Construction and Completion Risk Mitigation
Contractual arrangements, insurance and performance bonds/warranties have been reported as the most effective mechanisms for mitigating construction risks. Lenders might further seek to reduce construction risks by collaborating with experienced project sponsors and construction companies.
The construction contract allocates construction risks from the project company or special purpose vehicle to the construction company, which then typically transfer risks to sub-contractors. EPC (engineering, procurement and construction) or turnkey (LSTK) contracts are the most common type of contract for transferring these risks.
The construction company or contractor usually guarantees completion of the construction on a fixed date, at a fixed budget and with set performance goals. Contractors are commonly requested to provide insurance, guarantees, liquidated damages or contingency funds to mitigate risks and cover potential cost overruns.
The construction contract frequently requires construction companies to obtain insurance cover to transfer construction risks. Insurance can only cover risks such as time delays, cost overruns and performance risks when these have resulted from property damage. Private insurers can provide:
- Construction All Risk (CAR) and Erection All Risk (CEAR) insurance, covering property damages to operations and assets on the site during the construction phase
- Delay in Start-Up (DSU) insurance, which covers additional interest costs, revenue losses and fixed costs linked to delayed project completion
- Third Party Liability insurance, which protects against third party insurance claims in connection with construction risks that affect property, health, and loss of life
- Marine Cargo insurance, which covers damage of equipment during transport.
In Southeast Asia, both the number of infrastructure projects and the demand for insurance have been increasing over the past few years, with the region’s dynamism and economic growth encouraging private insurers to increase their activity. For example, most of the top 25 reinsurers in the world located their regional hubs to Singapore, where the underwriting of construction projects reached USD 4.5 billion in 2014 and is forecasted to reach USD 6.5 billion by 2018.
Surety Bonds and Warranties
Sureties provide a guarantee to the project company or lender, that the contractor will deliver the facility to the agreed characteristics. The main instruments are:
- Performance bonds and bank guarantees, which ensure the facility is delivered to the agreed performance standards
- Bid bonds and payment bonds
- Warranties guarantee the functionality of the facility for a determined period
- Surety bond contracts are agreements between three parties: the surety, the project owner and the contractor. After a claim, the indemnity is paid on demand, with the surety compensating the project company or equity investors for higher operational costs or foregone revenues.