Insurance is an essential component of a construction risk management plan. Insurance is a contract, represented by a policy from an insurance company, in which an individual or entity receives a guarantee of compensation for specified loss, damage or bodily injury in return for payment of a premium. Insurance protects against specified and identified risks; it is not a blanket protection as all insurance policies identify specific perils they cover as well as numerous exclusions. Insurance is an important risk management issue that affects both parties in a design or construction contract. Before purchasing insurance for construction projects, it is essential to identify potential risks associated with the project in order to ensure comprehensive coverage with policy terms and limits reasonably sufficient to cover potential losses.
Risk management is based upon balancing cost and perceived risk, as typically the more risk averse the entity the more insurance will cost. In this article, we will offer a summary of the most common types of insurable risks in construction, factors to consider when buying insurance and the types of insurance instruments generally utilized in the construction industry to address those risks. As outlined in our companion article, Construction Risk Management and Project Delivery Strategies, every project has its own set of risks – risk being defined as anything that can go wrong on a construction project, such as:
- Development risk – entitlement or jurisdictional approvals, anything that may restrict or prevent you from completing the project
- Financial and investment risks – loss of funding, cost overruns due to uncontrolled change orders, unstable or inflated market conditions
- Unforeseen conditions – unforeseen soils or subsurface conditions, hazardous materials, environmental, weather or natural disaster risks or labor unrest
- Disputes – deriving from misunderstandings, poor performance, poor scope, inadequate or ambiguous documentation or unrealistic expectations
- Schedule – if it’s over schedule it usually means it’s over budget
- Defective work – potential for design or construction defects
- Safety – accidents, injuries, theft, vandalism
Insurance rarely covers the work product itself or cost or schedule overruns–understand that generally only the last two categories of risk are actually insurable. This is why a total risk management plan is so important.
Not all insurance or insurance carriers are equal.
A key step in selecting insurance should include reviewing the insurance carrier. It is the carrier’s financial strength and stability as opposed to the contractor’s viability which is fundamental to their effectiveness in protecting you in the event of an insurance claim, because it will be the insurance carrier who will provide financial remuneration for losses and defend against 3rd party claims. The industry widely consults AM Best, an independent association that reports on insurers and evaluates carriers on the basis of two criteria: financial strength, which is the ability to meet claims and obligations, and financial size, the size of its statutory surplus. Many public and private contracting entities will specify an insurance carrier that meets, for example, A- X or better. This means a carrier must be rated A- as well as have $500 to $750 million in surplus to be able to pay claims. We typically vary the rating request for the carrier depending upon the risk of the particular project and contracting entity.
Unfortunately, many contractors shop insurance policies on the basis of price rather than coverage. For example, a small trade contractor frustrated with escalating annual premiums may request his insurance agent to find insurance at the same rate paid previously. Naturally, this practice results in eroding coverage and more exposure for the contractor and his clients.
Types of insurance for construction projects.
General Liability. With regards to insurance coverage for a general or trade contractor, commercial general liability (CGL) is the most common form of liability insurance in the construction industry. A construction site is a very busy and potentially dangerous environment. CGL insurance covers the contractor in the event of personal injury or property damage on the site.
One of many important distinctions between policies is the ability to provide coverage for completed operations – this is what protects the contractor against construction defects discovered after completion.
Additional Insured Endorsement – AI. This endorsement extends CGL protections to additional parties not automatically included. In construction, the contractor typically names the owner and potentially other entities under his CGL for the project. It is important to clarify the owner’s protection by way of contract and being named as additional insured on the policy itself by proper endorsement.
Liability policies vary widely in terms of limits, coverage, endorsements, exclusions and their proper negotiation and handling are beyond the purview of this article. It is important to have a qualified professional specify appropriate insurance requirements for the project, as well as review all policy details including exceptions, conditions, limitations and premiums, deductibles and documentation requirements and pay attention to potential gaps in coverage.
Alternatives to CGL. Other insurance products can be substitutes for a traditional contractor’s CGL practice policy. These include the following:
- Project specific CGL. This policy is taken for a specific project, and has the benefit of not being encumbered by other potential claims on the contractor for other projects. Often, the project specific CGL can provide better coverage at a lower premium than the contractor’s practice policy.
- OCIP. The Owner Controlled Insurance Program is one type of a “Wrap Up Policy”. It generally provides insurance protection for the contractor, subcontractors and owner for a particular construction project. As it is owner controlled, one benefit is that the owner maintains the policy even if midway through the project the general contractor is terminated. Generally subcontractor credits are negotiated as they can exclude the project from their own practice policies. Administration is generally necessary and performed by a third party.
- The Contractor Controlled Insurance Program is similar to an OCIP except it is controlled by the contractor.
- Excess liability. This policy generally extends the limits of the CGL to a higher amount and may cover other perils and sit on top of other policies noted below.
Property Insurance During Construction. Apart from the liability of the contractor, owners must insure the actual project or property during construction. Builder’s Risk insurance is a specific type of property insurance that covers damage to the project itself. Typically, these policies cover an increasing value for the emerging structure, and any stored materials while construction is underway. Builder’s Risk policies are generally specified for the duration of the project and coverage limits are based on the total value of the completed project. Note that all perils may not be included – for example, flood and earthquake coverage may require separate policies and as with all insurance policies there are numerous exclusions.
Professional Liability. Professional liability insurance covers claims for negligence against design professionals, typically architects, engineers, consultants and construction managers. These policies generally exclude CGL perils but cover financial losses instead; for example, the cost to rebuild a defectively designed structure due to faulty engineering.
Workers Compensation. Workers’ Compensation Insurance refers to coverage for an employee’s medical expenses, lost wages, and rehabilitation services that result from a workplace injury or illness. Workers’ Compensation Insurance is known by many names from Workman’s Compensation, Workers’ Comp, Workman’s Comp, and others. In the State of California, Workers’ Compensation Insurance coverage limits are statutory and are a mandatory requirement of an active contractor’s license.
Contractor’s Pollution Liability. Environmental cleanup and remediation for hazardous materials such as asbestos, lead, PCBs, mold and other toxins is covered by a specific policy or rider called Pollution Liability. This coverage could be essential if demolition occurs as part of the project.
Performance and Payment Bonds. While not technically an insurance instrument, bonds offer protection if a contractor fails to perform or deliver the project as contractually required. In the event a contractor defaults or declares bankruptcy during the project, a performance bond will protect the owner against possible losses and a payment bond guarantees the payment of the subcontractors on the project if the general contractor fails to pay them. Bonds are issued by either a bank or an insurance company who act as surety. Costs are the responsibility of the contractor but are passed on to the owner. Performance and payment bonds are most often used in public works projects.
Importance of an Overall Risk Management Plan.
Insurance is just one part of a total risk management assessment that considers the owner’s exposure from multiple perspectives. The needs and risk of all project participants including the owner, general contractor, subcontractors, design professionals, consultants, financial institutions and others must be considered to ensure that each entity has appropriate coverage for its exposures and that there is sufficient coverage to protect the owner and the project’s interests. Construction management in large measure is intertwined with risk management. Consult your professional construction manager for an overall risk management plan.