Contracting to Appropriately Allocate Risk

RT-210 Topic Summary
RT 210

Overview

There is wide consensus that risks are often inappropriately allocated in construction contracts: The party with the strongest negotiating position shifts the risks to those with less leverage (primary contractor, who pushes the risks to the subcontractors and suppliers). As a result, risks are very frequently allocated to parties least able to control and influence those risks, with adverse financial impact on the project and all participants, especially owners.

In response to this problem, CII Research Team 210 conducted an extensive study of literature on contracting and risk allocation as well as surveys of several owners and contractors on their contracting practices with regard to risk, and how they affected the financial performance of the projects. Through analysis of the data collected, RT-210 quantified the financial impact and how it was distributed among the participants. The research team also performed extensive review of contracting case law. The results are summarized in Research Summary RS210-1, with full details in Research Report RR210-11. The team also developed documentation on legal perspectives outlining equitable risk allocation principles, and a two-party risk allocation tool.                                                                            

Key Findings and Implementation Tools

1 : Leadership Needed to Change Risk Allocation

Risk Allocation is a process by which the possibility of loss associated with each of the identified risks is contractually assigned between the contracting parties. In place of the current adversarial contracting approach, we need a culture of more collaborative contract negotiation practices in order to minimize inappropriate risk allocation. For example, industry lawyers, instead of leading the negotiations and engaging in risk allocation battles with the opposing attorney(s), will need to play a supporting role. This change requires top down leadership. (RS210-1, p. 6)
Reference: (RS210-1)

2 : Inappropriate Risk Allocation – What Does it Cost you?

There is ample empirical evidence showing that inappropriate risk has significant adverse financial consequences to both the party trying to avert the risk (by transferring it to another) and party accepting the risk. For example, the owner pays a risk premium (usually in the form of contingency) for transferring risk to contractors. Refer to RS210-1.
Reference: (RS210-1)

3 : Which Risk are Most Often Misallocated?

RT-210 identified 14 “hot button” risks – these are the risks which are most frequently allocated inappropriately. (RS210-1, p. 10)
Reference: (RS210-1)

4 : Basic Principles of Risk Allocation

The research describes two categories of risk allocation principles: “general risk allocation principles” and “legal risk allocation principles.” See IR210-3, Equitable Risk Allocation: A Legal Perspective, pages 2-5, for the complete list and explanations / examples of these principles. 

The following are some of the general risk allocation principles:
  • Many risks cannot be entirely eliminated, but can be controlled.
  • Eliminating one risk may cause new risks to materialize.
  • Many risks are interdependent so it is important to evaluate risk dependencies to be able to predict the cumulative impact or “domino effect” that may materialize with the realization of one individual risk.
Some legal risk allocation principles are listed below.
  • Stricti Juris – Courts will construe contractual provisions exactly as they are written; extreme care should be taken in drafting the contract language, to mean exactly what both parties agree.
  • Strictisimus Juris – Courts will construe a contract in a manner that will do substantial justice to the parties.
  • Contra Proferentum - Contractual ambiguities will be construed against the drafting party.
Reference: (RS210-1)

5 : Recommended Contract Language for Risk Allocation

The team also developed a table showing recommended contract language for the 14 “hot button” risks. For each risk, the tables provide examples or descriptions of contract language 1) favoring the buyer, 2) favoring the seller, or  3) compromise. The issues shown at the top of each table should be considered when negotiating clauses pertaining to these risks. The language presented in the contract language tables are recommended, and can be used a starting point or guidance in negotiating the language appropriate to risks considered important by one or both of the parties. (IR210-3, p. 10)
Reference: (IR210-3)

6 : How Have Courts Interpreted Risk Allocation?

The Research provides legal perspectives and covers legal research on common law interpretations of 10 of the 14 “hot button” risks. For each of the 10 risks addressed by the research, the findings are described, along with a “Legal Issues and Considerations” flow chart. The flow charts are especially instructive on how courts may assign responsibility between owner and contractor. RR210-11 covers the legal perspectives in more details and includes detailed descriptions of relevant court decisions relating to the 10 risks.
Reference: (IR210-3)

7 : Implementation Tool #1

IR210-2, Equitable Risk Allocation: Two-Party Risk Assessment and Allocation Model

This publication provides a risk assessment tool in the form of Excel spread sheets for single party and two-party assessment to identify major risks which are coomon to both parties as well as those for which the perception risk is not the same for both parties. IR210-2 also contains a tutorial, which describes the risk allocation model framework, value added by the model, and the sequence of the model components. The tool is a valuable tool for both parties to first do single party assessment and obtain internal alignment on risks (within each organization) and then find alignment between the two parties by using the two-party risk assessment tool. This should be used in conjunction with the legal perspectives document and contract language tables to arrive at contract terms acceptable to both parties and allocating risk equitably.
 

Reference: (IR210-2)

8 : Implementation Tool #2

IR210-3, Equitable Risk Allocation: A Legal Perspective

This is a companion publication to IR210-2, and should be used in conjunction with IR210-2. Significant contents include listing of “hot button risks” (risks most frequently allocated inaprropriately), list of general risk allocation principles and legal risk allocation principles, and a contract language table for each of the “hot button risks.” IR210-3 also includes a legal issues and considerations flow chart for each risk. These charts help minimize the confusion and ambiguities surrounding the allocation of each risk.

Reference: (IR210-3)
rt-210

Key Performance Indicators

Reduced/improved risk

Research Publications

Contracting to Appropriately Allocate Risk - RR210-11

Publication Date: 08/2007 Type: Research Report Pages: 613 Status: Reference

Equitable Risk Allocation: Risk Assessment Worksheets Tutorial - IR210-2

Publication Date: 02/2007 Type: Implementation Resource Pages: 86 Status: Tool

Equitable Risk Allocation: A Legal Perspective - IR210-3

Publication Date: 02/2007 Type: Implementation Resource Pages: 62 Status: Tool

Equitable Risk Allocation - RS210-1

Publication Date: 09/2006 Type: Research Summary Pages: 46 Status: Supporting Product


Presentations from CII Events

Plenary Session - Equitable Risk Allocation: A Challenge to Leadership

Publication Date: 06/2006 Presenter: Number of Slides: 17 Event Code: AC06

Implementation Session - Equitable Risk Allocation: A Challenge to Leadership

Publication Date: 06/2006 Presenter: Number of Slides: 28 Event Code: AC06

Session - Equitable Risk Allocation

Publication Date: Presenter: Number of Slides: 25 Event Code: PIW408

Session - Equitable Risk Allocation: Who Is Using It and Why

Publication Date: Presenter: Number of Slides: 12 Event Code: PIW408

Session - Equitable Risk Allocation

Publication Date: Presenter: Number of Slides: 28 Event Code: PIW1009


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