Building the Right Builders Risk Policy
Christopher Brophy | October 1, 2011
Builders risk insurance is often misunderstood; the nuances of coverage are often not addressed until an actual loss occurs. A properly designed builders risk program will protect your investment in your construction project not only for property damage repair costs but also for business interruption losses and higher "soft costs."
Builders risk insurance protects the owner of a construction project for losses caused by many reasons, including fire, explosion, hurricane, fire, flood, vandalism, and others perils. Most builders risk policies are written on an "all perils" basis—the loss is covered from any cause, unless specifically excluded by the policy. Coverage under builders risk typically ends when the construction is complete. The premium charged contemplates that the insured value of the project increases over the term of the policy as the construction progresses.
While builders risk coverage is most often considered in the context of commercial or residential construction, it is an important aspect of coverage for many industrial or manufacturing construction projects. For example, a chemical company building a new plant may have builders risk coverage to augment its coverage under standard property coverage 1.
Time Element Coverage
A builders risk policy generally covers business interruption or losses of rent resulting from the delay in completion, which is referred to as the "period of indemnity" or "period of restoration." Determining the period of indemnity may require a detailed analysis of the pre-loss and post-loss construction schedules to determine the actual impact of the delay. Time element coverage includes business interruption coverage, which provides insurance for lost sales less costs that discontinue, and extra expenses incurred as a result of the incident.
Rental Value Coverage
Rental value coverage provides coverage for the loss of rent during the period of restoration when the property has been damaged by a covered cause of loss. If the property is used by the insured rather than rented, it typically would provide coverage for the fair rental value of the property.
Insurance policies differ as to the methodology that should be used to measure a time element loss, whether it be for business interruption losses and extra expenses or rental value losses. The graph below shows the impact of an incident on a construction project. Most construction projects go through a "ramp-up" period after opening. In this case, the occupancy of the building is projected to start at 0 percent at opening and increase to 90 percent after a ramp-up period. An incident occurred, which delays the completion for several months. When the property does reopen, it goes through the same ramp-up period.
Impact of Catastrophe on Construction Project
Some insurance policies use wording more aptly suited for first-party property insurance and define the period of indemnity as beginning with the date that the loss occurred and ending when repairs are complete. For a builders risk policy, this doesn't make sense as the property would have no revenue during this period. (See A on chart.)
Others define the period of indemnity as beginning with the date that construction would have been complete had there been no incident and ending with the date that construction actually was complete. This is not optimal either, as it reflects the projected revenue during the ramp-up period, which will still occur and simply be shifted. (See B on chart.)
The best approach, which measures the true actual loss sustained, defines the period of indemnity as beginning when the ramp-up period would have ended had there been no loss and ends when the ramp-up period is over after repairs are made. (See C on chart.) Note that, in each case, the loss would be measured as the occupancy at the level marked in red as compared to 0 percent occupancy, as the property was closed for this period as a result of the incident.
Keep in mind that a major catastrophe could have a detrimental impact to the construction project, in addition to the delay in construction. For example, a construction project expected to be complete during a robust economy may suffer additional losses if the delay results in opening after the economy has slipped into a recession. Also, the stigma associated with occupying a property where a catastrophic loss occurred may make it difficult to find tenants. Your broker can help you design a policy that meets your specific needs and risk exposures.
Soft Costs
Most builders risk policies include coverage for additional "soft costs" incurred as result of the delay in construction. This should include all construction overhead costs, such as the following.
- Additional interest (both on construction and permanent financing)
- Real estate taxes
- Advertising expenses
- Insurance
- Architect fees
- Extended general conditions
- Bond and permit fees
- Legal and accounting
- Other administrative costs
Code Upgrades and "Green" Coverage
Some policies offer coverage for "change in law or ordinance," which would reimburse the insured for costs incurred to upgrade to new building codes in place at the time of the loss. Other policies offer coverage to upgrade your construction to meet higher "green" environmental standards.
Conclusion
Builders risk insurance, which is critically important to building owners and others with projects in the development phase, can be tricky and include wording that can be problematic should a loss occur. Coverage that will properly and thoroughly address any lost profit and additional costs, including "soft costs," must be carefully considered. Other areas of coverage, which can be added as an endorsement to your policy, should also be evaluated. Build the right policy, understand your exposures, and be ready should you need to file a claim.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
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