Insuring construction what risks?

Projects and investments always represent opportunities and risks. As a rule, the greater the opportunities, the higher the risks, and construction projects are no exception.

The adoption of good risk management practices is therefore an important management act, in particular risk transfer.

Not that Managing Risks outwear themselves by their transferal: Risk Management is a tool whose efficacy has already been proven in protection against material losses, which constitute a significant part of the risk to which major construction project are exposed.

In addition to the general risks that are higher than in a completed project, there are others that are highly specific to construction projects such as:

• Technological progress, new building techniques and the development of new materials, which lead to increasingly bolder projects;

• Working in different locations, which obliges companies to adapt to the unknown circumstances of each geographical area;

• Hiring "local” labour, whose qualifications are often unknown

In what other ways can companies in the construction sector protect themselves against the imponderables that can arise in any construction undertaking?

• Over-sizing and/or applying high safety coefficients is certainly not a solution because, in addition to going against common practice, it would result in a loss of competitiveness.

Even so, this "absurd” solution from a technical and economic point of view would still leave companies exposed to the Natural risks, such as storms, earthquakes and floods.

• Setting up a reserve (provision) to meet these imponderable risks is a possible solution. The difficulty lies in fixing in advance an amount large enough to cover the consequences of a loss. Even when there are statistics on similar undertakings, the possibility of a major disaster makes establishing this reserve extremely difficult and also reduces the company’s competitiveness. 

It is in this context that transferring the risk by taking out an insurance policy is an important and a fundamental risk management tool, as it guarantees appropriate protection against material losses at a cost that is known in advance and can therefore be included in the work budget.

It is also important to remember that the risks are not only damage to work or equipment but also damages to third parties.

This importance is clearly shown by the fact that many major projects were only possible because an insurance cover was available.

There are many participants involved in construction activity and they all have different duties and responsibilities.

There is the principal, who is the owner of the undertaking, the promoter, who will promote and sell it, the project’s financier, the designer, who prepares all or part of the plans, the control office, which checks the plans (calculations and their application) and supervises the work, the general contractor, who performs, coordinates and answers for all the other companies involved in the construction of the development, the contractors, who carry out the specialized work in the development, subcontractors, who are hired by the contractors to perform secondary work, suppliers, who supply the material needed for the development, the local authority, which has jurisdiction over all aspects of the development and the user, who will make use of the development.

Whatever their size or nature and regardless of whether they are promoted by the public or private sector, all construction projects are born from an idea. This idea may be to improve public services, meet private needs or merely take advantage of a business opportunity.

These projects are divided into different stages. planning and conception include all action taken from when the idea for building appears to when the project begins, and include feasibility studies and approval by the authorities. The plans include the design, calculations, specifications and coordination between the different designers and the other preliminary studies required to define the conditions in which the job can be carried out. The tender procedure includes drafting the technical specifications and assessing the resulting bids. Execution is when all the construction and assembly work is performed. The handover normally takes place in two stages: the provisional handover, which marks the beginning of use and the contractor’s obligation to provide maintenance services (guarantee period) and the final handover, when this period ends.

During the guarantee period, the contractor has to carry out all repair work and replace materials or equipment required for the proper functioning of the development.

The oldest known code on responsibilities during construction is the Code of Hammurabi, which was drawn up in 1760 BC and laid down harsh penalties.

In modern legislation, the harsh penalties established in the Code of Hammurabi are replaced by compensation for losses. (see the following diagram)

The Civil Code does not go into much detail when dealing with the responsibilities inherent in the act of building. It legislates in general on contractual responsibilities, damage caused by objects, animals or activities and compensation for third parties.

There are, however, other documents that lay down rules to be respected during construction, such as Regulamento Geral das Edificações Urbanas (General Regulations on Urban Structures), Regulamento de Segurança no Trabalho da Construção Civil (Civil Construction Safety Regulations) and the law on public works contracts.

A construction contract is a legal instrument dividing responsibility for the financial risk between the development’s promoter and the contractor. Among other stipulations, it defines the contractor’s general responsibilities, the obligation to take out insurance and information on risks and their assessment.

There are several standard models of construction contracts that have been developed by professional associations and institutions. There are those, for example, drawn up by the Fédération Internationale des Ingénieurs-Conseils (FIDIC) and the London Joint Contracts Tribunal, but they are by no means mandatory and so promoters and contractors are free to draft their own agreements or adapt standard contracts to meet their needs.

Construction All Risks insurance (CAR) is intended to protect against the risks of any construction, renovation or refurbishment, whatever the class of works, ranging from a simple private residential building to complex public works like dams, metros or airports.

Like many other forms of insurance, this one originated in Britain. The first policy of this type is thought to have been issued in 1929 by Lloyd’s of London to cover the construction of the Lambeth Bridge in London.

But it was after the Second World War that, due to major reconstruction efforts in the countries involved, this type of insurance developed, with the construction or reconstruction of roads, bridges, railways, airports, factories, dams, etc.

A Construction All Risks policy means that it insures against damage resulting from all sudden, unforeseen causes other than the specified excluded.

It is therefore a policy that does not list the risks that it covers but rather only those that it does not (i.e. exclusions).

It covers all parties involved in the works as each of them is insured. This represents a huge advantage, in view of the complexity arising from their participation and duties in the different stages of the development.

It is usually the Principal that signs the insurance contract, as he has no other guarantee, and will be bare by him the cost of a stoppage. It may also be the general contractor to whom the job was awarded or the contractor in charge of performing the work in accordance with the programme that writes the insurance.

This policy is based on a modular structure, through which it is possible to insure against:

• Physical loss or damage to the works and plant and equipment used in them;

• Third-party liability arising from the work;

• Financial losses (Loss of profit) resulting from delays in the completion of the work as a result of an accident.

This insurance structure, which allows great flexibility, is complemented by additional coverage that can be added to the policy as necessary. In other words, it is possible to tailor a policy on the basis of the risk and this is another advantage.

In most cases, the parties involved are likely to have their own third-party insurance policies and the policyholder is therefore tempted not to include this coverage in the construction policy on the account of all the participants. But this is never a good idea and poses a high risk, as there are a number of factors that can result in the failure of one of them, such as different coverage or insufficient capital, not to mention non-payment of the premium.

The coverage provided by the policy begins when the work begins, or more precisely after the first materials have been unloaded at the contract site and ends on the date of handover of the development or when it goes into operation.

For the construction plant and equipment, coverage begins when they are unloaded at the building site and ends when they leave it.

In the case of third-party insurance, as it often includes the maintenance period, which begins after the handover of the work and ends after the insured period runs out, normally 12 or 24 months, the coverage only actually expires at the end of this period.

As a rule, the amount insured should be the reconstruction value, which should include all costs of materials, labour, transport costs, customs duties and any other materials or goods supplied. This value, other materials or goods supplied. This value, which represents the maximum compensation payable by the insurance company, also serves as the basis for calculating the premium.

For major developments lasting several years, it is easy for deviations from budget to occur (improvements, unplanned alterations, difficulties with the land, inflation, etc.), which may be substantial in some cases, and so it is essential to adjust the value insured during the work in order to prevent a situation of insufficient capital.

It is widely accepted that a building is made to last and , that the owner had nothing to do with either its design or construction and that the normal use of a building does not affect its stability or solidity.

It is in this context, Inherent Defects Insurance (IDI) was originated, from a law published in France in 1978, known as the Spinetta Law.

This law, which was intended to be a response to technological progress in the construction sector, protecting consumers and moralising the sector itself in terms of quality, created a dual obligation where insurance was concerned.

On one hand, the client had to take out damage insurance and, on the other, the contractors, builders or any other parties performing construction work had to take out liability insurance.

In Portugal, the project of law on real estate promotion is also intended to ensure greater protection for property buyers for a period of 10 years against construction defects that appear or are detected after purchase.

"… Accompanying trends in other European countries and recognising the lasting nature of buildings, the guarantee period against structural defects is extended to 10 years and insurance covering damage to the building’s structure within this time is required for new buildings intended mainly for housing. Proof of this insurance is now a condition for the transfer of these properties…”

In general, this law provides for:

• Mandatory insurance against structural damage (applicable to buildings intended mainly for housing);

• An insurance policy beginning on the date of handover of the building and lasting for 10 years as of that date;

• Mandatory monitoring of the construction work by a legally qualified, certified body;

• Compulsory specific geological or geotechnical survey;

• Cost of insurance and monitoring of the construction work to be borne by the promoter.

In practice, this insurance will act as a guarantee of quality of the construction, as:

• The construction is audited by an independent technical control body;

• It guarantees repair of damage if it occurs.

We could also say that it is almost a kind of finance agreement, as another major purpose is to provide rapid compensation for damage suffered by the construction work without seeking to assign liabilities. In other words, the insurance company has to pay as quickly as possible to finance the repair of the damage.

The guarantee takes the form of compensation paid to the policyholder, and the insured are all the successive buyers of the property.

This policy covers:

• Material damage to the structure caused by defective design, materials or construction of the basic work (foundations, pillars, floors, walls and ceilings) compromising the stability and solidity of the building;

• Material damage to the building’s secondary work, installations and equipment, whenever it is a direct consequence of an event affecting the basic work;

• The cost of repairs and reinforcements that have to be carried out to eliminate the threat of collapse of the basic work;

• The cost of any demolition and removal of the rubble necessary as a result of accidents subject to compensation.

• Defects in the waterproofing of façades and roofs, although for a shorter period (normally three years with a 12-month waiting period);

• Indexing of capital to prevent underinsurance.

The policy lasts for 10 years as of the date of handover of the development, although the coverage only comes into effect afterissue of a certificate of approval by the technical control body.

Indeed, the mandatory existence of this control body, which must be approved by the insurance company, is a characteristic of this type of insurance. The control must begin at the start of the work and must include at least:

• An analysis at the start of the work of the design, specifications and other documents for the purpose of risk assessment;

• Technical control of designs;

• Control of the performance of the work;

• Presence at the handover of the development.

The amount insured must correspond to the final cost of the development (value of the building), insured at the time of handover, including designers’ fees, technical control, licences, taxes and, in general, any other cost of its construction.

For all these reasons, professional monitoring in this area is essential.

By Tiago Mora, MDS