When you think of the cycles of real estate, most think in terms of its fluctuating market value. However, in evaluating the risk cycle of real estate, we are referring to changes in the asset itself from vacant land, through development and to a demolition or remodel project. As the asset changes in use and or occupancy type, the current policy in place may not offer adequate coverage, or may even exclude the new use of the property. Commercial Insurance, specifically commercial property insurance, is not a one size fits all. A strip mall policy will not offer the same coverage and endorsements as a single tenant or apartment policy. By assuming your current policy will automatically cover your new commercial use you may well be assuming the liability of that coverage.
Insuring Your Specific Risk
Commercial Insurance Companies have different rates and premiums based on the use of the commercial property. Some of the more popular classes are apartments, condos, mixed use, single tenant and multi-tenant programs, just to name a few. When evaluating your commercial coverage, you should consider how the property will be used and if the carrier is aware of its use.
From the carrier’s perspective, every program follows unique underwriting guidelines which are used to evaluate fire hazards and life safety concerns based on their company’s previous loss experience. Based on the submission of facts, the underwriters determine the eligibility and premium for the limits requested. If the submission is accurate going in, your coverage should be correct going out. As the property changes within the “cycle”, the current program may not be the correct program for the changes made. The changes could reduce or even void the coverage you assumed were in place. (Assumed coverage=liability)
Risk Cycles Defined
What is it you are trying to insure against? The loss of real property, claims made by third parties, and your liabilities. By understanding where you are in the development process of your project, and what type of policy applies to that area, you are able to mitigate your risk as a developer, business owner or property owner. For any commercial risk you have, the two facets of risk you must address are your property risk and your liability risk. In some cases you may not have a specific risk at the present time, but could incur that risk as the project progresses.
As we address each Risk Cycle, I will point out the property and liability risk and what type policy is used to insure against liability claims and or property loss. As an example, for this article, we will act as developers for a commercial “box”. However, it is not important in this general overview to define what will occupy the finished project. For simplicity, we will start at the beginning of the cycle, build a generic box type structure, lease the structure for a period of time and then demolish the structure to complete our cycle. Within each section we will discuss the overall risk within the cycle and then review the policies we would purchase or use in our sample development project. The following outline shows the general flow within each cycle, naming the risk and the policies required to cover the property and liability risk in our sample project.
- Planning and Design Risk
Development usually begins with the acquisition of land followed by hiring architects and engineers to design our project and move into construction. As we began our project, we will need to consider the professionals we hire and the insurance they carry. Often we are able to “piggy back” on an existing policy carried by the architect or engineer by being listed as an additional insured, which will provide us with the project/developer coverage we need in the event of a structural failure. The point to remember, as a developer, is we must either secure our own policy or be named on someone else’s policy to have the coverage we need during development. Some of the activities which occur in the Planning and Design Risk phase are:Purchasing vacant land or other assets for development or conversion. Architectural Design and Structural Engineering. Each of these activities involves an insurable risk which requires a policy to cover our risk. Either a policy is purchased or we are named as an additional insured on an exiting policy.
- Vacant Land, Liability Risk
With the acquisition of vacant land, we have a liability to third parties. A vacant land policy is used to insure against claims such as a slip, trip and falls. If the property contains anything of value, it may not be considered vacant. If the land has been developed and there is a structure on the property, vacant or occupied, we move to our third risk cycle: Occupied Risk Cycle, which is discussed later.
- Design and Engineering, Liability Risk
As we move beyond the development process through the Planning and Design Risk, our architects and engineers are the next areas of risk to review. Within this stage, our risk as a developer has increased greatly. If we are to have any negative environmental impacts from our structure, or a structural failure, it will begin at this stage. By using reputable, licensed and insured professionals, we are able to insure our risk by being listed as an additional insured on their Errors & Omissions Policy.
Caution: Just because your professionals carry an E&O Policy does not mean they are insured for every project. Many E&O policies have exclusions which limit the type of projects they can undertake. The most common exclusion for an architect is a Condo Exclusion which excludes any claims made under their policy for any condo projects. Make sure your professional trades are licensed and insured for the work they are to perform.
As we begin our project to construct a “box” from which we will collect rents in the future, we will first purchase a parcel of vacant land. We then place a vacant land policy to cover our liabilities against third party liability claims. At the same time we are working with architects and engineers through the planning and design process to begin construction. We ensure our professional trades are licensed and carry the appropriate Errors and Omissions policy to cover any oversights, and we require them to name us as an additional insured on their E&O policy in the event we are sued over a construction defect at this early stage.
Vacant Land Liability Risk: Vacant Land Policy purchased by the owner.
Property Risk: This risk typically does not exist, otherwise the land is not vacant.
Planning and Design: Liability Risk: Errors and Omissions Policy. We must be listed as an additional insured on their policy.
Property Risk: As our land is still vacant, this risk does not yet exist.
- Construction Risk
During the construction phase of our risk cycle, our risk level as a developer is at its highest. Our vacant parcel becomes a construction site where security and safety become a real issue. Banks are funding construction loans, and time and material expenses begin escalating at alarming rates. Construction workers are on the property/project on a daily basis, and commercial vehicles and equipment are driving on and off the property day and night. Where does our risk begin and end during this construction risk?
Back to building our box: Our vacant land policy will soon offer no protection as the policy has exclusions for construction and other triggers terminating coverage at this point. However at this time we have, or will be hiring, a General Contractor (GC) to build our box. Our GC in turn will hire many Sub Contractors (Subs) to complete portions of the project. As we begin construction, our materials show up onsite and/or offsite and our risk now consists of both property and liability.
- Course of Construction, Property Risk
With any type of construction loan, the bank will not fund without the appropriate insurance in place. Specifically they will require a “Builders Risk Policy” , also known as “Course of Construction” (COC), to insure against real property loss. As the project begins, the real property does not yet exist, but as we begin to receive materials and build our project the risk of property loss increases. As the project begins, from foundation to framing to build out, it’s our Course of Construction Policy which will insure our building against loss, such as theft or a fire. This policy is purchased by the developer, who is the named insured on the policy, with the bank being listed as loss payee.
Let’s assume a construction budget of $10 million for our sample box project, which consists of $9 million in hard cost and $1 million in soft cost. Our hard cost consist of time and materials we have invested in building the box, while our soft cost are all other fees, permits and expenses to get to construction. Both hard and soft costs can be insured in our COC policy. For this example we will secure a $10 million COC policy for a 12 month term.
- Course of Construction, Liability Risk
As discussed previously, we have both property risk and liability risk that we need to insure against. Our liability as a developer can be covered to some extent by “piggy backing” on a Commercial General Liability Policy (CGL) from the GC. By hiring a General Contractor and being named as an additional insured on their policy, we are granted the same rights and protection as the policy holder (GC). The GC in turn contractually requires each sub to provide the same limits of coverage as their current policy, also naming the GC as an additional insured. By each company, or trade, naming the entity above as an additional insured, and the use of hold harmless agreements within the GC and Subs contracts, the developer “builds” up many layers of coverage for liability and construction defects coverage.
Note: There is a “grey” area between the developer risk and the contractor risk as it relates to the GC policy providing coverage to the developer. When we rely on a policy other than our own, we are only covered as well as the other policy is written. In the event their policy offers no coverage for the risk we may have as a developer, or our claim is beyond the scope of the policy of those we hired, we will not have the coverage we need . We may therefore be without protection from the carrier, and would have to pay for our own cost to defend any claim.
Other policies required to be in place, but are primarily the concern of the GC and Subs are:
Workers Compensation Insurance: Medical and Disability coverage for all trades on the project, where applicable.
Commercial Auto Insurance: Both property and bodily injury coverage for vehicles and machinery on site.
Excess Liability or Umbrella: used to increase the limits on all primary liability policies for which the umbrella is secondary to a primary limit.
- Owners/Contractors Protection Policy, Liability Risk
The Owners/Contractors Protection Policy is purchased by the developer and used to insure against the “grey” area between the contractor and the developer as described above. This policy is an elective by the developer and requires the developer to be named as an Additional Insured on the GC policy. It is not to be used as a primary CGL policy in the event our GC or Subs policy expires or lapses. It is only secondary to an existing policy.
With our sample box project, our risk as a developer during this phase is both third party liability and construction defect liability, as if our box is not structurally sound and safe over a period of time. We will have our GC name us as an additional insured on their policy and we will purchase an OCP, Owner/Contractors Protection Liability Policy, to cover the “grey” area between us and the GC.
Construction Property Risk: Course of Construction Policy (COC) purchased by the developer to insure against real property loss during construction.
Liability Risk1: Commercial General Liability Policy from the GC naming the developer as an additional insured.
Liability Risk2: OCP policy purchased by the developer in addition to the general contractor’s CGL policy.
Note: If the project is a Condominium Development, the developer will be required to purchase a WRAP policy, also know as an Owner Controlled Insurance Policy (OCIP). As noted earlier, most CGL policies for contractors exclude coverage for any work performed on any condo project due to the 10 year construction defect liability the developers carry. To insure against this risk, the OCIP or WRAP is used to provide coverage for all trades who are enrolled in the OCIP policy providing coverage for their members during construction. The benefit of the WRAP policy is the uniform coverage it provides across all contractors, and the extended coverage for construction defects the developers carry long after all the other trades are gone. The policy is written for the developer, provides coverage for all trades throughout the construction period, and continues to protect the developer throughout the 10 year statute for construction defects. This statute will vary state to state, but the condo exclusion with the basic CGL for contractors is national in most cases.
- Occupied Property Risk
As the project approaches completion, some of the policies in force will begin to self terminate. An example is the COC policy, which typically expires 30 days after the Certificate of Completion is issued. During this phase of construction the project begins to approach a vacant building status where both current property and liability policies may not offer any protection at all. At this point we should purchase both property and liability coverage for the intended use of the project. In many cases the project will be refinanced and the new bank will require to be listed as a loss payee and additional insured on the new policy. In many cases with a recently completed project the standard insurance markets will offer terms for coverage of the vacant property with the understanding it will be occupied quickly. If the property remains vacant for a defined period of time, or the occupancy rate is too low, it may be necessary to replace the standard insurance policy with a vacant building policy.
As our sample box project is completed, all the contractors have completed their work and have left the job site. Our new tenants are moving in and we are ready to start collecting rents. Now we need to place the final commercial insurance coverage for the nature of the property risk. In this case, we will have a single tenant retailer in our box. As the owners of the box, we will need to place both property and liability coverage protecting us as owners. We will look to insure the building replacement value, the loss of rents in event the building is unoccupied due to covered cause of loss (theft, fire, etc.) and we will insure any other business personal property we may have within the project property.
The occupant will have a separate policy, known as a Business Owners Policy (BOP), providing both property and liability coverage for their business risk, naming us as an additional insured. In the event the business is sued and we are named in the suite, it’s their BOP policy which will defend us first rather than our building policy. Within the property coverage, we will make sure the tenant is insuring their own tenant improvements they make and any inventory or business personal property they have installed. In the event of a full loss in the property, such as a fire, each entity will have a policy written on their business risk, with separate limits for their loss.
Occupied Risk: Owner’s Risk:
Property Risk: A Commercial Property Policy insuring the buildings replacement cost, loss of rents and any business personal property lost for a covered cause of loss.
Liability Risk: A Commercial General Liability Policy protecting the owner from third party liabilities that are beyond the scope the BOP policy from the tenant and insuring against some contractual obligations to the tenant.
Property Risk: A Business Owners Policy (BOP) covering the property of the tenant, inventory and any tenant improvements made with the property.
Liability Risk: A Business Owners Policy (BOP) providing liability for the business risk of the tenant, the operations of the tenant business and their third party liabilities.
The Risk Cycle of Real Estate is a slow and continuous cycle based on the use of a parcel of land. Although the cycle may take decades to make a full turn, inevitably the commercial property undergoes a transformation. As an example, after the useful life of a project the building may be demolished, or it can be re-purposed for a different use. Under this scenario, the insurance required will cycle back around to Construction Risk in the event of remodel, or start back at the beginning of the Risk Cycle with the demolition of the structure bringing us back to the Planning and Design risk with the vacant land.
Although this article is generic in nature, the Risk Cycle of Real Estate as managed by us at Commercial Coverage Insurance Agency is very specific to all property owners. Our intention is to create awareness that not all commercial property policies cover all the risk you incur through the Risk Cycle Of Real Estate. Very little is left to interpretation on behalf of the agent or carrier. As an example, if your property “use” has changed based on its original intended use, you should notify your Agent of this change. In many cases you may not feel the need to notify your Agent of these changes, but then your assumed coverage can actually be your liability, as your policy is an insuring contract with endorsements and exclusions either adding or reducing coverage. You may not have coverage based on the insuring contract even if the problem or condition is not known to exist. I therefore recommend you work very closely with your Insurance Agent, or Broker, as a partner in developing a strategy to insure your risk for all phases of the Risk Cycle of Real Estate.
Paul C. Tradelius Jr.
Commercial Coverage Insurance Agency