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Effective Risk Transfer: Key Construction Terms

Mar 3, 2021 9:06:53 AM

Construction Risk

The term “risk transfer” means just that: a risk that one party bears is transferred to another. In reality, risk transfer in the context of a contractual transfer of risk from an insured to an insurer is better understood as a transfer of the financial costs of certain risks. For example, if a subcontractor injures a third-party or damages their property, the subcontractor’s commercial general liability policy should provide the subcontractor with defense and indemnification coverage. In other words, the financial cost of a covered risk is transferred from the insured to its insurance carrier. The ability to finance the costs of potential risks is a key tool in how most construction contracts are structured. Here is how.

Construction contracts rely on insurance products to manage risks and transfer the cost of risks to third-party insurers. They accomplish this by using several common contract terms. Before discussing those, it is important to understand the rationale behind this structure. In a macroscopic view, transferring risks from the contracting parties to an insurance carrier: (a) avoids disputes between the contracting parties by directing them to their insurance policies instead of having to look to each other for defense and indemnification, (b) avoids financial impacts on the contracting parties that could impede their ability to do the work or even continue as a going concern, and (c) reduces uncertainty surrounding how to quantify the amount of financial exposure that the parties may be exposed to by insurable risks. With that backdrop, let us turn to some of the specific contract terms that are intended to effectuate risk transfer in a construction contract.

The first provision assigns risks to particular parties as well as setting out their duty to obtain and maintain certain specified coverages. While there are different ways to accomplish that within the structure of a written contract, most of the recognizable form documents follow a simple structure. For purposes of this article we will consider these concepts within the framework used in the AIA A201 -2017 General Conditions. Article 11 § 11.1 of the A201 – 2017 sets out the general requirements for the contractor in with respect to the insurance policies and bonding required. Here is the specific language:

The Contractor shall purchase and maintain insurance of the types and limits of liability, containing the endorsements, and subject to the terms and conditions, as described in the Agreement or elsewhere in the Contract Documents. The Contractor shall purchase and maintain the required insurance from an insurance company or insurance companies lawfully authorized to issue insurance in the jurisdiction where the Project is located. The Owner, Architect, and Architect’s consultants shall be named as additional insureds under the Contractor’s commercial general liability policy or as otherwise described in the Contract Documents.

Note that this language does not specify policy type or policy limit. Rather, it recognizes that those particulars are set out elsewhere in the contract or contract documents, such as in, for example, AIA A103A Exhibit A – 2017.

The second provision attempts to prevent exposure to subrogation claims. In the context of insurance, a subrogation claim is a claim by an insurer to recover its losses incurred in paying a claim from the party, other than the insured, that caused the covered loss. Provisions requiring waivers of subrogation are the solution. In the A201, the requirement for waivers of subrogation is found in Article 11 § 11.3.1, which states that:

The Owner and Contractor waive all rights against (1) each other and any of their subcontractors, sub-subcontractors, agents, and employees, each of the other; (2) the Architect and Architect’s consultants; and (3) Separate Contractors, if any, and any of their subcontractors, sub-subcontractors, agents, and employees, for damages caused by fire, or other causes of loss, to the extent those losses are covered by property insurance required by the Agreement or other property insurance applicable to the Project, except such rights as they have to proceeds of such insurance. The Owner and Contractor, as appropriate, shall require similar written waivers in favor of the individuals and entities identified above from the Architect, Architect’s consultants, Separate Contractors, subcontractors, and sub-subcontractors. The policies of insurance purchased and maintained by each person or entity agreeing to waive claims pursuant to this section 11.3.1 shall not prohibit this waiver of subrogation. This waiver of subrogation shall be effective as to a person or entity (1) even though that person or entity would otherwise have a duty of indemnification, contractual or otherwise, (2) even though that person or entity did not pay the insurance premium directly or indirectly, or (3) whether or not the person or entity had an insurable interest in the damaged property.

This requires insurers to waive the right to subrogate. In doing so, the contracting parties can avoid the possibility of subrogation claims that not only expose them to potential liability to other project participants’ insurers.

In short, effective construction contracts not only transfer risk from the project participants to third-party insurers, but also prevents those same risks from resurfacing as a subrogation claim. To accomplish that requires well drafted construction contracts and strict adherence to the insurance specifications contained therein. Engaging qualified legal counsel and insurance brokers can be an effective and efficient way to avoid some of the costly mistakes that can occur when contractual risk transfer is not effectuated or structured properly.

Topics: Risk Management
Mark A. Rysberg

Written by Mark A. Rysberg

Mark Rysberg practices in the areas of construction law and commercial litigation. He represents construction industry clients involved in complex matters. He has tried cases in numerous state courts, state appellate courts, federal trial courts, federal bankruptcy courts, and federal appellate courts. Mark also assists contractors and business owners with pre-construction consulting relating to public and private contracting endeavors. He maintains an emphasis on minimizing risk by using sound contracting documents, utilizing best practices, and evaluating risk and the ability to transfer the same.