contractor and the developer, and later covenants in the development agreement to insure in the joint names of the funding institution, the developer and the contractor, this will be in conflict and give to the funding institution a good discharge for the insurance monies and it would partially have control over them (see Penniall v Harborne 7). If he does this under the funding agreement, then clearly the contractor must consent to such an arrangement.

Agreements for lease

15.11 As with the development agreement, similar obligations exist under the agreement for lease between the developer or the funding institution as landlord (where the funding institution is granting the lease and the developer carrying out development obligations, in the agreement for lease between the developer, the fund/landlord and the tenant). 15.12 Important features worth noting:

(1) the developer’s obligations to carry insurance up to practical completion and the fund’s obligation to carry such insurance beyond that date, as if the lease with the tenants had been granted, and thereafter fulfil the obligations of the landlord under the lease;
(2) the tenant’s interest as prospective lessee of the building or part of the building, should be acknowledged by whoever carries the insurance responsibility, whether the funding institution as landlord, or the developer or contractor.

15.13 It should be noted that usually there is no general obligation imposed upon a landlord under a lease, unless there is a provision to this effect, obliging a landlord to use the insurance monies received from the insurers to reinstate the premises.

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15.14 Section 83 of the Fires Prevention (Metropolis) Act 1774 provides that where a loss is incurred by a fire that is covered by insurance (and covers only fire insurance: see Vural Ltd v Security Archives Ltd 8), any person or persons interested in such building, the occupier, owner of the property, or indeed the mortgagees (see Sinnott v Bowden 9), as the case may be, can call upon the insurer to apply the insurance monies to the extent possible in rebuilding the premises, instead of paying them directly to the insured. This Act applies to properties in England and Wales and is not limited to the metropolitan area, and applies only to buildings. However, the application to the insurer must be made before the insurer pays out sums involved to the insured. 15.15 The tenant should not rely on the Act but should obtain a direct covenant by the landlord to reinstate the property, including the cost of removal of debris and demolition and obtaining planning permission, as well as full compliance with building or other regulations. This will secure the rebuilding, because otherwise the landlord may simply be obliged to apply the insurance monies towards reinstatement, in which case the landlord would not be obliged to top up any difference between what is required and what is received from the insurance company (see Mumford Hotels v Wheeler 10). 15.16 It is possible to contract out of the provisions of the Act if it suited, say, a bank under a mortgage not to make available the rights under the Act to a borrower. However, it could clearly not defeat other interested persons. 15.17 Also, the tenant is interested in knowing that the insured is under an obligation under the agreement for lease to actually reinstate the premises or such part of it as is damaged, and not simply to use the insurance proceeds for the purposes of reinstatement, except to the extent that this is impracticable or impossible. 15.18 Furthermore, in relation to impracticability or impossibility the courts would have to decide what is impracticable or impossible, and, if acting for a landlord, it is important to qualify such expression as far as possible, with the words “in accordance with the views of the landlord or their advisers”. 15.19 There are problems relating to the ownership of insurance monies if reinstatement is impossible or prevented (see Re King 11 and Beacon Carpets Ltd v Kirby 12) and therefore it is still common to expect a landlord to require a right to break a lease if reinstatement is impossible or prevented within a number of years from the date of the event of damage or destruction. 15.20 Under an agreement for lease, usually the prospective landlord shall, until the grant of the lease, arrange insurance cover for the prospective tenant under its buildings insurance, but if the landlord is carrying out works then, in addition, the landlord will keep insured or arrange to keep insured (in the joint names of both) itself, tenant, any developer (if the landlord is not carrying out the development itself), the contractor and the landlord’s works (sometimes called shell and core

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works) at not less than the full reinstatement rebuilding and/or replacement cost against loss or damage by the risks covered under a comprehensive CAR policy. 15.21 Full reinstatement or rebuilding cost in the circumstances means the full cost that might properly be expected to be incurred at the time of reinstatement. 15.22 In essence the landlord uses the policy under the building contract, taken out either by itself or by the contractor, as its way of fulfilling the insurance obligations to the tenant under the agreement for lease. 15.23 If the tenant is also carrying out tenant’s works (often called fitting out works), the landlord will wish to have these works covered and integrated into its CAR policy (taken out for the landlord’s works) or that they be subject to a separate obligation (for the tenant to arrange cover either itself or through its contractor in the joint names as abovementioned). 15.24 With both landlord’s works and tenant’s works proceeding in parallel, the insurance position can be tenuous and complicated, and therefore it is best for the insurance brokers of landlord, tenant, developer and insurance representatives of the contractor to communicate and plan the insurance arrangements as early as possible. Of course, when the landlord’s works are finished, and practical completion or equivalent stage has been reached, then the lease is usually granted and the building owner’s building insurances (probably the landlord himself) come into effect. The landlord’s works become integrated into the fabric of the building or structure being insured. Equally, after the tenant’s works are completed, either pursuant to the agreement for lease or a licence to alter, these works will be integrated into the fabric of the building or structure and the main buildings insurance policy will take over. Hopefully the lease and the buildings insurance policy will be integrated and use common parlance and adopt the same description of risk cover.

Lease

15.25 After the lease is granted to the tenant, pursuant to the terms of the agreement for lease, the terms and covenants in the lease will dictate:

(1) whether the landlord or tenant assumes the basic property insurance, third party liability insurance, and the loss of rent insurance;
(2) which party therefore assumes the obligation to reinstate the premises;
(3) the responsibility of the tenant to pay premiums; and
(4) the availability of the policy or a copy or details thereof, to the party not assuming the prime insurance obligations.

15.26 The lease, whether headlease or underlease, as abovementioned, will be granted only when all preconditions under the agreement for headlease or under-lease is granted, including any building works being completed. 15.27 The landlord will usually keep the buildings or structures (other than plate glass - where a waiver will be sometimes granted) insured against loss or damage by insured risks in the full reinstatement cost (taking into account building costs inflation). The insurance obligations are subject to the agreed exclusions, limitations, etc. and insurance being available in the relevant insurance market - London, Europe, the world - on reasonable terms acceptable to the landlord.

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15.28 The landlord will usually be paid by the tenant the insurance rent and insurance valuation costs (every so often but usually not more often than once a year) less deductions or excess sums. 15.29 In addition there are usually covenants by the tenant:

(1) to give notice of material information or matters;
(2) not to make void the policy of insurance;
(3) to comply with insurer requirements;
(4) to give notice of damage or loss relating to the property;
(5) not to effect other insurances, but if the tenant receives proceeds of other insurances they must pay the proceeds to the landlord;
(6) to pay the landlord an amount equal to the amounts that the insurer refuses to pay out because of an act or omission of the tenant.

15.30 There is also an obligation by the landlord to reinstate using the monies received from the insurers, and if there is any deficiency in monies the landlord pays the difference. This risk arises because the landlord nominates, if he insures, the amount of the insured sum. If the insured sum is not enough, then he must suffer the financial consequences. The tenant should bear this point in mind. 15.31 Also, if an insured event happens, then the rent, insured rent and service charges under the lease are suspended for a period of time (from two to five years but commonly three years), pro rata to the amount of damage or destruction caused. Usually the landlord will have taken out alongside his buildings insurance or integrated into it a loss of rent policy that covers for the loss of rent etc. during this period. 15.32 Also, if it proves impossible or impractical to reinstate the building or structure, the landlord is commonly given a right under the lease to terminate it on short notice (keeping any proceeds of insurance, and without prejudice to rights and remedies available to the landlord against the tenant). The right to terminate a lease is also often given to a tenant if the property has not been reinstated by the landlord within a reasonable period, e.g. two years after damage or destruction. Where the proceeds of a policy are paid out in lieu of reinstatement, in a situation where the buildings cover had been taken out in the names of both the landlord and the tenant the proceeds were shared between landlord and tenant in proportion to their respective interests.13 15.33 If in doubt as to what is included as “insured risks”, insured risks will include fire, explosion, lightning, earthquake, storm, terrorism, flood, bursting and overflowing of water tanks, apparatus, or pipes, impact by aircraft, and articles dropped from them, impact by vehicles, riot, civil commotion, and any other risks that the landlord insures against.

Loan documents

15.34 The banks lending money to commercial property development will require that all policies taken out by the developer or by a commercial landlord will be taken

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out in joint names of the bank or fund, and the property owner. The insurances should be in full force and effect, in the full reinstatement value and the lenders will seek a warranty that there has not been nor will there be any omission to disclose a fact which would entitle any insurer to avoid or otherwise reduce its liability under or in respect of any such insurance to less than the amount provided in the relevant policy. Also the banker will require a warranty that there are no other insurances in effect under which the borrower is insured or has any rights except for the insurance taken out. The detailed requirements for the contents of the insurance are usually summarised in a schedule to the loan or credit agreement, and will comprise a summary of the policy, any exceptions, and any important detailed provisions.

Refurbishments

15.35 Complications can arise under the development agreement and the building contract when one is dealing with refurbishments. In relation to the majority of standard JCT building contracts there may be clear reasons why the developer or, in the case of a building owner who is also funding the refurbishment, developer/landlord wishes to retain overall responsibility throughout the building works for insurance. 15.36 The situation usually arises because of the problems of having more than one policy covering the building and the contractor’s works. In the event of a claim, which affects both policies, e.g. if the refurbishment works include improvements to an existing envelope of a building, there could be a chance that if there were two policies in existence, one with the landlord covering the external envelope, and the other with the contractor covering the work, both insurers under the separate policies might claim under the “contribution” rules that they are entitled not to pay out the full amount of the insurance proceeds. Thus the sum total of the insurance proceeds under both policies would not cover adequately the monies required to reinstate fully. This is sometimes the reason why tenants’ fitting out works are required to be covered by the landlord under the landlord’s insurance policy.

Collateral warranties

15.37 The diagram in includes reference to a network of collateral warranties. Increasingly throughout UK building projects, collateral contracts have become the norm under which the tenants, funding institutions and purchasers of buildings expect to receive direct contracts from the professional consultants and the contractors engaged on the project. This practice arose because of inherent difficulties in establishing direct relationships in the law of tort between funds and tenants, the members of the design team and/or contractors engaged by a developer on a project. Following the decision by the House of Lords in D & F Estates v Church Commissioners 14 collateral warranties have become much more widely used. This case has radically curtailed negligence claims in the construction industry and Caparo Industries plc v Dickman 15 (which related to auditors’ advice)

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confirms that professionals are in the same position and is generally accepted as creating a precedent for professionals’ liability in the construction industry. above summarises the principles of the law of tort so far as relevant for present purposes. 15.38 The various decisions at the highest level discussed in establish that there is now a severe limitation upon the tortious remedies available to those with an interest in buildings (e.g. funders, purchasers, tenants, etc.). Accordingly such interested parties would be ill advised to rely on their remedies in tort but should rely instead on contractual remedies, hence the growth in use of collateral warranties. 15.39 Collateral contracts, commonly described as collateral warranties or duty of care agreements, are merely expressed as contracts collateral to the main appointments of the design team and the building contractors, under which such members of the design team and contractors enter into direct duty of care obligations to the beneficiaries of the warranties, e.g. funds, purchasers or tenants, and acknowledge their duty of care to such persons. 15.40 It is intended that such collateral contracts are assignable by the beneficiaries to future purchasers of the building, as well as to assignees of the leasehold interests acquired under the lease by the tenants (albeit that professional consultants and contractors try and resist attempts to allow such warranties to be assignable). The most common clauses in collateral warranties include:

(1) obligations to owe a duty of care to the beneficiaries of the warranties;
(2) obligations to maintain professional indemnity insurance for a given number of years, usually reflective of the period of liability of the consultant under the collateral warranty (6, 12 or 15 years);
(3) a licence granted to the beneficiaries of the warranties allowing them to reproduce documents for the project and throughout the life of the project;
(4) step-in, or novation rights, entitling the funding institution, say, to step in and take over the engagement of the professional consultant or contractor, if the developer becomes insolvent or there is an event of default under, say, a loan agreement or a funding agreement.

15.41 From the insurance perspective, there are various ways in which the collateral warranties affect insurance liabilities. They are as follows:

(1) In relation to the collateral warranties coming from the design team, it is common for there to be a duty on behalf of the consultant owed not only to the developer under the original appointment, but also to the third party beneficiary, to maintain professional indemnity insurance, or at least to use best or reasonable endeavours to maintain such insurance. Safeguards are usually introduced into the warranty to ensure that this obligation proceeds only so far as such insurance is commercially available in the insurance market. This obligation therefore discourages a professional consultant from failing to continue his professional indemnity insurance by not paying his premiums, because this would be tantamount to risking the duty of care liability under the collateral warranty. PI cover is renewed annually and therefore the warranty should be covered on such renewal.

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PI cover operates on a “claims made” basis (see ) and therefore it is crucial that the warranty be covered by insurance through its duration. The warranty may be uninsured if the policy wording is amended or restricted during the term of the warranty.

15.42 It should be acknowledged that the value of a professional consultant’s duty of care is only as good as the professional indemnity insurance he has, because there is a significant risk that the underlying partners of a professional practice these days, or worse still, a limited liability company set up by a professional firm for the purposes of engaging in their work, would not be able to meet the liabilities incurred if contractual negligence or negligence generally is established against a particular practice in relation to a project. The professional consultant will therefore be guided by the terms of its PI cover, because otherwise his own position, and the position of those seeking to rely on the warranty, may be adversely affected.

(2) In relation to contractors’ collateral warranties, the duty is usually to the third party to maintain the CAR policy in force, in either the joint names of the existing contractor, and possibly the developer, as well as the third party tenant or fund. These may present problems with the contractor’s own insurers, particularly where the contractor has a company-wide policy covering all its projects and whereby insurers will try and resist a third party name being inserted on the policy. However, mortgagee protection clauses will commonly be included in the policies in any event and sometimes funders will acknowledge that a note of their interest on the policy will be sufficient for their purposes, rather than full joint names. There are clearly dangers in allowing the third party to engage upon carrying insurance itself, to the extent that it feels that the contractor has not taken out a sufficient policy and it may well be the case that third parties are unlikely to have a proprietary interest in the property until, for example, practical completion in any event and therefore the problem may not arise. They will, however, have a contractual interest and it may serve their purposes to advise the contractor’s insurers in writing of their contractual interest under the relevant agreement for lease or the funding agreement as appropriate.

15.43 The warranty should require the insurance to be maintained for the duration of the warranty. To ensure that the warranty is covered by insurance, approval from the insurers to the collateral warranty in question should be obtained.

(3) If the collateral warranty does not contain an obligation on the part of the consultant to carry PI insurance, this may allow the consultant and its PI insurers to settle or compromise claims made against the consultant without first obtaining the permission of the beneficiary of the warranty thus putting in jeopardy the claim and value of the consultant’s obligations under the collateral warranty (see Normid Housing Association Limited v R John Ralphs and Others 16).

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Contracts (Rights of Third Parties) Act 1999

15.44 These days, collateral contracts have, to an extent, been replaced (but not entirely) by rights under the Contracts (Rights of Third Parties) Act 1999 under which rights are defined and established under the original contracts with the construction and design teams. The JCT regime offers this as an option to collateral warranties.

1 [1986] QB 211.

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