Risk Transfer by Contract

Design and construction contracts perform several functions. One of these is the allocation of risks among the participants on a project. Identifying and providing for a variety of risks is an important aspect of drafting and negotiating contracts.

Broad Risk Transfer Provisions

One of the broad risk transfer tools is "hold harmless and indemnify" language. The intent is to assign risk to a project team member that is to "hold harmless and indemnify" another. Often a project owner seeks to be held harmless by the design professional or the construction contractor. The owner, presumably not very experienced in design or construction, seeks to pass off the risks to someone experienced and in a better position to understand and control or provide for those risks.

Another broad risk transfer tool is the use of warranty or guarantee language. The provider of a product - and sometimes a service - commits to make good if the product or service fails to perform.  This can function well when a product of some kind is involved.  A deficiency can be addressed by simply fixing or replacing it.  On the other hand, a warranty or guarantee of a service - especially a professional service involving the use of judgment and making complex decisions - can become problematic.  And professionals need to keep in mind that the cost of meeting warranty obligations is generally not covered by professional liability insurance.

It is wise for design professionals to avoid contractually assuming too broad of a range of project related risks. There are certain risks that are within the control of the design professional and others that are not. One way to avoid assuming broad risks is to stay clear of such broad risk transfer provisions in service contracts.

Identifying Project Risks

Perhaps the first step toward contractually apportioning risk if identifying project design and construction risks.  What are some of the project risks to consider?

  • Unexpected Changes in Costs
  • Funding and Payment Delays
  • Weather Delays and Impacts
  • Unexpected Geologic Conditions
  • Design Errors, Omissions and Oversights
  • Construction Defects
  • Delays in Delivery of Project Components
  • Permit Approvals
  • Contractor/ Subcontractor Failures
  • Labor Disputes

These may be others to consider.

Categorizing Project Risks

The next step is to categorize the risks.  There can be several useful ways to categorize construction project risks. One is by risk characteristics.  For example:  economic, nature, regulatory, labor, and materials is one approach. This can be helpful in understanding the risks but not so helpful in allocating them among project participants.

A more useful approach is to categorize construction project risks by which participant in the project has the most influence with regard to managing that risk. In other words, the identified risks can be allocated to the project owner, designers, and contractors according to which of these participants is in the best position to manage it.

Acceptable Risks for Design Professionals

One would expect the design professional to agree to be held accountable for delivering design and limited construction related services meeting a professional standard of care. But one would not expect the design professional to assume total responsibility for delivering a completed project meeting the owner's expectations. Not all of the steps of delivering a completed project are in the control of a consulting design professional.

The Professional Liability Insurance Limitation

What makes taking on too broad of a range of project risks particularly problematic for a design professional is that professional liability insurance usually is written with limitations on coverage for those aspects of project involvement that are not in the design professional's control. In other words the design professional may sometimes contractually -take on risks for which there will be no insurance coverage.

Contractually Allocating Construction Project Risks

The goal is to contractually allocate construction project risks to the project team participant that is in the best position to manage that risk. Some risks are best addressed by the project owner. Some are best addressed by members of the planning and design team. And others are best addressed by one or more of the contractors, subs, or materials suppliers.

The first step toward this goal is clearly understanding and defining the roles of each project participant. Smaller projects generally have fewer participants making this a simpler task. On larger projects with many participants this becomes more of a challenge.

The many participants can be thought of as layers of the general categories of owners, designers, and builders. Owner layers can include project managers, planners, and financing entities. Design layers can include the many specialties involved. Builders can include subs, material suppliers, equipment providers, and more.

The specific roles and obligations of each of these project participants are defined by contracts which also express the intent as to risk allocation. That contractual risk allocation should, ideally, reflect each project participant's ability to manage the specific identified risks.

Perhaps, on a complex project, some sort of matrix or chart would be helpful in sorting out this combination of risk categories and project participants.

Insurance as a Risk Transfer Tool

Insurance coverage is a tool for transferring risk to a third party in exchange for a payment of premium.  In order to allow an insurer to adequately price the risk that it assumes, a variety of considerations are taken into account.  These are generally reflected by an application for insurance.  The information in the application is used by underwriters who determine whether to accept a risk, how to price it, and what limitations to place on the accepted risk.

When addressing risk and risk transfer when drafting design service and construction contracts it is important to understand the nature and limitations of the various kinds of insurance.

Contractual Provisions Requiring Insurance

Design service and construction contracts contain provisions addressing insurance requirements.  This is a topic worthy of an entirely separate article. As to design professionals a proper expectation is that professional liability insurance meeting certain limits be carried.  There are a few key considerations that need to be reflected in the professional service contract.

First, project owners or developers often insist that they be named as additional insureds on professional liability policies.  This can create major problems.  It is important to understand that professional liability insurance is "liability" insurance.  In other words the policy agrees to pay an injured party on behalf of the design professional.  By becoming an additional insured the argument can be made that the policy will pay to others than an Insured under the policy.  In other words loss  payments to the project owner who was named as an additional insured could not be made under the policy.

Secondly, a professional liability policy is typically written to cover liability for loss arising from professional services.  Since the project owner is, generally, the recipient rather than the provider of professional services there is no situation under which the policy could be applicable to the owner as an additional named insured.

Another consideration when drafting insurance related contract language is making sure that the coverage will be in place at the time when a claim may materialize.  General liability insurance, for example, is usually written on an occurrence basis.  This means that coverage is triggered when an accident or loss occurs.  One would expect the policy being in place to be important during the periods of time when accidents are likely to occur - like during the construction process.  But accidents can occur and claims can also arise after completion of a project.

Professional liability insurance is usually written on Claims Made basis.  This means that there needs to be a policy in effect at the time when a claim is first presented to the design professional.  A project owner might want to require the design professional to have a professional liability policy in effect for a period of time after the project is completed with the understanding being that claims can arise after the project is completed.  Depending on the type of project there may be a period of time during which claims are more likely with the probability of claims dropping off as time passes.

Project related contracts provide for other kinds of insurance.  A full discussion of these is not within the scope of this article.  However, there are a few more important considerations.

One of these is that it generally is not enough to require that various kinds of insurance be procured.  It is important to make certain that insurance requirements have been met before a project starts by obtaining certificates of insurance reflecting the coverage that has been procured. Although a certificate of insurance makes certain representations as to the nature and scope of the coverage it is not the insurance policy and, especially important, it does not make the holder of the certificate an insured under the coverage that it describes.

The insurance provisions in design and construction contracts are important, can become complex, and are best addressed with the assistance of an insurance broker familiar with the kinds of coverages that are relevant to construction projects.

Surety and Performance Bonds

Another risk management tool provided for in design and construction contracts is the bond.  There are several kinds.  They are not insurance.  The are basically guarantees of performance and payment.  The surety agrees to advance payment or complete the work in accordance with contract requirements if the principal is unable to pay or perform and before legal liability disputes are resolved.  The surety then seeks to recover the costs from its principal.

Since consulting design professionals do not undertake to make payments nor provide finished construction projects, they are generally not required to post bonds.  But contractors and material suppliers typically are contractually require to do so in order to avoid problems with completion of projects while disputes are sorted out.

Liability Disclaimers

The opposite of assuming risks best controlled by others is use of disclaimers. Expressly disclaiming responsibility for unknowns and risks that can only be managed by others is a good practice. Often design professionals are reluctant to point out risks and then disclaim responsibility for them. It creates doubt and discomfort for the client.

In Summary

There are many risks associated with the planning, design and construction of capital projects.  And there have been many tools developed to manage those risks.  Contracts are used not only to define the rights and obligations of the parties participating in constructions projects but also to allocate those risk to the appropriate parties - generally those with the greatest ability to avoid and control those risk.  Those drafting design and construction related contracts sometimes attempt to transfer risks.  Hopefully this discussion can be helpful in sorting out the issues that can arise.

 

This article expresses ideas for consideration and should not be taken as recommendations applicable to any specific situation. When making a decision on how to address a specific situation consulting with an experienced risk management, insurance professional, or attorney is recommended.

The objective of this blog is to share information about issues that architects, engineers, and their attorneys encounter. If you have any ideas or suggestions for specific topics to address, or if you would like to contribute an article for publication please let us know by submitting a comment.

© 2017 John Wersyn, All Rights Reserved

 


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