Real World - May 2013: Mind the gap – insurance issues for tenant fit-out works

by Dechert LLP
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Imagine the following scenario; your company has acquired a lease of a prime piece of real estate to accommodate its fast expanding business. The building’s footprint lies in the heart of the city’s commercial centre. The building is a glass facade, high-rise, multi-tenanted, swanky office block valued at multi-million pounds. Your fit-out contractor has produced sumptuous designs to complement your new environment and the only thing that remains between you and a smooth seamless transition to the new business home is finalising the fit-out contract. The JCT is usually the preferred standard form for these types of works, and parties eager to close the deal agree insurance Option C will apply for an existing structure. Everything is going smoothly until your fit-out contractor negligently causes a fire. The whole building is damaged and uninhabitable. Who pays for the damage? The contractor, right? Well, not quite and here’s why:

Under JCT Option C, the ‘employer’ takes out:

  1. ‘All risks’ insurance in joint names for the period of the works.
  2. Insurance relating to the whole of the building.

But, as a tenant of a multi-tenanted building, it is unlikely you will have an insurable interest in the whole of the building and so you will be unable to comply with (2) above. Even if you do have an insurable interest as a tenant, the cost of insuring the whole of the building may be disproportionate to the value of the works proposed. This creates a gap in insurance. There are a number of ways this gap can be mitigated:

A. Landlord’s Insurance

To comply with (2) above, you must ensure the landlord’s insurance policy is extended to cover the works.

The landlord will usually take out insurance over the entire property. A tenant, with no insurable interest in the remainder of the building, may have its interest noted on this policy, but this noting has little practical benefit. Under the building insurance, the insurer will have rights of subrogation, meaning they can pursue tenants, in place of the landlord, for breach of any licence for alterations in the event that a claim is made. A tenant should seek an express waiver of this right upon taking a tenancy.

In recent years, there has been much resistance from landlords and their insurers to extend such cover. If such extension cannot be obtained and JCT Option C is selected without making any further amendments, there is likely to be a gap in insurance and you may be in breach of your obligations by failing to insure the whole of the building.

B. JCT Option A

Whilst the JCT states Option A is for new build works, there is nothing precluding you from using this option for existing buildings, and in fact it may be a preferable option, as the contractor has responsibility for insuring the works. The option does not mention insurance of the building and the contractor will remain liable under the normal indemnity provisions in the contract. But you will need to satisfy yourself the contractor has sufficient insurance in place to meet all such liability in the event of a worst case scenario.

C. Contractor insurance

Under the building contract, a contractor is ordinarily required to maintain a public liability insurance policy (“PLP”) to protect itself against damage to third-party property as a result of the works. If using Option A, ensure the PLP is sufficient to cover liability for reinstatement of the building. Usually, such third party property may not include the parts of the building outside the tenant’s demise. Even if it does, the PLP may exclude certain expensive risks such as loss of profit or business interruption. Further, the PLP is likely to be capped. This cap may be woefully insufficient for large multi-let properties where reinstatement costs may reach hundreds of millions of pounds. Protecting against full reinstatement of such properties may be prohibitively expensive relative to the works undertaken.

Contractors are increasingly aware of the risks and gaps this will cause and are offering PLPs with adequate limits of indemnity to respond to claims arising from damage to the existing structure.

Conclusion

Ultimately, responsibility to insure will be determined through commercial negotiations between the tenant, contractor, landlord and landlord’s insurer.

The most cost-efficient approach for a tenant would be to:

  1. Use Option A as the basis of the works contract, holding the contractor, rather than the tenant, liable for damage caused by the works up to the limit of its PLP (provided that such PLP does not exclude damage to the landlord’s property not subject to the tenant’s occupation).
  2. Negotiate with the landlord and its insurer to get both the tenant and the contractor named on the landlord’s insurance policy for the period of the works. This insurance should be extended to cover any specified risks not covered under the PLP (such as loss of profit or business interruption).
  3. Share with the contractor the cost of any uplift in the premium for the landlord’s insurance in order to obtain (2) above.

As landlords are increasingly resisting such extensions, speak to your contractor. Some contractors have begun to procure insurance policies with high insurance caps, so that they can assume liability to help compete for work.

Insurance of works is an important issue that should be resolved at the earliest possible stage. Where the works lead to the destruction of the building, for example through fire or flood, the tenant could find itself subject to a multi-million pound claim from the landlord’s insurer (if rights of subrogation have not been waived). The tenant may, in turn, be able to pursue the contractor under an indemnity in the contract, but if there is a shortfall because the contractor’s PLP is capped, this could be very costly indeed.

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