This is the second of three articles bringing clarity to the complex and challenging course of construction exposures and providing solutions for mitigating risk through builder’s risk insurance coverage. Part I, Builder’s Risk Coverage – Language Matters, addressed a select few critical exposures to projects under the course of construction. Part II addresses how a standard builder’s risk policy may respond to a loss arising from defective construction and alternative insurance market offerings that can help with specific costs associated with construction defect loss.

Coverage for Loss Ensuing from Faulty Workmanship

Part I tackled the standard builder’s risk exclusion that applies to losses arising from faulty materials or workmanship. Traditionally, carriers do not have an appetite for covering a contractor’s failure to perform their work properly. There is one exception, which is coverage is available for ensuing loss – or the resulting damage to other property from faulty workmanship.

If the excluded cause of loss (i.e., faulty workmanship) causes resultant damage, the builder’s risk policy will cover the damages to the extent the peril of fire is covered. The ensuing loss exception limits the faulty work exclusion to costs directly related to repairing or replacing the faulty work.

For example, suppose faulty wiring work leads to a fire which damages part of a structure under construction. The faulty workmanship exclusion would apply to the actual faulty wiring work, but if fire is a covered peril under the policy (this is nearly always the case), the policy would respond to the structure’s fire damage.

Coverage for ensuing loss is either stated as an exception to the faulty workmanship exclusion or by limiting the faulty workmanship exclusion language. Working with a broker to assure a properly written ensuing loss provision is critical.

LEG – London Engineering Group Exclusions

The London Engineering Group serves as a consulting body to various insurance and reinsurance companies, as well as various Lloyds syndicates providing, among others, construction insurance. LEG published three variations of defects exclusions, known as LEG 1, LEG 2 and LEG3, with increasing levels of coverage for defective construction. While initially available through London markets, these endorsements, or similar “cost of making good” endorsements are increasingly available from domestic insurers.

• LEG 1. Broad Exclusion serves as a baseline endorsement broadly excluding “loss or damage due to defects of material workmanship, design, plan or specification.” This can also serve to exclude ensuing loss, as mentioned above.
• LEG 2. Compromise Exclusion provides coverage for costs to remedy ensuing loss to covered property and costs to remedy damage to property supported by defective property. LEG 2 excludes the costs incurred to remedy a defect immediately before the damage occurred.
• LEG 3. Narrow Exclusion is most broad by only limiting the exclusion to costs incurred to improve original materials, workmanship, design, plan or specification. Thus, in addition to the cover provided under LEG 2, LEG 3 will respond to the costs to remedy damage to defective property, costs to put right defective “part, portion or item,” and loss, damage or expenses incurred to access defective parts (rip and tear).

Under both LEG 2 and LEG 3, an ensuing loss exception is no longer necessary. The policy states that the entire loss will be covered less a specified amount. The loss payable is the total amount of the covered loss minus what it would have cost to replace the faulty work prior to the loss (LEG 2) or the cost to improve the original materials, workmanship or design (LEG 3).

Any claim under LEG 2 or LEG 3 will only respond if the project suffers damage or destruction. Rectification of a known defect, part or system that has not manifested damage is not an insured loss.

LEG – Loss Example

An HVAC unit placed between floors of a partially completed five story building is being commissioned. A fire occurs and causes $3 million in damage to the HVAC unit and parts of the building surrounding the unit. It is determined insufficient electrical wires were installed. To access and replace the fire-damaged HVAC unit, $400,000 of undamaged property will need to be ripped out to replace the damaged unit. Engineers determine the wiring requires an upgrade at an additional cost of $65,000. A $75,000 policy deductible will apply. LEG response:

• LEG 1 – Loss is not covered;
• LEG 2 – Pays $3,000,000 damage to covered property less $65,000 the before-loss cost to replace the inadequate wiring less $75,000 deductible. Final Claim Value is: $2,860,000; or
• LEG 3 – Pays $3,000,000 damage to covered property plus $400,000 rip and tear costs less $75,000 deductible. Final Claim Value is: $3,325,000.

The language in the builder’s risk policy matters. If a construction loss occurs, it can determine the company’s financial future. An insurance broker can help review, construct and understand policies, ensuring critical loss is a covered matter.