Financing Focus

It's A Wrap

Proper insurance coverage helps condo developers reduce risk.

While condominium demand outpaces supply in many markets, some lenders are starting to tighten their financing parameters in anticipation of a possible market slowdown. To maximize their opportunities in this changing environment, commercial real estate developers must carefully manage potential risks.

Increased Condo Risk

The increase in condominium construction in recent years likely will lead to an increase in construction litigation. To minimize risk associated with litigation and safeguard their projects, condominium development teams should purchase adequate insurance coverage.

Unfortunately, many traditional insurance carriers in the industry are unwilling to insure condominium projects due to the high risks associated with them. Condominium projects attract litigation proceedings for three reasons. First, courts often view condominiums as a series of "manufactured goods" making them subject to strict liability standards rather than negligence standards generally applied to other construction types. Second, many condominium owners who previously lived in single-family homes often are disappointed with condominium projects' increased density and less private living conditions, making them more likely to litigate against the development. And finally, plaintiffs' lawyers usually assert construction defect cases on a contingent-fee basis, which makes it easier for condominium owners to sue. With fewer carriers in the marketplace, premiums are higher, and many subcontractors and design professionals also struggle to find condominium insurance, thereby limiting the number of qualified professionals who are able to bid on these projects.

Insurance Strategies

"Wrap" insurance is one solution condominium developers can use to fill the insurance void. The owner or general contractor purchases a project-specific policy to cover the development team, including the general contractor, subcontractors, and sometimes even the design professionals, although the latter usually are covered only for bodily injury and property damage. Wrap insurance policies often are divided into owner-controlled insurance programs and contractor-controlled insurance programs. OCIPs and CCIPs for commercial projects generally include workers' compensation and general liability coverage.

While often more expensive, OCIPs and CCIPs offer advantages over having each development team member purchase individual insurance coverage. First, by combining the insurance into one project- specific policy, the development team can increase its purchasing power for expanded lines of coverage. A skilled broker can utilize the pooled funds to buy coverage that the individual development team members may not be able to obtain on their own.

In addition, placing all of the workers' compensation coverage under one project-specific policy with no prior loss history may provide premiums lower than if each team member purchased coverage. By maintaining one policy, the owner and contractor can ensure that the policy is not canceled or materially modified as opposed to gathering renewal certificates and endorsements from the entire development team to assure that the policies remain in effect. Utilizing OCIPs or CCIPs also allows one insurance company to cover all members of the development team. With one carrier, claims should be more efficiently managed and processed.

While some insurance policies are self-depleting, meaning each dollar spent defending a claim reduces the policy amount, OCIPs and CCIPs have much higher policy limits to absorb self-depletion. For instance, if a developer with a $1 million self-depleting policy is sued and the defense costs are $1 million, no money is left to satisfy any judgments or settlements in the case. However, with a wrap policy, it is typically recommended that defense costs be handled inside the deductible or self- insured retention and outside the general liability policy limits to prevent the limits from being eroded. For example, a $1 million policy would remain entirely available to satisfy judgments or settlements if defense costs were handled through deductibles or self-insured retentions.

Lastly, by maintaining one project-specific policy, the owner or the contractor can ensure that the OCIP or CCIP is renewed for the entire length of the statute of limitations or statute of repose for construction defects. If an OCIP or CCIP is not utilized on a large project, as many as 100 smaller insurance policies may need to be monitored to ensure that they remain in force for the entire statute of limitations period. This can be an impossible burden that may require owners to purchase tail coverage, which is expensive and difficult to obtain. If tail coverage is purchased, the carrier assures that the insurance coverage remains in force for a specific number of years. In the case of claims-made policies, tail coverage extends the time for reporting events that occurred before the claims-made policy period expired.

Condominium developers, owners, and contractors must explore other issues before electing to utilize an OCIP or CCIP wrap program, including the overall insurance costs, the cost of administering an OCIP or CCIP, the uncovered risks for off-site work, and the use of credits to capture the amounts that individual development team members would have spent if not for the existence of the OCIP or CCIP. To capture insurance credits to offset the OCIP or CCIP costs, the broker should gather detailed insurance cost information from each contractor, design professional, and subcontractor and assure that if an OCIP or CCIP is utilized on the project, each covered entity reduce its contract amount by the cost of each unneeded individual insurance policy. In addition, many carriers and brokers may offer to return a portion of the premiums if claims are below a certain threshold for a project. However, developers should not rely on receiving a return on premiums since construction defect claims are likely to occur on most condominium projects.

Condominium projects can be very rewarding and lucrative investments for commercial real estate professionals who know how to manage the risks associated with them. Developers should consult a qualified construction attorney and insurance broker to perform a detailed cost/benefit analysis before engaging in wrap insurance or other risk management strategies.

Bryan C. Jackson, JD, and Kevin Edwards

Bryan C. Jackson, JD, is chair of the construction transaction group at Allen Matkins Leck Gamble and Mallory LLP in Los Angeles. Contact him at (213) 622-5555 or bjackson@allenmatkins.com. Kevin Edwards is OCIP coordinator with Lockton Insurance Brokers in Los Angeles. Contact him at (949) 252-4423 or kedwards@lockton.com.

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