Q. Why are contractors limiting their liability under contract?
A. From a principal contractor’s perspective, the profile of a contract may not be acceptable where they are obliged to accept open-ended liability for certain risks. Prudent contractors make informed decisions on the relative risks and rewards of each contract, and if the risks outweigh the rewards they may decide against tendering the contract at all. However, by applying a limitation of liability, it may be possible for the contracting parties to achieve a more reasonable risk / reward equilibrium.
A good example is a contract involving a single floor fit-out of a multi storey commercial building. In the absence of a limitation of liability (or risk transfer – a point we discuss later), the contractor could be exposed to potentially significant risks associated with damage to the existing structure - not to mention consequential losses from the tenants. In these circumstances the limited rewards, i.e. the contract value, do not correlate to the substantial risks, and the contractor may be unwilling to tender for this contract without some form of liability cap.
A limitation of liability can be applied to defined risks in isolation, (for example the employers consequential / indirect losses, design defects, employers property), or as a cap on the contractor’s overall liability arising from the contract. They often take the form of a monetary limitation; a defined figure or percentage of contract value, but can also be time related, e.g. indirect losses arising from first 14 days of non-availability.
I should point out however that it is not legally permissible to limit certain risks under contract, examples being personal injury caused by negligence and statutory fines / penalties.
Q. What impact does this have on the employer?
A. If an employer accepts a cap on the main contractors’ liability, then in the event of a loss they would have no right to seek indemnification from their supply chain in excess of that limitation.
As such, the employer should carefully consider how they manage these risks, with two principal options available to them;
i. Retain – in other words, they can accept the risk of loss against their balance sheet, or maintain a fund from which the loss will be financed
ii. Transfer - they can transfer the risk through insurance or an alternative mechanism.
Q. How does this impact on the insurance policy?
A. As far as the contractor is concerned, application of a limitation of liability provides certainty over the maximum loss which they can sustain. This has the potential to influence their insurance procurement strategy, in other words, if they rigidly apply a GBP10m limitation of liability on their design liabilities under all contracts, they may consider that this is the maximum Professional Liability (PI) limit which they need to maintain.
A limit of liability should also shape the employer’s insurance purchasing decision, and one of these considerations is whether the employer or contractor is responsible for procuring insurances. In circumstances where the employer accepts a greater level or broader range of risks than the contractor (as will be the case where a liability cap applies), and these risks are insurable, then it is logical for the employer to retain this responsibility. It may also influence the employer’s decision making in terms of the types and limits of insurance policies required.
To consider this further, I return to the example of a low-value fit out in a significant existing structure. Let’s suppose that the Contractor has successfully negotiated a GBP1m liability cap for damage to the employer’s property. This means that the contractor is largely protected against the substantial risk of damage to the existing structure – great news for their Third Party Liability insurers. What does this mean for the employer though? As they carry the risk of loss, I would expect the Employer to take on responsibility for insuring the existing structure, i.e. the contract specifies an Owner Controlled Insurance Programme (OCIP). They will also need to take a decision on the most effective means of covering the structure; with the options being:
i. Extension of the owners Material Damage policy
ii. Project specific Third Party Liability insurance
iii. Inclusion of existing structures as insured property under a Construction All Risks policy.
Q. What insurance policies can employers put in place to mitigate their exposure?
A. There is actually a raft of different exposures which could fall to the employer as a result of the contractor limiting their liability under contract; some of these are insurable and some are not.
Where the employer looks to the insurance market to cover these liabilities, they may consider a number of different policies. In addition to those which we have already highlighted, employers may consider the following;
Latent Defects Insurance (LDI)
This policy provides indemnity for post-completion physical damage arising from inherent defects. It would provide valuable cover where the contractor has limited their liability for design defects, and this proves to be the cause of the damage.
Delay In Start Up Insurance (DSU)
DSU insurance indemnifies the employer for lost revenue in the event that the project is delayed by physical damage during construction. The employer may consider this insurance where the contractor limits their liability for consequential losses suffered by the employer.
Single Project Professional Indemnity insurance (SPPI)
In the event that the contractor limits their liability for design to a defined monetary limit, employers may consider procuring PI cover to protect themselves from losses arising from the professional activities of the whole supply chain including principal contractor, designers, engineers and architects.
Q. Will contractors continue to apply caps on liability in the future?
A. Contractors operate on notoriously tight margins, and one underperforming contract can eliminate the profits earned on multiple well-executed projects. Recent history has seen the industry sustain some high profile casualties which serve to demonstrate this point; Carillion being the most obvious example.
The days of securing turnover at all costs are well and truly over, and contractors are now exercising far greater caution when making bid/no bid decisions. Increased awareness and scrutiny of the contract terms and conditions is an inevitable by-product.
Alongside this, the construction insurance market has been hardening over recent months (most notably in relation to PI insurance). In a sellers’ market, underwriters can afford to be selective in the risks which they write, and we see this leading to a renewed focus on contractors’ corporate governance.
For these reasons, I believe that the application of appropriate liability caps will continue to form a key aspect of the contractors’ contractual risk management strategy.
