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Risk Performance Metrics

For the past several years, up to three of the top five concerns expressed by respondents to CFMA's Construction Industry Annual Financial Survey have been insurance-related. And, contractors continue to seek how to leverage their investment in safety and risk management.

The traditional view of safety has been as a line item expense calculated within administrative overhead or as a cost center. Construction Financial Managers use a variety of techniques to evaluate the cost effectiveness of recommended safety and risk reduction investments. These include: ROI, ROE, and/or ROC calculations; cost benefit analyses; and breakeven analyses.

However, some forward-thinking contractors have gone beyond seeing the direct link of profitability from safety and risk management to establishing safety as a profit center. A select few have captured even greater value by making safety part of their brand image.

Either way, a program that measures safety — and risk-related leading indicators, loss analysis rates, and indirect costs can provide contractors with a competitive advantage that goes far beyond lower insurance rates.

Leading Indicators

Some companies understand that the fixed cost of insurance, the premium, is the smallest piece of the insurance pie. They recognize that true savings more often result from decreasing the variable costs of their insurance program — the loss dollars from claims.

These companies have learned that proactive safety and risk management programs increase profitability — they reduce risk, prevent claims, and contain costs through aggressive claims management.

What is their secret? Through the ongoing measurement of risk indicators, these contractors establish goals for improvement and continuously monitor their company's performance. Some traditional measures include such frequency and severity incidence rates as:

  • Total OSHA recordable cases
  • Total lost workday cases
  • Total lost workdays
  • Number of fatalities1

Called lagging indicators, these measures are passive metrics of prior results without consideration of the activities that influence the results. Also called downstream measures or trailing indicators, lagging indicators provide feedback on data collected and analyzed “after-the-fact.” These metrics are diagnostic and sometimes prescriptive; they reveal past performance and highlight improvement opportunities.

In contrast, current and leading indicators provide different views of safety and risk performance. Designed to influence real-time outcomes, current indicators provide almost immediate feedback on present activities. Current indicators include a supervisor's same-day completion of an incident report or the number of job safety observations completed on a project each day vs. an established goal.

Leading indicators are proactive measures of focused activities to prevent incidents of a general or specific nature. Also called upstream measures, these metrics are “beforethe-fact”2 and can predict future performance.

For example, a high number of safety orientations should help decrease the frequency and severity of onsite accidents. (The first table below compares lagging, current, and leading indicators for safety performance. The second table lists examples of emerging leading indicators for productivity, quality control, and risk management.)

Lagging, Current & Leading Indicators
Lagging
(Past Results)
Current
(Present Snapshot)
Leading
(Prevention Activities)
  • Workers' Comp Experience Rating Modifier
  • OSHA recordable rate
  • Total lost workdays
  • Average cost per claim
  • Daily record of incidents
  • End-of-shift record of incidents
  • Daily job safety observations
  • The number of safety orientations conducted
  • The percentage of project pre-plans completed
  • The number of safety meetings held
Emerging Leading Indicators
Productivity
Measured by the Number of:
Quality
Measured by the Number of:
Risk Management
Measured by the Number of:
Field supervisors with laptops or hand-held technology Independent third-party expert reviews on prototypical designs or materials Pre-bid constructability, scope, and schedule reviews completed
Administrative staff trained on automated functions Architect and engineer approvals for changes to specified materials or design specifications Pre-qualified or pre-approved subcontractors on the eligible bidding list
Open trade/craft employee positions filled compared to percentage needed Quality assurance inspections completed Subcontracts signed before starting work
Days with no idle equipment Detected defects corrected Project sites properly planned and laid-out for logistics, traffic control, and work zones
Projects with proper sequencing of trades Project files with digital photos of conformance to specifications Project sites inspected for compliance to safety and risk controls
Projects completed on time Completed projects with no open punch list items Projects that had a post-mortem review of project risk performance

Loss Analysis

While many contractors know their basic loss picture, fewer understand the factors that cause or contribute to accidents and claims. To leverage safety and risk management, contractors need to identify where to invest time, staff, and other resources. An analysis of historical claims and loss experience provides an excellent starting point.

There are many methods of analyzing claim and loss data, but it's important to conduct both macro- and micro-level analyses, which provide the clearest perspective on what types of accidents are loss leaders, in addition to clues about necessary prevention activities. Trend, type, causal, and lost workday case analyses are four basic and reliable methods.

Trend Analysis
A trend analysis determines the number of claims and the total incurred losses (the dollars paid plus the dollars reserved to pay for the future cost development of the claims) for each line of insurance coverage over a period of time. This provides a quick “big picture” view of claim count and loss experience by policy year.

Type Analysis
A type analysis summarizes the frequency of claims and the resulting incurred claim costs by type of loss. This method uncovers the leading types of loss for your company. For example, you may learn that two or three leading types of loss account for greater than 70% of your loss dollars.

By highlighting the areas that have the greatest impact on risk management performance, this analysis helps focus prevention efforts.

Causal Analysis
A causal analysis determines the reasons for accidents and resulting claims by evaluating various causal factors for each leading type of claim. It indicates areas for possible incident prevention activities and safety management controls.

Ideally, you'll be able to determine the job classification with the greatest number of claims and highest claim costs. For example, you might learn that “falls” are your company's leading type of workers' comp claim, making up 20% of your total claim count and 65% of your total incurred losses.

By evaluating the causes of your company's losses, you may discover that 60% of the falls were the result of a fall from an elevated surface — with 40% resulting from slips, trips, and falls on the same level. You might also learn that 10% of the total falls from elevation claims occurred from a scaffold or ladder, but that the other 90% resulted from getting into or out of vehicles or heavy equipment.

The safety and risk management controls for each of these causes are different. Depending upon the findings in the causal analysis, additional drill-downs should provide even better clues.

The success of this analysis hinges on the depth of your company's accident reporting and investigation process, as well as the quality of the claim coding information. Some of the best factors to evaluate include:

  • Day of week
  • Time of day
  • Date of loss vs. the date of hire
  • Objects and materials involved in the loss

Lost Workday Case Analysis
Why focus on lost workday cases? After fatalities, lost workday cases are among the most serious type of workers' comp claims.

Greater than a third of all workplace injuries result in lost workdays. According to the National Safety Council, the average cost of lost workday cases across all industries in 2005 was $38,000, an increase from $28,000 in the year 2000.3

The average for the construction industry is not calculated separately. However, the construction industry figure should be significantly higher for three reasons:

  1. The median number of days for each lost workday case is higher for construction than across all industries. The Bureau of Labor Statistics (BLS) reports seven days as the median number of lost workdays per case for all private industries in 2005.

    In contrast, the median is eight days on average for specialty trade contractors, nine days for general building contractors, and 11 days for heavy and civil contractors.

  2. The construction industry has some of the highest average labor wage costs among major industry groups.
  3. Modified or restricted duty assignments in formal return-to-work programs appear to be increasing throughout the construction industry.

    Yet, pockets of resistance still exist among some employers, employees, labor groups, and medical practitioners — even though such resistance results in longer absences and higher costs per case.

A lost workday case analysis determines the number, type, and severity of lost workday cases by occupation and body part. The most important portion of this analysis is the comparison of minor and major lost time cases.

“Runaway claims” can be identified by comparing the average length of cases greater than nine days (the overall median for the construction industry) vs. the average for cases less than nine days.

The distribution of lost workday cases by duration metric helps underscore the need to evaluate policies, procedures, and administrative controls to improve accident prevention and claim management.

Here's how it works: The chart below summarizes one contractor's average duration of lost workday cases. The contractor's totals were benchmarked against the average Bureau of Labor Statistics totals for the construction industry. In this case, 54% of lost workday cases exceeded 31 days of lost time, slightly more than double the construction industry average.

Distribution of Lost Workday Cases by Duration

Further analysis revealed that the median number of lost workdays for each case was 37 days (four times higher than the figure for the construction industry). The average length of cases less than nine days was only three days each; however, the average for cases longer than nine days was 90 days.

This meant that, on average, this contractor incurred a “runaway” claim after the fourth day of lost time for every injured worker. In effect, excessive days of lost work time unnecessarily increased this contractor's total loss costs.

From the contractor's point of view, this analysis helped demonstrate the importance of injury prevention. Severity reduction of lost workdays was identified as the goal and the contractor decided to partner aggressively with the claim service team on:

  • prompt reporting and thorough investigation of all injuries;
  • coordinated identification of modified duty assignments; and
  • better nurse case management to help injured employees return to work sooner.

Indirect Cost Assessments

New, sophisticated tools are now available to help contractors measure, monitor, and align safety and risk goals with overall financial performance.

As already mentioned, risk performance metrics provide useful information about the following key performance indicators:

  • leading types of losses,
  • their causal factors, and
  • possible corrective actions.

The next factor plays to the Construction Financial Manager's expertise: demonstrating the financial impact of insurance claims.

Not only does this metric show the financial benefits of safety, but it also creates a compelling business case for proactive safety and risk management.

Direct vs. Indirect Costs
Like other areas of construction financial management, insurance claims have both direct and indirect costs. For our purposes, the insured loss costs are considered direct costs, and the uninsured loss costs are indirect costs.

The indirect costs are the “hidden” costs and share three key characteristics:

  1. They act as a multiplier upon direct (insured) costs that increases the total cost of insurance claims.
  2. They are often not captured or calculated and, therefore, are not consistently charged-back or recovered in job costing systems.
  3. The net effect of factors one and two is a drain on contractor profitability.

There are many different estimates used by safety and risk management professionals for calculating the impact of indirect costs. Safety industry sources indicate an average ratio of indirect to direct accident costs from 2:1 to 4:1.

One conservative method is available at the OSHA Web site, where a sliding scale multiplier is provided that depends on the total direct cost. Note that the indirect cost multiplier decreases as direct costs increase. To calculate your company's ratio using this method, go to www.osha.gov/Region7/fallprotection/safetypays.html.

Required Revenue Replacement
Achieving buy-in for safety and risk management programs from other construction executives and operational managers can be a challenge. However, the revenue replacement tool is a convincing way to show the additional sales needed to offset the cost of insurance claims.

This number varies based upon total cost of losses and the company's profit margin expressed as a percentage:

Annual Losses (in dollars) ÷ Company's Profit Margin

With this metric, it's simple to see the total additional sales required to offset the cost of claims. Once upper management appreciates how substantial claim costs can be, it's much easier to obtain buy-in for proactive safety and risk management practices.

Conclusion

The most important outcome of risk performance metrics is the focus on continuous risk improvement initiatives. Incident prevention and claim management initiatives can significantly improve a contractor's jobsite productivity, quality control, risk management, and safety programs.

The net effect of this investment is a potentially significant increase in profitability, not to mention a bidding advantage for contractors.

More Resources

  1. National Safety Council
  2. BLS Table R65: Number of nonfatal occupational injuries and illnesses involving days away from work by industry and number of days away from work, 2005
  3. BLS Table R66: Number and percent distribution of nonfatal occupational injuries and illnesses involving days away from work by occupation and number of days away from work, 2005
  4. Harvard Business Review: “Competing on Analytics” by Thomas H. Davenport (January 2006)

Endnotes

1 Petersen, Dan, “Setting Goals, Measuring Performance: Frequency Versus Severity,” Professional Safety, Vol. 50, No. 12. December 2005, pp. 43-48.

2 Janicak, Christopher A., Safety Metrics: Tools and Techniques for Measuring Safety Performance, Government Institutes/ABS Consulting, Rockville, 2003.

3 National Safety Council. (2006). Injury Facts®, 2006 Edition. Itasca, IL.

Internal Vs. External Benchmarking Of Insurance Claim Data

Data-driven analysis is a critical decision-making tool for Construction Financial Managers and other industry leaders.

Decision-making is arguably the most important responsibility of company leadership.

Companies that make better decisions make fewer mistakes, and achieve a distinct competitive advantage in the marketplace.

The underlying purpose of benchmarking is to continually improve the quality of organizational decision-making.

Overview
As construction risk management consultants, we help contractors prevent accidents, mitigate claims, and reduce the total cost of risk through a continuous improvement process.

We believe companies must instill management accountability for continuous improvement by linking performance measurement to both prevention activities (leading indicators) and operational results (lagging indicators). As the adage goes:

“What gets measured is what gets done.”

In our consulting roles, we frequently help companies establish realistic performance measures by conducting various types of claim and loss analysis.

This type of data analysis is usually the starting point in a performance improvement process — and a common practice among insurance agencies, brokerages, carriers, and risk management consulting firms.

In addition, we are often asked to conduct a benchmarking analysis that compares one company's claim and loss data against peer companies or to the construction industry as a whole.

Benchmarking
The term “benchmarking” refers to the comparison of a company's performance results against those of similar peer companies. Benchmarking evolved out of the quality improvement movement in the late 1980s and early 1990s.

Its initial intent was to identify leading companies regardless of industry sector, and apply their best practices to improve one's own company. Over time, benchmarking has become synonymous with process improvement.

The traditional view of benchmarking required two separate disciplines focused on performance improvement: measures and methods. Identifying and capturing performance indicators (the measures) is only the first step; developing and implementing performance improvement (the methods) is the second and most important step for the benchmarking process to be truly effective.

The Health Club Analogy
There is limited value in benchmarking without applying new methods to address continuous performance improvement. Performance improvement requires more than the measurement of performance indicators; it requires the implementation of changes in management disciplines to attain improved operational results.

Using only performance indicators without implementing new methods to improve operations is akin to joining a health club and expecting the benefits without actually using the equipment or committing to an exercise program.

Merely jumping on the scale and gauging your weight relative to others doesn't help you achieve your own weight loss goals anymore than comparing your pulse and respiration rate to others helps you attain your aerobic or cardiovascular fitness goals. What matters most is that a person embarking on a weight loss or fitness program stays committed to the process and monitors his or her own progress.

Similarly, we believe the ongoing monitoring of claim and loss data specific to an individual company is even more important than the initial measurement of insurance claim and loss data relative to other companies.

Baselining As Benchmarking
The term “baselining” refers to the internal benchmarking process that occurs when a company compares its performance against its own results year after year. Ongoing, internal monitoring allows a contractor to determine if the company's claim and loss trends are improving or deteriorating, and to make the critical performance improvement decisions necessary to facilitate a change in results.

Referring back to the health club analogy, baselining does not compare an individual's weight and aerobic fitness to that of the other health club members. Instead, individual fitness goals and measures are established, monitored, and tracked to verify continuous personal improvement.

Similarly, a construction company can develop a baseline analysis of its loss cost performance by reviewing loss and claim data for a minimum of 3-5 years. Company results are compared from year to year, and ideally are broken down by operating entity, division, project, manager, or even crew levels.

Exhibit 1 provides a sample of a baseline analysis that compares one company's relative claim and loss performance within all of its operating divisions.

2001-2006 Total Claim Cost per Man-Hours Worked by Division

 

This analysis reviews the historical loss cost data for the entire company and breaks it down into meaningful data relative to each operating division. The total workers' comp, Comprehensive General Liability, and auto liability incurred claim costs (sum of paid and reserves) for each company division over a five-year period were compared to the total man-hours for each division, producing a cost per man-hour figure.

The results illustrate dramatic differences in total claim costs per man-hour for each division. This baseline analysis was the first step in raising awareness of the predominant loss leaders within the company. This increased awareness led to a detailed analysis that established plans of action and realistic cost targets by company division for the upcoming year.

External Benchmarking
We acknowledge that there are numerous benefits to measuring the frequency, type, and cost of insurance claims compared to peer groups and/or the entire construction industry. Such analyses provide the ability to:

  • Identify leading types and sources of claims
  • Establish strategic objectives to prevent the occurrence of common industry claims
  • Increase knowledge of industry best practices
  • Determine operational performance improvement priorities
  • Create awareness among managers and employees about the costs of claims and the impact on profitability
  • Post positive results on company websites and for use in other marketing materials

The Bureau of Labor Statistics provides safety-related data so that companies can externally benchmark injury and illness data against specific industry groups. (Check out the Web Resources section at the end of this article for more information.)

In addition, Bureau of Labor Statistics data is used to calculate and compare OSHA Recordable Incident Rates and Lost Workday Incident Rates, both of which are common construction industry benchmarks. This data is useful when making high-level comparisons within construction industry segments relative to injury and illness rates.

We also use external benchmarking analyses to establish risk reduction, loss prevention, or cost containment goals. In “Risk Performance Metrics” by Calvin E. Beyer in the September/October 2007 issue of Building Profits, a sample benchmarking comparison shows a representative contractor's duration of lost workdays workers' comp cases in median number of days compared against the median duration for the industry. Results such as these can highlight the importance of an increased focus on injury management and return-to-work programs.

The benchmarking analysis in Exhibits 2A and 2B compares a contractor's workers' comp claim and loss performance to an established group of peer contractors in the same specialty trade. (These companies engaged in similar work, and performed in states with similar insurance laws and legal climates.)

WC Claims Per $1 Million WC Payroll by Company

The analysis was based on total incurred workers' comp costs and total number of workers' comp claims as compared to payroll for each entity. Overall, Company D had worse results than the other three companies.

This prompted an in-depth review of Company D's workers' comp losses by division and occupation. As shown in Exhibit 3, the company experienced significant claim frequency and severity issues within the first six months of employment.

WC Claim Count & Cost by Length of Service

These findings triggered the development and implementation of specific activities designed for Company D's new employees.

Below are some of the activities that were incorporated into the formal improvement plan:

  • hiring processes
  • new hire skills assessments
  • orientations
  • daily planning meetings
  • formal training

Other Sources Of Benchmarking Data
Professional associations and industry trade/peer groups also provide comparative data for benchmarking purposes.

The Construction Financial Management Association's Construction Industry Annual Financial Survey is an excellent source for understanding the key drivers of contractor profitability. We use the survey data to determine comparative profit margins for different types and classes of contractors when we calculate a revenue replacement analysis to show the additional sales volume needed to offset the cost of insurance claims. (This technique was highlighted in the “Risk Performance Metrics” article previously mentioned.)

Similarly, the Risk and Insurance Management Society (RIMS) conducts an annual benchmarking survey that reviews insurance rates, program coverages, and measures of total cost of risk.

An example of a peer group data source for benchmarking is the Construction Industry Institute (CII). The Construction Industry Institute is a voluntary “consortium of more than 100 leading owner, engineering-contractor, and supplier firms from both the public and private arenas” (www.construction-institute.org). It develops industry best practices and maintains a benchmarking and metrics database for its participating members.

Another peer group example involves members of captive insurance companies sharing and comparing claim and loss data for the group as a whole. There is a major advantage when a true peer group shares benchmarking data: Such data sharing often leads to peer pressure in the form of increased ownership and accountability for improvement by the companies shown to be the poorest performing members.

We continue to search for more new sources of industry best practices and comparator data. A possible emerging source for the construction industry is the National Business Group on Health. This organization has developed standardized metrics known as Employer Measures of Productivity, Absence and Quality™ (EMPAQ®).

EMPAQ® helps member companies gauge the effectiveness of their injury and absence management and return-to-work programs. The founder and principal of HDM Solutions, Maria Henderson, served as a project sponsor for EMPAQ® from 2003-2007, and co-presented with Calvin E. Beyer on “Return to Work as a Workforce Development Strategy” at CFMA's 2008 Annual Conference & Exhibition in Orlando, Florida.

Limitations Of External Benchmarking
We fear that the increasing popularity of external benchmarking analyses may indicate that it has become a “quick fix” solution or a management fad. When asked to conduct an external benchmarking analysis, we always ask the following questions:

  • What is your purpose in seeking these comparisons with other companies?
  • Who are you trying to convince and what are you trying to convince them to do?
  • What specific peer companies should be used for comparative purposes?
  • Are these companies (and their operations and exposures) truly similar enough for a fair comparison?

Beware Of Pitfalls
There are many hurdles to surmount in locating suitable companies for external benchmarking comparisons. Generally, when benchmarking comparisons can be made, more often than not the greatest value lies in the workers' comp line of insurance coverage.

Here are some key factors to consider when choosing contractors for external benchmarking comparisons:

  • Percent of self-performed work vs. subcontracted work
  • Payroll class codes and hazard groupings of selfperformed work
  • Differential geographic labor wage rates
  • Payroll rate variances between union and merit shop operations
  • Size of insurance deductibles
  • Claim reporting practices

For example, claim reporting practices must be similar in order to minimize distorting the frequency or average cost of a claim. If one or more comparison companies self-administers minor claims or does not report all claims to their carrier, using carrier loss reports for the comparison is an invalid method.

We also find that comparing the frequency of claims and total loss dollars divided by thousands or millions of dollars of payroll (exposure basis) is a helpful workers' comp benchmark between companies of similar operations in similar states.

Likewise, a suitable benchmark for auto liability performance compares the frequency of claims and total loss dollars per one hundred vehicles.

When benchmarking fleet-related claims, ensure that the number and size of fleet vehicles — as well as the type of driving (urban vs. rural) and the total number of miles driven annually — are similar among the contractors whose claims are being compared.

Benchmarking comparisons of Comprehensive General Liability insurance results are especially challenging due to delays in reporting third-party bodily injury and property damage claims, in addition to the expected long tail of loss development for these claims.

All of these factors are compounded by vastly different litigation trends and liability settlements in various states and regions of the country.

Common Limitations Of Data Sources
Whether or not you intend to develop a baseline of your company's claim data or to benchmark your company's performance against a peer company, there are several issues that must be successfully resolved regarding the data's quality and integrity.

Based on our experience, we classify the key challenges associated with exposure and claim/loss data into the categories shown in Exhibit 4: availability, accuracy, accessibility, standardization, reliability, comparability, and date-related problems.

Seven Data Challenges

Value Of Multiple Measures
Evaluating data from various sources and different angles is also valuable. Why? Because it's possible to gain a better understanding of the whole by dissecting the parts. This practice illustrates the principle of multiple measures.

This approach is substantiated by 2006 research, which concluded that the “simultaneous consideration” of frequency and severity provides a more comprehensive result than performing analysis based solely on one factor.1

This is similar to our approach when we conduct a “Claim to Exposure Analysis” and review historical frequency and severity vs. the relative bases of exposure for each line of casualty insurance coverage.

Returning to the health club analogy, when starting a formal exercise program, you often begin with such general baseline measurements as height and weight; this is usually followed by additional measurements, such as BMI, body fat content, and the girth of arms, legs, and chest (the baseline).

As we all know, weight alone is not always the best indicator of success in fitness efforts. In fact, since muscle weighs more than fat, an increase in total body weight may actually occur after beginning and maintaining a fitness program.

Although you might not experience a dramatic weight drop, you could see a reduction in waist size and BMI — positive changes that would not be evident unless multiple measures were being used and reviewed.

Benchmarking insurance claim and loss data performance is like comparing one person's height and weight against the ideal height and weight charts based on the entire population.

Wouldn't it be more effective to establish your baseline weight and other multiple measures initially so you can see the progress you are making?

This is similar to the baseline measurements that a company should take (as well as the multiple measures) that are necessary to meet your company's performance improvement goals for financial success, operational excellence, or risk reduction.

Web Resources:

  1. U.S. Department of Labor BLS Incidence Rate Calculator and Comparison Tool
  2. National Institute for Occupational Safety and Health Work-Related Injury Statistics Query System
  3. Risk and Insurance Management Society, Inc. Benchmark Survey
  4. Construction Industry Institute Benchmarking & Metrics
  5. National Council on Compensation Insurance, Inc. (NCCI Holdings, Inc.) Benchmarking Tools
  6. Employer Measures of Productivity, Absence and Quality EMPAQ
  7. CFMA's Construction Industry Annual Financial Survey with Benchmarking Builder CD

Authors
Cal Beyer collaborated with Greg Stefan in writing this article. Greg is Assistant Vice President, Construction Risk Control Solutions, at Arch Insurance Group. As a member of the Southeast Regional team in Atlanta, GA, Greg supports underwriting and claims in risk selection, claim mitigation, and risk improvement activities. He is also responsible for high-risk liability risk reduction initiatives including contractual risk transfer, construction defect prevention, and work zone liability management.

1 Baradan, Selim, and Usmen, Mumtaz A., “Comparative Injury and Fatality Risk Analysis of Building Trades,” Journal of Construction Engineering and Management, May 2006, pp. 533-539.

Construction Defects: A Primer For Construction Financial Managers

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:

  1. Improper design;
  2. Poor workmanship that leads to poor finishing quality;
  3. Improper means or methods of installation or fastening;
  4. Improper materials;
  5. Defective material or poor material performance;
  6. Missing or inadequate protection from weather or environmental conditions;
  7. Water intrusion/infiltration and moisture; and
  8. 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.

Scheduling Pressures
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.

Sequencing Issues
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

Risk Financing
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:

  1. It is proven that one party is liable for causing or contributing to the construction defect; and
  2. 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.

Completed Operations
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

Leading Indicators
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
Pre-Construction

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

Post-Construction

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:

  • Awareness
  • Prevention
  • Detection and measurement
  • Mitigation
  • 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

  • Vision and culture for zero defects, zero punch lists, and/or zero rework
  • Quality management organizational structure and staffing
  • Owner selection practices and risk-adjusted process for project approval
  • Prevention measures throughout the construction life cycle
  • Subcontractor prequalification and oversight process
  • Insurance and contractual risk transfer review
  • Conformance verification vs. nonconformance detection during course of construction
  • Project closeout and owner education processes
  • Warranty period and maintenance callback processes
  • Response and mitigation of known or suspected problems
  • Claim coordination and documentation for defense
  • Measurement and continuous process improvement
  • Management accountability systems that include quality measurement in personnel performance evaluations and decisions about bonuses
  • Quality awareness education and staff training

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.

Moving Forward

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.

Endnotes:

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.

6Ibid.

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.

© 2012 by the Construction Financial Management Association. All right reserved. This article first appeared in CFMA Building Profits. Used with permission.