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Construction Contract - Insurance Policies
[Audit of Construction Projects]
by Gursharan Singh
1.0 INTRODUCTION
1.1 Owners, Financiers and others who have any pecuniary interest in the Implementation of ‘CONSTRUCTION PROJECTS’ would normally require that their respective interests be safeguarded against known and unknown risks. The safeguard instruments generally used are Cash Deposits, Performance Bonds issued by Financial Institutions and Insurance Policies issued by Insurance Companies. This article will make reference to the specific provisions pertaining to INSURANCE POLICIES that are generally prescribed in commonly used ‘FORM OF CONSTRUCTION CONTRACTS’ formats they may be issued by the relevant regulatory authorities and others who may have direct/indirect interest in the construction industry such as the technical/accounting/legal and other professional bodies.
2.0 FORM OF BUILDING CONTRACTS
2.2 Standard ‘Form of Building Contracts’ are generally available in most countries. These formats are suitable for common usage for owners/clients whose need is on an ad-hoc basis as and when they may be involved in the construction projects.
INFRASTRUCTURE CONSTRUCTION PROJECTS
2.3 In addition to the above referred ‘Standard Formats’ there are cases of scope of works under mega infrastructure projects that would need special terms and conditions and may be appropriate for individually designed contract formats. Project owners may appoint legal firms who posses the relevant expertise to design contract formats that would cater to specific needs of the scope of works. Examples of such mega projects would include construction of Railways Track Works [that would include associated works such as signaling, wooden/concrete/steel sleepers, welding, etc.], Airports, Harbors, Highways, and Bridges. In these cases it is a normal practice for the Project Owner/Client to appoint a ‘Project Manager’ [or Main Contractor] who is then to be assisted by a team of Technical and other Professionals to advise him. Further, the whole Mega Project may then apportioned into ‘Packages’ that may then be awarded to several ‘Main Sub-Contractors’ for specific ‘Scope of Works’ relevant to their expertise. These ‘Main Sub-Contractors’ are generally subject to Terms and Conditions that are similar to those imposed on the Main Contractor also referred to as ‘Back-to-Back’ conditions. It is common practice for these ‘Main Sub-Contractors’ to appoint their individual teams of Technical & Other Professionals.
3.3 Infrastructure construction projects may also be constructed using other methods such as ‘Turnkey’, ‘Design & Build’ and ‘Build-Operate & Transfer’. The need for financial safeguards will exist in all types of the method of implementation.
3.0 INSURANCE POLICIES
3.1 All construction works have basically three types of risks for it is prudent to have insurance policies. These risks are:
[a] Damages to ‘Works’ being constructed including equipment and materials on site;
[b] Accident to construction works involved in the works; and
[c] Injuries to third parties and property that would include all outsiders and private property.
3.2 In addition there are laws in several countries pertaining to safety of workers and others under which there would be compulsory contributions to relevant authorities/specific funds to which regular payments must be made. This is another form of ‘insurance’ that is employed in the developed and most developing countries. A specific clause would be incorporated in the contract terms and conditions to provide for requirement to ensure compliance with such laws. Their compliance of the relevant clauses should be strictly enforced.
3.3 In the case of mega infrastructure projects that are subject to ‘Back-to-Back’ conditions the Main Sub-Contactors may be required to or prefer to take additional supplementary insurance policies due to the limited coverage such as ‘Quantum of High Excess Clause’ and other risks that may not have been adequately covered in the policies for the main scope of works or risks. Special attention should be paid to ensure their compliance.
4.0 ROLE OF THE ‘SUPERINTENDING OFFICER’
4.1 All ‘Standard Contract Formats’ appoint ‘Superintending Officer’ [‘SO’] who may be the lead civil engineer [for engineering projects] or the architect [for building projects. In some cases the ‘project manager’ may be appointed the ‘SO’. Consequently it would be reasonable to assume that he is also the designated officer to be responsible for the compliance of the relevant prescribed terms and conditions. Thus, as the representative of the ‘Employer’ [or ‘Client’ or ‘Project Owner’] it is his responsibility to ensure that the insurance policies are relevant to the scope of works and would protect the interest of the ‘Employer’.
5.0 SCRUTINY OF THE CONTENTS OF INSURANCE POLICIES
5.1 The insurance policy is a legal document that is designed to provide the required and necessary safeguards to protect the Employer against losses arising out of the implementation of any construction contract. It is for this purpose that an insurance policy is taken to cover against known and some unknown risks. The basis of all insurance policies is that it is subject to, among others, the following main aspects:
[a] ‘Full Disclosure of all Material Facts’ that would effect the acceptance of the risk including any subsequent events or changed conditions.
[b] Payment of Premium Amount within the prescribed period but before a policy becomes legally binding;
[c] Scope of Cover;
[d] Period of Insurance including any Extensions;
[e] Prescribed Procedure, Period and Method of Reporting of Accidents/Damages for Claims purposes; and
[f] Terms & Conditions including any ‘Endorsements’.
Non-compliance with any of the above aspects may render the policy invalid and thus unenforceable in the event of any accident and claims.
5.2 There are several contributing factors that make it almost impossible for the ‘SO’ to do a comprehensive scrutiny of the contents of the insurance policies. Some of the more important factors are listed below:
[a] The legalistic language used in the various clauses, terms and conditions. It is impractical and almost impossible for any person without the relevant expertise in the insurance field to understand the implications [legal and financial] of the terminology used in the policy;
[b] The small size print and the large number, further discourages any person even to attempt to read the clauses, terms and conditions contained in the policy;
[c] The scope of insurance cover is further affected by the inclusion of many ‘Endorsements’ that either provide cover against additional risks [for additional premium] or reduce the cover from specific risks.
5.3 It is important that the ‘SO’ fully understands the legal aspects of the contents of the insurance policies and their financial implications. Advice is generally sought from ‘Insurance Brokers’ who are deemed to posses the relevant expertise in insurance matters. However, it should be remembered that ‘needs’ of insurance for construction projects is a specialized field. Thus it is recommended that advice should also be sought from other technical/legal professionals with the relevant expertise in construction matters to ensure that sufficient insurance cover is taken to cover risks that exist in the implementation of construction contracts and that these insurance policies remain legally valid and effective during the need of the contract implementation until its handover to the client.
6.0 BASIC ASPECTS IN INSURANCE POLICIES
6.1 The following basic aspects in insurance policies generally should include the following:
[a] Parties Insured [Employer, Contractor & Sub-Contractors and Professionals/Visitors to Site];
[b] Scope of Works - [i] Public Liability [Third Parties: Property & Public]
[ii] Workmen Compensation [All Workers]
[iii] Works [Works in Progress and Materials/Machinery on Site]
[c] Value – [i] Public Liability [Commensurate with the Possible Risk]
[ii] Workmen Compensation [Quantum of Payroll]
[iii] Works [Contact Sum]
[d] Duration - Construction Period including Extended Periods and Defects liability Period
[e] Proceeds of Any Claim – Receivable by Employer [For Apportionment & Payable as Due]
7.0 MANAGEMENT ROLE IN RESPECT OF INSURANCE POLICIES
7.1 One of the common problems in construction companies is the absence of comprehensive records pertaining to the claims that can be made under the insurance policies and their status at any one time. While the major claims may be brought into account due to their financial implications on the ‘bottom line’, there could be several cases where the individual claim may not be material but the cumulative quantum could be substantial. Thus it is important for Management to ensure the maintenance of the required comprehensive records regarding all cases where losses arising from damages could be claimed.
7.2 The claims should be submitted promptly to the insurance company on the prescribed formats and with complete supporting documents. Periodical follow-up should be done to ensure progress and decision and settlement where agreed. It will be necessary to maintain safely the relevant documents as these claims could take long periods. It is suggested that all outstanding claims should be brought to account in the financial statements to ensure that they are not overlooked pending settlement.
8.0 SOME EXAMPLES OF WEAKNESSES OBSERVED IN INSURANCE POLICIES
8.1 Scrutiny of Insurance Policies in the past during Audit of Construction had revealed the following weaknesses:
[a] The ‘Clauses’ pertaining to the ‘Insurance Policies’ do not make any reference to any ‘Cover Notes’. However, these ‘Cover Notes’ had been accepted in lieu of Insurance Policies and the ‘Clauses’ deemed to be complied and accounted for computation of progress payments.
[b] Insurance Policies had been taken for ‘Scope of Works’ where the risk did not exist. The ‘Earth Works’ and ‘Paving of Roads’ were insured against the risk of damage by fire even though such risk did not exist. ‘Fire Insurance Policy’ should be taken based on ‘Need’ of the Scope of Works.
[c] Over Pricing of Value for Insurance under ‘Preliminaries/Mobilization’ compared to Actual Premium Cost. ‘Lump Sum’ Provision was $7.0m compared to Premium Paid Amount of Less than $2.0m as per Receipts. In another case the amount paid was $30.0m against ‘Lump Sum’ provision of only $9.0m.
[d] Insurance Company was not informed of additional works that were issued through a Variation Order. The Original Bridge Construction Contract was valued at $600.0m whereas the Additional Road Junction Works were valued at $180.0m. The VO is deemed to be new Scope of Works for which additional insurance Coverage is necessary. Failure could result in rejection of any claims even on the original scope of works.
[e] Insurance Company rejected Contractor’s accumulated claims of over $11.0m for damages to underground cables/pipes that arose from damages over a two years period. Reason for rejection was that they were not covered by the policy as had been stated in an attached ‘Endorsement’. The delay in the rejection decision was due to the contractor not providing the required reports and supporting documents promptly. Remedial action to could have been earlier if Management had prompt action had been taken on the first claim.
[f] Contractor’s poor claim record resulted in the Insurance Company rejecting extension of the policy when the policy for the original period expired. On appeal the premium rate was substantially increased resulting in contractor not taking the extension but carrying its own risk.
[g] ‘Endorsement’ had stated that people involved in a bridge construction where the height of the bridge from the water level was less than [30] meters. The policy may be ineffective as past [50] years of records showed that the height difference even during dry season had never been more than [27] meters.
[h] The ‘Risk’ in some cases were ‘Over Insured’. Examples are given below.
[i] A land clearance contract was to be completed within one year and specified that the Workmen Compensation Insurance Policy should be 20% of the Contract Value of $20.0million. However, as the works were implemented by heavy machinery the total ‘Wages Value’ of the ‘Machinery Operators’ for the duration of works did not exceed $500,000.00. Thus the premium paid on $2.0million was excessive.
[ii] A ‘Public Liability Insurance Policy’ was taken for a new property development project valued at over $200.0million in a remote area where there was no ‘Public’ or ‘Property’ that could be at risk.
[i] The ‘Risk’ was grossly ‘Under Insured’ in one case in respect of ‘Public Liability Insurance’ for a [88] storey high rise building that was being constructed in a heavily developed area in the city center where there are several high rise commercial buildings, heavy vehicular traffic and concentration of citizens where the ‘risk’ quantum could be in hundreds of millions compared to the stated ‘maximum liability’ of $1.0m per incident though the number of incidents were stated to be unlimited.
8.2 Insurance companies generally provide ‘freebies’ that may not have any benefit or value to the client, even if there is no cost involved. An example of such a ‘freebie’ would be ‘full compensation’ to the locals in the event of a ‘nuclear’ attack of which the risk is almost non-existent. However, insurance cover for known/possible risks such as a ‘local’ attack [or vandalism] will be subject to additional premium payment.
9.0 RECOMMENDATIONS
9.1 The compliance of the basic requirements can be easily verified by the ‘SO’ but there area several aspects that are not easily understood and thus verifiable. It would be inappropriate for any Employer to expect the appointed ‘SO’ to be able to do a comprehensive scrutiny of the clauses that is prescribed in the various insurance policies. Thus it is important that the ‘SO’ understands and identifies the ‘hidden’ risks for which there may not be any cover and protection or the financial implications of the ‘under/over’ insurance policies.
9.2 Management should also ensure the preparation of a periodical ‘Status Report’ that should be required to be submitted. This ‘Status Report’ will enable the taking of any appropriate, including remedial, action promptly. This ‘Status Report’ is an important internal control that can enable the Management to monitor the progress of the outstanding claims and should be extended to all relevant levels of management. It should be strictly enforced by all concerned.
9.3 The ‘Status Report’ should be scrutinized and analyzed periodically to identify the risk areas and works that are susceptible to accidents. Proper action can then be instituted for remedial actions to ensure ‘damages-free’ working conditions or at least minimize the remedial costs. The reduction in remedial costs and claims against the insurance can create a ‘safe’ track record that can be translated to reduced premium costs. Additional savings can be achieved from lower costs for remedial works that consume resources such as time, labor, facilities and materials that can be used to improve the implementation processes. These will also enhance the ‘goodwill’ and ‘reputation’ of the Company that can result in new construction projects for the future.
Insurance Policies Involve & Effect All in Construction Company - Adversely or Positively
GSK/Mar 05
[P.S.:The writer welcomes any enquiries or exchange of views.]
- GURSHARAN SINGH C.M.I.I.A.
[Trainer – Retired Audit Officer]
116 Jln Hujan Manik O.U.G. Jln Kelang 58200 Kuala Lumpur, Malaysia
[Tel, No. [H] 603-79824492 E-mail: gsk38@hotmail.com]
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