Risk and Insurance

Chapter 14
Risk and Insurance

14.1 Insurance in construction

One of the first, clear definitions of insurance principles was formulated by the English Insurance Act (1601). According to its drafters, insurance was intended to meet the following primary functions:

  • to distribute individual loss across many;
  • to encourage individuals to take a risk by promising them compensation in case of loss; and
  • to motivate young people to become entrepreneurial.

The large number of restoration programmes that followed the devastation of the world wars (going hand in hand with the rapid development of manufacturing processes) resulted in a consolidation of the risk management principles of responsibility, liability and indemnity. Consequently, it was at this point in history that insurance became recognized as an important need in the construction industry.

Construction insurance covers all indemnity agreements within the limits of individual construction activities where insurance is selected as a risk (liability) assignment instrument. The following are the main types of insurances relevant to construction projects:

  • political risk insurance;
  • exchange risk insurance;
  • bank guarantee insurance (guarantee for bid, performance, advance payment);
  • lost profit insurance;
  • construction all risk insurance;
  • erection all risk insurance;
  • professional liability insurance;
  • employer’s liability insurance;
  • public liability insurance.

Within construction projects, risks are usually allocated by the two most important contracts – the contract between the employer and the service provider (contract administrator, designer, and so on), and the contract between the employer and the contractor.

Insurance costs have escalated so much in recent years that they have become one of the most important cost items of a construction project. Construction project participants must, therefore, understand risk management issues, in particular, risk allocation and insurance. Insurance is widely recommended to protect the contracting parties against the financial implications of unexpected losses, damage or liability. The primary participant (i.e. the employer) usually requires of the secondary party (parties) (i.e. the contractor, designer, consulting engineer as a contract administrator and so on) to be insured against risks in connection with their role and activities. Therefore, a primary party is not then necessarily a direct party to the insurance contract.

The level of the insured amount shall be determined on an estimate of the potential damage the other participants can cause to this party by their activity or inactivity. Potential damage also depends on the nature and duration of the contract, the place where realization takes place and on other circumstances (risks).

14.2 Commercial risk, risk of damage and exceptional risk

When analysing individual construction project risks and their likely nature, we can distinguish between two main categories. The first contains the hazards and risks leading to injuries, death and physical damage, such as defective materials, floods and work-related accidents. The second comprises hazards and risks giving rise to financial losses and delay, such as late site hand-over, delayed instructions and variations.

The above categories further differ because the former (i.e. physical risks) are insurable risks and the latter (i.e. non-physical risks) are not insurable. These categories are handled in different ways even within the standard forms of contract that normally regulate the issues of insurance. The first category is typically dealt with by a separate, specific chapter in the contract. The second category is usually ‘spread across’ the entire contract with basic employer’s risks typically specified in one section.

The question still remains: who is to bear the risk, which is not expressly allocated to one of the parties? The answer is that the party bearing such risk depends on the particular wording of the contract and/or on the governing law.

FIDIC forms in the 1999 First Edition did not solve this problem. FIDIC DBO, published in 2008, contains a significant update of mentioned risk and insurance provisions. The clauses have been restructured in a more logical sequence matching the natural flow from risk allocation to responsibility to liability to insurance. Furthermore, the risks carried by both the employer and the contractor have been identified and allocated and different types of risks have been identified as the commercial risk (risk which results in financial loss and/or time loss for either party where insurance is not generally or commercially available) and risk of damage (risk which results in physical loss or damage to the works or other property belonging to either party, other than a commercial risk).

‘Exceptional risks’ were established to replace the force majeure that is preserved under the term ‘exceptional event’ (FIDIC, 2011a).

Other risks such as The Employer’s Risks during the Design-Build Period are found at Sub-Clause 17.1 and read as follows:

Subject to the provisions of Sub-Clause 17.8 [Limitation of Liability], the risks allocated to the employer and for which the employer is liable during the design-build period are divided into:

  1. The employer’s commercial risks, which are:

    1. the financial loss, delay or damage allocated to the employer under the contract or for which the employer is liable by law, unless otherwise modified under the contract;
    2. the right of the employer to construct the works or any part thereof on, over, under, in or through the site;
    3. the use or occupation of the site by the works or any part thereof, or for the purpose of design, construction or completion of the Works other than the abusive or wrongful use by the contractor; and the use or occupation by the employer of any part of the permanent works, except as may be specified in the contract; and

  2. The employer’s risks of damage, which are:

    1. damage due to any interference, whether temporary or permanent, with any right of way, light, air, water or other easement (other than that resulting from the contractor’s method of construction) which is the unavoidable result of the construction of the works in accordance with the contract;
    2. fault, error, defect or omission in any element of the design of the works by the employer or which may be contained in the employer’s requirements, other than design carried out by the contractor pursuant to his obligations under the contract;
    3. any operation of the forces of nature (other than those allocated to the contractor in the contract data) against which an experienced contractor could not reasonably have been expected to have taken adequate preventative precautions; and

  3. The exceptional risks under Clause 18 [Exceptional Risks].

The biggest difference is in the new wording of Sub-Clause 17.2, where ‘The Contractor’s Risks during the Design-Build Period’ are stated as follows:

Subject to the provisions of Sub-Clause 17.8 [Limitation of Liability], the risks allocated to the contractor and for which the contractor is liable during the design-build period are all the risks other than those listed under Sub-Clause 17.1 [The Employer’s Risks during the Design-Build Period], including the care of both the works and the goods.

Exceptional risks are defined in Sub-Clause 18.1 which reads:

An exceptional risk is a risk arising from an Exceptional Event which includes, but is not limited to:

  1. war, hostilities (whether war be declared or not), invasion, act of foreign enemies;
  2. rebellion, terrorism, revolution, insurrection, military or usurped power, or civil war, within the country;
  3. riot, commotion or disorder within the country by persons other than the contractor’s personnel and other employees of the contractor and subcontractors;
  4. strike or lockout not solely involving the contractor’s personnel and other employees of the contractor and subcontractors;
  5. munitions of war, explosive materials, ionising radiation or contamination by radio-activity, within the country, except as may be attributable to the contractor’s use of such munitions, explosives, radiation or radio-activity; and
  6. natural catastrophes such as earthquake, hurricane, typhoon or volcanic activity which are unforeseeable or against which an experienced contractor could not reasonably have been expected to have taken adequate preventative precautions.

The list is not exhaustive and the contractor may claim that an event gave rise to an exceptional risk allocated to the employer under Sub-Clause 18.1 if the contractor considers that an event has occurred which falls within following definition (Sub-Clause 1.1.37):

‘Exceptional Event’ means an event or circumstance which is (a) beyond a party’s control; (b) which the party could not reasonably have provided against before entering into the contract; (c) which having arisen, such party could not reasonably have avoided or overcome; and (d) which is not substantially attributable to the other party.

The reasons that these exceptional risks are allocated to the employer include the fact that they are the initiator, ultimate user and beneficiary of the project. Furthermore, it would be extremely difficult for the contractor to price such a risk if they were required to bear it. Moreover, the likelihood of such risks arising is small and it is better for the employer to absorb the costs of such risks if and when they occur, rather than ask the contractor to include it in the contract price and be responsible for them (FIDIC, 2011a).

The following risks can be categorized as belonging to the first category. That is, hazards and risks that lead to injury, death and/or physical damage:

  • insurable risks that are required to be insured on the basis of a contractual agreement;
  • insurable risks that are not required to be insured on the basis of a contractual agreement; and
  • non-insurable risks.

The insurable risks that are required to be insured on the basis of a contractual agreement are most frequently covered by the contractor’s comprehensive insurance policy, construction all-risk insurance, public liability insurance, professional liability insurance or contractor’s and employer’s liability insurance (for employee workplace-related accidents).

Insurable risks that are not required to be insured on the basis of a contractual agreement are most frequently the subject of a contractor’s, consulting engineer’s and designer’s professional liability insurance and employer’s liability insurance.

Non-insurable risks are the contractor’s or employer’s responsibility, depending on their allocation.

14.3 Risk management in the standard forms of contract

Associations of professional organizations have created standardized sample forms of contract in order to ensure well-balanced and fair contractual relationships. This form of unification reflects the preferred tendering method based on comparisons of individual contractors’ bids to employer unified requirements. A side effect of this is that the provisions of such sample forms of construction contracts concerning risk and insurance are becoming increasingly complex.