There is a continuous discussion around best practices, differences, and use cases among construction and renovation lenders regarding General Liability Insurance and Builder’s Risk Insurance policies. These two insurance products are not interchangeable and serve entirely different purposes. In this blog, we will explore the key differences between general liability insurance and builder’s risk insurance and lenders will understand how to mitigate risk on all their construction loans.
The Key Differences Between General Liability and Builder’s Risk Insurance
Generally speaking, all general contractors should maintain a General Liability Insurance Policy, and every construction project should have a Builder’s Risk Insurance Policy. The following table shows the differences:
|General Liability Insurance||Builder’s Risk Insurance|
|Also Known As:||“Commercial General Liability Insurance”|
“Business Liability Insurance”
|“Course of Construction Insurance”|
|Are there different types of insurance?||Standardized policy as determined by the state.||Standard policy. The policy should be in the borrower’s name, including borrowers who are also the builder. A builder’s risk policy could be replaced by a homeowners policy, and sometimes has the conversion built into it once the certificate of occupancy is proven.|
|What is its Purpose?||Covers the general contractor from liability associated with accidents involving bodily injury or property damage, or to protect the general contractor against potential lawsuits involving advertising, copyright infringement, or reputational harm.||Covers the building and building materials that will become a permanent part of the completed structure. Coverage will end once the project is completed with a Notice of Completion from the local jurisdiction.|
|When should insurance be required?||Whenever work is being performed by a builder or contractor. It’s also recommended that the contracts be constructed to use only licensed and insured parties.||New construction: All projects|
Renovation: It is required when the homeowner’s insurance does not cover the work during a renovation. The homeowner’s insurance policy will disclose the exemption and the lender should review it to know if there are exemptions for construction. In the event that there are exemptions the lender should review the work being performed and require Builder’s Risk when any of the following work is performed: 1.) New addition, 2.) New Roof, 3.) Exterior Siding where the siding will be exposed, 4.) Significant interior structural work.
|Who is the Policy Holder?||Generally, the general contractor, but other subcontractors, suppliers, architects, etc, may also have their own policies, and most states require a general contractor to carry General Liability Insurance in order for their business to be licensed.||Typically, the Builder’s Risk policy is purchased by the property owner. The insured is the owner/borrower. In addition, a Builder’s Risk policy should name the lender that has a financial interest in the property as a lost payee. The only exception is if the borrower is named as a loss payee on the insurance.|
|Why is it Important?||To the general contractor: To ensure their business can survive a liability claim and avoid a business failure.|
To the lender: If the contractor fails on the project and their business can’t survive, this can impact the completion of the project if the general contractor is not well-capitalized. At a minimum, it’s a major distraction for the general contractor and could impact project completion.
|To the general contractor: The insurance could protect the borrower or general contractor from financial losses for damaged or stolen property. The general contractor may not have the capital to replace the materials or may look to the borrower or lender to resolve the shortfalls.|
To the lender: If the contractor is not well capitalized to absorb the loss then this could impact their ability to complete the project. At a minimum, the delays would impact project completion.
|What Does it Cover?||Coverage can include the cost of medical and legal expenses, or the cost of repairs related to:|
A policy may also protect against damage caused by:
|Construction building materials that are prone to damage or loss during construction, and the labor to replace them. Coverage includes;|
Extended coverage may also protect:
It can also cover tools and equipment within certain parameters.
|What Does it NOT Cover?||Coverage excludes:||Coverage excludes damage caused by:|
|Who Gets Paid in the Event of a Claim?||Claim checks go to the injured party and not necessarily the general contractor. General Liability Insurance is essential for a general contractor to be able to manage the inherent liability risks in the construction trades.||All claim checks will go directly to the policyholder.|
|How should we calculate the minimum amounts of coverage?||Amounts may vary by lender, however if the coverage being reviewed is less than the amounts below, consult the lender and let them know the amounts for the policy appear to be below industry averages of acceptability. Get written confirmation on how they would like to proceed. It may be necessary to update a lender’s P&P if constant issues arise over the coverage amounts.|
Renovation Contractors: $300,000 minimum
Vertical Construction Builders: $500,000 minimum
|The builder’s risk insurance policy will pay for damages up to the coverage limit. The limit must accurately reflect the total completed value of the structure (all materials and labor costs, excluding land value) OR the loan amount, whichever is greater. The construction budget is the best source for determining the appropriate limit of insurance.|
Insurance Best Practices for Construction Lenders
Both insurance policies have their benefits to reduce risk and to be used as a tool for lenders to help ensure project completion. Construction lenders, as a best practice, should require that all general contractors maintain the minimum levels of General Liability Coverage during the course of the project. This should be reviewed during a lender’s pre-close due diligence on the acceptability of the general contractor. The lender should maintain a policy that describes the minimum levels required and verify that it is placed prior to the closing of a construction loan. Verification can happen by requiring a copy of the evidence of insurance/declaration page. Lenders can also take an extra step by contacting the issuing company to verify that the policy is active.
Additionally, lenders should require that a Builder’s Risk policy is in place on the date of the closing of the loan, which will be prior to the commencement of construction and covers the greater of the loan amount or cost of construction.
Lenders that create policies and procedures that require the general contractor to carry liability insurance and require that a project have a builder’s risk policy are protecting both their borrowers and themselves in the long run. Loss occurrences may be few and far between but a single incident can be enough to impact the lender. The implications of a loss could result in broken trust, reputational damage, legal issue, or financial loss. The financial loss may not be limited to the collateral for which the mortgage is secured.
We find lenders that clearly communicate these requirements to borrowers and general contractors have the greatest opportunities for success while those that simply state the requirements in a document often deal with a customer service impact. Lenders that choose to leave these best practices to borrowers and general contractors to manage often have early success but see impact as their portfolios grow and the probability grows.