Identifying construction risks

Builders risk claims often include numerous complex issues. Delay-in-completion claims add a layer of complexity with general conditions and construction loan interest being the more common issues that lead to disputes. Each can involve significant claim dollars, and each can be a source of dispute and confusion.

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Builders risk delay-in-completion claims — General Conditions

“General conditions” is a construction term, typically understood to be a catchall for construction overhead and other project expenses that are not trade specific. Because the term is often perceived as vague and all-encompassing, it provides occasion for the potential overstatement of claimed and measured amounts.

General conditions, depending on the wording of the construction contract, may involve either on-site or off-site expenses for some or all of the parties engaged in the project. These expenses are typically not trade-specific, like carpentry work or plumbing would be, but they are still costs required to complete the project.

On-site general conditions can include construction trailer rental, cell phone bills, site lighting, portable toilets, snow removal, job office rental, site utilities, temporary heat and power, superintendent’s salary, rubbish removal, and site security.

Off-site conditions can include home office rent, salaries of project manager or accountant, and cost of hiring consultants, including testing labs, surveyor, engineers and others. The contractor typically invoices the costs on a monthly basis, with a detailed list of all charges for the previous period.

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Questions to ask

To ascertain which general conditions are claim-related, key information is necessary. Some information may present coverage or adjusting issues for the underwriters and adjusters to address.

1. If the general conditions costs are claimed as a soft cost resulting from a delay, are they incurred during the delay period?
2. Are the claimed general conditions costs consistent with what was charged during the pre-loss or pre-delay periods?
3. Are the general conditions expenses additional, or would these expenses have been incurred, absent the loss?
4. Are the general conditions expenses necessary to repair the damage resulting from the loss?
5. Are the general condition costs being charged consistent with the base contract?
6. Is there a dollar limit or percentage of general conditions that is permissible in the underlying construction contract?
7. Does the contract specify how general conditions for extra work are to be addressed?
8. Are any general conditions expenses that are not consistent with the pre-loss period a direct result of the loss and potentially part of the property damage claim?
9. Is the identification of certain costs as general conditions in the claim an attempt to circumvent other sub-limits?
10. Are any of the general conditions related to extra work that is not loss-related, or outside of the scope of the initial contract?

Asking some mix of these questions should allow the measurement to be prepared accurately, subject to the coverage advice of the underwriter or adjuster. However, problematic issues or potential areas of dispute may still arise, as demonstrated in the following examples.

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Examples of general conditions claim issues

1. Relationship between the project fee and general conditions

The general contractor/insured and insurer agree that there is a delay resulting from a covered peril. The loss results in a four-month delay and the insured parties assert a claim for $25,000 per month based on the historical average general conditions. The general conditions have yet to be incurred, but the estimate includes the following costs:

• Trailer rentals — $5,000
• Home office rent — $10,000
• Project manager time — $4,000
• Superintendent time — $6,000

Prior to the loss, only trailer rentals and project manager time were included in the General Conditions. Moreover, the prime contract specifically delineates what costs are allowable v. excluded. Home office rent is specifically excluded and superintendent time is included in the fixed fee that the general contractor is charging on the time and materials of the job.

The corrected claim for general conditions costs is $9,000 per month during the delay period.

2. Labor allocated to multiple jobs

The insured makes a claim for project management time of $7,000 under the general conditions component of its costs. The insured sustains a bona fide delay of four months. However, the project manager is seen at multiple other construction sites prior to the loss, during the reconstruction and the resulting delay period. Timesheets support that the project manager is actively involved in three different construction projects. The question of what the insured is owed may become more complicated than simply allowing one-third of the incurred costs attributable to the loss site during the delay period.

3. Duplication of claimed general conditions

General conditions per the prime contract are charged as 4.5% of the overall time and material costs for the project. The insured submits a claim for the repair costs resulting from the loss event of $1,000,000 plus the 4.5% general conditions allocation. The insured separately submits a general conditions claim as a soft cost during the delay period. Depending on how the insured is incurring the general conditions costs, this scenario may result in a potential duplication of the claimed amounts in both the property damage claim and the soft cost claim.

General conditions as part of builders risk delay-in-completion claims are often a source of complexity, misunderstanding and overstatement. Asking the right questions will help avoid common measurement deficiencies and result in more accurate claims.

Construction loan interest

The proper flow of funds on a construction project is critical to the existing construction project as well as other concurrent and future projects for developers and contractors. Construction projects are capital-intensive, and construction loan interest is often the largest component of a delay-in-completion claim.

A thorough understanding of the financing mechanism(s) of a project during and after the construction phase is necessary to determine the potential for additional interest expense exposure that may be incurred by insured parties in the event of a delay related loss. Additional considerations include the security interest encumbering the property improved or created, the repayment provisions of the loan agreement, and the insured’s intent to repay the loan upon completion of the project.

Financing for construction projects is dependent upon many factors, including the economy, creditworthiness, credit availability, and geopolitics. Lenders for non-public construction projects are typically banks making construction loans. Other funding mechanisms are:

• Syndicated loans
• Bonds
• Mezzanine loans

The interest component of a delay-in-Completion claim is frequently misunderstood. When measuring the additional construction loan interest, the additional and construction language typically included within the insurance contract is often overlooked. Soft cost claims involving construction loan interest are often presented as the full “normal” interest expense on all existing borrowed funds during the delay period.

For example, a project owner may present additional construction loan interest expense without considering if any of the loan proceeds were used for the land acquisition, and without considering whether the construction loan interest would have been ongoing, post-construction.

An owner’s presentation frequently contemplates the additional months’ interest that the project is being forced to carry because of the delay. This may seem like a reasonable basis for damages, without considering any other facts. However, this approach neglects to consider the ongoing construction loan interest expense of the project upon completion and potential overlap with continuing interest expense on related business interruption claims. Some background information is needed to determine if there is additional interest exposure, including:

1. The funding mechanism(s) financing the land acquisition and construction costs.
2. The term and other provisions of the loan agreement, i.e., the drawdown and repayment period considered, including the permanent financing mechanism. Many financing agreements specify a time period in which the construction project should be completed in order to adhere to the loan covenant.
3. Resetting interest rates — A delay in construction can also result in a higher interest rate or postpone the move to a lower interest rate upon conversion of the construction loan to a mortgage.

Measuring interest expense

Key measurement questions to ask the insured regarding additional interest expense during the delay period include:

• Is there a principal amount of money borrowed and repayable at some interest rate and within a defined time period?
• Has money been advanced in return for an equity interest in the insured’s company, with repayments to be made, in whole or in part, out of profits? Is this interest preferred over some other subordinate interest, or subordinated after some preferred interest?
• Were any loan proceeds used to acquire the property, and potentially part of the construction loan interest being claimed?
• When were advance payments made and how should these be used to offset the claim for additional construction loan interest, if considered at all?
• How has the scope of the insured’s construction (non-loss related work) changed since the beginning of the project and since the date of the loss? What is the effect on the loan balance?
• Is the insured making a claim for the lost profits related to lost sales (of condo units, for example) that were only delayed and how is this delayed sale amount incorporated into the interest payment?
• Does the business interruption loss include interest as a continuing expense?

Handling issues that arise

Answers to some mix of the previous questions will help prepare a better measurement. However, issues may still arise as described in the examples below where the developer is the insured:

1. Lost opportunity costs —  A developer acquired an historic post office building with the underlying land in downtown Boston. The developer acquired the property using capital from the proceeds of the record-breaking sales of another condo development in Boston. The scheduled completion date of the current hotel/residential condo project was December 31, 2015. On November 30, 2015, several pipes froze and burst, sending water cascading down into the lower floors. The developer submitted a delay-in-completion claim for four months, asserting that it lost its ability to use the anticipated return of capital that the sales of the units would have produced.

Under typical delay-in- completion definitions, this would not constitute additional construction loan interest. However, specialized wording or definitions may precipitate a need to analyze the developer’s weighted average cost of capital. Furthermore, additional review of the funds that financed the acquisition of land and the funds that financed construction may be necessary.

A second issue in this example is the existence of a potential business interruption loss of the hotel operation arising from its delayed opening. If a traditional construction loan was used, and was to be converted to a mortgage to be paid out of the operations of the hotel, then a close examination of the soft cost and business interruption claims would be needed to avoid duplication of the interest expense between the two claims.

2. Line of credit interest — Assume the same set of facts as above, except that the developer finances part of the land acquisition with a $20 million mortgage and finances the construction with a construction loan of $85 million. During the delay period, the developer draws down its line of credit to pay the required interest-only payments on the construction loan, while it waits for insurance proceeds. The developer is thus incurring interest on the line of credit in order to adhere to the loan covenant and related interest payments. By doing this, the project is incurring interest on interest, which may not fit the definition of construction loan interests under a soft cost policy wording.

3. Bond Interest —  The same insured issued $20 million in 10-year notes with an annual interest rate of 7% to finance the project. The insured included four months of interest due to the delay-in-completion as part of the soft cost claim. This amount would typically not constitute additional construction loan interest because the term of the bonds is fixed and not affected by the delay in completion.

The goal is to identify the relevant issues early on in the claims and measurement process, seek the underwriter’s instruction on the constraints of the policy, and provide a thorough explanation for the adherence to those constraints in arriving at the measurement.

Patrick Kelleher (pkelleher@meadenmoore.com) and Sean Sica (ssica@meadenmoore.com) are both vice presidents at Meaden & Moore. They specialize in investigative accounting services to the insurance industry and legal profession.