by William Reifsteck II, DBIA

How do you . . . manage risk for a design-build entity?

Summary: Among the many differences between design-build projects and design-bid-build projects is the insurance coverage. Of course, there are many similarities as well. In both instances, all parties have shared goals as well as individual concerns. Yet, because contractual relationships differ between these two broadly defined project-delivery approaches, so do the means of balancing risk.

“The first and most important suggestion to every owner is to select a broker for your insurance programs who is a specialist in your business. Dentists don’t do heart surgery.”

In the situation, for example, where the designer and constructor have separate contracts with the owner, if a problem arises there is a relatively clear distinction (if not resolution) between responsibility for a design flaw and mistakes in construction. Depending on the jurisdiction, though, there may be a statute of limitations on design errors and omission, which in turn may depend on when the flaw is discovered as opposed to when the building is substantially complete. For the constructor, on the other hand, there may be a guarantee that the building functions properly with a time limit of, say, a year.

What a complicated mess! It can get worse if you don’t know what you are doing. Here is an example:

The owner of a new school building in the Midwest has just come back from summer vacation and the students are exhibiting symptoms attributable to “sick building syndrome.” The design-build air-handling system renovation of two summers ago is a likely culprit, and the owner calls the design-builder to remedy this problem. Their first answer is: “It is not our problem and the building is already past the one year warranty.”

Several months pass. The school has hired several independent testing agencies, and it is determined that the heating and air conditioning system delivers inadequate air quantity and poor indoor air quality. It is found that the problem is because of a combination of factors, including improper air balancing at the completion of construction and inadequately sized ducts due to a computational error on the part of the mechanical engineer. All through this time, the parents of the students are threatening to sue the district as children become sick. The school board is advised by their lawyers to move the children out of the building to other facilities and temporary trailers. Costs are mounting. What do they do?

This is just one of the many different types of claims that I have seen over the last few years that arise out of the improper placement and purchase of insurance products. These types of problems are complicated and require that owners and design-build entities look for new and innovative ways to protect themselves from risks that only a decade or so ago were unfathomable. For everyone concerned, the typical or old ways of insuring design and construction errors and omissions might not be adequate for these types of projects that on the surface appear to be simple but in reality have very complicated ramifications.

Before we move into more detail, it is important to note that in the example above, which is the basis of the following discussion, the design-build entity was a constructor. The points raised here apply equally well to design-build entities controlled by the architect.

Professional liability checklist for design-builders
• Have its own errors and omissions insurance and layer it as excess over the architect’s E&O.
• Review the policy period and make sure it meets the project requirements.
• Make sure that you understand the extended reporting period rules.
• Make sure that you understand the claim notification procedures.
• Examine the terms and conditions of policy including key exclusions.
• Ask for the policy not just a certificate of insurance from your subcontractors and sub-consultants.

Select a specialist broker
The first and most important suggestion to every client I work with is to select a broker who is a specialist in the business at hand. The converse is most often evident in healthcare projects, for instance, where the person in charge of the procurement of the construction insurance is the same person who handles the medical malpractice insurance. I liken this to having a dentist doing heart surgery.

In the school project above, the design-builder, after spending $50,000 in legal costs out of pocket, compelled his mechanical design-build subcontractor to rebalance the system, costing $18,000. That work would not be covered by any insurance product as it is considered “defective work” and therefore excluded from the commercial general liability insurance.

The other problem, the inadequately sized ducts, was eventually addressed after several months of legal maneuvering and costs. The mechanical subcontractor needed to have his engineer resize the ducts. The mechanical subcontractor made a claim against the engineer’s errors and omissions insurance to compel the engineer to do this work. Since E&O is most often written on a “claims made” basis, the date the claim was made triggered the coverage. This engineer, at this point, already had another claim that predated this one amounting to $200,000 of the $500,000 limit of his policy. This means that there is only $300,000 left to handle the cost of this claim including legal expenses. The cost of the repair and associated legal, business interruption, and other impacts exceeded $1.2 million.

In this instance, a not atypical scenario, this engineer had less than $50,000 of retained earnings that could be seized to pay the remainder of the claim. The mechanical contractor and design-builder were on the hook for more than $900,000 for the error that was made by the engineer. In this case, the mechanical contractor also did not have adequate resources to pay the claim, so they were liquidated to pay the claims. This left the design-builder with an excess of $800,000 to pay out of pocket.

In addition to the above situation, claims were made for bodily injury exposure to contaminants (mold and Legionnaires’ disease) as well as loss of use and economic distress by the school district and the parents of the kids. The design-builder submitted the claims to its general liability insurer who immediately referred the design-builder to the exclusion page of their policy that excluded mold coverage.

This was news to the design-builder who thought the policy covered them for “all risk.” It even said “All Risks” on the policy. Even though the policy was written on an “All Risks” basis, the exclusion page stated that mold was not covered. Consequently, the design-builder was on the hook for all claims made as a result of mold. The insurance company, however, did pay the claims that were Legionnaires’ related as they were a result of bodily injury and property damage and not because of mold. In this case, the design-builder was left to solve $2.2 million in mold-related claims. This design-builder was unable to cover the $3 million costs and was forced to close its doors. If this design-builder had the right type of insurance, this need not have had to have happened.

This is not an isolated case. As more and more companies become involved in design-build delivery systems, they cannot rely on the simple insurance programs that served them in their general contracting days. Owners also need to be aware that there are significant gaps in the coverage that can also impact them.

Before undertaking design-build projects, follow these steps
• Review your risk needs with a certified construction risk consultant.
• Find a construction specialist broker.
• Visit IRMI.com for the latest in construction insurance information.
• Remember the Design-Build Difference: You are the single source of delivery and risk for the delivery of the project.

So how do we solve the above problem?
Firstly, the general liability insurance that the design-builder relies on needs to have modifications made to it. If a company is going to do design-build work, it should make sure that the policy has the means and methods rider (Insurance Services Office CG-2279) or the design-builder rider (CG-2280). This is an important part of any program to afford a proper level of protection that a standard contractor’s general liability (CGL) policy would not.

Additional insurance that should be considered by a design-builder is contractor’s pollution liability (CPL), including a fungus rider. This is a way that damages as a result of mold may be covered. An alternative to the CGL riders and CPL policies mentioned above is for the design-builder to purchase a separate contractor’s protective professional and indemnity (CPPI) policy. A CPPI policy can include both professional and pollution liability coverage in one policy as a means to protect the contractor. These options are very complicated and should be discussed with the design-builder’s broker prior to placement.

Another area that was complicated in the above school case was caused by improper placement of professional liability coverage (errors and omissions) insurance. Professional liability insurance is risk of liability to third parties for bodily injury and or property damages as well as economic loss caused by a negligent act, error, or omission in the performance of professional services. This policy provides legal defense costs up to the policy limit for legal fees arising out of a negligent act. Negligence is the key here. You have to prove negligence in order to “perfect” a claim.

The mistake I most often see is a design-builder who comes from a general contracting background relying only on the E&O of the architect. This was the case in the school above. In this case the error was made by the design-builder’s subcontractor’s engineer. Since the school district did not have a contract with the engineer, it will need to make a claim against the design-builder, the party with which the school district has contractual relations. The design-builder then makes a claim against the mechanical contractor that then makes a claim against the engineer’s professional liability insurance. The design-builder and the mechanical contractor are now in the middle and all costs in connection with this will be the responsibility of the design-builder even thought he or she was not at fault. Most design-builders are of the opinion that they are covered. They are not. Even worse, if the coverage left on the engineer’s policy is not adequate to pay the judgment, then the design-builder is left to pay the remainder out of operating expenses.

For that reason it is a best practice that the design-builder purchase its own CPPI insurance.

Finally, bonding is an area that is often misunderstood in design-build. What are bonds? Surety bonds are a credit instrument between the contractor and surety for the benefit of the owner. Surety bonds are not insurance, even though they are often sold by insurance brokers. In design-build, most often the surety bond that an owner needs, but often does not ask for, is a 100 percent performance bond that includes the design effort. All too often the design-builder will enter into a contract to provide design and construction services. The design-builder is responsible for providing 100 percent surety bonds to cover the entire contract. The design-builder then goes out and purchases surety bonds to cover the construction value of the contract and does not get a surety bond that covers the cost of the entire design-build contract. In this case, the design-builder is in default of its contract. This could cause all types of unintended consequences; too many to detail here. It is a best practice that the design-builder makes sure that it buys surety products that include the entire contract cost.