You're building an office building, residential complex, hotel, or multiuse construction project for an estimated cost of $120 million, and your lender says it wants $120 million of insurance coverage for wind storm, flood, and other perils. But wait—is that amount suitable for the project?
What is your "maximum probable loss"? What about delay in completion or business interruption losses that stem from property damage? What else should you consider and provide to underwriting to better assess your risk?
Determining a Reasonable Amount of Coverage
A comprehensive maximum probable loss (MPL) assessment for a builders risk policy should address the amount of coverages that are reasonably necessary and should consider other factors to help the insured match their exposure to insurance coverage, including the following.
Details concerning location and the risk of loss
A detailed estimate of the replacement cost of assets
Consideration for the potential delay in completion or business interruption losses and the likely period of indemnity
Descriptions of hazard mitigation measures employed to reduce the risk of loss
Details of a disaster recovery plan
Projected revenues and operating expenses after opening
Specific policy provisions being considered
The MPL analysis should consider potential perils and issues that would likely have a significant impact on the amount of loss. This is the time to do a basic "walk through" of how an insurance claim might be handled in the event of a significant loss. It is helpful to review the ramifications of specific policy provisions that are being considered as well. Policyholders can benefit greatly from this "up-front" look; it is much better to identify issues and address potential coverage shortcomings ahead of time rather than be forced to work through them after a loss.
Details Concerning Location and the Risk of Loss
A starting point for every MPL analysis is to understand the specific risks to the insured location(s). A property being built on Miami Beach, for example, has a larger risk of loss from wind storm than a property located further inland. Similarly, a property located by a river or creek has a heightened exposure to flooding. Insurers are keenly aware of geographic-based risks and, thus, typically have regional restrictions on the scope and/or limits of coverage for losses attributable to such risks. A property on the coast may bear a higher cost or will contain a higher deductible (such as a deductible that is a percentage of the property value) than a property located in the plains.
Policyholders should pay particular attention to the limitations on the coverage afforded for storm-related losses, which present significant exposure for catastrophic property damage. For example, in determining the risk for flood, policyholders should consider how "storm surge" is defined under the policy. In some policies, it is defined as "windstorm" peril; in others, it is defined under "flood." This was a significant issue after both Hurricane Katrina and Superstorm Sandy. Many policyholders believed that they were fully insured as the hurricane approached, as they had excellent windstorm coverage. They failed to realize, however, that the resultant "storm surge" was considered under the peril of "flood" rather than "windstorm." Many were not insured or were underinsured for "flood" and found themselves with a significant coverage shortfall.
Case law illustrates the significance of policy wording. In Northrop Grumman Corp. v. Factory Mut. Ins. Co., 563 F.3d 777 (9th Cir. Cal. 2009), the Ninth Circuit Court of Appeals concluded that the insured's damages from wind-driven tidal waters were subject to the policy's "flood" exclusion. Unlike other policies that encompassed a "named storm" or "windstorm" peril, which included "storm surge," the policy did not include any provisions that would alter the ordinary interpretation of tidal water damage as "flood." The court stated the following.
Because there was no defined coverage for Wind nor Named Windstorm, there was no reason for the excess policy . . . to specifically exclude or even reference those terms. . . . In light of the above, we hold that the Flood Exclusion unambiguously bars coverage for the water damage to Northrop's shipyards under the excess policy.1
Conversely, in SEACOR Holdings Inc. v. Commonwealth Ins. Co., 635 F.3d 675 (5th Cir. La. 2011), the court held that the policy's deductible and sublimit for flood loss did not apply to the claim because the insured's property damage loss was proximately caused by a "named windstorm" (i.e., Hurricane Katrina).
We have concluded under the deductible provision that all of SEACOR's damages were proximately caused by the Named Windstorm, then those damages cannot trigger the Flood liability limit because such losses were not caused by the peril of Flood.2
Detailed Estimate of Replacement Cost of Assets
For a completed project, a comprehensive appraisal of the replacement cost of assets can be very helpful. For a property under construction, the estimated cost to complete the project is probably the best estimate of replacement cost. This will increase over time as construction proceeds, as shown in the example below.
When a construction project begins, the MPL for property damage is likely to be low, but this amount increases as the level of construction increases. When construction is completed on one portion, a standard property policy may replace the builders risk policy. (In the chart above, the condominium and the hotel portions of the project are expected to be completed before the retail portion, so the required limits of builders risk coverage may decline if replaced with standard property coverage.)
It is also worth considering that catastrophic losses often put a high demand on building materials and labor, as repair work can be widespread. Consequentially, it is typically more expensive to repair or replace property after a storm loss than it is under normal circumstances where property damage is isolated to the insured.
Completion Delays, Business Interruption, and the Likely Period of Indemnity
To better estimate the MPL, it is helpful to consider the length of time that may be necessary to complete repairs in the event of a significant loss. For example, a loss during the construction of a large warehouse may be repaired quickly, but a loss during the construction of a large chemical plant may take years. Although this is often subjective, the time period for repairs should be considered.
Additional consideration should be given to the likelihood of delay in completion losses after repairs are complete. For example, if the opening of a new hotel is delayed due to a fire during construction, it may take some time to recover bookings or develop its customer base once it finally opens, as potential customers will be staying at competing hotels during the repair period. Since the ramp-up period immediately after opening will be delayed, the insured will likely incur loss of business even after repairs are complete. Thus, the insured should consider "extended period of indemnity" coverage.
The recent case of Citadel Broad. Corp. v. Axis U.S. Ins. Co., 162 So. 3d 470 (La. App. 4th Cir. 2015) demonstrates the potential value of an extended period of indemnity. In this case, Citadel Broadcasting Corporation suffered a loss of business due to the shutdown of three of its radio stations damaged by Hurricane Katrina. Citadel had acquired extended period of indemnity coverage from AXIS U.S. Insurance Company, which covered business interruption losses for each radio station for a duration of 360 days from the date each station became operational. (It also had contingent business interruption coverage that covered losses caused by damage to customers or suppliers of any tier.) Citadel was awarded approximately $5.9 million for economic losses sustained, as it persuaded the court that it suffered ratings declines caused by (1) listeners switching to competing stations while repairs were being made to Citadel and (2) damage to the property of its customers and suppliers. Because these losses spanned beyond the dates of repair, Citadel was awarded damages for losses incurred through the extended period of indemnity.
Mitigation Measures Employed to Reduce the Risk of Loss
An assessment of the MPL often involves a review of the hazard mitigation measures that are planned for the project. For example, if a project is prone to flooding, it is helpful to demonstrate that flood barriers will be installed to reduce the risk. If a project is in an area prone to windstorms, it is helpful to show that wind-resistant windows will be installed. Other such items include the availability of backup power generators, sump pumps, etc.
Many insurance policies cover the cost of loss mitigation measures taken as a peril (such as a hurricane) is approaching, as they may reduce more significant covered damages. The relevant provisions affording such costs include "sue and labor" and "preservation and protection of property."
Details of Disaster Recovery Plan
It may be helpful to show that the insured has a comprehensive disaster recovery plan (DRP) that addresses steps to be taken designed to minimize the size and length of a loss. The DRP should assign responsibilities in the event of a loss. A good DRP should provide specifics as to the steps to take should a loss occur, thereby demonstrating to insurers that the insured is well prepared.
Projected Revenues and Operating Expenses after Opening
Having a good understanding of the revenues and operating expenses that the insured is expected to achieve after opening is also important in determining the MPL. This is often more challenging for a new business than a business that has been open for many years with significant historical data. The insured should provide its best assessment of projected monthly revenue and costs and provide as much support as possible. Utilizing bank loan projections or actual results from similar construction projects can provide good support for the earnings projections.
Specific Policy Provisions Being Considered
Attempting to identify the majority of likely potential exposures will help you to understand how your insurance coverage may respond when a loss occurs. While insurance may be purchased with the intent to be made whole when a loss occurs, it is seldom the case that insurance will provide 100 percent recovery. Policy limits, deductibles, and coverage exclusions act to reduce or eliminate coverage. Valuation (the necessary costs to repair or replace the damaged property and/or the calculation of the amount of economic losses suffered) is also a common subject of dispute between policyholder and property insurer.
Importantly, the scope of coverage afforded under builders risk insurance can vary significantly between insurers. It is therefore important to understand the specific limits, coverages, and exclusions contained in the contemplated policy. While price is always a factor when selecting insurance, it should not be the only consideration. Some of the other key factors to consider when purchasing property/builders risk insurance are as follows.
What are the limits of coverage? Are there sublimits for higher risk losses?
Is there coverage for hurricane, flood, and/or earthquake losses?
Is there adequate coverage for "soft costs" (tangential costs associated with the actual repair/replacement of the damaged property), such as increased security, extended insurance premiums, additional loan interest payments, etc.?
Is there coverage when the project is not physically damaged but is impacted by outside forces (e.g., loss of utilities, civil authority (government shutdown), ingress/egress (lack of access to business), etc.)? Many companies in New York that were spared from the physical damage caused by Superstorm Sandy still suffered losses.
Are there significant deductibles or self-insured retentions that reduce coverage for higher risk causes of loss (e.g., percentage-based deductibles for storm-related losses or waiting period deductibles for economic losses)?
Are there arduous/overly broad exclusions? Particular attention should be paid to "faulty workmanship/design" exclusions and "earth movement exclusions," since losses often involve some component of human error or shifting/settling of earth (whether man-made or naturally occurring).
Does the policy exclude consequential losses (e.g., delay, loss of use, loss of market)? If so, does it specify that the exclusion does not apply if the losses are otherwise covered by the policy?
Do key exclusions contain "anti-concurrent" language? If so, the insurer may contend that the exclusion applies even where the proximate (or dominant) cause of the loss is covered. This issue has been frequently litigated, and the courts have reached differing conclusions. Compare, for example, Leonard v. Nationwide Mut. Ins. Co., 499 F.3d 419 (5th Cir. Miss. 2007) (anti-concurrent language in water damage exclusion precluded coverage even when the dominant cause of loss was the covered peril of windstorm) with Corban v. United Servs. Auto. Assoc., 20 So. 3d 601 (Miss. 2009) (anti-concurrent clause in flood exclusion did not negate damage caused by wind immediately before flood occurred).
In light of the considerations noted above, it is beneficial for an insured to review its insurance coverage before a loss occurs. Businesses with larger construction risks should consider retaining an insurance professional, such as a seasoned broker and/or insurance lawyer, to assist in this endeavor. Additionally, to ensure that the amount of coverage is reasonable, it is often helpful to have a forensic accountant with insurance claims experience complete a maximum probable loss analysis. This will help to ensure that the insured has a reasonable amount of coverage. If the values are too high, you may be paying too much premium. If your values are too low, you may be at risk of being underinsured should a loss occur. This analysis can be shared with your lender to help them understand the amount of coverage that is reasonable, the level of risk involved, and which coverages are appropriate for the project being insured.
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