This version of INDECS Insight

reviews the basic objectives of indemnity and insurance clauses in major construction contracts;
considers the traditional approaches for allocating the risk of loss or damage to property in the course of construction;
analyses the advantages and disadvantages of the traditional risk allocation; and
considers the recent trend towards principals providing indemnities to contractors as an alternative to market Construction All Risks (CAR) insurances.

Indemnities as a tool for risk allocation

Indemnity clauses in contracts are an efficient way of allocating risks arising from work performed under a contract. Each party agrees to indemnify the other, should a party incur expense arising from a risk which the first party has agreed to accept during the provision of the service or work. Contracts cannot change the laws that determine liability; however risk can be allocated by means of the contracting parties agreeing to exclude their liability to each other and indemnify each other for the financial cost of claims, irrespective of negligence or where primary legal liability might fall.

The process of allocating risks imposes financial obligations on the parties and so indemnity clauses are usually accompanied by insurance clauses, which embed an obligation to provide insurance which is intended to ensure that there is financial wherewithal to meet the indemnity obligations.

As a matter of practice, risk allocation should not be designed to adapt itself to the parties’ insurance arrangements. Risk allocation should be agreed on a fair and transparent basis, and appropriate insurances should be arranged to support the agreed risk allocation.
Loss or damage to property in the course of construction

Traditional contracting approaches in major EPC lump sum contracts generally follow the principle that the contractor has risk of loss or damage to the property in the course of construction, until handover of the project. In order to manage and finance this risk however, the principal (and sometimes the contractor) undertakes to conclude a comprehensive CAR insurance policy in the insurance market for the full period of the project, covering all parties undertaking work on the project. In essence this insurance covers loss or damage to property in the course of construction, and the premium is paid by the principal since the property at risk is the principal’s investment. Such coverage is of considerable importance to contractors and they are keen to secure as much information as possible about the insurance. It is deemed good practice for principals to provide copies of the policy wording to the contractor but not the commercial terms or any Delay in Start Up elements.
Traditional CAR insurance for loss or damage to property in the course of construction

The advantages of the traditional approach can be summarised as follows:

Insurers provide a disinterested source of third party finance for major property damage risks.
Insurers also provide risk engineering and warranty surveyor support and risk management input with the aim of reducing the project’s cost of risk.
Conditions and warranties in the insurance, ensure that the insured parties understand the project risks and how they may be mitigated.
Insurers generally agree to provide interim funding for large covered claims as repair expenditure is undertaken.

The shortcomings of this approach may be summarised as follows:

Whilst the insurance is comprehensive in nature, there are some key risks which are not insured, such as faulty design, corrosion, bad welding.
Over the years the coverage generally available has reduced.
Insurance policies contain some rigorous Quality Assurance and Quality Control and due diligence provisions, failure to comply with which may reduce or eliminate cover available.

Principal Indemnities

Over the past few years we have seen the development of a variant to this approach in major construction contracts. The contractor continues to accept liability for loss or damage to property in the course of construction, however instead of providing commercial insurance to finance the risk, the principal provides a simple indemnity to the contractor. The advantages of such a solution are as follows:

Where this indemnity is provided by a financially strong principal, it may be deemed to be as valuable as insurance if not more so.
There are no insurance policy exclusions or conditions.
There are no due diligence or warranty obligations.
Other insurance complexities such as deductibles, limits and insurer security are not encountered.

Whilst this is a simple and elegant solution, it does have some shortcomings. These may be summarised as follows:

Principals often do not make financial provision for the indemnity and project managers do not have a ready budget to reimburse claims.
Principals often do not have the loss adjusters’ skill in investigating and moderating claim settlements.
There is a tendency for principals to consider claims for damage as just another contractual claim which is bundled together with other claims for resolution at the end of the project.
A principal’s willingness to settle the indemnity may be adversely affected by perceptions of contractor poor performance.
Principals may not be as willing as insurers to consider interim funding of claims.

Conclusion

It is recognised that companies and contractors have particular strategies with regard to indemnities and insurance, nevertheless we would counsel caution when principals or contractors consider provision or acceptance of an indemnity as an alternative to insurance for the risk of damage to property in the course of construction. In particular, contractors may not value the indemnity as much as a principal may think, and may insist on insurance because of its independent perspective on claims. Furthermore contractors may transact such insurance in addition to the indemnity, and principals may end up paying for this in unspecified overheads. Should any of our clients require support in structuring effective risk allocation strategies or advice on particular contract negotiations, INDECS would be happy to provide assistance.