Wrap-Ups and the Distressed Properties Dilemma
January 2010
While we may be seeing some light at the end
of the current economic tunnel, we are still confronted with many insurance
challenges presented by local headlines such as, "Stalled Construction Site
Total Hits 515."
by Richard
Resnick
Aon Risk
Services
Properties in distress are challenging the most veteran of wrap-up professionals
to provide solutions and risk management considerations on these projects. When
owners go into default on their loans or declare bankruptcy on existing construction
projects, what are the risk management implications on existing wrap-ups? On
a positive note: we do know for sure that (as per Insurance Services Office,
Inc. (ISO), General Liability Policy Conditions) "bankruptcy or insolvency of
the insured or of the insured’s estate, will not relieve us [the insurer] of
our obligations under this coverage part."
There are several technical issues that need to be addressed in these critical
situations. Again, we will assume that a wrap-up has been in place on the existing
project from its inception. While we could not possibly address every contingency,
we hope this article will be helpful as it touches on important areas such as:
- Status of project
- Policy assignment
- Release of past liabilities (claims, premium payments, audits)
- Contractor considerations
- Completed operations
Status of Project
Where in the timeline the project is when financial challenges surface is
key to how we begin to approach the wrap-up program. The closer we are to the
end of the project, the more flexibility there may be as to terminating the
program by either the current owner, lien holder, receiver (if appointed), or
new owner (through an assignment). One thought to bear in mind throughout this
process is that the bankruptcy courts have always placed a priority (ahead of
other creditors) on premium payments. The short of it is, no matter who controls
the policy, the bank will make sure that payments continue to be made in accordance
with previous installment agreements.
Notwithstanding contractual obligations (to be discussed later in this article),
it may well be in everyone’s interest to terminate the program if we are at
the tail end of the construction phase. At that point, standard operational
insurance can be placed. It is not uncommon for wrap-up programs to terminate
prior to completion of the final punch list or final nail to be hammered in
place. This approach certainly eliminates much of the anxiety of dealing with
"construction coverage" at a time when other financial issues are paramount.
A discussion on policy assignment follows, but suffice to say that, no matter
where in the time frame the construction may be, assignment of the policy (subject
to approval by the underwriter) may be the course of least resistance and provide
the smoothest transition as one goes through the default process.
Policy Assignment
As previously mentioned, assignment of the wrap-up policies to another party
is the simplest solution. Yes, there are forms to sign and underwriters' consent
to obtain, but once this is accomplished, the parties can move forward with
the wrap-up program without missing a beat. However, being that nothing is always
so simple, there are pitfalls to recognize. The assignment may be a difficult
process if the current owner refuses to do so. While not every situation is
the same, assignment should be a goal of all parties (particularly the lien
holders).
Practically speaking, this may not always be the case. Keep in mind, some
owners, as they go through the bankruptcy process, may try to hang on to their
property by looking for other investors. In such a case, they may also try to
hold onto the "insurance asset" (wrap-up policies) as long as possible. Although
the owner may be in default, and the bank may have begun bankruptcy proceedings,
it does not necessarily mean the owner is out of the picture.
At the same time, the court may appoint a receiver to take over management
of the property and thereby have responsibility to maintain the insurance. This
would include (should construction still be ongoing) a wrap-up program.
What options does a receiver have to fulfill the mandate of the court to
maintain insurance? The receiver may look for an assignment as mentioned above.
Based on the particulars of the proceedings, this may go very well or not so
smoothly. The receiver may also look to incept their own wrap-up, but this may
present numerous underwriting challenges based on the possible advanced timeline
and the fact that two wrap-ups may be in place simultaneously. In the event
a current owner canceled its wrap-up (toward the end of construction), and the
receiver elected to purchase a new wrap-up, the terms and conditions would be
very restricted based on the potential risk to the underwriter versus the premium
generated by lesser construction values, let alone the time constraints in placing
such a program. Wrap-ups usually adhere to certain underwriting protocols that
would probably not be present in this example. Underwriters call this adverse
selection.
Release of Past Liabilities
As previously alluded to, the assignment of the wrap-up polices appears to
be a simple solution to the distressed property scenario. However, there are
obligations that will now fall on the new parties (be they new owners, receivers,
lien holders, etc.) that need to be closely examined. A clause such as the one
that follows would not be unusual in an assignment agreement:
The Receiver hereby agrees to assume and shall be solely responsible
for any and all provisions of the Program Agreement and the Policies, including
any amendment, extension or renewal thereof, including, the obligation of
the Previous Owner to pay or reimburse losses and/or allocated loss adjustment
expense, and the Program Agreement is hereby amended to provide that the
Receiver assumes the responsibility to pay all losses and allocated loss
adjustment expense relating to the Previous Owners obligations.
"Buyer beware," as we say. The policies, as well as any payment documents,
collateral agreements, and endorsements, need to be reviewed diligently. Recognizing
that most wrap-up programs are written with large deductible obligations on
the named insured, past losses (especially reserves) need to be examined carefully
to determine the extent of the financial obligations. Premium payment agreements
will need to be upheld because they, too, are part and parcel of the assigned
policies.
Most losses under a wrap-up program are secured (collateralized) with a financial
instrument known as a letter of credit (LOC). However, it might also be cash
or even some form of a trust agreement. This, too, needs to be thoroughly vetted
for the new parties to understand their obligations.
Contractor Considerations
An area often overlooked is the contractual obligation owed to both the general
contractor and the subcontractors as respects timely notice in the event termination
of the wrap-up is necessary. While these parties tend to be the last ones we
think of in these situations, they are certainly deserving of consideration.
When contractors enroll in wrap-up programs, they do so under the assumption
that they will be covered from the start of their scope of work through project
completion and on through the extended completed operations term. Not only is
this assumed, it is further strengthened by contractual terms.
When financial issues arise in projects with distressed properties, contractors
have every right to be concerned. Most critical in this scenario is the contractual
obligation to provide timely notice (somewhere between 30 and 90 days appears
to be common) to contractors in the event a wrap-up is terminated. This can
occur at the project's end or at any other time in the construction timeline.
There are administrative issues to consider if:
- The wrap-up is prematurely terminated.
- The wrap-up is rewritten.
- The wrap-up is assigned.
In the event the wrap-up is terminated, assuming it is done so in accordance
with contract terms, the contractors will then need to provide certificates
of insurance evidencing their insurance policies. Additionally, contractors
will be billing the owner for their cost of insurance, most probably in accordance
with the original bid deduct or add alternate. The billing will continue until
the contractors' scope of work is completed and closed out.
If the wrap-up is rewritten, and assuming there is no gap in coverage between
the canceled program and the rewritten one, then the contractors need to receive
new certificates of insurance evidencing participation in the program. New enrollment
forms will be necessary to properly enroll the contractors in the new program.
Existing contractors will need to continue deducting their price of insurance
(bid deduct) from their invoices.
When a policy is assigned, new certificates will be necessary due to the
change of the named insured. Enrollment forms and bid credits should flow through
as before.
As you can see, contractor considerations may fall into the background as
more prevalent financial issues take precedence. However, remain diligent when
addressing these administrative issues and make them an important part of the
agenda.
Completed Operations
Well, I have saved the best for last. If there is any one issue that continues
to be crucial in this process, it is the issue of completed operations and extended
completed operations. It is most critical that the new owner of an assigned
policy has extensive information on the term of extended completed operations
and the definition of completed operations including (most importantly) when
the extended period begins. While a completed operations claim can occur on
any project type (commercial or residential), it takes on somewhat different
proportions when we are dealing with a residential "for sale" exposure. The
new owners will want to make sure that the assigned policy conforms to any existing
statutes of repose.
The above paragraph assumes an assignment versus
a new owner obtaining his own wrap-up program once the current one may have
been canceled. This is where a gray area may exist. Assume for a moment that
the previous owners (for whatever reason) cancel their wrap-up. The new parties
come in and purchase their own wrap-up on the remaining work. For the new underwriter
(it would certainly be wise to use the same underwriters as the original wrap-up),
there is an area of potential conflict when it comes to extended completed operations.
The assumption is that Insurer A (original) should be picking up
extended completed ops claims on work constructed
during their policy period. Insurer B (new) should pick up construction work
arising out of the remaining construction value. This alone may lead to conflicts.
Now, let us dissect this further. Let us say, for instance, that some of the
remaining work was either "warranty" or repair work resulting from the original
construction. Taking it one step further, now there is a completed operations
claim arising out of the repair work. Which insurer steps up and defends the
claim? Insurer A may declare that Insurer B should respond to "completed operations"
claims for all the remaining work (i.e., repair work or new construction). Insurer
B in the meantime looks at the claim and states that extended completed ops
should pick up repair work from the original construction. "Work that may need
service, maintenance, correction, repair or replacement, but which is otherwise
complete, will be treated as completed," per the ISO Comprehensive General Liability
Form, Section V Definitions, 16. Products-Completed Operations clause (2).
So, the situation is not as neat and tidy as hoped. In situations such as
these, policy language must be crafted carefully to determine exactly what the
intent of the new insurer will be.
Conclusion
Nothing ever appears as it seems to be. There is much to this issue of distressed
properties and the impact on wrap-up policies. It is not a simple "one, two,
three." If you pictured a decision tree on this issue, you could imagine "the
branches" going off in all different directions.
I have used the word "diligent" on more than one occasion throughout this
discussion. It was not by accident. Each step of the way must be studied carefully,
and each choice will have a direct impact on the next step. Do not go this distance
alone. Dialogue should commence with not only insurance personnel, but legal
and financial experts as well. Together, the team will be better positioned
to make well-thought out decisions that will have a positive effect on the choices
selected.
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