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Risk Management For Construction Projects

Patrick O'Connor is a co-author of Bruner & O'Connor on Construction Law, a 7 volume treatise that addresses the major issues of American construction law. This set offers an in-depth analysis of ... Read more

Three Way Approach: Insurance, Risk Allocation, Loss Prevention

For many construction participants, the concept of risk management is roughly equivalent to insurance. In reality, however, insurance is only one of the mechanisms available to manage and transfer construction project risks. The most significant risk allocation tools are the contracts governing each participant's project responsibilities. The most effective loss prevention mechanisms are sound business and construction practices: proper preconstruction planning, proven construction means and methods, use of experienced personnel, and stringent safety programs.

Only some construction project risks are insurable – generally those that permit insurers to classify and price the risk. Insurers looks for risks which have measurable losses; reliable estimates of claim frequency and severity; little potential for catastrophic loss; feasible premium levels; and a large pool of potential insureds to distribute risk.

Insurance is therefore confined to discrete classes of risk. Risk of loss due to bodily injury is one major focus of insurance. Workers' compensation insurance, automobile liability insurance, and commercial general liability (CGL) coverage respond to most of the bodily injury losses that can occur during construction. Another focus of insurance for construction operations is the risk of loss arising from property damage, and associated loss of use. Such losses may be covered under either first-party property insurance and/or the CGL policy of one or more of the participants.

We have identified almost 200 distinct construction project risks, from project planning and contract formation, through on-site activity and contract administration, to project completion. (A table listing those risks appears in the on-line version of this article.) Of all the identified risks, roughly two-thirds (66%) are not directly insurable. For example, one of the first risks identified is subcontractor selection. If a subcontractor's poor safety practices result in an work site injury, or the subcontractor's defective work results in property damage, the general contractor's CGL policy may well respond to such losses. But the risk of choosing the wrong subcontractor is generally not properly mitigated through insurance. Insurance coverage for another 10% of the identified risks is unpredictable, because the insured's right of recovery varies from jurisdiction to jurisdiction. A number of property damage losses fall into this category. In sum, between two-thirds to three-quarters of all project risks are best managed by means other than a standard insurance package.

Standard Insurance Program

Almost all construction contracts contain insurance provisions. As a benchmark we refer to the insurance program in the American Institute of Architects (AIA) 1997 form documents, principally the General Conditions document (AIA Document A201-1997).

The insurance program envisioned by the AIA General Conditions is broken down as follows: (1) Contractor's liability insurance (¶ 11.1); (2) Owner's liability insurance (¶ 11.2.1); (3) Management protective liability insurance (¶ 11.3); and (4) Property insurance (¶ 11.4). The contractor's liability insurance includes the following coverages: (1) workers' compensation; (2) employers' liability; (3) commercial general liability; and (4) automobile liability. The project owner's liability insurance obligation is to purchase and maintain its "usual" coverage. The project owner is not required to evaluate whether its coverage is adequate for the planned construction. Nor must the owner purchase liability coverage if its "usual" situation is to be self-insured (or uninsured).

The 1997 AIA General Conditions contain a provision entitled "Project Management Protective Liability Insurance." This is a relatively new coverage and, as yet, there are few products on the market under this description. CNA markets a project management protective liability policy. This coverage resembles owners' and contractors' protective (OCP) liability coverage. Under the AIA General Conditions, the project owner is given the option to require the contractor to purchase this coverage (at the project owner's cost), as an alternative to requiring the contractor to name the project owner and the architect as additional insureds on the contractor's liability insurance coverage.

Under the AIA scheme, obtaining property coverage is the project owner's obligation. Property coverage must be written on a builder's risk "all risk" or equivalent policy form. The coverage must include insurance against the perils of fire and physical loss or damage due to theft, vandalism, malicious mischief, collapse, earthquake, flood, wind storm, false work, testing and start-up, temporary buildings and debris removal and demolition. The owner may purchase and maintain coverage against loss of use of the owner's property due to fire or other hazards. The AIA General Conditions (¶ 11.4.3) provide mutual waivers of subrogation between the construction participants, leaving the risk of loss covered under the required property coverage with the property insurer.

The AIA's Owner-Architect contract documents do not expressly require the architect to purchase liability insurance. Generally, however, designers maintain professional liability insurance, as well as general liability coverage. The limits of coverage available to designers through professional liability insurance are often insufficient, particularly for large projects. By contrast, the CGL limits secured by general contractors of any substantial size are usually fairly significant. In addition, many general contractors carry a layer of excess coverage over their primary general liability insurance. Because excess coverage often "follows the form" of the underlying primary policy, the breadth of coverage is not enlarged, but the available dollar limits of coverage can be considerably increased.

Extended Insurance Programs

In "soft" insurance markets, extended insurance products may be available for construction project risks. These products often tighten or even disappear in "hard" markets, due partly to the fact that these coverages have thin markets. For extended coverages issued by only one or two carriers, the decisions of individual carriers can have a significant impact on coverage availability. Furthermore, the availability and specific terms of extended coverages tend to depend on the economic leverage of the prospective insured and the negotiating skills of the insured and its insurance agent.

Risk Management and Surety Bonds

Many construction contracts contain performance and payment bond provisions. Bond credit is less common in private construction than risk financing through insurance. Surety bonds are more in the nature of credit enhancement devices than true risk transfer mechanisms. Even though the surety charges a premium, the surety requires the contractor to reimburse it in the event of loss by the surety on the bonds. The risk transference that bonds achieve is to shift the credit risk of the bonded contractor being able to perform its obligations from the owner (under a performance bond) to the surety. In contrast to insurance, in order to obtain surety credit, contractors and their equity holders routinely execute indemnification agreements, agreeing to indemnify the surety for all losses the surety incurs as a result of issuing bonds on behalf of the contractor.

[ Download Chart - Risk Management : Insurance and Bonds ]

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