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Building a Risk Management Program for Construction Projects

There are many potential hazards during construction projects. While these hazards can be mitigated either with risk management or risk transfer, it is important to ensure they are all addressed.

The relative exposure to these hazards has a significant impact on the structure, limits and cost of an insurance program.

Construction Site

Builders risk and delay in startup (DSU) coverage are recommended for all construction sites. DSU coverage can include net income plus fixed expenses or fixed expenses only. Values insured should include all reoccurring items in the event of a loss and any items the insured would intend to recover. A few examples of expenses that may not reoccur are engineering, site preparation work, and potentially pilings and foundations.

Critical Contractor’s Equipment

The builders risk policy insures all property destined to become part of the permanent works and DSU arising from damage to the insured property. For example, if the project requires specialized or heavy lift equipment, loss to this equipment could delay operational startup. If the exposure is present, the builders risk policy should be extended to insure this exposure.

OffSite Manufacturers, Fabricators and Storage Locations

Coverage for these items depends on which party is responsible for physical damage and the potential delay in opening in the event of damage occurring offsite. If third parties are contractually responsible for such physical damage, and if liquidated damages would cover all delay in startup costs, the third party would provide primary coverage, and the owner should obtain evidence of insurance. If liquidated damages do not adequately cover the delay in startup costs, the owner’s builder’s risk policy can supplement coverage with sufficient sub-limits of coverage for offsite DSU and physical damage.

Ocean and Inland Transit

Similar issues arise from ocean and inland transit exposures.

  • Does the title pass the freight on board jobsite or shipping point, and who is responsible for the delay in startup if the property is lost during transit?
  • If insurance is provided from the carrier, is it on a released or full-value bill of lading?

If some key components will be sourced from overseas, an ocean transit policy separate from the builder’s risk is most likely required. Key information to be obtained includes the highest value on any one conveyance for physical damage and the potential downtime arising from shipments on a shipment-by-shipment basis for all components.

Loan Covenants

Loan covenants typically include insurance provisions that frequently stipulate the types of coverage as well as limits and deductibles required. These mandates can be onerous for the owner to maintain compliance.

Contingent Third-Party Supply/Off-Take Agreements

Contractual agreements with third parties should be reviewed to determine financial exposures. What is the impact if either a supplier or purchaser can declare force majeure for ongoing operations? Are there liquidated damages?

If the exposure is retained and not passed contractually to the third-party providers, contingent extra expense, contingent DSU or service interruption (SI) should be considered. The appropriate amount of coverage is dependent upon the site’s ability to receive whatever service was interrupted. As an example, it may be possible to pay extra for feedstock from another source, but not water or power. In this situation, insurance should be structured to provide contingent extra expense to purchase feedstock and DSU for water and power.

Soft Costs

Soft cost coverage includes construction loan fees and loan origination fees. Construction loan fees are the additional cost incurred to rearrange loans necessary for the completion of construction, repairs or reconstruction, including the cost to arrange refinancing, accounting work necessary to restructure financing, legal work necessary to prepare new documents, charges by the lenders for the extension or renewal of loans.

Loan origination fees include additional fees for architects, engineers, consultants, attorneys and accountants needed for the completion of construction, repairs or reconstruction.

Amount of Insurance, Including Sub-limits

While the risk profile and asset size of an insurance buyer are frequently the determinants of the method employed in selecting the appropriate level of insurance for property damage, it is vital the appropriate limits of liability be established.

Assessment of the accuracy of the underwriting information begins with a thorough review of the physical damage and time element values. The values provided should include all reoccurring items in the event of a loss and items the company would intend to recover. A maximum foreseeable loss study should then be conducted to understand the loss potential and to purchase limits based on this evaluation and not full project values. This is an effective study to discuss with lenders when full replacement values are requested.

Deductibles

Deductible levels, whether monetary or stated in a time waiting period, are variable, as is the breadth of desired coverage. There is an obvious correlation between these items: the lower the deductible and broader the coverage, the higher the premium.

Manufacturers’ Warranties

If equipment used in the project is warranted for the intended purpose by the manufacturer, underwriters will request that the warranties become part of the insurance policy and look to the manufacturers to respond if an issue arises due to the warranty. As with most warranties, collateral damage or consequential loss is excluded under the warranty and the subject for DSU insurance.

Term of Insurance

Builders risk policies, including the hot testing period, are typically rated using a monthly rate applied to the insured construction values previously discussed. Recognizing a longer term may result in higher premiums, it is important to have an in-depth conversation on how early coverage should begin and how long it should be in place. Depending on the exposure to loss (man-made or by natural catastrophe) and client risk tolerance, coverage inception typically focuses on whether there is a need to insure items such as site preparation, foundations or pilings.

In addition to site activities, pre-site construction insurance considerations should be evaluated. These can include contingent cover for vendors and manufacturers facilities, transit and offsite storage exposure.

There should be a reduction in the value build if certain portions of the build will be put in service and insured under the operational program prior to final completion of the project. In either event, permission to occupy and use a portion of the build should be included in policy language.

Hot testing covers the period of time beginning with introduction of feedstock into the unit. Hydrostatic and pneumatic testing are not hot testing. Hot testing is the most critical time during the construction phase as most, if not all, of the values are onsite and could be damaged in a loss. It also represents the time when there is little opportunity to mitigate a time element loss. Underwriters charge significantly higher rates for this exposure.

It may be important to establish if the entire project will be commissioned/hot tested at once or if units can be tested individually prior to a full plant test. If all units and the facility can be hot tested within the same time period, there is no concern; however, a staggered test period prior to full commissioning may have significant impact on the premium if not presented properly to markets. The process needs to be described and presented to underwriters accurately so the higher rate is applied to the appropriate unit value and not the entire project.

A comprehensive, cost-effective construction program requires a thorough understanding of issues. Without proper analysis of the exposures, a poorly designed builders risk program can lead to significant underinsured or uninsured exposures, unnecessary premium charges or a dissatisfied customer in the event of a loss.

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