17 Insurance and bonds
One of the primary functions of a construction contract is to allocate certain risks to one or other of the parties. This may be done by providing that one party (X) shall be liable to the other (Y) if a particular kind of loss or damage occurs, thus placing the risk of that loss or damage on X. It occurs equally under a provision that X shall not be liable to Y for a particular kind of loss, since this effectively places the risk of that kind of loss on Y.
In view of the enormous size of some of these risks in financial terms, it is obvious that the party to whom a risk is allocated may want to cover it by means of insurance. What may not be so obvious, however, is that a party to whom a risk has not been allocated may still insist on insurance backing for that risk. This is simply because, while the contract may say for instance that the contractor shall be liable to the client for certain kinds of damage, the client’s right to sue the contractor will be of little use if the contractor cannot afford to pay any damages awarded. In such circumstances, the client will only be protected if the contractor has either ‘liability insurance’ or some ‘guarantee’ of performance.
In this Chapter we discuss briefly the legal principles on which insurance is based and the main types of construction insurance policy, illustrated by clauses from JCT SBC 11. We also consider professional indemnity insurance and the use of ‘bonds’ or ‘guarantees’ as a means of protection against contractual failure.
17.1INSURANCE
It is essential to understand that all insurance policies in the construction industry (including the professional indemnity insurances of consultants) fall into one of two categories. JCT SBC 11 contains examples from each category.
17.1.1Types of insurance
Under a liability insurance policy, an insurer undertakes that, if the insured person (the client) becomes legally liable to someone else (the ‘victim’), the insurer will indemnify the client against damages and legal costs which become payable. A familiar illustration of this type of policy is ‘third party’ insurance for a car driver. By contrast, under a loss insurance policy, the insured person is entitled to be compensated by the insurers for loss or damage which that person has suffered, whether this is caused accidentally or by someone else’s negligence. Such a policy may even provide cover in respect of loss or damage caused by the insured person’s own negligence, although this is sometimes excluded or restricted by
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special terms in the policy. A ‘comprehensive’ motor insurance policy is an example of this type of policy.
Liability insurance
Examples of liability insurance commonly found in the context of construction include public liability policies for contractors and professional indemnity policies for architects and other consultants. What must be clearly understood is that, where an insurance policy is of this kind, the insurer’s legal duty is owed to the client and not to the ‘victim’. Indeed, the insurer is in theory not responsible at all until the insured person has actually been held liable to the victim by a court or arbitrator. In practice, however, the insurer will normally be brought into the picture as soon as a legal action is started against the client. Indeed, if the action is thought worth defending, the insurer may take over the actual conduct of the case.
The fact that liability insurance is seen as something that affects only the insurer and the client places severe restrictions upon the protection it offers to victims. An important limitation was exposed by the case of Normid Housing Association Ltd v Ralphs,1 where the claimants brought a professional negligence claim against the defendant architect for an amount of money far greater than the limits of the defendant’s professional indemnity insurance policy. The wording of this policy was in fact not entirely clear as to the maximum the insurers could be made to pay, and the defendant agreed with the insurers to accept £250,000 in full settlement of all claims on the policy. (It should be pointed out that the defendant had no great interest in attempting to make the insurers pay more than this, since the excess, which he would be personally liable to pay to the claimants, was enough to render him bankrupt.) The claimants, who felt that the insurers could have been made to pay more, attempted to have this settlement agreement overturned, but their attempt failed. The Court of Appeal held that, since the defendant was under no legal duty to have liability insurance at all, any genuine settlement of the claim was a matter for the defendants and their insurers. The claimants had no rights whatever to intervene, unless they could establish that the settlement agreement between the defendant and the insurers had been reached in bad faith.
Had the defendant in this case actually been made bankrupt before settling with the insurers, the claimants could have utilized a procedure laid down by section 1(1) of the Third Parties (Rights Against Insurers) Act 1930. This provides that, where a person or company with liability insurance becomes insolvent, any claim the insured person could have made against the insurers is automatically transferred to the victim. As a result, the claimants here could have refused to settle with the insurers as the defendant had done, and could have instead sued the insurers for the higher amount they claimed was due under the policy.
Although the 1930 Act improves the position of victims, it is still subject to strict limits, as was demonstrated in the case of Bradley v Eagle Star Insurance Co Ltd.2 The House of Lords ruled in that case that the 1930 Act only transfers to a claimant those rights which the insured person already had against the insurers, and
1 (1988) 43 BLR 18.
2 [1989] 1 All ER 961.
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pointed out that these do not arise until the insured person has been held liable to the claimant. As a result, unless a successful claim is made against a company while it still exists (or at least while it can still be restored to the Companies’ Register), the victim cannot take action against the company’s liability insurers.
The Bradley decision carries an important implication, albeit on a point which did not arise in the case itself. It is that any defence an insurer would have against the client is equally available against a victim who takes over the client’s rights by virtue of the 1930 Act. Thus, for example, where a person who has become bankrupt has failed to comply with some condition of his or her liability insurance policy (for example by failing to give notice of claims within a specified time), the insurers will be entitled to refuse payment to a victim, just as they could have refused to pay the client.
Loss insurance
As mentioned above, a loss insurance policy provides cover, not for a person’s legal liability to others, but for losses which fall directly upon that person. In the construction field, such cover is required by a client on whom the contract places the risk of damage to the contract works or the existing structures.
There is an important general principle of the law governing loss insurance which is called subrogation. Under this principle, where a loss insurer pays the client in respect of a loss that has been caused by someone else’s default (such as a breach of contract or a tort), the insurer is then entitled to take over any legal rights that the insured person could have exercised against the third party responsible. In such a way the insurer will seek, by suing in the client’s name, to recover from that third party the amount that has been paid out to the client.
However, it must be stressed that there is no right of subrogation against any person who is also insured under the same ‘loss insurance’ policy. This is why many building contracts provide that any loss insurance policies which the contract requires are taken out in the joint names of the client and the contractor, and sometimes also of any sub-contractors. The legal effect of such a practice is shown by the case of Petrofina (UK) Ltd v Magnaload Ltd,3 in which a contractors’ all risks policy taken out in respect of an extension to an oil refinery defined the insured persons as including the employer, contractors and/or sub-contractors. The contract works were extensively damaged due to the negligence of sub-contractors engaged to lift heavy equipment, whereupon the insurers duly paid the owners. It was held that the insurers were not then entitled to recover their loss from the subcontractors under the doctrine of subrogation.
17.1.2Claims under insurance policies
Where an event occurs, a claim is made against the policy. As with any other form of contract, it is necessary to ensure that the claim made falls within and is, therefore, covered by the policy.
3 [1984] QB 127.
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Even where an event, such as a fire, falls within the policy, there may be disputes as to whether the fire caused the loss. For example in Trebor Bassett Holdings Ltd and The Cadbury UK Partnership v ADT Fire and Security plc4 a claim for £100m was made following a fire at a popcorn factory. Issues arose as to whether the fire caused all of the loss or whether some or all loss was was caused by the property owner’s own contributory negligence.
Typically, the insurance policy will define carefully what events are covered by the policy with the consequence that events falling outside that definition will not be covered. A limit on the amount recoverable is generally set out, as are the procedures and time period within which a claim must be made. In one case a contractor’s policy required claims to be brought by the insured within nine months of an event. A claim was made more than nine months after a fire and the claim was initially declined. However, it was held that, until the amount of liability with the insured’s sub-contractor had been ascertained, the policy could not be activated by the insured and, therefore, the nine-month period only started to run once the main contractor had settled with the sub-contractor.5
As noted above, the extent of coverage under a policy will depend upon the policy amounts, limits, definition of risk events and procedures for making claims. Both employer and contractor will have an interest in ensuring that the insurance policies held as required and that the policy cover is adequate. Construction contracts contain detailed provisions setting out insurance requirements. Some specialist insurers maintain policies for work under specific contract forms.
17.1.3Professional indemnity insurance
The various professional members of a design and construction team, such as the architect, specialist engineers and quantity surveyor, will each have their own insurance policy to indemnify them against liability for professional negligence. Such policies, which are often taken out as part of a scheme run by the relevant professional body, will of course vary greatly, but a few general points are nonetheless worth bearing in mind.
The terms of appointment of the professional may be under an agreement with the employer or with the contractor in the case of a design-and-build project. The terms will typically contain the minimum insurance cover that the professional is to hold as well as specific terms relevant to the type of claims that might be made under the policy. There may be terms relating to the form of policy anticipated.
A contractor, at least one who does not specialize in ‘design and build’ work, may well not have insurance cover of this kind; indeed, any limited company may find such insurance difficult or impossible to obtain. As a result, the client may have less insurance protection in respect of a contractor’s design input than under a conventional set-up in which design is carried out by professional consultants.
4 [2011] EWHC 1936 (TCC).
5 William McIlroy (Swindon) Ltd v Quinn Insurance Ltd [2011] EWCA Civ 825.
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The cover provided by most professional indemnity insurance policies is subject to financial limits and, once those limits are exceeded, the professional’s own money is at stake. And, of course, once that money is exhausted, the loss inevitably falls on the client.
Professional consultants are normally required by their institutions to take out and maintain a specified level of indemnity insurance. However, while failure to do so would be a breach of the professional’s code of conduct, it would not usually be a breach of contract with the client. This is because very few of the standard terms under which professionals are engaged in the construction industry (Section 2.2) contain any requirement to take out or maintain professional indemnity insurance (notable exceptions are the standard RICS terms). Indeed, even where they do, the client’s only remedy for failure to insure would presumably be to claim damages, which, presumably, the uninsured professional would be unable to pay. In any event, as we noted at the beginning of this Chapter, a liability insurance policy of this kind is a contract between the insured and the insurer; the client has only very limited direct protection.
Standard professional indemnity policies cover the insured against liability for professional negligence, but there are considerable doubts as to whether they extend to other forms of liability. Thus, if an architect is held to have guaranteed the suitability of a design, rather than merely undertaking that reasonable skill and care has been used, any resulting liability might well not be covered. Indeed, many policies specifically exclude liabilities that the professional voluntarily assumes by way of such guarantees. As we shall see in Chapter 21, such considerations have caused major problems in the context of ‘collateral warranties’.
It is worth noting that most professional indemnity policies consist of a series of annual contracts written on a claims-made basis. This means that they cover claims actually made against the professional person during the period of insurance, regardless of when the negligent act took place. As a result, it is essential that insurance cover is maintained, even after the retirement or death of the professional concerned, and this can usually be arranged on a single-premium ‘run-off’ basis.
One might assume that the benefit of cover on a ‘claims made’ basis is that one is protected in respect of acts of negligence committed before the policy is taken out. However, while this is, broadly speaking, true, what should not be overlooked is that a person who seeks insurance has a legal duty to disclose all ‘material facts’ to the insurer. As a result, a professional who, on taking out a new policy or renewing an old one, fails to reveal to the insurers that a claim is pending, may find, when a quite separate claim arises at a later date, that the policy is voidable and that the insurers are under no obligation to pay.
Under JCT SBC 11 at clause 6.12, the contractor is obliged, if it is not already in place, to enter into a professional indemnity policy in respect of contractordesigned work, where the CDP option is used. Details of the policy amounts and limits must comply with requirements in the contract particulars. Documentary evidence that the policy is being maintained must be provided on request.
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17.1.4Construction insurance under JCT SBC 11
The general scheme of the insurance provisions of JCT SBC 11 operates in two stages. First, it allocates as between client and contractor the risk of various kinds of loss or damage, which may arise in the course of building work. It then imposes responsibility for insuring against those risks.
Personal injury and damage to property
Where risks to third parties are concerned, the crucial provisions are clauses 6.1 and 6.2, under which the contractor undertakes to indemnify the employer against certain kinds of liability ‘arising out of or in the course of or by reason of the carrying out of the works’. In particular, this indemnity applies under clause 6.1 to any liability the employer incurs (for example in the capacity of occupier of the premises) for injury to or death of any person. However, the contractor need not indemnify the employer to the extent that the latter’s liability is due to any act or neglect of the employer or of any person for whom the employer is responsible.
As to the persons whose ‘act or neglect’ can be attributed to the employer for this purpose, these clearly include members of the employer’s staff, any direct contractors on the site and (probably) the contract administrator. However, they do not include any sub-contractor, whether domestic or nominated. This means that where a person is injured or killed through a sub-contractor’s negligence, any resulting legal liability for the employer may be passed on to the main contractor.
The contractor’s duty to indemnify the employer also covers, under clause 6.2, damage to property, but in this instance only to the extent that the damage is due to negligence, breach of statutory duty, omission or default by the contractor or by someone for whom the contractor is responsible. In this context, the contractor bears responsibility for the conduct of anyone properly on the site in connection with the works, except for those persons who are the employer’s responsibility (presumably the same as those falling within clause 6.1).
An earlier version of what is now clause 6.2 did not make clear whether the contractor’s obligation was merely to indemnify the employer against any claims made by third parties whose property was damaged, or whether it also covered damage to the employer’s own property (including the contract works). However, the current version expressly provides that the only parts of the contract works included in clause 6.2 are those in respect of which a certificate of practical completion has been issued or which have been taken over by the employer. The remaining parts fall instead under insurance option C, found in Schedule 3 of JCT SBC 11, which is discussed below.
As for other property of the employer, a distinction must be drawn between existing structures (in the case of a contract for extension or refurbishment work) and property which is completely separate from the contract. Damage to such independent property clearly falls within the contractor’s obligation to indemnify the employer. However, in relation to the existing structures, it appears from insurance option C that the contractor will not be liable for causing these to be damaged by a ‘specified peril’ (defined in clause 6.8 to include such things as fire, explosion, flood, burst pipes etc.). However, the contractor will be liable for
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negligently causing or permitting such property to be damaged in other ways, such as by impact, subsidence, theft or vandalism.
Duty to insure
Clauses 6.1 to 6.3 of JCT SBC 11 define the scope of the contractor’s responsibility to the employer for causing personal injury or damage to property. Clause 6.4 then provides that the contractor shall take out and maintain certain insurance policies, which will for the most part cover these forms of liability. In the case of damage to property, cover is to be at a financial level imposed by the employer by means of an entry in the Contract Particulars. In practice, this obligation will normally be satisfied by a combination of the contractor’s ‘public liability’ and ‘employer’s liability’ policies, although the ‘third party’ section of the contractor’s motor insurance policy may also be relevant in appropriate cases.
To protect the employer’s position in respect of these insurances, clause 6.4.2 requires the contractor on demand to provide evidence that the policies are in force and that they provide the necessary cover. If this is discovered not to be the case, then the employer is empowered to take out personal insurance against any liability or expense that may be incurred and to charge the premiums to the contractor.
A loophole in the protection effected by similar clauses in an earlier version of the JCT form of contract was discovered in the case of Gold v Patman & Fotheringham Ltd.6 The employer was there held strictly liable in nuisance to the owner of neighbouring property, for damage to that property due to subsidence caused by the works. However, the contractor had not been guilty of any negligence and was therefore not bound to indemnify the employer. To deal with the result of this case, JCT SBC 11 clause 6.5 now permits the contract administrator in certain circumstances to instruct the contractor to take out and maintain an additional joint names policy. This policy will indemnify the employer both against strict liability to third parties and against any damage to the employer’s own property (other than the contract works and materials on site) resulting from collapse, subsidence, heave, vibration, withdrawal of support, lowering of ground water and similar causes. It should be noted that this policy can only be called for where the Contract Particulars so state; further, although it is the contractor’s responsibility to take out and maintain the policy, it is to be done at the employer’s expense.
Insurance of contract works in new buildings
If there were no specific contractual provisions on the matter, and assuming that there had been no negligence by either employer or contractor, the risk of damage to the contract works would lie on the contractor. This is because it is the contractor’s basic obligation to complete the job. On this basis it was held in
Charon (Finchley) Ltd v Singer Sewing Machine Ltd 7 that, where the works were damaged by vandalism, the contractor’s duty of substantial performance of the
6 [1958] 2 All ER 497.
7 (1968) 207 EG 140.
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contract included everything that was necessary to restore the works to the contractual standard.
This basic legal position is substantially altered by JCT SBC 11 clauses 6.7– 6.10 and Schedule 3. These clauses are extremely complicated, but an important key to understanding them lies in the distinction that they maintain between two classes of insurable risk. On one hand are the ‘Specified Perils’, a list of catastrophes which includes damage from fire, lightning, explosion, storm, tempest, flood, burst water pipes, earthquake, aircraft and riot. On the other hand is ‘All Risks Insurance’, which covers ‘any physical loss or damage to work executed and site materials’, subject to some specific exceptions such as wear and tear, design defects, radioactivity or other nuclear-linked damage, sonic booms or terrorist action. This is not the place for a detailed comparison of the two lists, but ‘All Risks’ is clearly much wider than ‘Specified Perils’ and includes for example such causes of damage as impact, subsidence, theft and vandalism.
Where the contract in question is concerned with the erection of a new building, JCT SBC 11 offers a choice of two alternative clauses. These place the responsibility for taking out ‘All Risks Insurance’ in joint names on either the contractor (insurance option A) or the employer (insurance option B). Such insurance must be maintained until the issue of the Practical Completion Certificate. Whichever of these choices is adopted, it is provided by clause 6.9 that the party taking out the insurance must see to it that all sub-contractors are protected from any ‘comeback’ action by the insurers. However, it is important to note that this protection for sub-contractors extends only to damage which results from a ‘Specified Peril’.
Under the Private editions of JCT SBC 11, any failure by either party to maintain the required insurance cover will entitle the other party to insure and charge the cost to the defaulter. In the Local Authorities editions, this remedy is available only to the employer. It is however specifically provided that the contractor may fulfil this obligation by maintaining a suitable annual policy to which the names of the employer and the sub-contractors can be added.
A significant difference between insurance options A and B lies in their treatment of any repair or restoration work which may be necessary and which it is the contractor’s obligation to carry out. Where the contractor has insured, payment by the employer for this work will not exceed what is received from the insurer; by contrast, where the employer has insured, the contractor’s work will be valued as if it were brought about by a variation under clause 5.1. The effect is that, if insufficient insurance cover has been taken out, the resulting loss will be borne by the party responsible for that under-insurance.
Insurance of existing buildings and of contract works in them
Where the contract works consist of alterations to or the extension of existing structures, neither of the above options should be used. The appropriate provision is option C, which effectively requires the employer to take out and maintain (until the issue of the Practical Completion Certificate) insurance to cover damage to both the contract works and the existing structures. In so far as it applies to the contract works, this provision broadly follows option B; it is for the employer to insure in joint names on an ‘All Risks’ basis, and to see that all sub-contractors are
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protected. However, in relation to the existing structures, option C differs from option B in two important respects: first, the employer need insure only against the ‘Specified Perils’, rather than against ‘All Risks’; and, second, there is no obligation to protect sub-contractors against any ‘comeback’ claims by the insurers.
A further feature of option C is the provision that, where damage is caused to the contract works by an insured risk, either party may terminate the contractor’s employment if it would be ‘just and equitable’ to do so. This provision, which is only intended to be used in cases of very serious damage or destruction, is discussed in Chapter 22.
Effect of insurance on liability of contractor
Where a contractor or sub-contractor negligently causes damage (either to the contract works or to existing structures) of a kind which falls within the insurance policies described above, the insurance provisions discussed above may have a significant effect on their liability. In Co-operative Retail Services Ltd v Taylor Young Partnership,8 a disastrous fire in a partly constructed office block was assumed for the purposes of the case to have been caused by the combined negligence of the architects, consulting engineers, main contractor and electrical sub-contractor. When the employer sued the architects and consulting engineers for negligence, these defendants sought contribution (under the Civil Liability (Contribution) Act 1978) from the contractor and sub-contractor, on the ground that they would also, if sued by the employer, have been liable for the same damage. This claim was rejected by the House of Lords, who held that, since the contractor and sub-contractor were covered by a ‘joint names’ insurance policy taken out in accordance with the predecessor of option A, they could not have been made liable for the damage in question.
The effect of this principle on the liability of a sub-contractor is considered further in Section 19.5.1.
17.1.5Construction insurance under NEC3
The NEC3 ECC form’s clauses relating to insurance are Core Clauses 80 to 87 and optional clauses X15 and X18. Project-specific data relevant to these clauses is added by the parties in part 1 of the contract data. The arrangement of these provisions differs from those in JCT contracts and contains a number of innovations.
Clauses 80 and 81 identify the risks that are carried by the employer and contractor. The risks to be insured by the contractor are stated as being all those risks not carried by the employer. The employer’s risks are listed as:
Claims arising from the employer’s use of the site.
Negligence or fault by the employer or its persons, other than the contractor.
8 [2002] 1 WLR 1419.
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Loss or damage to the works due to the usual excluded risks of war, strikes, radioactive contamination and the like.
Loss or damage of employer-supplied materials and plant until transferred to the contractor or taken back on completion by the employer.
Additional risks as listed in the contract data.
An insurance table at clause 84.2 lists the type of insurance required as loss of or damage to the works, loss of or damage to equipment, liability for damage or injury to third parties and liability for death or injury to the contractor’s employees. The coverage required against each of these is also stated. The overriding provision, at clauses 81.1 and 84.1 is that the contractor provides all insurances in accordance with this table, except any that the employer is supplying, as specified in the contract data. Interestingly, there is also a provision that the contractor may insure a risk for which the employer has not secured a policy as required, and the cost of that insurance is paid by the employer. It is notable in these provisions that insurance covering contractor’s design is not treated separately.
The contractor has design liability for defects in any design work it carries out. Optional clause X15 limits this to reasonable skill and care. In practice this is an important provision because the contractor might otherwise be liable to provide a design that is fit for purpose. It may only be possible to secure professional indemnity insurance covering reasonable skill and care. Wherever a contractor is to provide some design it would be expected that clause X15 also applies. Under optional clause X18 the contractor’s liability to the employer can be limited to amounts stated in the Contract Data.
17.1.6Construction insurance under FIDIC (1999 Red Book)
Under clause 18, provision is made for several types of insurance. This follows the conventional JCT and old ICE provisions. It includes requirements for the contractor to maintain insurance of the works including the contractor’s equipment and insurance against injury to third party property and persons. There is a clear explanation as to what risks are to be insured. Although insurance is arranged by the contractor, and is to be in the joint names of the employer and contractor so that either might make a claim under the policy, the employer must approve the policy. This is, perhaps, a safeguard to ensure that adequate cover is available.
Interestingly, in a provision not seen in UK standard forms, there is also provision to insure contractor’s personnel against personal injury, sickness and death. The contractor must also indemnify the employer and engineer in respect of any such claims unless due to neglect on the part of the employer or engineer. This insurance is, therefore, in large measure for the employer’s benefit to manage potential liability arising on projects often carried out in remote or hazardous areas. The insurance also reflects a legal requirement in many countries to provide insurance for staff.