Article

Navigating uninsured and uninsurable risks in the construction industry

Uninsured and uninsurable risks can jeopardise the successful completion of a project and contribute to profit-at-risk (PaR) exposure, threatening the financial sustainability of the organisations involved.

By Francois DeMadre ,

National Practice Construction & Surety, Marsh Canada

26/10/2023 · 7 minute read

Risk is an inherent part of any construction project. Many factors can result in costly delays or even outright project failure, from unforeseen design flaws to unexpected ground conditions. Among these, uninsured and uninsurable risks pose unique challenges. In a worst-case scenario, uninsured and uninsurable risks can jeopardise the successful completion of a project and contribute to profit-at-risk (PaR) exposure, threatening the financial sustainability of the organisations involved. This article explores these risks, their impact on construction projects, and emerging solutions for more effective risk management.

The impact on profit-at-risk

In general, uninsured risks are those that a contractor has chosen not to cover with an insurance policy, while uninsurable risks are those that insurance companies will not cover due to their unpredictability or high likelihood of occurrence. Key risks in both categories include:

Design and engineering risks: could arise from errors, omissions, or negligent acts in a construction project’s design or engineering phase.
Contractual risks: related to non-compliance with contractual obligations, project delays, or non-performance.
Environmental risks: can include unexpected conditions such as soil instability, ground water conditions, biodiversity exposure, or hazardous materials.
Political and regulatory risks: arise from sudden changes in regulations, legal disputes, or political instability.
Market and financial risks: can include changes in material and labour costs, interest rates, or economic conditions.

These risks can affect the PaR. Such risks can usher in unforeseen expenses, cause project delays, or even trigger cancellations, thereby augmenting the PaR exposure and potentially neutralising projected profit.

To help control PaR, contractors should weave risk management strategies into their core business operations. This involves pinpointing and evaluating potential risks, determining their potential financial ramifications, and formulating and applying mitigating strategies. Persistent monitoring and periodic reassessment of risks are vital to ensure the continued efficacy of these strategies throughout the project's duration.

Addressing uninsured and uninsurable risks: Embracing risk quantification for enhanced collaboration in construction

Traditional design-build and public-private partnership delivery methods frequently fail to address both insured and uninsured risks adequately. A 2021 Travellers infrastructure study pinpointed design risks as a significant contributor to the subpar outcomes in standard delivery methods like design-build projects.

One major issue identified by Travellers was the expectation for contractors to submit fixed-price proposals based on designs that are only about 30% finalised. The insurer's data suggests that contractors struggle to do this with accuracy, leading to substantial operating losses.

This often results in disagreements concerning cost overruns, change orders, and project delays. In traditional contracts, to safeguard their profit margins, contractors build in contingencies to offset potential issues. The combined challenges of a lack of transparency and restricted risk-sharing exacerbate the effects of these risks, and increase the extra contingency contractors often include in their bids as a protective measure.

So what can be done to improve risk sharing? Embracing risk quantification is one potential solution. Risk quantification is a process that assigns a numerical value to the potential impact of a risk and it is a critical component of risk management in construction projects.

By quantifying risks, construction firms can effectively prioritise risks, allocate resources, and negotiate contracts. This practice can also enable firms to make more informed decisions about risk mitigation and insurance coverage.

This objectivity can lead to better risk allocation among stakeholders, enhance risk transparency, and encourage more effective risk sharing. This can foster more collaborative relationships among stakeholders and lead to better project outcomes.

Emerging industry solutions

The need to enhance risk-sharing among project stakeholders is promoting innovative solutions to leverage risk quantification efficiently. These solutions, outlined below, aim to provide a comprehensive understanding to all project stakeholders of potential risks and address their financial impacts.

By fostering greater collaboration, transparency, and data-driven decision-making, these solutions can significantly reduce the negative consequences of uninsured and uninsurable risks, leading to improved project outcomes and increased profitability for all parties.

1. Probable maximum loss (PML) studies for non-catastrophic events: PML studies, traditionally used to assess potential losses from catastrophic events, are now being applied to non-catastrophic risks in construction. They can be used to analyse first-party and third-party risks, providing a comprehensive view of potential financial impacts.

Consider a scenario where a heritage building is being renovated. The building could be structurally sound, however, the construction work might introduce risks that could lead to significant damage. A PML study in this context would assess the potential maximum loss due to the construction activity.

The PML study would consider factors such as the age of the building, its structural integrity, the nature of the planned construction activities, and the potential risks associated with these activities.

It would provide a quantified estimate of the potential financial impact of these risks, informing risk management strategies, insurance decisions, and contingency planning. Similarly, in the case of a tunnel renovation project where operations continue during construction, a PML study could assess the potential risks associated with construction activities, the operational risks related to the continued use of the tunnel, and the potential interplay between these risks.

2. Contractual actuarialised liability: This is a contract negotiation method where each party’s potential liability is quantified using actuarial techniques. This approach allows for more balanced and fair contracts, as each party's obligations are based on their ability to control or influence the risk.

Consider a scenario where a contractor and a subcontractor are negotiating the terms of a project contract. They might use contractual actuarialised liability to determine who should bear the cost of the insurance deductible in the event of a claim to negotiate a fair and proportionate allocation of the deductible cost by quantifying the potential risks associated with each party's activities.

For example, if the actuarial analysis shows that the subcontractor's activities present a higher risk of leading to a claim, the contract might stipulate that the subcontractor is responsible for a larger portion of the deductible.

Conversely, if the contractor's activities present a higher risk, they might agree to bear a larger portion of the deductible.

By using contractual actuarialised liability to manage deductibles, parties can agree to distribute the financial burden of insurance claims in a manner that reflects the actual risks associated with each party's activities. This can lead to more balanced contracts and help avoid disputes over deductible payments in the event of a claim.

3. Cross-portfolio projects contingency approach: Instead of treating each project in isolation, this approach collectively manages a portfolio of projects. By pooling contingency reserves across multiple projects, contractors can spread risk and potentially offset losses from one project with gains from another. Traditionally, contingency planning in construction has been handled on a per-project basis. Each project would have its own contingency fund to handle unexpected costs and delays.

There are limitations with this approach. For instance, it could result in the underutilisation of funds in one project while another is facing a shortage. Additionally, it does not account for the risk correlation and diversification benefits that might exist across different projects in a portfolio.

For example, consider a construction firm with a portfolio of ten projects, each with different risk profiles and contingency requirements.

With a cross-portfolio approach, instead of allocating a 10% contingency to each project (which could lead to over- or under-funding), the firm could create a shared contingency fund based on the overall portfolio risk. The fund could cover unexpected costs across all projects.

This approach can be beneficial because it allows for greater flexibility in allocating contingency funds. If one project encounters unexpected costs that exceed its individual contingency, funds can be drawn from the portfolio-wide contingency without jeopardising the project’s success.

Moreover, this approach promotes efficiency by reducing the likelihood of having idle contingency funds in one project while another is facing a deficit. In addition, a cross-portfolio approach can facilitate better risk management as it encourages the firm to consider the interdependencies and correlations between different projects. By understanding how risks in one project can impact others, the firm can develop more effective risk mitigation strategies and make more informed decisions about where to allocate resources.

4. Collaborative project delivery methods: Alliancing, integrated project delivery (IPD), and progressive design-build (PDB) models are growing alternatives in the construction industry due to their potential to enhance risk sharing among project stakeholders. These methods tend to foster greater collaboration and transparency, aligning the interests of all parties toward successful project completion.

For instance, an alliance contract brings together the client and non-owner participants as an integrated team, sharing risks and rewards, which can help manage uninsured risks more effectively. IPD forms a multidisciplinary team from the project's outset, enhancing joint decision-making and risk mitigation.

PDB allows for early contractor involvement in the design, identifying and managing potential risks ahead of time. As the industry continues to embrace these collaborative approaches, they offer promising potential for mitigating uninsured and uninsurable risks, which in turn can improve project outcomes and profitability.

Let’s consider, for instance, a complex, large-scale infrastructure project such as the construction of a new airport terminal. In this scenario, the stakeholders include the airport authority (owner), multiple architectural firms, several contractors, and a number of subcontractors, each with their unique set of responsibilities and risks.

In a traditional project delivery method, each stakeholder may work in isolation, focusing on their individual tasks and responsibilities. Risks are managed within each entity and communication between stakeholders might be limited. This can lead to a lack of coordination, misunderstandings, and even disputes, contributing to project delays, cost overruns, and increased uninsured and uninsurable risks.

Now, imagine the same project being executed using an integrated project delivery (IPD) approach. At the outset, the airport authority, architects, and main contractors come together to form a single multidisciplinary team. From the initial design stage to final completion, this team collaboratively plans and manages the project, sharing information, insights, and responsibilities.

In this environment, risks are no longer isolated within individual entities. Instead, they become shared concerns of the entire team. The architects might highlight potential design risks early in the process, the contractors can bring attention to potential construction challenges, and the airport authority can provide crucial insights into operational and regulatory risks.

This joint decision-making process allows for early and proactive identification, assessment, and management of potential risks, reducing the impact of uninsured and uninsurable risks. Furthermore, because of the shared risk and reward structure in IPD, all parties are incentivised to manage and mitigate potential risks proactively.

If a particular risk materialises, the team collectively absorbs the impact, helping to avoid blame games and costly disputes. Conversely, if the project is completed successfully with minimised risks, all parties share the benefits, leading to a win-win situation.

Effective risk management

Managing uninsured and uninsurable risks is essential for the success and profitability of construction projects. By embracing risk quantification, adopting collaborative delivery methods, and implementing innovative risk-sharing strategies, the construction industry can mitigate the impact of these risks and foster more transparent and efficient project execution.

As the industry continues to evolve, these practices are expected to play an increasingly important role in ensuring the successful completion of projects and the long-term sustainability of construction firms.

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