Strategic Planning: Analyze Your Risks

Attorneys: Schoumacher, Bruce H.

Related Practices: Corporate/Commercial    Insurance Coverage

Related Industries: Construction

Winter 2014
Construction has inherent risks.  The basic risks are (1) loss on a project due to poor estimating; (2) loss because of poor management; (3) failure of a key subcontractor or a vendor to complete its work, most often due to insolvency; (4) defective construction which has to be remedied; and (5) the activities of the contractor or its subcontractors may cause damage to others; such as, damage to property of third parties or personal injuries due to the contractor’s negligence.
In the strategic planning process, the contractor should decide on how to control each of these risks.  Obviously, one alternative is for the contractor to invest sufficient capital in the business to protect from estimated losses resulting from occurrence of these risks. However, this may not be a good alternative to adopt because (1) the amount of capital necessary to control these risks may be difficult or impossible to estimate;  (2) the capital could be used for better uses for the business; and (3) the contractor may not be able to raise sufficient capital to protect it from these risks.
Usually, a better way to control risks is to allocate the assumption of risk by contract or insurance.  Obviously, the first two risks, bad estimating or poor management, can be controlled by price based on cost plus a markup for overhead and profit.  Of course, most owners will not agree to a cost-plus price, because they do not, and should not, want to bear these risks of construction.  Rather, they will require a fixed price or GMP contract.  So these two risks can only be controlled by proper management.
The third risk, failure of a subcontractor to perform, may be controlled by:
  1. personal guarantees of the owners of the subcontractor;
  2. letters of credit;
  3. construction payment and performance bonds; or 
  4. Subguard or similar insurance policies. 
Contractors should not rely solely on personal guarantees, because they only are as good as the assets of the guarantors.  Letters of credit are not regularly used to guaranty the work of subcontractors, because banks only will issue a letter of credit to companies with sufficient cash or short-term debt instruments to back them up.  Although some general contractors require key subcontractors on larger projects to provide bonds to protect the contractor from subcontractor default, enforcing the bond is not necessarily easy.  Bonding companies often delay payment and frequently challenge the validity of the contractor’s claim.  Accordingly, more contractors are turning to Subguard or similar insurance programs which indemnify the contractor for losses it incurs due to subcontractor default.
The fourth risk, issues due to defective construction, may not be covered by insurance.  Some states hold that a contractor is not covered for defective construction caused by its own work, often finding that the insurance policy only covers “accidents” or “occurrences” and that defective construction is not an accident or occurrence.  Further, most commercial general liability policy business risk exclusions are used by insurers to deny claims arising from defective construction.
Even though the contractor may not be protected from claims for defective construction of its own work, it can pass on to its subcontractors the losses it incurs due to defective work performed by its subcontractors.  Most construction subcontracts now contain indemnity provisions under which the subcontractor agrees to hold the owner and contractor harmless from any loss incurred due to defective construction of the subcontractor.  The contractor also can require the subcontractor to obtain a performance bond under which the surety agrees to remedy any defective construction of the subcontractor.  In addition, the contractor’s general liability insurance policy may contain a provision insuring the contractor from loss it incurs due to a claim made against it for defective construction of its subcontractors.
The fifth risk involves the situation where defective construction of the contractor results in damage to property other than its work.  As an example, a roof constructed by the contractor may leak causing damage to personal property inside the building.  This risk usually can be insured against by a general liability policy. In addition, the general liability policy insures against bodily injury claims due to the contractor’s construction.  Of course, injuries to its own employees should be covered by the contractor’s workers’ compensation insurance policy.
Although the contractor may not be able to cover itself with insurance for each of these five major risks, as part of the strategic planning process, the contractor should evaluate alternatives it can use to minimize potential losses.  Its risk manager, insurance broker and/or lawyer can assist it to find a program which best suits its needs.
Reprinted with permission from  Business Development: Helping AEC Firms Win New Business, Volume 2, Issue 1, January/February 2014.
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