Demystifying Construction Risk Management and Insurance

This is Part 2 of a continuing series Construction Communiqué articles that have been designed with our existing and prospective construction clients in mind.  These articles will provide our readers with a basic understanding of risk allocation and insurance policy principles most relevant to the construction industry.  The goal of this series is to provide our existing and prospective clients with a basic understanding of risk management fundamentals to assist them in better managing risk on their next project.

The Spectrum of Hazards and Risks in Construction

We talked in our last issue about the unique nature of constructed facilities – that the owner is purchasing a “yet-to-be built” product based on graphical and verbal descriptions of the end item, rather than the completed item itself.  Since the purchased item is to be produced (rather than being in a finished state), there are many complex issues which can lead to failure to complete the project in a functional and timely manner.  The number of project participants and issues that must be dealt with prior to project completion lead to a complex level of risk for all parties involved including owners, designers, constructors, suppliers and government authorities.

There are many risks associated with each phase of a construction project, from feasibility through to operations.

Risks associated with the feasibility stage include the owner’s choice of professional and contractor team, the owner’s terms of reference to the professional and contractor team, choice of site, adequacy of soil investigations, adequacy of surveys and inspections, and adequacy of financing.

Risks associated with the owner’s choice of professional and contractor team are highlighted by an incident that took place on March 27, 1981 where the reinforced concrete roof of the Harbour Bay Condominium in Cocoa Beach, Florida collapsed during concreting operations, bringing down with it the whole building and resulting in the death of eleven construction workers and the injury of twenty-three others.  The five story structure was designed by two retired structural engineers.  The collapse was due to numerous errors in design and construction, and a failure to perform certain engineering calculations that were fundamental for this type of structure.  The weight of the external masonry walls, for example, was not taken into account in the calculations and the foundation failed.  Ultimately, two engineers, an architect and two contractors were charged with negligence, misconduct and failing to conform to state and local building laws.  This incident highlights the importance of the owner’s choice of professional team and selecting the right consultant for the particular project – or even for the particular discipline.  It is a cautionary tale that although a professional may be qualified and experienced to carry out the design of a certain project, they may still lack knowledge of a particular aspect of the design.  If they do not realize their limitations, they may proceed without executing their duties properly which could result in significant property damage, personal injury and even death.

The terms of reference are the anchor of any project. Odd that, so often, scant attention is paid to them. The terms of reference set out the basic definition of the project.  Terms of reference specify geographical, financial and technical constraints; objectives, capacities and key components; and desired useful life of the completed project.  Misunderstandings in this area have caused, and continue to cause, failure in the construction field.  A typical example is failure due to a change in use of the project that was not envisaged by the designer and yet contemplated by the owner.

When a site is chosen for a project, the natural characteristics of that site must be investigated.  The professional team should not depend entirely on the owner’s undertakings or assurances as to the suitability of the site.  Take for example, the construction of a school where a contract for construction was entered into and work on the foundations proceeded satisfactorily until the spring when the snow started to thaw and large quantities of run-off water accumulated in the low point of the chosen site.  The run-off formed a shallow but large lake that submerged the foundations.  The architect who participated in selection of the site was blamed and his professional liability insurer had to step in to rectify the situation.

Risks associated with the design phase include inappropriate choice of design, negligence and lack of care, state of the art, codes and technical knowledge, lack of knowledge, work carried out in haste, lack of communication, use of untested and unproven techniques, and inadequate performance of mechanical and electrical equipment.

Choice of construction contractor is critical.  There is an implied warranty in a construction contract that suitable material will be used and labour will be performed in a good and workmanlike manner.  Nevertheless, the cost to rectify defective material and substandard workmanship after the fact can be prohibitive and, depending on the facts, uninsured.  Therefore, it is important to mitigate the risk of defective material and workmanship in a construction project by careful selection of the contractor and any subcontractors to be named in the contract.

Risks during construction include excessive rainfall, flooding, wind and storm, subsidence, landslide, rockslide and avalanche, temperature extremes, earthquake, underground obstructions.  The low strength and lateral instability of uncompleted structures make them especially vulnerable to wind, storm and earthquakes.  Acceptability of the project by local residents is also a risk that can arise during construction.

Risks during construction associated directly with human acts are many.  Human error, negligence and lack of care, fraud, theft, failure to comply with insurer’s conditions and requirements, arson, strike, incompetence, malicious acts, inefficiency and delay, inadequate site supervision, variation from contract documents, illegal activities (i.e. non-compliance with building codes) all need to be considered by the contracting parties.

Risks associated with post-construction include safety, fatigue, resistance to fire and arson, resistance to natural and other hazards, resistance to man-made hazards, fitness for its purpose, operation and resistance to wear and tear during its designed life span.  As well, all parties need to be mindful of risks associated with settlement of foundations and deflections due to loads including wind, strain and creep deformation.

Finally, serviceability and risk of a faulty maintenance program in respect of a completed facility is important and one that could affect not only the owner of the project, but also others involved in its execution.  When things go wrong after a project is complete, the owner (including past or future owners) or tenant (or both) will undoubtedly be looking for ways to fix liability for any property damage, injury or lost revenue on one or more of the project participants.

Risks are Not Necessarily Scaleable

As a construction project increases in size, the risks inherent in its planning, design and execution do not simply multiple in proportion to the increase in size.  Instead, new and peculiar risks emerge which need to be identified and taken care of prior to the commencement of design.  See for example Nael G. Bunni in Risk and Insurance in Construction (2ed) where:

1. the financial resources required to complete a major project may be so large that more than one financier and the government may be required to be involved, all of which increases project risk;
2. the financial aspects of major projects provide a high element of risk to the contractor;  if a major contract proves to be unprofitable, the outcome, from the contractor’s point of view, can be disastrous;
3. if the period of construction is long, the economic viability of the project may be fraught with high risk for all project participants if at the end of a long period of construction there are adverse changes in technology, product, inflation, currency fluctuation and the need of society, each of which may render the project obsolete;
4. major projects generally involve many contractors and subcontractors, suppliers and sub-suppliers; this situation is prone to bottlenecks some of which are very critical to the progress of work on or off the site; and
5. high labour context, with multi-million man-hours per month, new and advanced technology in one field or another connected with a major project and unproven performance of materials or their strength, combine to bring with them high and concentrated levels of risk.

Risk Allocation Fundamentals

For identified risks, the parties can decide who will bear a particular risk or whether that risk should be shared and if so, by whom.

However, an important question arises in relation to any unidentified risk.  If and when an unidentified risk eventuates, to whom should the consequences be allocated?  The contractor may be liable for the consequences of all risks that are not specifically allocated to the owner.  This is the approach taken in FIDIC’s standard forms of contract. Against that view, the contractor would argue that if and when such risks eventuate, they should best be borne by the party who gains in the long run the benefit of the project – namely, the owner. The American Institute of Architects adopts that view and accepts that all risks belong to the owner when no other party can either control the risks or prevent the loss.

If risks are not allocated in a contract and a dispute arises between the parties as to whom a particular risk is allocated, then an arbitrator or a judge may consider the following criteria and determine the dispute accordingly:

1. which party could best foresee the risk in question?
2. which party could best control that risk and its associated hazard or hazards?
3. which party could best bear that risk? and/or
4. which party most benefits or suffers when that risk eventuates?

First and Third Party Policy Basics

To the extent the risk allocation process results in a desire or an obligation (project lenders will almost always impose insurance requirements as a condition of the construction loan) to shift risk to insurers, a basic knowledge of insurance terminology is critical to ensure the parties fully understand the risks that are (and are not) insured for a particular project.

It can be useful to think of insurance in terms of first party and third party coverage.

First party coverage involves a claim by a policyholder to their insurance company in connection with loss or damage suffered by that policyholder.  Think of a straight line.  At one end, you have the policy holder and at the other end, you have the insurance company.  The policy holder is asking the insurance company to cover them for loss or damage to their own property i.e. buildings or equipment owned by the policyholder.  Life insurance is an example of a first party insurance policy.  Property insurance is also a first-party coverage.  The insurance is intended to provide direct benefits to the insured for losses to covered property.  Property insurance will be written on an “all risks” or “named perils” basis.  Although an all risks policy does promise broader coverage, it does not mean that every conceivable risk is covered – it means that coverage will be dictated by the numerous exclusions.  The less expensive named perils policy is narrower in scope and covers only those losses caused by one of the enumerated perils such as fire, explosion or windstorm.

Unlike property coverage, third party coverage does not involve a loss directly by the policyholder.  Instead, a third party is claiming that that the policyholder has caused them loss.  In this context, a third party is a party who is a stranger to the insurance contract between the policyholder and the insurance company.  Think of a triangle.  You have the policyholder, the insurance company and a third party (who is frequently a plaintiff).  In this particular situation, the policyholder turns to the insurance company and asks the insurance company for two different protections:

1.  a duty to defend the policyholder; and
2.  a duty to indemnify the policyholder.

The duty to defend is where the insurance company pays the fees and related expenditures of legal counsel in connection with the claim of the third party against the policyholder.  The duty to indemnify is the duty to pay either the settlement or the judgement in favour of the plaintiff against the policyholder.  Examples of third party policies are directors and officers insurance and errors and omissions insurance.

There are two types of coverage that have both first and third party coverage.  One of them is homeowners’ insurance.  The other is automobile insurance.

A homeowner’s policy will provide you with coverage for fire.  If your house burns down, that is a first party claim. A claim by you the homeowner against the insurance company in connection with your loss (the loss of your residence).  Two parties are involved – you and your insurance company.  In contrast, if a neighbour is hurt on your property (say they fall down your broken steps), that is a third party claim.  A claim by your neighbour against you in connection with a loss suffered by your neighbour.  There are three parties involved – your neighbour, you, and your insurance company.

An automobile policy will provide you with comprehensive coverage for fire, theft and so on.  If your car is hit by lightning and is damaged or destroyed, then you will make a first party claim to the insurance company for the loss.  In contrast, if you rear end a car on your way home from work, then the person ahead of you will look to you to pay for the damage to their car and any bodily injury.  There are three parties involved – the person ahead of you, you, and your insurance company.

Other than homeowner and automobile insurance, most insurance policies are either first or third party policies.  For example, an owner will carry commercial property insurance to cover their buildings and equipment.  An owner will also carry separate commercial general liability insurance to cover claims made by parties against the company.

Next Issue:  First and Third Party Policy Basics (con’t); First and Third Party Construction Insurance Basics.