INSURANCE

Builder's risk insurance is a special type of property insurance which indemnifies against damage to buildings while they are under construction.

NECESSITY

Buildings are subject to many different risks while under construction. They may catch fire, be damaged by high winds, or fall victim to other force majeure. One common theory is that any new construction becomes property of the owner once it is located on the owner's site. The general contractor may be responsible for any losses caused by his own negligence, but the owner is responsible for most other losses. Builder's risk insurance indemnifies against some of these losses.

COVERAGE

Builder's risk insurance usually indemnifies against losses due to fire, vandalism, lightning, wind, and similar forces. It usually does not cover earthquake, flood, acts of war, or intentional acts of the owner. Coverage is typically during construction period only.

WHO BUYS BUILDER'S RISK INSURANCE

It is usually bought by the owner of the building but the general contractor constructing the building may buy it if it is required as a condition of the contract.

ALTERNATIVES

If the project involves renovations or additions to an existing building, the owner's existing property insurance may cover the work under construction, obviating the need for builder's risk insurance. However, in the case of new buildings under construction on vacant sites, the owner may not have an existing policy that provides coverage.

In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior.

Two types of behavior can change. One type is the risky behavior itself, resulting in what is called ex ante moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms).

A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. This may be called ex post moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forego medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.

Deductibles, copayment, and coinsurance reduce the risk of moral hazard since the insured have a financial incentive to avoid making a claim.