MATTHEW CULLUM: Hello and welcome to our WTW Construction Blueprint podcast. I am Matthew Cullum. A director here at WTW within our UK construction team, and I'll be your podcast host. I'm delighted to be joined today by Peter Wallace, a leading underwriter in the latent defects market at Castel. In this episode, we'll be looking to explore the benefits of latent defects in the wake of some high-profile contractors' demise and how they can look to benefit and protect developers and owners. So, Pete, welcome today.
PETER WALLACE: Thank you.
MATTHEW CULLUM: I'm going to fire a couple of questions at you and hopefully nothing too strenuous. The first one really is, what is latent defects? Or some people may have heard of it as inherent defects. What are those products?
PETER WALLACE: Yeah, sure. Well, they're the same product. It's known in the UK as latent defects insurance, and that's the common phrasing law or name for it here in England, Ireland, up in Scotland, Wales. But in Europe it's sometimes referred to as inherent defects insurance. And as I underwrite on behalf of some European insurance-reinsurance companies, we sometimes internally, and sometimes that spills out externally, referring it to as an inherent defects insurance. But it's the same product-- latent defects or inherent defects.
And what that drills into, what that means is that it is any defect in a building that manifests itself after completion of that building that was not known at the time of completion. So it sprung up from a standard exclusion in property policies in the UK. Because most of your property policies will have a specific exclusion, saying we exclude inherent vice and defect, which is, like I say, anything unknown at the time of handover. So our policy steps in and covers the unknown anomalies, as it were, as a right back for that exclusion for property markets.
MATTHEW CULLUM: OK. Thank you. In the simplest terms, why should our clients look to purchase latent defects or inherent defects?
PETER WALLACE: Sure. So in the UK the product became popular starting off in the late '80s, early '90s, around the time of the large previous recession, much more severe than ones we've had in recent years, where you'd have a lot of contractors going into insolvency. Some developers also. And then owners of buildings, landlords or banks that have been financing their construction found that there was nobody there to make good on repairs and damage that had occurred a number of years after completion of the site where they could have previously relied under guarantees, warranties from the contractors.
They had nothing in place because these people had gone bust. And everything was voided. And that's when the product came over to the UK from France, where it's been rated for over 100 years. And the product steps in and it gives cover for up to 10 years post completion or 12 years sometimes in the UK only.
So post completion of the building for 10 or 12 years, it's a pay-first first party policy that looks after the interests of the owner of the asset. I mean, that could be the landlord, could be the developer, could be a bank. So it's a product that's taken up by those people, and it protects them against the risk of the contract and not being there.
It also protects them as it's a non-negligent policy. If there's a defect there, if there's damage there, the policy steps in. You don't have to prove contractual liability. And we will pay first, and then we will look at any subrogation options we have.
And these are quite technical losses. You can imagine you say eight years after completion, who exactly was at fault if a column starts cracking? Was it misuse of the building? Was it insufficient compaction of concrete eight years ago on a cold day in February?
These are things that landlords don't really want to be taking the time to worry about. So our policy steps in, and the specialists within the claims handling side of the reinsurance companies and insurance companies will actually go back and look to subrogate. But if we can't subrogate, we carry the loss and that's--
MATTHEW CULLUM: OK. Thank you. There's a lot talk with regards to insolvency for many high-profile cases that have been in the news lately. What kind of additional protection can this policy offer against the contractor insolvency?
PETER WALLACE: Yeah, so as previously mentioned, our ideal and the vast majority of policies are written on behalf of a developer, funder or a landlord. So in our policies, we don't have the contractor as a named insured. They are someone that's carrying out work on behalf of our insured party.
And so if a contractor changes, then the policy almost has nothing to say on it. In practical terms, we would look at the site situation and the risk on site at the time a contractor goes into insolvency and stops work on site. If you have a project that's in an exposed state, so let's say the walls, the roof haven't been completed and you don't have any closed facade, then we might look to ask what protections can we put in place. So that when the work restarts, are we satisfied that it's coming on with the same level of protection and quality as it was when we underwrote it?
So in the event of a contract going bust, we do do additional auditing of a project. And if it's not for like level of contractor coming in afterwards, then that can be considered a material change or risk that we might look to vary in terms. That rarely happens by the way.
But for the most part, the idea is that the policy is picked up by developers, financiers, landlords. And one of the reasons they do it is protection against insolvency. So were a contractor to go bust either during the construction period or during the defects liability period, or any period after that, then that doesn't void the policy. That's one of the buying rationales for people when they purchase it in the first place.
MATTHEW CULLUM: Obviously, in this changing world, we see that properties change hands all the time. Can this policy be transferred from one party to another in the event that the building is sold and transferred to another ownership?
PETER WALLACE: Yeah, that's one of the benefits of the policy. We have an assignment to any new owner. They just have to notify us.
There's never been a declination of change of owner. We have to be notified simply because if you were, say, moving from an office owner and they were selling onto I don't really know. It's highly unlikely.
I mean, they might sell an office to a hotel. You might see that in London these days around the city where we work. There is a slight change of risk there, but not one that causes concerns.
However, let's say that hotel was installing a swimming pool on the fifth or sixth floor, that creates new risks around water, escape, and low paths. We do need to know what's going on with the changes. If it's office owner to office owner, then it gets signed through, no questions. But if it was a change of use for the building and some serious modifications to the building, we might have a look at it then.
But for your standard M&A transaction, where landlords just sell them after two or three years. And it's happening in the city this year. There's some big buildings that are up for sale - is one and I forget the second. But when they just transfer from one office owner to another, the policy just moves straight across with that.
MATTHEW CULLUM: Thank you. So when we're looking to get you involved in the project and look to take out the insurance, when is the optimum time that you want to be involved? And is it compulsory that once works are complete that you take out the policy or that the client takes out the policy?
PETER WALLACE: Yeah, we need to be engaged. Before you would engage someone for a construction insurance cover, we need to be looking at the design, stage three, stage four, which is the develop design stages of a project because we need to set up our underwriting. And also our auditors to go on site throughout the construction So we need to be told as early as possible and given the opportunity, ideally to get on site before completion of any foundations. We like to see the foundations going in, or at least the end of the foundations, and that also applies if you've got basements with external water tanking systems. We like to be able to see that type of thing.
So the best time to purchase your policy, if you want it at the best price, is before a shovel goes in on the ground. We are able to commence policies later on, but they will be with higher deductibles. The rates could be as much as double, and we might put restrictions on cover for things that we weren't able to see either.
Just today actually, as it goes, a purpose-built student accommodation but only one single cover for two blocks. One finished eight months ago and one is just about to start. And we are offering them cover on both because they had architects' inspections on site independently. But the premium for the completed building is 90% lower than the premium on the building that's about to commence the same design, same type of structure.
So it can be done. We don't do it very often. And there is a penalty on premium to do so. Once the project- I think your second question was at PC they have set a policy on?
Yeah. The tenants probably starts at practical completion of the building. It starts when the building is handed over from the contractor to the client. If it's a residential policy in the UK, then they have to take it out. That used to be called Council of Mortgage Lenders, now Finance UK Requirement. So if any units are going to be sold with a mortgage then they have to go through the policy.
But if it's a commercial policy then they do have the option. We take a deposit premium at the start of construction, and then they have the option to pay the balance premium and take out the policy. What we don't like is a wait-and-see approach. Some clients will try and delay any decision making, but we have premium payment clauses in the contract. Typically 90 days perhaps from completion is to get the premium paid.
That's the limit that we would look at for a developer. Because we don't want someone waiting to see and then deciding to take the policy out. So if they're going to go forward, that decision does have to be made at practical completion, plus or minus a couple of months. Should they not go forward, then they just don't pay the months of premium.
MATTHEW CULLUM: So can you give us a bit more detail as to what the different type of sections, and what different types cover that can be purchased? And can you purchase them individually or do you need to buy each section as an all-encompassing package?
PETER WALLACE: Sure. So the main heads of cover of a structural ICI policy are the main areas we consider are the building structure, and then the building envelope, and then the water ingress into the building. The structure is quite obviously-- it's just what it says on the tin. It's anything that is a load-carrying element of the building-- beams, columns, stairs, shear walls, those types of things. And any damage to those elements or imminent damage to those elements that causes structural instability or safety loss or damage that would be covered.
The second area is the building envelope. This would be everything around the facade and roof of the building and the basement, actually. Mainly on the facade, you're talking about glazing panels or cladding panels that could become loose or damaged, could fall off so they would be covered if they fall off or don't suit their design intent.
And then on water ingress that comes through the facade as it goes, but it is a separate cover. So it's water ingress into the building through any means, any story. So the above ground stories, the below ground stories, if the client chooses to buy that and through the roof. So those are the three main areas.
There is a 12-month waiting period on the water ingress coverage, just so that we have a chance to see what's happened with waterproofing systems. Because if you have a defect, they should become known rather quickly. But if it's in a basement and you've got a thick concrete slab or wall, it can take a while for the water pathways to come through.
So there is that 12-month waiting period for the water ingress cover. But for all the other covers, they start at practical completion. We don't like being asked to cover one element and not the others.
From a moral risk that gets you a bit into negative selection. So we do raise the question, why are you only asking for this part of the cover? Does the client know something's up or is the engineer indicating something?
Where that might be different is if you have legal requirements around coverage. So if you have specified wordings in certain countries, like in Portugal or in New South Wales in Australia, where they do specifically require certain things, then we can look at specified subsections of a policy. But if it's on a open form, buyer can choose to buy or not, then we don't get into the slicing and dicing of the policy just to cover one subsection.
MATTHEW CULLUM: Thank you. And what about mechanical and electrical equipment? Can that be covered under the policy.
PETER WALLACE: Yeah. Mechanical-electrical can be underwritten in the same way as structural and audited the same way as structural and then taken out of completion. We can do that for mechanical-electrical systems in a building as well. And then on top of those covers you have the loss of rent option in the mechanical and electrical covers.
So if you have an event, a loss, that means that you can't rent out part or all of the building, then we sometimes give coverage there up to a specified indemnity period. We don't like to go above our exposure being a third maximum of the structural work's value for the loss of rent. So if you have $100 million building, we wouldn't like to give more than 30 million cover. We are asked a lot in Central London because you can have some pretty high rents in Liverpool Street or in the city. But yeah, third is -.
MATTHEW CULLUM: And from my understanding, there always appears to be a much lower anyone event limit for mechanical and electrical when the sums insured can be multiples of those. Can you give a rationale as to how your underwriting calculates that exposure?
PETER WALLACE: Sure. I mean, there's two parts to that, and I wouldn't want to speak too much in detail because the M&E is a very closed box single market. Well, there's two markets that are able to buy the capacity for M&E where it ultimately feeds back.
So that would be the first thing to say. It's a very limited marketplace for the exposure. You just simply don't have a lot of companies willing to write air handling units for 10 years, so you have a limited pool of capacity.
Secondly, the projects we're talking about in the locations and for the clients that we work with, your mechanical-electrical systems are coming with some pretty good warranties anyway and product guarantees from the suppliers, be they Samsung, Mitsubishi, and then people like that. So it really is a belt-and-braces product. So if you have say 50, 60 million pounds of installations from a mechanical-electrical point of view, then you might see a 10 million M&E limit on the policy.
And that is a function of those two things- limited markets and positive alternative guarantees and warranties. Because it's easier to find the source of a defect in a mechanical-electrical system than it is in a lump of concrete. Eight years after the event, you know who supplied that ventilator, who installed those lifts. Whereas, with the contractor side and the construction, it gets a bit more murky and more fragmented.
MATTHEW CULLUM: Thank you very much. That was very informative. Just going back on a point that you touched on earlier, would it be possible and how much of a challenge would it be to amend the change of use mid-term from, say, a commercial to a residential to fall in line with the UK finance CML requirements?
PETER WALLACE: With the product that Castel provides to - which is through a residential firm called - with the product we have, you are able to change from a commercial policy to a residential. However, there are constraints on when you can do this. When you write a residential policy, you have a defects liability period where there is an increased exposure because early days in the product post-completion the developer is held liable for more things in their residential policy.
So if we've written a policy that's commercial, we would say that you can switch to residential, but not during the defects liability period. So if there's a one or two-year period with the developer and the contractor, we don't allow a switch in that initial period. But afterwards, yes, you can do it.
We've never had requests to have a policy that's able to change from residential to commercial. Because, obviously, if you have a block commercially, you might choose to raise more money by selling off some of the units. So you might want, to flip commercial to residential by selling instead of renting.
It doesn't work the other way around. If you've already sold units in the building and there's mortgages held there, then unless you buy back those from those people and then have everything as your asset again to choose to bring back to a rent home, any build-to-rent product, then it could happen. But I just don't believe that's anyone's financial model. So commercial to residential, yes, after defects liability period. Residential to commercial, I don't see that that's ever going to be requested, although I could well be wrong.
MATTHEW CULLUM: Never say never.
PETER WALLACE: Yeah.
MATTHEW CULLUM: Especially in the world that we live in at the moment. One question that we get commonly asked by our clients is, why are you effectively charging for mechanical-electrical sum insured twice within the property damage and the business interruption aspect, and again within the mechanical and electrical sections?
PETER WALLACE: Yeah, the answer is we're not. In the structural property damage policy, you have a sum insured of 100 million, let's say. But if you dig into the operative clause and really examine the defects, we are covering damage at the source.
The source would be the structural failure, a facade failure or a water ingress failure. And then let's say you had a structural failure because that's the most obvious for a total loss. Let's say your ground floor columns all collapsed one day after, I don't know, whatever reason.
Now, hopefully, it won't happen in the UK. But if your structural columns collapsed, that would be-- of course, the root cause would be a structural defect covered. The whole building falls down. And if that's 100-million pounds building, we pay you 100 pounds million to restore the building. And that would include the lost M&E, all of the elements of the building that have gone into the sum insured into the start of the policy.
So that's everything. That's partitions, that's ceilings, that's floors, that's lights, that's sinks, toilets, so on and so forth. Would include furniture and client-furnished elements afterwards, but the defect would have to come from a covered peril, which is the structure of the facade or the water. And then you would get coverage for the M&E. So the M&E would be listed in the sum insured in the main structural policy.
But if there was a problem that, I don't know, if let's say you had a lift failure, the structural policy wouldn't respond to that. And it's hard to see how a lift failure could propagate into a bigger problem for a building. Let's say you had an M&E failure or an air handling unit failed, caught fire, burned down the entire building, I mean, that would have to be sought under your fire policy or it wouldn't be covered under the latent defects one.
If you had an M&E cover, which was specifically cover latent defects in the mechanical-electrical elements, I don't want to speak too much for HST on whether or not that would be a valid payable claim. But that's where the cover could be triggered from a defect in the M&E. So you need the separate M&E policy to cover defects in those elements rather than those elements just being covered as consequential damage.
MATTHEW CULLUM: Well, thank you, Peter. I think that clarifies a lot of the situation. And I think that will hopefully help a lot of our listeners be able to understand the potential double coverage perception. Is there anything else that you would like to discuss today that we haven't actually touched on as of yet?
PETER WALLACE: Yeah, I think one main thing to talk about, specifically in relation to WTW, is territories and appetite for new markets for latent defects insurance. I had a meeting with a couple of the guys over at WTW last week discussing Central and Eastern Europe territories for the product, also North America, Australia and other areas where you can grow the business. Because markets that buy it like it and understand the value of having it and its appetite and information spread is growing quite well.
Certainly, countries in South America have mandated requiring latent defects on certain construction recently. China has certain provinces where they're doing this. New South Wales and Australia are having a government panel to review the product and looking potentially to mandate it on certain products down there. So it's something that has good global growth opportunity.
It being a first party pay-first primary policy that doesn't need to prove negligence in order to pay out a loss, does give it advantages over other completed ops products or bonds or other things that are done to give some security to owners. So the territory spread is certainly something that is already in discussion with you guys, and something that we at Ryan are definitely keen to push and make the most of. Our binders allow it.
We have certain countries where we don't because our carrier partners have strong treaty relationships, but that's a handful of countries. Anywhere else then we have a free hand to market, look at, and develop these products. So that's something that hopefully will drive some good growth in the size of the market in the next couple of years.
MATTHEW CULLUM: Now that sounds all very interesting. Hopefully, WTW can play part of that and help Castel grow.
PETER WALLACE: Yeah, I think there's definitely some big scope there. I think if you've had US banks funding projects and buying the cover in the UK, then next time they're financing and funding something abroad. Same as some US developers, they buy it on all their coverage here.
Some big US developers went in the UK and then asked about it when they're back in the States. So there's hopefully some untapped potential there. I look forward to going through that with you guys.
MATTHEW CULLUM: Pete, I just wanted to thank you for your contribution today to this episode and for sharing your perspective on such an important topic. Thank you to everyone for listening, and thank you for joining the WTW Construction Blueprints podcast. We'll talk to you on the next one.
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