Construction Insurance and UK Construction Contracts

Marshall Levine and Roger ter Haar KC

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CHAPTER 4 A broad overview of risks in construction projects and the role of insurance

4.1 Risk assessment for construction projects is a science not an art form. In any competent organisation concerned with delivering construction projects there will be a process of risk assessment. The assessment carried out will vary depending upon the commercial interests and function of the party on whose behalf the assessment is carried out - usually the developer client. At the end of the process there will be some risks that it is accepted cannot be passed on; some that will be dealt with by contractual arrangements with other parties to the construction project; and some will be dealt with by insurance. Self-evidently each party in the process will try to achieve a position whereby as much as possible of relevant risk rests with other parties and as much as possible of the chance of profit is retained. In PFI/PPP projects risks will lie usually with the party best placed to manage them (see ). 4.2 It is helpful to consider these competing considerations at each stage of the journey from initial inspiration for a project to ultimate completion and use or disposal of the completed project.

The vision

4.3 Every project starts with an idea - it may be good or bad, obvious or unexpected. Construction projects range from digging a hole in the ground to construction of a multi-billion pound project such as the Channel Tunnel. In each case the project also usually commences with a person or organisation wanting to consider the feasibility of carrying out the works. In this chapter that visionary is described as the “employer”.

Method of risk assessment

4.4 There are several construction contracts, in a modern form such as the JCT Constructing Excellence Contract (CE 2007) and the Project Team Agreement (CEIP 2006) that accompanies it, which embrace having a risk register dealing with all the risks (with options for allocation of these risks) discussed in this chapter, and others in a register forming part of the construction contract.1

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The assessment of project feasibility

4.5 Having had the vision, the employer has to consider whether the project can be achieved and, if so, whether the balance of anticipated costs and rewards makes the proposed project desirable. 4.6 Leaving aside the very simplest projects, until about 30 years ago the participants in the vast majority of construction projects consisted of the employer on one side of the fence, accompanied by a professional team usually including an architect, quantity surveyor and sundry engineers (civil, structural, mechanical and electrical etc.). On the other side of the fence was the “contractor” fronting subcontractors and suppliers. 4.7 In this traditional world, as between himself and the contractor the employer took the design risk as well as the risks of delay caused by unforeseen circumstances necessitating changes in the work, and most market risks associated with the ultimate profitability of the original concept. The employer relied upon his professional team to limit his risks, expecting them to carry professional indemnity insurance in order to enable them to discharge any liability arising from errors or omissions in carrying out their functions. The only risk arising out of the period before works started on site undertaken by the contractor in this way of arranging matters related to assessment of the cost of executing the projected works as reflected in the tendered price and terms of tender. 4.8 Whilst some projects are still arranged on that traditional model, they are perhaps now a minority, certainly of the major projects commenced in recent years. At a government level within the United Kingdom (and increasingly overseas as well) the political desire, for the last two decades, has been that large publicly funded projects should have considered an option to let as PFI2 or PPP3 contracts whereby so far as possible all construction and operational risk in the project is passed to the “contractor” and/or “operator” in return for a fixed programme of payments over a period of years from the public purse. The insurance implications of these arrangements are considered below.4 4.9 The first necessity for a construction project is the availability of somewhere to execute the project whether on land or at sea or both (such as a project for an oil refinery with jetties for tankers). Whether or not the employer can acquire the necessary project area if it is not already owned is a risk usually borne by the employer and is unlikely to be an insurable risk. If, however, the project area is already within the control of the employer, there is always a risk of the employer being dispossessed, for example by expropriation. Within the United Kingdom expropriation is lawfully effected through the statutory machinery of compulsory purchase, which carries with it an entitlement to compensation. There is not a significant market for insurance against expropriation risks in respect of United Kingdom-based projects. By contrast, there is a lively market for political risk insurance in respect of projects in certain countries outside the United Kingdom.

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4.10 Whilst the risk of expropriation within the United Kingdom is not significant and not commonly insured against, there are nevertheless significant political risks within the United Kingdom to which the employer is exposed. These principally concern the town and country planning system. The chances of profitable development of land for any commercial purposes are dependent upon having or obtaining necessary permissions from the local or central planning authorities. In itself this is unlikely to be an insurable risk, but the employer, if not himself experienced in these matters, protects himself by engaging planning consultants to advise upon the consents likely to be available and to take such steps as are reasonably practicable within the law to obtain such consents and then by engaging an architect or other design consultant to maximise the development potential of the project within the confines of the consents obtained or likely to be obtained. The risks associated with the obtaining of consents fall primarily upon the employer, but to the extent that losses arise from a failure on the part of his advisers to exercise reasonable skill and care, those advisers would normally be expected to have obtained professional indemnity insurance against that potential liability. 4.11 The professional indemnity insurance market has relatively limited capacity compared to other sections of the insurance industry, but the immense increase in the capitalisation of insurance companies and of insurers doing business through Lloyd’s of London has significantly expanded the capacity of this market in recent years. The cost of professional indemnity insurance is a significant element of the costs of professional practices that cannot obtain unlimited insurance cover and that generally (apart from the large and global practices) would be unable to afford such cover even if it were available. Accordingly well-advised professionals seek by agreement to cap their liabilities to their clients to a sum within the available professional indemnity insurance limit. In practice the employer often bears the risk of losses arising from professional errors or omissions, either because by agreement the professional parties limit their liabilities or because many professionals have no significant assets with which to discharge liabilities in excess of their available insurance. 4.12 Leaving aside the prospects of profitability associated with planning or other consents, assessment of the market for a development and therefore of the project’s potential profitability rests with the employer and that risk is generally not insurable. 4.13 At the feasibility stage it is important for the employer to consider the build-ability of the proposed project: what are the possible impediments to it being built at all, built within a defined time scale, or built to a projected cost? 4.14 To take the question of whether the project can be built at all - there may be ground conditions not actually foreseen before construction works commence on site. This risk is usually mitigated by a careful consideration of the physical attributes of the project area during the feasibility and design stages. If the employer has sufficient resources, this may be carried out in-house, with the risk therefore resting primarily with the employer. Alternatively, the employer may engage outside consultants, for example to carry out ground investigations such as the drilling of bore holes. In the latter case the external consultants would be expected normally to carry professional indemnity insurance against liability for negligent errors and omissions. In the former case, many contractor developers take out professional indemnity insurance, which provides cover in respect of losses that would have been recompensed in the other case had external consultants been engaged. These insurances are discussed further in below.

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4.15 It is possible that in some cases, despite the exercise of due diligence in assessing the risks, a project is not buildable, perhaps because of unforeseen site conditions that could not reasonably have been anticipated. Such situations are likely to be rare given the wide range of techniques and equipment now available, but if they arise it seems likely that any resultant losses would be uninsurable because under English law except in respect of life insurance it is not possible to insure against a loss that is certain to occur.5 4.16 Finally, at the feasibility stage a view will generally have to be taken as to what is likely to be the cost of the project and how long it is likely to take to build. If an employer commits himself to the project based upon such assessments (for example by purchasing land at a price calculated by reference to such projections), he may suffer loss if those projections prove later to have been erroneous. In the example given, his possibilities to protect himself or to mitigate the risk are to enter into the purchase of the land conditionally, for example by obtaining an option to purchase on terms adequately protecting him, or to obtain professional advice as to the likely cost and duration of the project. Ultimately, however, these are usually part of the commercial risks that an employer assumes knowingly as part of the price he must bear in the pursuit of profit. 4.17 Thus, at the feasibility stage, the type of insurance primarily under consideration is professional indemnity insurance providing cover in respect of liability of professionals giving advice. The professionals whose activities are insured are not necessarily only professionals external to the employer’s organisation.

The design stage

4.18 It is possible conceptually to separate the feasibility stage from the design stage, although in practice the division may not be clearcut. Thus in an ideal world it might be thought that the employer would carry out the fullest possible assessment of a project before committing himself by entering into a contract to purchase land. However, that may not be desirable or practicable. The employer may wish to minimise costs incurred until he is certain that he has acquired legal title to land. The market may be such that the employer has to take a view and strike while the iron is hot. It may not be feasible to carry out full investigations until the land has been bought. There are numerous permutations. 4.19 The design process carries with it substantial potential for the creation of loss. Generally the losses will only reveal themselves when construction works commence or later. Inadequacies in the design process are liable to cause losses in a large number of respects:

delays in the design phase delaying start of the construction phase and therefore delay of completion of the project;
unnecessary expense in the design process;
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increased cost of construction works;
increase in the necessary time for execution of construction works;
failure to achieve the employer’s requirements for the project;
physical injury to persons on or off site;
physical damage to the contract works, existing property on site or to property off site;
consequential losses arising out of the foregoing.

4.20 As pointed out above, the traditional employer/contractor divide has changed substantially over recent years. In the traditional divide the risks of the above losses arising out of failures in the design process fell generally upon the employer, who would then be left to obtain whatever recompense he could from his professional advisers. 4.21 In the PFI/PPP arrangement the employer, that is to say the public body wishing to procure the completion of a project in the interests of the public, will seek to transfer the whole of the design risk to the PFI/PPP contractor, in the process usually ceding to the contractor substantial autonomy over the design process so long as certain performance targets are achieved. 4.22 Similarly, an increasing number of private projects are placed with a contractor on a design and build basis. Here also the employer specifies what he expects the contractor to achieve and leaves the contractor to achieve it. The contractor may then use his in-house resources to carry out the design functions or subcontract them to external contractors. From the employer’s perspective his primary protection is his contract with the contractor - he relies upon the contractor to do what he has engaged him to do. So long as the contractor’s ability to pay damages is sufficient, then a properly drafted contract gives the employer the protection he requires. The contractor’s ability to pay damages is often underpinned by the provision of bonds, particularly performance bonds, by financial institutions of repute.6 The employer will frequently also require a deed of warranty from any independent professionals involved in the design process, this being a collateral contract enabling the employer to pursue the professionals involved in the design process directly. (But now see Contracts (Rights of Third Parties) Act 1999.) 4.23 If the design is carried out by external professionals, whether engaged by the employer or by the contractor, it is to be expected that those professionals will have professional indemnity insurance. 4.24 However, modern technology has increasingly introduced another element of complexity into the design of construction projects. It is commonplace for projects to incorporate substantial elements of proprietary technology - for example computerised control systems incorporated to regulate building services systems such as air-conditioning systems, escalators and lifts, or complex lighting systems, to name just a few examples to be found in a modern office building. The role of the traditional professional design team is to specify what elements are to be supplied and installed - few professional design consultants can be expected to have detailed specialist knowledge of these types of technology.

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4.25 Usually such technology is provided by a specialist subcontractor or supplier. The employer’s primary protection is again his contract with the contractor; the contractor’s primary protection in respect of his liability to the employer is his contract with his subcontractor or supplier. Again the employer may have the benefit of directly enforceable warranties in his favour from the subcontractor/supplier. Whilst the role of the subcontractor/supplier may involve substantial design elements, as often as not the subcontractor/supplier is simply supplying and installing equipment designed and manufactured by another party, often a major multinational corporation. In this situation the type of insurance that comes into play to protect the subcontractor/supplier against his potential liability, if any insurance is involved at all, is likely to be a product liability policy or (less commonly) a product guarantee policy. 4.26 A vital part of the design stage for all parties is consideration of the allocation of financial risks. These risks crystallise in the contract executed. At that stage in broad terms the employer is committed to pay a specified price or a price calculated according to specified rules and principles for the work that is to be carried out, and the contractor is committed to carry out those works for the specified price. An understanding of the allocation of risks to employer, contractor and (in so far as appropriate and agreed) insurers is vital. A large part of this book is concerned with the way in which the financial consequences of physical damage are allocated under various standard forms of construction contract. 4.27 But the process of allocation obviously involves allocation of risks not necessarily arising out of physical loss or damage. To give an example: it is standard for most properly drafted English construction contracts to include a requirement for the contractor to pay liquidated damages on a daily or weekly basis in the event of delay in completion of the whole or sections of a project. There was a time when certain insurers and underwriters were willing to provide insurance to contractors against such liability. Such insurance is of limited availability in the English insurance market. Accordingly, the contractor generally has to approach the contract upon the basis that the burden of any liquidated damages will be borne by him. In these circumstances it is essential for the contractor to ensure that in pricing the contract and in agreeing to the terms of the contract he has allowed appropriately in his risk assessment for the possibility of an exposure to liquidated damages. On the other hand, for example, under most standard forms of contract the losses resulting from damage to contract works by fire will be borne by some form of project insurance policy: accordingly the contractor will only need to price for any part of the cost of insurance that he is required to bear. 4.28 Again in the traditional method of contracting, the employer would often, perhaps usually, have had the benefit of a quantity surveyor to advise him as to the appropriateness of the terms of the proposed construction contract and the financial risks undertaken. Today, sophisticated employers may need no outside assistance. On the other hand, a wide range of advisers may be involved in considering a proposed construction contract and advising the employer, including quantity surveyors (as in the traditional structure of relationships), project managers, management contractors and (particularly in the case of large-scale projects such as PFI/PPP projects) solicitors and financial institutions.

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4.29 Thus, as at the feasibility stage, the principal relevant role for insurers is the provision of professional indemnity cover.

The construction phase

4.30 During the construction phase, problems that were once only potential problems arising out of the earlier phases are now liable to emerge as actual problems and are liable to be joined by fresh problems arising out of events on site. Risks of loss during the construction phase include the following:

delays to the project because of late possession of site;
physical injury to persons on and off site;
physical damage to the contract works;
physical damage to property owned by the employer;
physical damage to third parties’ property;
delays to the project as the result of such physical damage;
delays to the project as a result of design errors, because of late issue of designs or instructions, or because of changes in the design;
delays to the project as a result of inefficiency or bad workmanship by the contractor;
delays to the project as a result of unforeseen events or circumstances;
delays to the project as a result of employment disputes;
delays to the project as a result of shortage of resources;
contractors’ additional costs/loss of profit as a result of delays;
employer’s additional costs/loss of profit as a result of delays;
consequences of government policy.

4.31 Some of these risks are easily insurable - there is a large and healthy market providing cover in respect of physical damage to contract works under contractors all risk policies. Likewise, there is a large and healthy market providing liability cover for third party liability and employers’ liability risks. An important purpose of this book is to set out how various standard forms of contract allocate responsibility for procurement of insurance to cover material loss and damage and for obtaining liability insurance between employer and contractor. 4.32 There is also adequate insurance capacity in the marketplace to provide cover in respect of at least some of the consequences of delay or disruption caused by the occurrence of physical damage, protecting the employer’s interest through either advance loss of profits (“ALOP”), delay in start up (“DSU”) or other business interruption cover. (Contract conditions often require a contractor to obtain such policies protecting employer’s losses as an extension to all risks policies, even though this potentially produces conflicts with liquidated damages clauses inserted by the employer to protect against the very same risks.) There are also policies available to protect the contractor against losses he may suffer following physical loss of or damage to the contract works. 4.33 Generally, as far as concerns projects in the United Kingdom, the other risks listed above are outside the remit of insurance cover and are left to be borne by the employer or the contractor as the construction contract may allocate.

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Testing and commissioning

4.34 One phase of a construction contract calls for particular comment, particularly in respect of such projects as the construction of process plants or power stations: that is to say the testing and commissioning phase. At this stage elements of the plant designed to work under pressure, such as boilers, are pressurised, and elements designed to work at heat, such as furnaces, are fired up. Even on the best designed and constructed project, this phase presents particular hazards. 4.35 Unsurprisingly, the risks attendant upon this phase of the works can produce particular problems for the insurance industry.7 From the insurers’ standpoint, it is important to understand the risks involved and to ensure that premium and other terms reflect those risks. From the contractors’ viewpoint, it is obviously important to ensure that cover is in place: particular problems can occur if a project overruns so that a contractor finds itself seeking an extension of the policy period in respect of a troubled project. The insurance market can sometimes be reluctant to extend the period of cover in such circumstances.

The maintenance period

4.36 Most standard forms of contract provide for a “maintenance period”, that is the period after practical completion or substantial completion of the construction works. During this period the contractor will often be off site but has a liability to return to site to finish off any minor elements of “snagging” or “punch list” items that remain to be completed and to put right any defects that may emerge. The period will vary from contract to contract. Frequently, contractors all risks and erection all risks policy cover terminates with the issue of the certificate of practical completion or the certificate of substantial completion:8 however, cover can be obtained to provide some cover during this period, either on a “visits” basis or an “extended maintenance” basis.

Post-completion

4.37 The insurance of property risks after completion of construction projects is generally outside the purview of this book. An exception to this is in respect of latent defects insurance policies (“inherent defects policies of insurance”), which are discussed in below.

1 See BE Guide to Risk Management and the Creation of a Risk Allocation Schedule (2006).

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Construction Insurance and UK Construction Contracts

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CHAPTER 4

A broad overview of risks in construction projects and the role of insurance