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FMI Quarterly/March 2012/March 1, 2012

New Game, New Risks

Tech19_imageContractors must remain vigilant to change, great or small, and not lose sight of the blocking and tackling necessary to manage risk effectively while creatively responding to the environment.

Successful contractors are responding in creative ways to today’s challenging operating environment. They are seeking out new markets and geographies to create and capture value. In addition, new techniques, delivery methods and construction materials all introduce fresh elements to the traditional construction process.

FMI’s Rick Tison recently spoke with Michael Davis, director of Professional Liability Products at Zurich North America Construction, about the impact of these changes on managing risk in the construction process and how best-of-class firms are responding.

Tison: There are many new things going on in the construction and engineering industries — from production techniques, delivery methods and construction materials to firms entering different markets and geographies due to the economic climate. What are your customers doing differently because of this “newness”? Are they embracing change or are they being more cautious?

Davis: Our customers are absolutely embracing these changes. Innovation is good. Value engineering often drives the use of these new designs, materials and techniques. It is intended to save money as well. We have customers who will be on the cutting edge, but at the same time, we expect those same customers will approach these new ventures in a thoughtful and prudent way.

Tison: Speaking of thoughtful and prudent ways, what are some of the specifics that firms are doing well and not quite as well?

Davis: Our claim evaluations show that all project team members tend to be more conscientious when working on something that is recognized as being innovative. For example, they bring their “A” game for those projects that are innovative and likely to end up on the cover of a magazine. What is not done as well is recognizing that subtle changes can also require that level of attention but proceeding as if things were business as usual. Because of the interconnectedness of the construction process, the unintended consequence of a change in one area may create problems in another. This can often lead to a big loss on the project.

Tison: Do you feel that interconnectedness is increasing?

Davis: I think the construction process has always been interconnected. What is changing is that the lines of responsibility are blurring. In some ways, that can be a good thing. As lines begin to blur, project team members are more likely to remain vigilant toward potential issues that were not previously in their sphere of responsibility. We’ve trained ourselves to be mindful of everyone’s role and responsibilities. The fact remains, if there is a problem on a project caused by one team member, then everyone on the project team may be affected. Liability issues aside, the problem needs to be addressed by all members of the project team.

Tison: What are some of the specific challenges created by things that are “new” in the construction process?

Davis: The primary challenge is to expect unintended consequences. The project team goes beyond those participants that you see on a job site — it also includes finance, procurement and suppliers as well as designers, contractors and the end user. Traditional insurance may not always fit risk allocation schemes in new delivery systems such as Integrated Project Delivery (IPD).

New man-made construction materials may react differently to environmental conditions either during storage, installation or end use than the way traditional materials would have reacted. We can do laboratory testing on new materials, but that is only going to approximate the conditions that occur in the real world. It is also unlikely that any product has been tested to see how it holds up over decades, which is often the expectation of things being built. Even pilot testing does not guarantee success.

A change in scale by itself can introduce something new. A structure that seems identical or a process that is recreated on a larger scale sometimes presents new challenges and consequences that may not have happened on a smaller scale.

Tison: You mentioned new construction materials. What are some of the other changes taking place in the construction and engineering industries that are creating challenges?

Davis: There is a lot of talk and interest around Integrated Project Delivery (IPD), Public-Private Partnerships (P3s) and global supply chains. Whenever there is an economic downturn, firms are going to look for new sources of work. That can mean going into new geographic areas or unfamiliar project types. It can also mean contractors buying engineering firms in order to move into design work or design firms moving into development to provide a more vertical service.

IPD has a much different approach to traditional risk and reward allocations among the project team members. This creates an insurance challenge since some traditional casualty insurance products are not set up to address this.

P3s are a fantastic way to fund needed construction, but in many of those projects, we see a substantial degree of interrelated, intercompany ownership comprising the principal entities on the project. Again, thinking how that may play out in a traditional casualty insurance program can create some challenges.

The global supply chain is another challenge. The 2010 volcanic eruptions that grounded air travel in Europe and the 2011 tsunami in Japan really drove home how an interconnected, just-in-time global supply chain can be interrupted by such events and in such unforeseen ways.

Tison: In addition to the challenges of adopting new techniques, it sounds like the issue is often compounded by firms operating outside their comfort zones as a means of surviving in this economic climate.

Davis: Absolutely. It is natural to want to explore new areas as a means of finding work. It is not an issue of whether or not a firm should do that. Instead, it is an issue of recognizing that when you make a change, either in the environment you operate in or the role that you traditionally play, there are going to be surprises. The goal is to expect the unexpected and to deal with it.

For instance, we have a customer that, due to the economic downturn, moved into a completely different business model. It went from negotiated commercial work to hard-bid public work and also expanded outside its typical region in order to find work. Unfortunately, it failed to recognize the risk of this change and, as a result, experienced significant subcontractor defaults when it previously had none. This change disrupted the company’s operations at all levels.

Tison: How do the traditional risk management approaches compare to operating in a new environment, both with incorporating new techniques, technologies, etc., as well as for a firm operating outside of its comfort zone?

Davis: In many ways, the traditional approaches stack up very well. When we analyze a tough risk, we often find that the construction and/or design teams are not doing the things that they already know they should be doing. An example of this is in concrete-slab construction, where we have seen a number of significant claims. The American Concrete Institute (ACI) provides clear and detailed specifications about the interactions among the owner, contractor and designer, regarding quality assurance and control. We think these guidelines are not always followed.

Tison: Do you feel with these claims that the involved parties are not aware of the risks and are not following the protocol, or are they aware and choosing to ignore the protocol?

Davis: I think there is danger in becoming so comfortable with something that you are not vigilant or are not paying attention to what you think is a low or nominal risk. Some of the loss is avoidable with very simple blocking and tackling — negotiating workable contract terms, addressing problems early and applying appropriate quality controls. We want our construction professionals to be on the ball with all of the elements of their business, whether it is maintaining technical competency or facing the challenges of managing their workforce.

One risk management approach that confuses people is when we think of risk in terms of avoidance. There is a legal prudence in not rushing to admit liability, but sometimes that can cause paralysis. Then the problem gets worse. As we discussed before, although there are clearly defined roles and responsibilities, project team members still have to deal with issues that someone else on the project created. Just because you did not create the problem does not mean that it will not affect your aspect of the project. There needs to be an effective means to address the problem, even though it is not directly within the scope of your role. This is a significant service that our risk engineers can provide to our customers when problems arise during the construction process.

Tison: So to summarize, it comes down to two things. Project members need to understand their roles and the risks they are responsible for managing. But they must also be aware of how their role may affect the risks that someone else is responsible for managing and how it may impact the overall project.

Davis: Yes, that as well as how to manage the impact to their work product from things outside of their defined responsibility.

Tison: How would you characterize the nature of these changes in the industry? The economic climate we have gone through and are still facing brought about dramatic changes in how businesses in our industry operate. On the other hand, some of these innovations are occurring over a much longer period. Are we facing revolutionary shifts or evolutionary changes?

Davis: As you said, it is a mix of both. The evolutionary changes seem more dangerous to me because they can easily go unnoticed. Everyone is on his or her toes when he or she sees the project as being innovative, but most changes are subtle. Frequently, existing technologies are altered ever so slightly or firms make a minor change to a traditional structural element, for either value engineering or aesthetic reasons. While these are not bad ideas, they sometimes result in multimillion-dollar claims because they did not work as anticipated.

Tison: How are the firms you work with responding to the risks associated with these changes?

Davis: Our customers typically employ robust risk management protocols. We have the benefit of seeing how projects go wrong, and we share those lessons learned. It often goes back to basic blocking and tackling. Like in the concrete slab example earlier, the answer is right there in the ACI code. Some of this may be the result of not enough qualified, competent and capable designers and contractors available to perform the work when there was a boom in construction a few years ago. That being said, we encourage following the ACI code.

From a designer standpoint, how they respond to requests for information (RFIs) from the contractor is crucial. They have to recognize what the RFI means and how they need to respond in order to keep the project on track. Subcontractor prequalification and management have also comprised significant best practices that we have embraced at Zurich and thus helped improve our customers’ practices.

Tison: Are there costs associated with these practices that may keep firms from putting them in place?

Davis: Expense management is everywhere in this climate. For risk management to be successful in any economy, it has to be embedded and viewed as part of the service that the firm is providing to its customer. If it is viewed as a necessary evil, then it has not been adopted appropriately within the culture of the organization.

It is rare that an element of risk management requires stopping business. Most of the time, risk management provides better project results and higher quality assurance. This helps save money, but only if you do it properly. It takes dedication and a willingness to pay more attention and to do the necessary blocking and tackling, which sometimes means hitting the pause button and saying, “we may have a problem here.”

From my perspective, the hardest thing for a company to do is to raise its hand and say it has a problem. There is even greater resistance to bringing problems to the attention of the insurance carriers. There is a concern that if it does, the insurance carrier will view it negatively. The truth is, we see enough of the business to understand that these problems are happening. What is important is our customers’ willingness to address these problems. When they do, we are thrilled to come in and help work through these challenges. We, as a company, are not risk avoiders. We know there is risk in the business that we insure, and we are here to help our customers manage that risk.

Tison: How do these industry changes and innovations make you look at your business differently?

Davis: We are always looking at these elements across all the lines of coverage we write. One of the most challenging things in our business is trying to identify the difference between the perceived risks that become reality versus those that do not. My favorite example of this is Y2K. The challenge is identifying the difference between Y2K and the discovery that asbestos causes mesothelioma. You are going to have a lot more Y2Ks that you are going to spend time and money trying to manage that turn into nonevents, but you don’t know which one is going to be a bet-the-company event. You still need to address and respond to them.

Tison: That seems like a rather overwhelming proposition.

Davis: To some people it is. There is a danger for them in letting that lead to broad-brush risk avoidance. For some, there is a fear that they need to boil the ocean, which makes them want to rely on just one, two or three risk management techniques. They think as long as they have good projects, clear project communications, technically competent designers or excellent customer relations with highly solvent customers that everything else will work out. All of those things are important. It is a lot and you cannot address just a handful, but you do have to start somewhere. It is an evolving process. Over time and through the course of your operation, the right amount of attention and protocols can be brought to all those things and more.

CONCLUSION

Challenging times call for contractors to respond creatively and vigorously. In doing so, how contractors respond to change will determine how successfully they manage the associated risk. While bleeding-edge innovation receives the lion’s share of attention, often the incremental changes create the greatest challenges and receive the least focus. Contractors must remain vigilant to change, great or small, and not lose sight of the blocking and tackling necessary to manage risk effectively while creatively responding to the environment.


The information in this publication was compiled from sources believed to be reliable for informational purposes only. Any and all information contained herein is not intended to constitute legal advice and accordingly, you should consult with your own attorneys when developing programs and policies. We do not guarantee the accuracy of this information or any results and further assume no liability in connection with this publication, including any information, methods or safety suggestions contained herein. The subject matter of this publication is not tied to any specific insurance product nor will adopting these policies and procedures ensure coverage under any insurance policy. Risk engineering services are provided by Zurich Services Corporation.

Richard Tison is a research consultant with FMI Corporation and may be reached at 919.785.9237 or via email at rtison@fminet.com.

 

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