July 25, 2012
Construction Defects: A Primer For Construction Financial Managers
Until recently, Construction Financial Managers outside the homebuilding sector may not have heard of or thought much about construction defects. However, these defects are now an industry-wide issue.
The construction industry's reputation has been tarnished by poor quality performance. Construction defects decrease the satisfaction of property owners and erode the confidence of the financiers, buyers, and end users of construction projects.
Total construction costs are increased by lost productivity, and higher rework and insurance costs. Defective construction undermines the reputations of affected contractors and threatens their profitability.
Until recently, Construction Financial Managers outside the homebuilding sector may not have heard of or thought much about construction defects. However, these defects are now an industry-wide issue.
Likewise, while formerly concentrated in the western states, construction defects are now a national concern to all Construction Financial Managers involved in either general contracting or the specialty trades within commercial building.
With a rise in reported construction defects, companies — now more than ever — need to improve quality during the construction life cycle.
This article discusses the basics of construction defects, and presents the barriers to and indicators of quality construction — in addition to the risk management consequences of poor quality performance.
The Origins of Construction Defects
Construction defects occur at the intersection of construction operations, real estate transactions, contract law, and business insurance.
A construction defect is a component of construction that is not built according to plan, specification, or in conformance to established construction codes and industry standards of care.
To be considered a construction defect in the eyes of the legal and judicial systems, physical damage to tangible property or bodily injury must result from the alleged defective construction.1 Construction defects can also include the loss of use of the “impaired property” — property that is not physically damaged, but is rendered unusable due to defective construction work.
Unfortunately, in our litigious judicial system, reality does not always match theory. Sometimes, “alleged” construction defects are pursued because attorneys think there's a good chance of winning a verdict or receiving a settlement. This can also happen when a group of people, such as a homeowners association, is “unified” for the purpose of class-action litigation.
In the U.S., the general legal doctrine that governs the sale of property is caveat emptor, or “let the buyer beware.” In order to receive legal protection, buyers have a general duty to inspect their prospective purchases before taking possession. The legal system recognizes the inherent limitations of such inspections, and therefore distinguishes between two types of defects: patent vs. latent.
There is a fundamental and legal difference between patent defects found during the course of construction and latent defects that manifest later.
Patent defects are regarded as conditions that can clearly be observed or detected in a reasonably thorough inspection prior to the sale or transfer of the property from the seller to the buyer. In contrast, latent defects are faulty conditions in a property that could not have been discovered during a reasonably thorough inspection.
Types of Construction Defects
The types and causes of construction defects vary and are influenced by many factors, which are commonly categorized into the following eight types:
- Improper design;
- Poor workmanship that leads to poor finishing quality;
- Improper means or methods of installation or fastening;
- Improper materials;
- Defective material or poor material performance;
- Missing or inadequate protection from weather or environmental conditions;
- Water intrusion/infiltration and moisture; and
- Soil subsidence or settlement.
These types of construction defects result from one or more common causal factors. Researchers at the University of Florida reviewed the common causes and types of building occupancies most often implicated in construction defects.
This study revealed that 45% of all construction defect claims occurred in multifamily housing.2 (A large percentage of which presumably relates to condominiums, given the potential for class-action litigation by homeowners associations.)
Another major study found that “…84% of claims are associated with moisture-related defects in building envelope systems (69%) and building mechanical systems (15%).”3
Causes of Construction Defects
The most common causes of construction defects are: 1) the nature of the construction industry itself, and 2) climate, weather, and environmental factors. Let's look at how scheduling pressures and sequencing issues are driven by both causes, and review their potential negative impact on construction quality.
Contractors face increasing demands for shorter schedules and faster project completion. The potential adverse effects of these types of pressures include cost overruns and nonconformance to specifications, as well as other quality issues.
As these increased schedule pressures contribute to compromised quality performance, the number of construction defects increases. The rework necessary to rectify these quality issues also adversely impacts productivity — and jeopardizes the project's overall profitability, as well as the profitability of all parties involved.
A problem related to scheduling pressures is the improper sequencing of material delivery and/or subcontractor trades. Construction projects require precise coordination of various suppliers and subcontractors. Conditions are ripe for latent construction defects when weather-sensitive materials, such as drywall boards, are delivered to a jobsite before the building has been enclosed and is weather-tight.
For example, if a load of drywall is exposed to moisture from humidity, dew, or rain, then the likelihood of mildew or mold increases. Likewise, if the various subcontractor trades are not properly sequenced, then additional punch list items or rework can result.
Exhibit 1 below summarizes quality management barriers and lists the factors that contribute to construction defects at the industry, company, and project levels.
Exhibit 1: Barriers of Implementing Quality Management in the Construction Industry
|Industry Factors||Company Factors||Project Factors|
|Traditional split between design, engineering, and construction functions||Type of company: GC vs. Specialty Trade contractor||Multiple parties involved in construction (subcontractors, sub-tiers, and suppliers)|
|No uniform definition for quality or quality management||Percentage of lump sum (hard bid) vs. negotiated work||Design factors, especially the building envelope|
|Increasing number of fast-track projects||Typical project delivery method used: Design/Bid/Build vs. Design/Build||Tight scheduling and sequencing of trades and tasks|
|Historically thin profit margins that shift priorities away from quality||Owner selection process and percentage of work for repeat owners||Jobsite geotechnical factors: water table, drainage, and soil type|
|Conflicting definitions of what constitutes rework||Commitment to a zero defects and management accountability culture||No overall assigned responsibility for quality management at the project level|
|Long tail before latent construction defects manifest as completed operations claims||Historical performance with liability insurance, especially completed operations claims for latent construction defects||Third-party design review completed and course of construction conformance inspections scheduled|
|Contractual risk transfer of liability through indemnification and additional insured contract requirements||Insurance program structure: deductible vs. guaranteed cost program, limits purchased, and premiums paid||Weather (especially wind-driven rain) and climate factors (including differential thermal vapor transfer due to temperature, humidity, air flow, and ventilation)|
|Lack of uniform quality management metrics to establish performance baselines or benchmark comparisons||Quality control and quality assurance staffing, programs, policies, procedures, and protocols||Lack of uniform methods to measure or monitor quality performance during the course of construction|
|Lack of systematic method for allocating uninsured indirect costs of poor quality||Failure to develop job costing method to capture and chargeback indirect costs of poor quality||Indirect costs not captured and charged-back to project in job costing|
The Role of Insurance
Insurance is a financial risk transfer method that may help resolve construction disputes or litigation that involves alleged defective construction. Insurance pays on behalf of an individual or business when two conditions are met:
- It is proven that one party is liable for causing or contributing to the construction defect; and
- It is determined that the party has a legal duty to correct or otherwise remedy the defective conditions.
Commercial General Liability Coverage
Specifically, Commercial General Liability Insurance is purchased to cover payments for bodily injury and property damage sustained by third parties arising out of business operations. These damage claims are known as third-party liability claims.4
Construction-related Commercial General Liability property damage losses are further divided into losses that occur during two different timeframes: the course of construction and completed operations.
Course of Construction
The course of construction involves construction operations from the inception of building activity until a certificate of occupancy (CO) is issued for the facility.
The completed operations aspect of Commercial General Liability coverage responds to allegations of construction defects. The completed operations component provides coverage from the time a certificate of occupancy is issued through coverage termination.
The increased severity and volatility of losses in construction insurance primarily stems from losses with a “long tail” — the length of insurance coverage extending beyond the term of the policy.
It's common for the coverage period to extend between 3-10 years (often to match the length of the statute of repose and/or statute of limitation). During the extended coverage period, latent conditions often manifest as insurance claims with associated monetary losses. In construction insurance, the long tail results from alleged and actual construction defects.
Completed Operations vs. Products-Related Coverage
While coverage for completed operations and products are included in the same limit of the policy, there is a distinction between the two types of coverage.
A general rule of thumb: Once a product is incorporated into real property, it loses its characteristic as a product and is considered a “completed operation.”
For example, a contractor that is also a supplier of ready-mix concrete has a “products liability” exposure until the time the concrete is incorporated into the building. At that point, it becomes a “completed operation,” and is subject to all of the provisions of that coverage part — including the potential to respond to construction defect claims.
Statute Of Repose vs. Statute Of Limitation
Generally, companies involved in construction seek to purchase completed operations insurance to correspond with either the legal statute of repose or statute of limitation. Both the statutes of repose and limitation restrict the total time period contractors are subject to liability.
What's the difference? The statute of repose is a specific legal limitation or length of time following the completion of the project in order to provide the owner or occupants an opportunity to discover if defects or non-conformance to specifications need to be rectified by the contractor. The statute of limitation bars legal action after a specified length of time following the discovery of a deficiency.
These statutes are state-specific and are used to adjudicate alleged construction defect cases in state court systems. After the expiration of the statute of repose, buyers have no standing to bring legal suit against the property seller.
The statutes of repose range from a low of four years in Tennessee to a high of 15 years in Iowa.5 The most common length of statutes of repose is either seven or ten years.
However, statutes of limitation are shorter for bringing suits once damage is discovered and usually range from 1-3 years.6
Subcontractors & Contractual Risk Transfer
Contracts govern how expectations are communicated, responsibilities are assigned, and risks are allocated to facilitate successful project execution.
Generally, subcontractors are expected to assume responsibility for the work they perform (both financially and legally). One of their legal responsibilities is to purchase insurance as a means to protect the owner and all other parties.
A gap between legal and financial risk transfer can occur if subcontractors are not able to obtain the required types of insurance coverage. This gap can also occur if the required policy limits cannot be obtained or if the coverage has exclusions for particular perils or exposures that are likely to occur during the course of construction.
Quality Management In The Construction Industry
When strictly adhered to, quality management systems instituted by contractors can minimize the need for rework on construction projects.
As the amount of rework decreases, a contractor's performance increases in the areas of quality, productivity, and profitability. Unfortunately, a universal or standard definition of “quality” does not exist within the industry. Instead, many competing definitions are used, including:
- Customer satisfaction
- Contract requirements met
- On-time completion
- Conformance to specifications
- Project completed within budget
- No rework required within warranty period
- Zero punch list items at project turnover
- Continuous quality improvement
In my article on “Risk Performance Metrics” (in the September/October 2007 issue of CFMA Building Profits), lagging indicators were defined as “passive metrics of prior results without consideration of the activities that influence the results.” So, lagging indicators are retrospective and trigger reactive, tactical responses.
In contrast, leading indicators are metrics established to gauge the effect of activities designed to prevent or counter the metrics that are monitored by the lagging indicators. Accordingly, leading indicators are drivers of strategic and proactive activities consistent with continuous improvement. Exhibit 2 below presents leading indicators for project quality management for the three distinct phases of construction: pre-construction, course of construction, and post-construction.
Exhibit 2: Representative Examples of Leading Project Quality Indicators
|Phase of Construction||Leading Indicators or Metrics|
Number of third-party expert reviews on building envelope designs and materials
Number of subcontractors with pre-approved quality programs
Number of projects with site-specific quality plans
Architect approval for changes to specified materials or design specifications
|Course of Construction||
Number of projects completed with zero punch list items open
Percent of documented moisture evaluations of incoming materials
Number of quality assurance inspections completed
Percent of discovered defects corrected
Percent of notifications on moisture, water intrusion, mold, or other key events
Percent of completed project files with documented inspections and corrections
Percent of project turnover video training programs documented
Number of signed and certified receipt of turnover documents by owners
Scheduled follow-up inspection process with owners verifying no quality issues
Number of maintenance callbacks during warranty period
The ability to deliver a quality project safely provides a significant competitive advantage among contractors. The integration of safety with quality management enables projects to be built within budget and schedule constraints.
Safety performance is improved through the quality management discipline of “continuous improvement” that increases communication and feedback among workers and supervisors. Similarly, projects with reduced safety incidents experience improved quality, schedule, and cost performance.3
As a risk management professional, I've seen proactive construction companies take various actions to minimize the adverse effects of quality issues.
These actions are divided into the following stages or phases:
- Detection and measurement
- Documentation for defense
The 5 Ps & 5 Rs
Similar to the 6P model as described in my article on “Return to Work: The Foundation for Successful Workforce Development” (in the September/October 2008 issue of CFMA Building Profits), the 5P and 5R models are offered to help increase awareness of construction defect prevention and response. (See Exhibit 3 below)
Exhibit 3: Strategic Processes for Construction Defect Prevention
The 5 Ps are proactive steps focused on quality control and assurance that help prevent construction defects: Program, Policies, Procedures, Protocols, and Practices.
The 5 Rs are reactive steps taken in response to potential or suspected occurrences of defective construction: Report; Response/Investigate; Root Cause Analysis; Remediate, Repair, or other Recourse; and Recordkeeping.
For construction companies, there are potential consequences of not implementing effective quality management systems. One adverse consequence is unintended and undesirable exposure to risk.
As shown in Exhibit 4 below, poor quality performance impacts a company's reputation and has financial, operational, insurance, and legal consequences.
Exhibit 4: Risk Management Consequences of Poor Quality Performance
|Consequences||Primary Risk||Secondary Risk|
|Decreased productivity due to required rework||Operational||Financial|
|Diminished profit margin (or loss) on project||Financial||Reputation|
|Delayed turnover of completed projects||Operational||Reputation|
|Loss of key clients due to dissatisfaction||Reputation||Financial|
|Possible liquidated damages from delayed completion||Financial||Legal|
|Higher deductibles, increased premiums, and/or lower limits for liability insurance||Insurance||Financial|
|Increased legal costs to defend against alleged construction defect claims||Financial||Insurance/Legal|
|Damaged partnerships between GCs and subcontractors||Reputation||Operational|
|Fewer opportunities to bid or negotiate for future work due to damaged reputation||Financial||Reputation|
|Type and size of projects limited for future work due to lowered surety bond credit line||Financial||Reputation|
|Surety bond default and company survival threatened due to decreased corporate profitability||Financial||Reputation|
Industry Changes Since 2009: Proceed with Caution
Since this article first appeared (in the January/February 2009 issue of CFMA Building Profits), the construction industry has experienced challenges and changes that have led to the continued emergence of construction defects as a pressing industry issue. Most notably, the U.S. and global financial crises have contributed to the protracted economic recession and lingering recovery.
There have been some positive outcomes as a result of these changes, including growing awareness of supply chain risk management practices, improvements in building envelope design, the adoption of controls for moisture and water damage prevention, and other construction quality improvement methods and techniques.
However, the aftermath of these challenges includes such negative effects as the precipitous decline in the residential housing and construction markets and marked shifts between private and public construction funding and hard bid vs. negotiated work.
As always, contractors must consider the financial, operational, risk management, and insurance impacts from these and other changes to avoid increased risk.
Specifically, unique challenges occur when contractors pursue business in new states and/or with new partners (owners, subcontractors, and/or joint ventures), use new delivery methods, and involve new types of projects/occupancies and new products and/or materials, with which they have less experience and are beyond their core competencies.
Shifting Sands & Slippery Slopes
The resulting and ever-changing landscape of construction defects has been caused by such factors as:8
- State legislation and judicial case law interpretations to the legal definitions of an occurrence, property damage, and resulting loss under CGL policies;
- Increased contention between GCs and subcontractors on matters of contractual risk transfer;
- The expansion of “business risk” exclusions and exclusionary insurance endorsements vs. the growing availability of construction defect coverage;
- Unproven impacts of innovative design features, new products, and integrated technologies involved in Leadership in Energy and Environmental Design (LEED) and green construction; and
- The emergence of e-discovery in construction litigation.
Unfortunately, the lack of aggregated industry data on alleged vs. actual construction defects increases the challenge of finding proven proactive solutions that are focused on prevention. As a result, information has been focused on reactive mitigation strategies based on lessons learned from construction defect litigation outcomes.
The adoption of quality management systems can positively influence the construction industry's reputation and contractors' bottom lines.
Moreover, those companies that elect to implement quality management systems are more likely to gain a competitive advantage in the form of improved productivity and reduced rework, which leads to higher profitability.
Upfront coordination and rigorous pre-project planning can reduce schedule dynamics that disrupt the entire system of a construction project. Successful project management entails quality, risk, and safety management among owners, designers, engineers, contractors, subcontractors, and suppliers.
Ultimately, with respect to construction defects, prevention is a better strategy than mitigation, and mitigation is a better strategy than litigation.
As incidents of alleged construction defects rise, they pose a serious risk to your company's tangible and intangible assets.
It's critical for contractors to fully understand the specific state legislation and case law that governs construction defects in the jurisdictions in which their companies have completed projects or plan to perform work.
Active, ongoing collaboration with construction specialty professionals in the areas of law, insurance, surety, and accounting can help your company stay abreast of the ever-changing landscape and make informed business decisions.
1 Wielinski, Patrick J. Insurance for Defective Construction, 2nd Edition, 2005. International Risk Management Institute, Inc. (IRMI). Dallas, TX.
2 Grosskopf, K.R. & Lucas, D.E. “Identifying the Causes of Moisture- Related Defect Litigation in U.S. Building Construction.” www.rics.org/site/download_feed.aspx?fileID=3158&fileExtension=PDF.
3Grosskopf, K.R., Oppenheim, P. & Brennan, T. “Preventing Defect Claims in Hot, Humid Climates.” ASHRAE Journal, July 2008, 40-52.
4 For more information on Commercial General Liability, see Wm. Cary Wright's article, “The Anatomy of a CGL Policy,” CFMA Building Profits, January/February 2009.
5 “Statute of Repose Limitations for Construction Projects.” American Insurance Association, Inc., January 7, 2007.
7 Chang, A.S., & Leu, S.S. “Data Mining Model for Identifying Project Profitability Variables.” International Journal of Project Management, April 2006, Volume 24, Issue 3, 199-206.
8 “Construction defects: Managing risk, covering exposure.” Business Insurance, www.businessinsurance.com/section/NEWS070102.