Professional Liability and a Progressive Approach

As the popularity of design-build contracts has grown in recent years, so has the professional liability exposure of contractors and other construction-related firms that agree to the arrangements.

These types of contracts, under which the contractor is responsible for both design and the construction, have resulted in a sharp increase in claims for builders and designers. And, while some contractors may believe that subcontracting project design to a third-party eliminates the exposure, the truth is that hold-harmless agreements with those firms may not provide adequate protection. In addition, cost overruns have become an issue on design-build projects that were bid at outdated or unrealistic prices. That’s partly because the traditional cost recovery options in design-bid projects are unavailable in design-build work.

In what has been traditionally referred to as fast-track design-build, locking in the lump sum or guaranteed maximum price of a project happens when the design documents are about 30% complete, meaning the contract is signed with a fixed price before the project is designed enough to accurately estimate the cost of large ticket items such as concrete, steel and earthwork.

Such an approach comes with a typical deviation in costs of around 20%, even if everything is well-planned. On a 1 billion project, that could amount to 200 million or more.

On well-executed design-bid-build projects that are budgeted when documents are 100% complete, the deviation shrinks to around 5%, or 50 million on a $1 billion project. Still a lot of money, but an illustration of the enormous risk that comes with starting a project before costs can be fully estimated.

“This was the biggest issue impacting design-build and professional liability claims,” says Michael Davis, Head of Construction Professional Liability. “On large, expensive bid packages, there simply wasn’t enough information with 30% of design development to create accurate estimates,” he adds.

Compounded with inflation and supply chain interruptions, these circumstances created a “real recipe for disaster,” Davis notes.

An approach called progressive design-build is partially addressing this issue that has led to increased professional liability claims. “Since the total cost of a fast-track design-build, lump sum, or guaranteed maximum price project is often fixed very early in the development of the design,” Davis explains, “the potential for large cost overruns is significantly increased, while the contractor’s ability to complete needed change orders under traditional bid-build delivery methods is limited. The progressive design build is a two-stage approach that gives owners and contractors an alternative if they fail to agree to terms and final pricing after the design is further developed, but still not complete.”

A progressive design-build arrangement is a single contract executed in two phases. Phase one involves much of the design as well as some preconstruction. Because a typical project’s design fees are much smaller than the construction values, and the design comprises most of the professional liability exposure, the premium for phase one appears disproportionately large compared to the percentage of total construction values for phase one. While that may look odd, the actual premium for phase one typically appears very reasonable when compared to the cost of a project-specific designers’ professional liability for the same risk.

It is expected that before the project moves to the second phase, a maximum guaranteed price will be locked in, as the design will be further developed at this point. This is where the insurer can typically provide a premium cost to extend the policy to cover phase two.

“If the owner and contractor do not agree on the guaranteed maximum price for phase two, or there is a break in the relationship and the owner wants a new contractor, there is an ‘off ramp’ in the contract that allows for such issues,” Davis explains “The professional liability coverage written primarily for the design and preconstruction phase will have to be adjusted according to negotiated details in the contracts, or the coverage can be replaced.”

Progressive design-build has gained attention because it is expected to reduce the severity and frequency of cost overruns that have multiplied losses, particularly, but not solely, in infrastructure projects such as roads and highways. While it’s not a complete cure, it should help reduce claims, Davis says.

Insurance coverage for construction and design professional liability risks, like that for many other liability lines, is experiencing challenging market conditions that are unlikely to soon change.

“There is a market for project-specific design professional liability coverage, but it’s very expensive and capacity is greatly reduced,” Davis says. “That has driven construction firms towards other project-specific solutions such as the Contractor’s Protective Professional Indemnity (CPPI) policy offered by Zurich.”

Still, very few insurers are deploying their maximum capacity, “which in turn makes pricing more expensive”, he adds, “the market isn’t expected to soften any time soon. In the broader professional liability market, there are a lot of small MGAs coming in, but not necessarily into construction areas. Things are not expected to change in the foreseeable future,” he notes.

While claims severity is up, the frequency of large claims, from Zurich’s perspective, has seemed to moderate from where it was a few years ago. According to Davis it’s unclear how long that will be the case, or whether that is reflective of the broader market.

The contractor’s market is still “quietly hardening,” Davis says. “Rate increases are rarely severe,” he adds, “but there is a tightening of terms and conditions and insurers are cautious about the limits they will offer.”

“Retentions are increasing, which makes sense because the scale of projects is a huge driver of risk,” Davis says.

Even projects considered moderate risks can still have significant exposures and meaningful losses. There are long-standing construction defect concerns that remain stubborn exposures for the industry. “Among them, designing and building waterproof structures continues to be a challenge,” Davis says. “Building envelope defect concerns are partly the reason condominium risks are difficult to insure. Additionally, building foundation settlement can become a major issue,” Davis points out. “These are expensive costs that lead to large claims.”

Beyond traditional four walls construction, conventional power generation has always been challenging from a professional liability viewpoint. “On the other hand,” Davis says, “renewable, sustainable power was challenging 10 years ago when it was early in its development and launch into the market, but projects like solar farms may be a more palatable risk as contractors have gained experience in the design, installation and weather-related exposures that are unique to those risks.”

Managing construction risks begins in the cost-estimating room. Mistakes here can have long-term and serious consequences.

The goal for any project is to have a team in place that understands the risk and how to complete a project at the agreed-upon price. From there, it’s about getting reasonable contractual protections, including a mutual waiver of consequential damages, a very clearly defined scope of services to help prevent misunderstood responsibility allocation, and fair indemnification language, among others.

“A well-executed contract is fantastic protection,” Davis says “But a difficult project does not become less difficult because there’s a strong contract in place. It is critical to understand the project’s challenges and the owner’s expectations,” he adds. “Be aware that agencies that may not be parties to the contract may have approval authority required to proceed, influencing scheduling and permitting. This is particularly true in infrastructure projects.”

While these are some of the most important considerations for construction firm’s design exposures, it’s certainly not a comprehensive list. A well-rounded insurance program remains a crucial component to any risk management solution for professional liability exposures, necessitating a strong relationship with your professional liability insurance broker and provider.