RISKVUE ARCHIVE | INDUSTRY WATCH > CONSTRUCTION

Builder’s Risk Insurance, Part 1

By Michael D. Grady, Adjusters International New Jersey, and Paul O. Dudey, CPCU

When businesses or individuals want buildings to occupy for whatever use, unless they want to buy a building already in existence, it is customary to approach a building contractor to construct a building for them.

Among the many items to be considered will be insurance on the property while under construction. The most common coverage to use is Builder’s Risk Insurance, a specialized coverage designed specifically to apply to buildings while under construction, also including materials and supplies pertaining to the construction. Other possible options to use instead of Builder’s Risk coverage will be discussed later in this article.

Depending on the terms of the construction contract, the Builder’s Risk coverage may be purchased by either the contractor or the building owner-to-be. In either case, though, all parties to the project who may have property involved in the construction should be named in the policy. This can include the owner, the contractor, any subcontractors (and there will frequently be many of them), any sub-subcontractors employed by the subcontractors, the financial institution supplying money for the project, and perhaps even architects and engineers involved in the project.

As can be seen, this is quite a complex list of insurable interests. It should be studied before the contract is completed, if possible, and the list of interested parties included or referenced in the contract. The apportionment of insurance costs should also be spelled out in advance. Some of the parties may have their own insurance and wish to be included, with their own coverage applying only as excess, in order to avoid involving their own insurance for any claims on the project.

Many options are available under the Builder’s Risk coverage. They depend on the policy’s provisions and the perils or risks to be insured against. These should be studied before the contracts are drawn and, ideally, spelled out in the contract to avoid misunderstanding and conflict among the various parties in the event of loss.

Policy Provisions

Most Builder’s Risk policies follow the Insurance Services Office (ISO) forms, which are the basis for the discussion that follows. There are also a number of insurers with independent forms which may or may not closely follow the ISO forms. When these are encountered, they should be examined carefully to determine in what ways they provide more — or less — coverage than the ISO forms considered here.

Several approaches are available for Builder’s Risk coverage. They include the Basic form, the Completed Value form, and Monthly Reporting form.

Basic Form

The basic ISO Builder’s Risk form simply provides a fixed amount of insurance, often with a coinsurance clause. Because, by their very nature, buildings under construction increase in value as construction progresses, the limit of insurance must be increased progressively as construction proceeds, especially when a coinsurance clause applies. This unwieldy feature makes the basic Builder’s Risk form quite undesirable, and it is little used.

Completed Value Form

Under this form, the limit of insurance is set at the expected completed value of the project, with a coinsurance clause applying. If, as is frequently the case, actual cost of the project exceeds the initial estimate, when this is discovered, it is necessary to increase the limit accordingly, or a coinsurance penalty can result in any loss.

Care must be taken in determining the limit of insurance to be applied. Common errors include:

(1) Using the amount of the construction loan as the limit of insurance. Unless the loan is substantial, e.g. including the value of the land, the amount of the loan will almost always be less than the completed value of the structure.

In a recent claim, an insured funded a significant portion of a building project with cash, did not include this amount in computing the completed value, and placed coverage only for the financed amount. The insured learned a hard lesson when the insurer applied a 50% coinsurance penalty to a $5.9 million loss.

(2) Have overhead and profit, commonly figured at 10% each, been included in the completed value? Some builders opt to leave these items out when determining a project’s completed value. This will turn out to be a critical mistake in the event of a loss. Because these items represent up to 20% of the completed values, omitting them would set the limit at only a portion of the completed value, producing a serious coinsurance penalty in the event of a loss.

(3) What other insurable values, if any, have been left out, resulting in inadequate insurance?

(4) Have items excluded from the coverage been included? Land value is a major item excluded. Including excluded items will result in overinsurance and extra cost with no benefit in the recovery of loss. In determining this, the insurance form should be examined carefully, as various items — excavations, underground work, and others — may be excluded. The list of exclusions may vary with the form in use.

(5) Cost overruns are commonplace in construction projects. When one occurs, to avoid a coinsurance penalty at time of loss the limit of insurance should immediately be raised accordingly.

Reporting Form

An insurance buyer may opt to purchase a Reporting Form Builder’s Risk policy. Under this form, a limit high enough to cover the expected completed value is chosen, and the actual value of property at risk is reported periodically (usually monthly) to the insurers.

Care must be used with this form to:

(1) Submit the reports of values in a timely fashion. Late reporting can produce a penalty because the values are increasing monthly, and a loss between the report due date and the time the report is submitted will usually be underinsured.

(2) Compute each month’s values carefully, and include the value of all covered property, the value of materials in place, as well as materials and supplies on the premises but not installed. Also include covered property of contractors, subcontractors, architects and engineers, to the extent that these items of property are included in the insurance. Don’t overlook the value of leased equipment on the premises for which the contractor or subcontractor has responsibility to insure.

The reporting form is frequently used by contractors who have numerous jobs going simultaneously and can be used to insure them all under a single program of coverage. The policies can be tailored to include automatic coverage for new locations (usually requiring that new locations be declared within a stated number of days — 30 days is the most usual — of the start of construction).

Perils Covered

Several levels of perils coverage (now renamed by ISO as “Causes of Loss”) are available, including limited perils (Basic Form), Broad Form and “Special Form” (formerly known as “All Risk”) coverage. The price will vary directly with the number of perils included.

The Basic Form covers what old timers will remember as Fire, Extended Coverage, Vandalism, Sprinkler Leakage, Sinkhole Collapse (but not Mine Subsidence), and limited Volcanic Action coverages (but not Earthquake or Earth Movement).

The Broad Form covers all of these Causes of Loss and adds Falling Objects, limited Glass Breakage, Weight of Snow, Ice, or Sleet, limited Water Damage (but not Flood), and as an additional item, limited Collapse coverage.

The Special Form, rather than covering named causes of losses, applies to any Accidental Cause of Loss not specifically excluded. In using this form, attention must be paid to the exclusions. While the exclusions under the ISO and AAIS forms are fairly well understood and have been defined in court cases, there are many independent forms that may differ in their language from the standard forms, and their exclusionary language may actually take away coverage that would apply under the ISO and AAIS Broad form.

Especially with independent forms, attention must be paid to the Exclusions to be sure that significant coverage has not been taken away. Where excluded coverage is needed, as with earthquake or flood, if the insurer will not offer to extend the coverage, separate coverage for any of these risks desired must be sought.

Exclusions / Perils Not Insured

Among the more important perils not covered under any of the Causes of Loss forms for Builder’s Risk insurance are Steam Boiler Explosion, Ordinance or Law, Earth Movement including Earthquake, Flood and most External Water Damage.

Boiler Explosion may be covered by separate Boiler & Machinery insurance. It will not be needed initially, unless there is an exposure from a nearby source, but as heating and mechanical equipment are installed and tested, this separate coverage should be considered.

Ordinance or Law is generally not a problem on new construction if the architect and project manager have done their job correctly, and the necessary construction permits have been obtained. However, if the Builder’s Risk coverage is used to cover value added on an addition or renovation project, this exclusion can produce problems, but can be eliminated by adding Ordinance or Law coverage by endorsement.

Earth Movement and Flood coverage are generally available only by separate policies, but the exposures are sufficiently severe to merit consideration, especially in, but not limited to, areas known to have potential exposure to these hazards. (Also see Difference in Conditions coverage later in this article.)

In areas with either of these exposures, many lending institutions require that the exposure be insured, along with conventional Builder’s Risk insurance, as the prerequisite to lending money on the construction project.

Other Provisions

The Builder’s Risk form has a number of standard provisions beyond those noted above. They generally correspond with similar provisions of the basic Building and Personal Property forms. Among the more prominent are a Coinsurance or Value Reporting clause, Debris Removal Clause and clauses relating to how losses are to be reported and adjusted. For detailed discussion on the operation of these clauses, see any current property insurance text.

The Debris Removal clause merits attention. It applies only to the cost of removing debris of covered property following an insured loss, but not debris of property not covered by the Builder’s Risk policy. Also, this coverage is limited to 25% of the amount of property loss paid plus $10,000. In a “worst loss scenario” this may not be a high enough limit, so an increase in this coverage should be considered.

When Coverage Ceases

Of particular importance is the “When Coverage Ceases” provision of Builder’s Risk policies. Unlike other property policies, the Builder’s Risk policy is intended to terminate after the building is completed and ready for occupancy, and it does not, unlike other property polices, require a notice of cancellation. Permanent Building and Personal Property insurance must then be arranged.

This can be a trap for the unwary, because if a loss occurs after the Builder’s Risk policy ends, with no permanent insurance in place, there will be no coverage for the loss.

Typical provisions in the policy that end coverage include instances in which: the policy expires or is cancelled, the property is accepted by the purchaser, the insured’s interest in the property ceases, or construction stops with no intention to resume.

The most common clause states: “Unless we [the insurer] specify otherwise in writing, coverage ends 90 days after construction is complete, or 60 days after the building is occupied in whole or in part, or put to its intended use.”

This later provision is of fairly recent origin. Previously, coverage ended immediately when construction was completed or the building was occupied or put to its intended use. There was considerable confusion in the past about the precise meaning of this clause, which preceded the present language, but the present language has clarified the meaning somewhat.

Property Off Premises

The standard Builder’s Risk policy offers only limited off-premises coverage, usually only property within 100 feet of the premises in the open or in or on vehicles. When broader coverage is desired, for example if the contractor is responsible for incoming shipments of materials or supplies to be used in the construction, transit coverage can also be provided on the incoming shipments. Or if property to be used is stored at a separate location, awaiting use in the project, this must be recognized and, if called for, the coverage extended appropriately to include it.

This article originally appeared in Adjusting Today, published by Adjusters International. Reprinted with permission.

Read Builder's Risk Insurance (Part 2)

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September 2004