A restrictive covenant found in due diligence can be priced, insured or removed; the arithmetic says when the policy is the cheaper instrument, and what it must cover.
Title indemnity insurance is worth buying when the expected cost of the defect, the probability that someone enforces it times what enforcement would cost, exceeds the premium. On an illustrative £12.5m purchase with an old restrictive covenant over a planned £3.0m extension, a 3.0 per cent chance of challenge and £1,320,000 of average loss if it comes give an expected cost of £39,600 against a £10,850 premium, 3.65 times. The policy pays for itself on expected value at any probability above 0.82 per cent, provided it insures the development and not only the existing use.
Worked in full in Real Estate Transaction Due Diligence by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Title review in due diligence regularly finds defects that are old, unlikely to be enforced and impossible to clear quickly: a restrictive covenant from a long-gone estate, a missing right of way, a breach of a covenant that nobody has complained about for decades. The buyer has three options: ask for a price reduction, insure, or try to remove the problem, for a covenant by negotiating a release or applying to the Upper Tribunal under section 84 of the Law of Property Act 1925. The arithmetic below prices the first two. The third has its own cost and delay, and starting it usually rules out the second.
| Input | Value |
|---|---|
| Purchase price | 12,500,000 |
| Planned extension: cost / value added | 1,600,000 / 3,000,000 |
| Probability someone with the benefit challenges, over the hold | 3.0% |
| If challenged: settled by a payment | 70% |
| Settlement payment / legal costs | 350,000 / 100,000 |
| If challenged: injunction, extension removed | 30% |
| Injunction: demolition / legal costs, on top of the value lost | 200,000 / 150,000 |
| Premium rate, single payment, share of limit of indemnity | 0.07% |
The covenant restricts building on the rear yard, where the extension will go. The limit of indemnity is set at the value after the extension, 12,500,000 + 3,000,000 = £15,500,000, and the policy is written for the proposed development.
Step 1: the loss in each outcome. A settlement costs the payment plus legal costs, £450,000. An injunction costs the value the extension added, its removal and the costs, 3,000,000 + 200,000 + 150,000 = £3,350,000, 2.4 times the £1,400,000 profit the extension was meant to make.
Step 2: the average loss if challenged.
Severity = 70% × 450,000 + 30% × 3,350,000 = 315,000 + 1,005,000 = £1,320,000
Expected loss = 3.0% × 1,320,000 = £39,600
Premium = 0.07% × 15,500,000 = £10,850
Break-even probability = 10,850 ÷ 1,320,000 = 0.82%
Excel: =Premium/(Psettle*LossSettle+(1-Psettle)*LossInjunction)
The expected loss is 3.65 times the premium, so insurance is the cheaper way to carry the risk. It also does something a price reduction cannot: a £39,600 price chip compensates for the average outcome, but the buyer still bears the whole £3,350,000 in the 0.9 per cent of cases where an injunction is granted. The policy removes the tail, and a lender financing the extension may well require it.
In negotiation the two instruments meet. A seller asked for £39,600 off the price will often prefer to pay a £10,850 premium; the negotiation in the book's own case ends with a premium paid by the seller among its four instruments. The diligence report should show both figures, because the gap between them, £28,750 here, is what the buyer gives up by accepting insurance in place of cash.
| Probability of challenge | Expected loss | Expected loss ÷ premium | On expected value |
|---|---|---|---|
| 0.5% | 6,600 | 0.61 | Premium exceeds expected loss |
| 1.0% | 13,200 | 1.22 | Insure |
| 3.0% | 39,600 | 3.65 | Insure |
| 5.0% | 66,000 | 6.08 | Insure |
| 10.0% | 132,000 | 12.17 | Insure, and expect a higher premium or a refusal |
Below about 0.82 per cent the premium costs more than the risk on average, but a buyer may still insure because the loss it removes is large relative to the deal. Above a few per cent the insurer's view of the probability will move with the buyer's, and the premium with it: insurance is cheap only for defects that both sides believe are unlikely to bite. A covenant whose beneficiary is known, local and has objected before is a case for negotiation or the Upper Tribunal, not for a policy.
The common mistake is to buy a policy for the existing use at the purchase price, here a limit of £12,500,000 for £8,750, saving £2,100, when the business plan depends on the extension. That policy pays nothing on the £3,350,000 injunction, because the development it is about was never insured. The other mistake is procedural: policies of this kind are typically void if the insured approaches the person with the benefit of the covenant, or applies to discharge it, so the decision to insure has to be taken before anyone makes contact.
Price a title defect as probability times severity, with severity measured on the use the buyer intends, and compare it with the premium for a limit that covers that use. Here £39,600 of expected loss against £10,850 of premium makes insurance the better instrument, and the 0.82 per cent break-even shows how unlikely enforcement has to be before it stops paying. Where the defect is better handled through the price, the mechanics are in how to size a retention. The companion files include the free workbook for this case, which sets each finding's instrument, deduction, retention, indemnity or insurance, against what it recovers.
It is a one-off premium priced on the limit of indemnity and the insurer's view of the risk, so quotes vary. At an illustrative 0.07 per cent of a £15,500,000 limit, the premium is £10,850. A policy limited to the £12,500,000 purchase price for the existing use would cost £8,750 but would not cover a planned extension.
Usually yes. Indemnity policies for restrictive covenants are typically void if the insured approaches the person with the benefit or applies to the Upper Tribunal to discharge the covenant, because that raises the chance of enforcement. Decide whether to insure before any contact; on the illustrative case the policy is worth 3.65 times its premium on expected value.
A price reduction equal to the expected loss, £39,600 in the illustrative case, compensates for the average outcome but leaves the buyer with the full £3,350,000 if an injunction is granted. Insurance at £10,850 removes that tail. A buyer that accepts insurance in place of cash gives up the £28,750 difference.
This article is one calculation from Real Estate Transaction Due Diligence. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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