Expert Commentary

Wrap-Ups and the Distressed Properties Dilemma

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."


Wrap-Up Programs
January 2010

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, 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.

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

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. 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.


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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