The Unintended Consequences Of Discounting In The Built Environment

Meggyn Marot on insurance claims for discounted building projects

Meggyn Marot, Principal Broker: Professional Risks at Aon South Africa
says that pursuing the cheapest option runs the risk of other costs, such as project delays or a delay or loss of usage of the facility.

John Ruskin once said, “It’s unwise to pay too much, but it’s worse to pay too little. When you pay too much, you lose a little money – that’s all. When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do.”

The unintended consequences of applying a free market economy principle to an emerging market landscape with high infrastructure demands, is that we begin to feed the wrong beast. Instead of encouraging quality builds that can stand the test of time and building a future, we fail to think long-term, and we encourage the cheapest and fastest options because we want results now, and we fail to plan. The irony is that it costs us more in the long run, not just in monetary terms, but the benefits of those projects that are lost to our country and our people.

The decision by project owners to pursue the cheapest option carries risks, with their own costs being project delays or a delay or loss of usage of the facility. In the current environment, we are seeing an influx of projects where consultants are expected to discount by more than 50%. This is what is required to “get the job”.

There are many aspects of this environment that are impacted by the discounting phenomenon, but let’s look at the risk environment and how it is impacted. First consider that we are looking at the insurance/risk market as a whole, in the Construction & Engineering space. The health of such markets is dictated by the sustainability of the premium pool.  Simply put, sufficient premium must be collected within a sector to sustain the claims or risk that arises out of such a sector. If this is not achieved, you run the risk of collapsing a market, and no longer being able to insure your projects in South Africa, or only being able to insure at an astronomical premium.

It is important to understand that insurance premiums are based on the annual fees declared or the turnover of a firm. Where these fees are reducing it is usually an indicator of less work being done, therefore theoretically, less risk. But in an environment where the fees are reducing due to the enormous discounts offered, the risk on that project is no less, but the contribution to the premium pool is reduced.

Discounting is starting to skew the view on risk, because fees are no longer aligned to the true risk exposure. Moreover, the consequences of discounting increase the likelihood of a claim on a project. Currently civil and structural engineering is responsible for more than 65% of the number of claims notified in South Africa, and around 87% of the quantum’s paid in the last 10 years are attributable to these disciplines. These are also the disciplines where the highest discounts are expected and applied when tendering. The total gross fees declared by consultants has reduced by more than 15% over the last three years, and number of claims notified increased by the same margin.

A single practice in the built environment is now reducing the ability of the insurance markets to respond, and increasing the probability of that same risk. When we are undertaking work at a reduced income simply to secure the business and make profits, we have to cut expenses or optimise efficiencies. The result is inevitably reducing the resources applied to that project, for example a more junior employee being allocated to the project, reduced supervision, reluctance to attend all project meetings, use of an overly conservative design to compensate for the low level of engineering being paid for – these are all ways to cut costs. Of course there is always room for improvement in efficiencies and cost cutting within any organisation, however when we shift our focus from internal quality management to profit, we unavoidably increase the risk to ourselves and mistakes are made. We must never forget a professional’s duty of care exists regardless of what they might be paid, and the quality expected by law is not altered by profit margins.

Project owners must appreciate that there is a basic cost for every project, and that cost will come through, if not in paying for proper engineering, then in increases to construction costs, or worse yet, in court. The international trend has seen a move in developed countries to quality based selection, where qualification, technical merit and experience are the yardsticks. Sadly, it would appear that it is not only project owners to blame for our current predicament.  The ability of the industry to stand up for the quality and ethics they strive for is damaged by the economic reality of keeping the lights on, and accepting these conditions at a loss to themselves or worse at a risk, as there is no doubt that discounting compromises quality and risks increase. Worse still, we cut the budgets for training and development, and we stunt innovation.  This compromises our future.

The reality is that you will never see a claim caused by ‘discounting’. A claim is caused by poor supervision, a design flaw or negligent advice because a junior engineer without the necessary experience is placed on a large and complex project – consequences of discounting. However there is no denying the claims have increased and irrespective of the root cause, the impact on the industry is real. Premiums will increase to compensate for the claims experience and the industry’s credibility suffers. Where we find ourselves in an increased claims environment, the affordability of insurance for a firm with an already stretched bottom-line becomes even starker.

It’s not all doom and gloom though.  The South African Insurance market sits in the very fortunate and strong position of having very good competition and capacity. South Africa’s insurance penetration rate is among the highest in the world and well above the level one would expect it to be, given its GDP per capita. This means we have a resilience, and the ability to withstand tough times, but we must preserve this, and rather than balancing the sustainability of such markets with increased premiums, we need to manage our risks better.

A resounding echo of the built environment across all professions, is that if we persist with dealing with the lowest bidder, be sure to load elsewhere for your risk. And if you can make provision for that risk, then you had enough to pay for something better to start with.

AUTHOR: Meggyn Marot, Principal Broker: Professional Risks at Aon South Africa

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