Professional Indemnity Insurance and Collateral Warranties

What is a Collateral Warranty?

Collateral warranties are supporting agreements to primary contracts and extend a contractor’s or professional’s liability to a third party beneficiary who is not party to the primary contract. They are a means for a contractor or professional to warrant that they have fulfilled their duties and obligations under the contract, for example using materials of an appropriate quality or undertaking work in a professional manner. Funders, purchasers and tenants with an interest in the project are examples of third party beneficiaries.

Collateral warranties are necessary as claims for compensation and damages relating to defects in buildings are deemed ‘economic losses’ and unlikely to succeed in a claim of tort. They are generally only recoverable through a contractual relationship and collateral warranties are a means of creating a direct contractual relationship between parties that would not otherwise exist. They enable the duty of care owed by the contractor or professional to be extended to a third party who is not party to a primary contract.

The Contract (Rights of Third Parties) Act 1999 can be used as an alternative to collateral warranties as it enables third party rights to be created by a contract, however, collateral warranties tend to be the preferred option of creating the direct contractual relationship at the present time.
Collateral Warranties generally apply for a period of up to 12 years.

Do Professional Indemnity Policies provide cover for liabilities assumed under a Collateral Warranty?

The answer will be dependent on the wording of the collateral warranty and your insurance policy.

Some professional indemnity policies exclude all contractual liability which would have not existed in the absence of the contract, warranty or agreement and offer no cover. However, others will cover liability assumed under a collateral warranty, although cover will generally be subject to the following conditions or exclusions.

  • The benefit of the warranty is no longer or greater than that provided to your client, ie you have not agreed to give a third party more contractual rights than your client.
  • Liability for liquidated damages or financial penalties are excluded.
  • Liability for express warranties or guarantees of fitness for purpose, satisfaction of purpose specifications or periods of completion are excluded.

To elaborate on the last point, express warranties or guarantees are absolute obligations that usually go beyond the standard of care that the law expects from a professional. The law does not expect perfection from a professional but applies a ‘reasonableness’ test meaning a contractor can be in breach of some contractual warranties even if they have not been negligent. Such contractual commitments not only go beyond the scope of a professional indemnity policy, but where the ‘professional’ work is subcontracted, may also mean that liability cannot be passed on to the actual professional who did the work.

A few other points

Most collateral warranties contain a cavate that the obligation to maintain the required level of insurance cover is subject to the cover being available at commercially reasonable rates and terms.

Some professional indemnity policies will restrict the number of assignments of the collateral warranties to other parties and checks should be made that the policy ties in with the requirement of the collateral warranty.

Professional Indemnity policies generally provide contingency cover for work subcontracted to specialist designers, consultants or sub-contractors but on the proviso that the policyholder has not waived or otherwise impaired the rights of recourse against such designers, consultants or sub-contractors. Some contracts can contain provisions entitling a third party to have control of claims which may affect policy coverage if they impair the rights of recourse.

Collateral Warranty Checking

Because of the complication with collateral warranties, some insurers offer a collateral warranty checking facility whereby specialist solicitors will check warranties on a contractor’s behalf, to identify contract clauses that go beyond the scope of their professional indemnity coverage.

For more information contact Stewart Murray (stewart.murray@nsure.co.uk), Dave Cole (dave.cole@nsure.co.uk) or call the office on 01903 520200