A closer look at SMEs in the Construction PI insurance market: their risk profile, their approach to insurance and the types of claims they are experiencing

SMEs make up the majority of businesses worldwide. In Australia SMEs account for 99.8% of businesses, with construction based SMEs making up 14% of the SME market.¹ When looking at PI insurance through the lens of a construction SME, there are particular drivers of purchase power and influences unique to the SME market.

The COVID pandemic has created a new set of challenges and compounded an already challenged construction PI market still recovering from the recent departure from the PI market of Lloyds syndicates and the cladding fallout following Grenfell in the UK and Lacrosse in Australia.

In a series of 3 papers we will look at the following topics concerning SMEs:

1. The risks currently faced by construction-based SMEs;
2. The approach construction-based SMEs take to insurance; and
3. Current claim trends in construction PI.  

Risk profile of SMEs

SMEs in the construction industry presently face risks in a number of key areas including business interruption (including supply chain disruption), pandemic outbreak (health and workforce issues, restrictions in movement), cyber incidents (eg cyber crime, IT failure/outage, data breaches, fines and penalties)^₂ and climate change/environment related risks.

Risks arising from the COVID pandemic

The global supply chain disruption brought about by the COVID pandemic is having a significant effect on the construction industry. Such disruption inevitably leads to delays in construction which in turn can disrupt the flow of payments to contractors and consultants. SMEs, typically cash poor businesses, are particularly vulnerable to supply chain disruptions and delays in their accounts receivable or non-payments. These issues can all impact on cash flow and profitability of SMEs.

The COVID pandemic has introduced new risks for all businesses in relation to their workforce and restrictions in movement. Key among those risks for SMEs is the risk of employees and staff contracting the virus and being unable to work. In the construction SME space, this risk is of particular concern for contractors where an infected worker is likely to come into close contact with other workers, meaning a raft of the SMEs employees/sub-contractors must self-isolate. Where construction sites are already operating at reduced capacity and experiencing delays, this can have significant flow on effects and present cost overrun risks. The length of the isolation period will depend on where you live. In Melbourne, contact with a COVID infected person means the close contact, regardless of their vaccination status, must isolate for 14 days. In England from 16 August close contacts of infected persons who have received double doses of vaccine are no longer required to self-isolate. However, if a vaccinated person or a person in their household contracts COVID, they are required to stay at home for 10 full days after the test was taken.

Restrictions in movement caused by extended lockdowns and social distancing requirements also present different risks for construction SMEs. In Melbourne and Sydney non-essential workers (the definition of an ‘essential worker’ varies across states/countries) are currently restricted to working from home. Project meetings and collaboration between (non-essential) professionals must take place over video conferencing. This is difficult where large scale drawings, physical samples, methods of construction or design layout are under consideration. Whilst there are usually work arounds, such as having samples requiring approvals couriered between relevant households, these types of processes usually take additional time, which contractors, already facing project delays due to lockdowns and COVID infections, are likely to be keen to avoid.

Similarly, inspection of construction works poses unique challenges and a PI risk for both contractor SMEs in respect of the professional services aspects of their work and design consultants who as part of their role need to carry out inspections. Design professionals are often contractually required to provide monthly certificates that construction works are being carried out in accordance with design documents. There are increased risks in the provision of such certificates in the current environment. Contractors with capped site numbers are unlikely to be amenable to allocating one of those valuable site numbers to a consultant, for inspection purposes. Remote inspections pose challenges and risks as non-compliant works may be studiously avoided by the person filming or photographing the works. Contractors requiring the montly certificates for progress claims are unlikely to be sympathetic to the risks facing consultants in the provision of certificates.

Overseeing the work of employees and developing QA and QC procedures that respond to the new working environments pose further challenges for SMEs. Short term issues that have a more direct impact on the cash flow of SME businesses such as bringing in new work and chasing up late payments, may be prioritised over tasks such as supervision of employees and managing QA and QC processes, where the risks of failing to do these tasks at all or well, may not be evident to an SME until after a claim is made.

Following the Grenfell disaster and the Lacrosse fire in Melbourne, cladding and fire safety claims have led to significant claims pay outs for insurers and renewed focus on these risks. D & C Contractors face risks in these areas, which depending on their policy wording, may be subject to sub-limits or excluded. Poor installation of fire-stopping and cladding, the failure of contractors to have good QC/supervisory/audit processes in place to ensure compliant installation (particularly with workplace numbers restricted due to COVID) leaves contractors vulnerable to claims that may not be covered by their PI policy.

Contractual risks

Outside of the COVID related disruptions and risks, SMEs can be more susceptible to contract and project risks than larger companies who have the capacity to employ staff and/or pay for specialist advice, aimed at minimising their exposure to such risks. In the construction space, both public and private clients typically insist upon passing through all design, construction and delay risk to the contractors engaged on projects. Contractors in turn seek to pass down design risks to consultants. SMEs can be particularly vulnerable to such risks as they often do not have the bargaining power or the commercial savviness to limit their contractual exposures.

Contractual indemnities in consultancy agreements are one example of this. Such indemnities are more often becoming the subject of claims against SMEs. Risks arise for both consultant SMEs and their insurers depending on the policy wording. Contractual indemnities are often excluded by PI insurance policies, such that any liabilities that the Insured would not have otherwise been liable for at law are excluded. Such clauses can impact SMEs in varying ways. For example, in certain States of Australia, parties can contract out of state based proportionate liability provisions (NSW, WA and Tasmania). If a consultant pursuant to the terms of a consultancy agreement, agrees to indemnify the client from all liability arising out of or in connection with an act or omission of the consultant and the relevant proportionate liability regime does not apply, the consultant’s exposure is likely to be greater than if the relevant proportionate liability regime applied to limit the SMEs liability to the proportion of loss or damage that is just, having regard to that party’s responsibility for the loss and damage. If the SMEs PI policy contains a contractual indemnity exclusion clause, then any loss for which the SME is liable, that is outside of what it would have been liable for at common law or pursuant to the Trade Practices Act 1974/Australian Consumer Law, will be an uninsured loss.

In circumstances where the construction SME is covered under the terms of its PI policy  for contractual indemnities, insurers can find themselves on risk for liability that encompasses much more than the liability the SME might otherwise have been liable for at common law or pursuant to the TPA/ACL. Often in the case of large multi-level residential projects, consultants are initially engaged by developers, with the consultancy agreement subsequently novated to the contractor once the building contract has been let. The terms of the novated consultancy agreement are often prepared by the contractor or developer and are usually broadly worded to protect the commercial interests of those parties. Indemnities can be drafted broadly and require the consultant to indemnify the contractor for all loss and damage suffered by the contractor arising from the wrongful act or omissions of the consultant, including legal costs on an indemnity basis. Consultant SMEs are usually powerless to negotiate more favourable terms. The terms will also be interpreted on the basis of what a reasonable businessperson would have understood the term to mean.^₃ That inquiry will require consideration of the language used in the contract and the commercial purpose or objects to be secured by the contract and generally it is enough to refer to the words of the contract alone. The contractual indemnity clause, if unambiguous or susceptible of only one meaning, will be given its plain meaning.⁴ The risk to insurers in this situation is significant where, if a consultant acts negligently during the project construction phase and there is consequential delay to the project, the insurer is likely to be on risk for the contractor’s delay costs, the contractor’s legal costs (on an indemnity basis), the consultant’s legal costs as well as the (potentially significant) costs of rectifying the damage caused by the negligent design/approval.

As construction PI lawyers, we often see situations where consultants have signed up to provide services (and accepted risks associated with the provision of those services) that are either vaguely described or which were never intended to be provided by the consultant. This type of contractual risk is prevalent amongst SMEs, who are unlikely to have sophisticated in-house teams reviewing contracts. In addition, the competition amongst construction professionals is fierce meaning SMEs can be hesitant to push back on onerous contractual terms or risk allocations for fear of losing work. Take the example of the SME fire engineer in the Lacrosse⁵ case. In that case the fire engineer entered into a contract with the developer, which was subsequently novated to the building contractor, requiring it to conduct ‘a full fire engineering assessment of the building in accordance with the requisite assessment level dictated by the [International Fire Engineering Guidelines]’. The IFEG in section 1.2.3 provided that in order to evaluate or design a building’s fire safety system, [the fire engineer] needs to identify the principal characteristics of the building and its normal mode of functioning, which includes the building’s ‘structure – construction materials’.⁶

It was alleged that the fire engineer failed to carry out a full fire engineering assessment in accordance with the IFEG and to inquire into and assess the range of construction materials for the purpose of establishing ‘potential fire hazards’ of the building.  The fire engineer maintained throughout that proceeding that it was not required to undertake an assessment of the building generally and assess whether there were any fire hazards, save for those identified by the building surveyor as deviations from the DTS requirements of the BCA (as identified in the building permits for the building). The Tribunal found that the fire engineer’s role was defined by the contract and the contract required the fire engineer to carry out a ‘full fire engineering assessment in accordance with the IFEG’, which it had not done.

Environmental risks

Another risk currently facing construction based SMEs are environmental based risks. Extreme weather events have been prevalent in Australia over recent years where we have seen numerous natural disasters including widespread flooding across New South Wales in 2021 and severe bushfires across Australia in 2019-20 with more than 5 million hectares destroyed, more than 2000 homes lost in New South Wales and 1.2 million hectares destroyed in Victoria. These types of events are on the rise. In the last 3 years insurers paid out more than $9.9 billion in natural disaster claims, with more than $6.1 billion paid out since the 2019-20 bushfires.⁷  With a significant need to construct buildings that can withstand the rise in extreme weather events, construction professionals face increasing risks in this area.

Rising sea levels, increased temperatures and rainfall, and exposure to damage from drought, fire, storms and floods are risks that need to be considered by design and construction professionals, particularly those working in areas that face a higher risk of extreme weather events. Following an extreme weather/ climate change related event, property owners look to recover losses. Whilst consultants are vulnerable to claims in this space, SMEs are particularly vulnerable as clients’ decisions during the design phase (prior to any weather event) are often driven by cost rather than minimising the risk of damage from environmental risks. There is usually an additional cost associated with designing a building to withstand weather and fire related risks. Cost conscious clients may seek to avoid those costs and it can be difficult for a SME, who may be reliant on word of mouth and happy clients for new referrals, to push back on such cost driven decisions.

SMEs also need to ensure they keep abreast of changes to the National Construction Code and ‘best design practice’ in this area to minimise their exposure to extreme weather event/climate change related claims.  

Cyber risk

Undoubtedly, cyber incidents pose a significant risk to all SMEs. Unlike their bigger corporate counterparts, SMEs are unlikely to have IT teams dedicated to protecting their business software, IT systems and client privacy, from failures/cyber-attack. PI policies can cover cyber risks, they can be silent on whether cyber is covered or they can expressly exclude cyber related claims. Since January 2021, Lloyd’s syndicates have been required to clarify their position on ‘silent’ cyber in PI policies.⁸ SMEs are particularly vulnerable to significant losses from cyber incidents and whilst cyber cover does not appear to be a priority⁹, for the protection of SME brand and viability, it should be.