Construction Defect Risks
Seven strategies to manage construction defect risks
Jody T. Wright
October 9, 2011
CONTRACTORS SHOULD TAKE a point by point approach to identifying and managing construction defect risks, says Jody T. Wright, senior vp and construction department manager at Lockton Cos. L.L.C. in Denver. Tapping these strategies also can show contractors how they can monitor loss history to uncover preventable trends as well as avoid the expense of potential litigation and reputational damage, he says.
Claims for defective construction can be enormously expensive and time-consuming. As contractors struggle with the challenges of finding profitable work in a hypercompetitive environment, the most progressive construction organizations are researching risk and making conscious decisions about work acquisition, target project profiles and mitigation tactics that can help protect their balance sheets.
What techniques might help you avoid the lawsuits, expenses and potential damage to your reputation that accompany disputes around construction defects? There are seven strategies being used around the country to identify, manage and mitigate your exposures to these kinds of losses.
STEP ONE: Refine your project appetite and match it to your insurance program.
Since many construction insurers have sought to limit the amount of high-risk work that their insured contractors are performing, understand the profile of your most profitable jobs. When measuring profitability, remember to keep the books open on your project costs until the statutes of limitation and repose have expired. Warranty and repair costs need to be tracked and built into future estimates to help measure the true final job costs and ensure future profitability on similar projects.
Many contractors have set up separate companies to separate riskier work from the more “traditional” projects within their work program. Insurance carriers usually price their liability coverage based on the perceived or proven risk of your previous projects and upcoming backlog, and a “silo” strategy to isolate the more expensive, riskier projects can protect the liability rates for the projects with lower risk. This might make you more competitive on hard bid work and could help you acquire new work.
Some contractors also insure higher-risk projects through consolidated insurance programs, or “wrap-ups.” This is another risk isolation technique that can protect the stand-alone pricing for more traditional commercial work. Insurance carriers typically view residential construction projects as riskier, but each carrier applies their own definition of what constitutes “residential.” Multifamily “for sale” projects are viewed by most carriers as the riskiest, but any project that creates a homeowners association carries a higher potential threat of future litigation.
Pricing for project-specific or wrap-up programs is especially competitive in the current marketplace.
STEP TWO: Determine what makes your liability insurer nervous.
Take the time to familiarize yourself with the key exclusions and limitations within your general liability insurance program. Ask your broker to review all of the exclusions with you and explain what they mean, and ask to meet with your underwriter to clarify any gray areas. The more you know about how your insurer prices your risk, the more accurate your pricing estimates can become, and the more sustainable your insurance program will become over time.
STEP THREE: Monitor your loss history and link it to your quality control/quality assurance efforts.
Your insurers are constantly tracking the profitability of your account. They keep score by compiling a history of the losses that they have paid on your behalf, and they compare that with the premiums they have collected from you every year. If this loss ratio gets too high, either your prices will go up or your insurer will not offer you renewal terms.
Ask your broker for periodic loss reports, and review them with your project teams to identify any trends that might show preventable patterns.
Look backward for the last three to five years, and recognize that your insurance carrier will perform the same analysis when pricing your account. For example, if water-damage claims persist, focus on tougher standards and more frequent inspections on those building components or systems that may have failed on earlier projects.
Consider design peer reviews or constructability discussions during the preconstruction phases of complex projects.
STEP FOUR: Negotiate your contracts.
In the current bidding environment, owners know they have an advantage and are seeking to contractually transfer more risk downstream to contracting organizations. When possible, seek competent risk and legal advice and push back on risk allocations that are out of proportion to the work you perform or to the amount of profit or fee you might earn. We have seen several recent large construction defect claims paid where the contracting party built the project in conformance with the plans and specifications, but the contract terms obligated them to indemnify the owner for the negligent work of others that they did not control. Strong contractual guidelines can help mitigate this risk.
STEP FIVE: Avoid new components and technologies.
Unproven systems and products carry a higher risk of failure than time-tested, reliable components and have recently produced an uptick in claims frequency, particularly around “green” or renewable materials and designs. Be cautious about pioneering in these areas.
STEP SIX: Make quality a larger component of your subcontractor prequalification process.
Ask your subcontractors to augment their prequalification packages with their own liability loss history. Avoid those subcontractors with loss patterns that might affect your project or reputation.
STEP SEVEN: Keep your ears open.
Research those owners with a pattern of suing contractors, and only bid their work at margins that support the increased risk. Learn who the most effective attorneys and expert witnesses were at a recent local construction trial, and consider hiring them to advise your team on how to avoid litigation before your next project starts. Ask your broker and insurer for suggestions to preserve your stellar track record and contain future insurance costs.
Construction defect disputes are complex, time-consuming, expensive and distracting. Consider a robust discussion of these seven steps at your next planning meeting, and select a few that your team feels can help you improve your construction performance and protect your net worth.
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