Risk Allocation in Construction contract


 Executive summary

The paper aims to shade intensive lights over risks allocation and its related aspects embedded with a construction contract. For this purpose, an in-depth study of different types of risks which generally arisen in large sized construction projects is presented within the paper. For making the context clear, the paper elaborates some significant information about construction contract and different parties which are generally involved within a construction contract. In this section, the nature of different construction contracts is also discussed, which becomes a prime reason behind different types of risk in the contract. Further, the paper discusses different types of risks availed by different parties so that raw data for proper risk allocation can be collected. Next section of the paper elaborates risk assessments and evaluation processes which are quite essential for the project manager to carry out as it help in prioritizing of different types of risks before allocating them. Further section of the paper is related with the risk allocation in a construction contract. The section explores disclaimer method for transferring risk from one party to other. Furthermore different roles played by different parties in the mitigation of risks in a contraction contract are also explained in the paper.

Introduction

In existing uncertain and highly fluctuating business environment, risk identification and its proper allocation has become an integral aspect of business management practices undertaken by commercial business organizations. In the same manner, proper risk allocation becomes quite essential and crucial in the industries like construction in which, a huge amount of investments are done by management of business organizations. The failure of proper identification and allocation of risks in major civil, mining and other types of construction projects can lead the concerning parties to pay some dire costs as they are needed to invest some significant amount of time, cost and efforts in construction project. Owing to this reason, it becomes quite essential for management of such types of projects and organizations to undertake some of crucial commercial as well as contractual arrangements for the purpose of allocating and minimizing risks involved within their project (Rojas 2009).

In recent period of time, there are different examples and incidents in which large construction projects have fallen out due to inappropriate allocation of risks during the entire project. These fallouts in construction projects can be proved quite critical as significant amount of resources have been employed within such projects. In the light of this fact, the paper aims to reflect different types of risks involved within a specific construction project and different measures employed for the purpose of allocating risk in the most effective manner so that the entire execution of a project as well as outcomes of the project can be managed. In existing dynamic business environment, different norms and practices related with risk allocation process have been changed quite intensively. A number of different measures and models have been started to be used in normal practices by construction business organization in order to manage as well as allocate risks involved in construction contract (Wu 2010). The paper highlights different measures which are generally adopted by organizations to manage and allocate risks in different construction related projects.

Construction contracts and parties involved

In order to mitigate risks involved in a construction project, there is a need of some crucial and effective contractual agreements and norms which can govern different construction related practices and norms. The legal agreement among different parties involved within a construction project is known as construction contract. The prime purpose of such contracts is to regulate the entire construction project and mitigate different types of risks. As per the definition provided by Housing Grants Construction and Regeneration Act 1996, part II (Which has been known as HGCRA 96 later), construction contracts can be considered as a measure of handling different discrepancies which has been presented within a construction project intentionally or unintentionally. As per the section 104(1) of the act a contract can only be considered as a construction project if it fulfills three different criteria listed as below:

  • · The project should carry out construction related operations and practices only.
  • · In the project different construction related operation must be carried out by the concerning party or by other under a subcontract
  • · In the project, involved parties either provide their own labor or the labor of others in order to carry out different operations related with a construction project carried out at a large scale (Daniel Atkinson Limited 2001).

In addition to this, section 104 (2) of HGCRA 96 has also elaborated the definition of construction contracts. The section elaborates that along with core construction related activities, the construction contract also governs different architectural, design or surveying work related with construction activity. In addition to this, the construction contract also provides the provision of providing advice on different aspects of building construction such as engineering, interior or exterior decoration, and layout of landscape (O’Reilly1999).

Section 114 (2) of the act also elaborated that construction contracts cannot be applied on a project in two conditions:

  • · When a claim is demanded for restitution in no contract conditions
  • o When due to environmental as well as operational uncertainties, the forcibility of a contract cannot be possible (The Nature of Construction Contracts 2007).

Nature of construction contracts

The nature of contracts done for construction project is quite complex and distinguished from other types of contracts.  There are a number of different specific aspects of a construction project such as size and length of the project, high degree of complexities, huge amount of investment made in the project, and fluctuations in the price agreed and amount of work done in the project with the progress of the project. These differentiated aspects of construction projects signify that the nature of conduction projects can be different with that of other types of contracts (O’Reilly 1999).

The nature of a construction projects can also be considered quite complex as it governs a wide range of different construction related activities, which are directly carried out both above (in the case of building and architect) and below ground (In the case of construction related engineering work). Construction related contracts may include variety of activities such as partial or fully demolition of existing building, refurbishment and extension of existing infrastructure, and fully reconstruction of a new building setup.  The requirement and norms of such different aspects of constructions related practices are quite different from each other. Owing to this reason, the nature and scope of a construction contract becomes quite comprehensive and complex (The Nature of Construction Contracts 2007).

Parties involved within a construction contract

In a construction contract there are a number of different parties involved which own their stakes in the contracts. They possess different interests, roles and responsibilities within a construction contracts. As per Construction Industry Development Board Act, 2000 (Act No. 38 of 2000), the construction contract can be applied on different parties listed as below:

Employer or owner of a project:  The employer is a juristic person who owns all rights and ownership of a construction site and project.

Contractor: Contractor is the person who comes under the contract with employer to perform different activities related with construction project.

Subcontractor: subcontractors are the party who contracts with main contractor or employer to perform different supportive construction related activities. Subcontracts not only assist the contractor but it also help in providing different supplies, services, or engineering and specified construction works.

Tenderer: Tenderer is a person who submits a tender offer for the purpose of accomplishing different construction related activities.

Agent: Agent is the party who is not the employer or employee but acts on the behalf of the employer of project (Construction Industry Development Board Act, 2000 (Act No. 38 of 2000) 2005).

These are some of the prominent parties involved within a construction contract who are responsible for different activities and practices included within a construction project. In the risk allocation process, these parties mitigate different types of risks involved within the construction project.

Types of risks in a construction contract

Risk is one of the most essential and integral aspects of practices undertaken within a construction projects. In this aspect, Abrahamson Principles of risk allocation in different construction projects can be considered quite effective. As per the principle, different parties involved within the construction contract face different types of risks in large or small sized construction project. Some of the risks are common for all the parties involved within contract, while some risks are specifically bore by a specific party.

Risks for the owner of the project

 As per Abrahamson Principles, owner of the project is known as Principal party. In this context, some critical risks bore by Principal party of the construction contract can be elaborated as below:

(1) Land Acquisition risk:

  This is the prime risk for the principal of the project. The owner of the project needs to have proper and legal acquisition of the land for his construction project. In the absence of proper acquisition of land, the entire project can be hindered due to different legal obligations.

(2) Insufficient resources

  Insufficiency of some of crucial resources like land, finance, human power can also be proved critical risk for a construction project. As construction project are commenced for a longer period of time, sufficient amount of resources for contingent situation is quite necessary for the owner.

(3) Delay in the project completion

  The completion of project on time is one of the major factors of the success of a construction project. Delay in the overall completion of the project due to natural or manmade reasons, can cost quite heavily for the owner of the project as he has to invest a significant amount of money and time in such types of projects (McInnis 2001).

(4) Increased cost of the project

  As generally construction projects are carried out for longer period of time, fluctuations in the overall cost and prices of raw material and labor over such a long period of time are quite natural phenomena. These fluctuations may lead to increase the projected cost of the entire project. Although, principals generally undertake contingency reserves for such type of fluctuations, yet still these increments in cost of the project can be probed quite critical risk for the project owner.

(5) Deficiencies in infrastructure or services

  There are a number of different other infrastructural services that can affect the successful completion of the project. For instance, for a residential or commercial construction project, there is need of better electricity and water facilities and better access of road. Deficiencies in infrastructure or services can lead to make the project unsuccessful (Loots, and Charrett 2009).

(6) Design and construction defects

  Defects in designing and constructing of the project can lead to efficiency of the internal operations and quality of the output of the project. In this direction, the project owner needs to have proper monitoring and effective evaluation of outcome of the project.

(7) Political risk

  Different types of political risks such as rules and regulations of government regarding construction activities, frequent changes in the government and its priorities, and incentives or tax levied by the government over different construction related activities, can hamper the success of construction projects in the most aversive manner.

(8) Market risk

In addition to other risks, risk related with market characteristics as well as trends can also be considered some of the critical risks availed by the owner of the project. Different types of market risks such as advertising of the project, Switching of potential customers of the project towards other alternative projects, and competitive rivalry within the construction industry are some of the prominent market risks which decrease the profitability of the construction project for its owner (Nansi 2001).

Risks availed by the contractor

Along with owner of the project, the contractor of the project also bears some of the critical risks associated with a research contract. As per Abrahamson Principles, a contractor is required to face some critical risks throughout the entire stage of a construction project i.e. negotiation over contract terms and conditions, deigning and construction of the building and proper and careful maintenance and follow up the contract in the most effective manner. Some of these risks can be listed as below:

(1) Condition of Site:

The existing working conditions of the construction site leads to present risks in front of the contractors to finish the entire project on time. Different natural or manmade problems can lead to delay the project delivery, which is quite problematic aspect for a contractor.

(2) Social conditions:

Lack of acceptance of the construction project by the society is the factor that can lead to put question mark over successful accomplishment of the project and viability of project deliverable. There can be some unexpected incidents like labor strike, religious and social belief of local people, and so on, which are to be handled by the contractor only (Rojas 2009).

(3) Defects in the construction and engineering:

  There can be some of critical defects in the project which can only be identified in the finished project. The detection of such types of defect becomes quite difficult for the contract during the construction process. These defects can be proved quite critical risk for the contractor of a construction project as these defects decrease the quality of the project.

(4) Increase in the cost:

  In existing business environment, rise in different types of related cost such as labor wages, cost of raw material for construction and construction equipments are some of critical risks bore by the contractor of the project (McInnis 2001).

  These different types of risks are quite essential for the business organizations to be handled and allocated as in the performance of a construction contract, these risks present different hurdles and problems.

Risk assessments and evaluation

After having a proper understanding about different types of risks associated with a construction contract, parties involved within the projects is required to assess and evaluate risks. In the process of risk assessment, existing as well as potential risks related with the project are indentified and a proper evaluation of impact and ways to mitigate such risks are done. In this direction, there are five important steps for the purpose of assessing and managing risk in a construction contract.

(1) In the first step of risk assessment, some potential sources of occurrence of risk related with the project are spotted. For this purpose, external as well as internal environment analysis for the project is done so that potential weakness of the different crucial factor can be revealed.

(2) In the second step, the entities or areas of operation, which can be got affected due to such risks are revealed. The main purpose of this practice is to identify the potential impact of such risk over the successful completion of the entire project.

(3) Assessment of the degree to which, the risk can harm the construction project and parties related with the construction contract, is done in the third step of the risk assessment.

(4) In the fourth step of the risk assessment plan, some of the crucial measures and procedures for reducing the potential risks are determined. In the step the alignment of the requirement of different measures of risk mitigation is done with the existing available resources.

(5) This is the final step of the risk assessment plan in which, the drafting of the final risk allocation plan is done with the help of thorough review of the different element of risks which can hamper the proper accomplishment of the construction contract (Mead 2007).

Control of risk

While assessing and evaluating different types of risks, it is quite essential to reveal the entities or areas where the control of the risk lies. On this basis, overall risk to the project can be graded in five different categories.

(1) Unpredictable External Risk:  Risk which cannot be controlled by either project manager or project owner comes under these categories. Such types of risks are quite unpredictable. These risks are arisen and controlled by interference of third party such as society, and government within the consecution contract.

(2) Predictable but uncertain risks: some risks can also hamper the project, which are uncertain despite having predictable nature. For example natural disaster and bad weather are expected in the project but the degree to which, they will affect the project cannot be assured. These risks are also beyond the control of human being. However, for addressing such risk, the owner of the project undertakes agreement with other external parties such as banks, insurance companies.

(3) Internal technical risks:  These risks arise due to faults in deigning of projects, tools and techniques used in the project and technical breakdown of the operations of the project. These risks are in the control of the subcontractors who provides facilities of engineering and other technical assistance to the main contractor of the project (Cooke, and Williams 2004).

(4) Non technical internal risks: These types of risks arise due to the failure of proper management of the entire project activities. These risks take place because of lack of proper control and cooperation between different teams employed within a construction. The control of such types of risks is undertaken by both the project owner and contractor of the project.

(5) Legal risks: these risks are related with the incompatibility of the construction project with local legal rules and regulations. Legal risks can only be controlled by the owner of the project as he possesses all the legal rights and responsibility of the entire project.

These different controllers of various risks can be proved quite effective in proper allocation or transfer of the risks from one party to another for the purpose mitigating risk involved in the contract (Rojas 2009).

Allocation of risk in construction contract

The assessment and evaluation of different types of risks involved within a construction contract provide a competent base for allocation of risks throughout the entire project. As there are a number of different risks associated with a construction contract, it becomes quite crucial to have proper allocation of risks to the party that can handle and mitigate risk in the most effective manner. The allocation of risks in the contract is done by prioritizing the risks elements related with the construction project. The prioritization of risks allows the project manager to have a proper order in which different resources are to be employed in the risk mitigation process. In a construction contract, different risks can be prioritized on the basis of two different criteria:

  • · Probability of the occurrence of risk during the entire project
  • · Severity of the ultimate impact of the risk on the successful completion of the entire construction project

The allocation of risks in the contract is done on the basis of these two aspects. As per such criteria, risks, which occur within the project quite frequently and have severe and strategic impact over the project are taken and allocated on priority. Before the allocation and treatment of risk, proper and effective prioritization of different risks is quite necessary as it helps the project owner and manger to employ adequate resources for addressing the most critical risk (Lee, Lee and Wang 2009).

Treatment of risk

  Allocation of risk includes the proper treatment of the risk assessed within the contract. The treatment of risks can be done with the help of four different strategies namely:

(1) Risk Elimination:

The elimination of risk is done by not preceding the risk further. This treatment is used for risks which occurs rarely and cast least impact over the construction contract.

(2) Risk reduction:

  Risk reduction strategies imply the project manager to undertake further investigations and lawful actions for the purpose of avoiding the occurrence of the risk in future. Through this strategy, risks which occur quite frequently within the project but are less harmful by nature. Undertaking of this type of risk reduces the chances of the occurrence of the risk in future (Cooke, and Williams 2004).

(3) Risk transfer:

  Transfer of risk can be done with the help of different legal and contractual agreement with other external parties such as Insurance Company. For transferring the risk over other party different instruments such as guarantees, contractual exclusions, performance bonds, limitations of liability, insertion of a risk premium indemnity clauses, and risk transference are used by the project manager. For risks, which are having unpredictable nature are allocated by this strategy.

(4) Risk retention:

  The retention of risk is done for risks which occur due to internal deficiencies in the project management. These risks can be measured and identified quite easily. For this purpose, different measures like self-insurance, internal management of risk, and bearing large deductibles are undertaken by the management (Mead 2007).

Risk allocation in contract

As no construction project can be accomplished without confining with different types of risks, it becomes quite essential for the project manager to regulate different risks and allocate these risks to different parties so that risks can be managed effectively. Owner of the project usually shifts project risks towards the contractor who involves directly to the contract. For this purpose the owner uses disclaimer or exculpatory clauses in the construction contract. These disclaimer clauses are used for the purpose of transferring risks from one party to another party on the legal terms (Zaghloul, and Hartman 2002). With the help of these different clauses included in the contract, the owner can exclude himself from his liabilities towards the construction contract.

However inclusion of disclaimer with the construction contract enhances the existing cost of the project for the owner. For the sharing the risk with the owner of the project, contractor charges some additional and hidden costs. In addition to this, the disclaimer can also have different clauses related with some unpredictable incidents such as restricted bid competition, high potential for claims, risks related with the adverse relationship between owner and contractor, and disputes. These incidents can cause for some critical risks in the accomplishment of the project success. For the purpose of allocating risks within a construction contract there are five different and important types of declaimers are taken into account by project owners and contractor. These disclaimer include, (1) delay in predetermined events and project activities, (2) indemnification for any practical loss and injury to the project owner due to delay in the project accomplishment (3) Uncertain status of the working conditions at the project site, (4) liquidated damages within the project, and (5) sufficiency and easy availability of different important contract documents which make the legal position of each party in the contract (Zaghloul, and Hartman 2002).

An owner of the project can allocate his risks involved within the construction project through four different types of disclaimer included within a contract. These disclaimers are Site investigation provisions clauses, unforeseen site condition Clause, Submittal and Shop Drawings Clause and Payments Clauses, These different types of clauses are having different span and scope. The proper and effective implication of such clauses within a construction contract enables both project manager and contractor to understand the nature of risk embedded with the project and reduce it by sharing it in the most effective manner (McClelland 1996).

Roles of external and internal parties

  In a construction contract, there are a number of different external and internal parties involved. These different parties play different role in the proper mitigation and diversification of different types of risks. Role of different parties can be discussed as below:

(1) Project Owners: Project owner is the party which directly got affected with the success or failure of a construction projects. This party can minimize legal and political risk by accomplishing different legal requirements in the most effective manner before commencing the project.

(2) Project contractor: project contractor helps in coping up with different risks arises due to internal operations of the projects. In addition to this, different predictable risks related with scarcity of raw material, lack of adequate human resource and skilled man power, faults in technical equipments and processes are also dealt by project contractor. The role of project contractor is quite important in mitigation of risk as different project related activities are managed and monitor by the contractor. This is the party which is directly involved in the project activities. Owing to this reason, contractor can find faults in the existing practices undertaken within a construction contract (International Marine Contractors Association 2006).

(3) External parties: Different external parties can play a vital role in minimizing some of critical and unpredictable risks related with project. Different external parties such as bank guarantor and insurance company aim to address different unpredictable risks such as natural disasters, bad weather, which can hamper the project deliverables. For the purpose of sharing risk of the project, such external parties charge their fees from the owner of the project.

(4) Employees: employees of project owners or contractor also play an important role in minimizing risks in a construction contract. The successful completion of a construction project heavily depends upon the efficiency and efforts employed by employees for accomplishing their assigned tasks. They are required to handle a number of different operational risks related with the working conditions, project tools and equipments, raw material and so on. An employee can manage such operational risks with the help of his skills and attitude (Best, and Valence 2002).

In this manner, different parties involved in a contract are important in sharing and allocating risk in order to practice the construction contract and project in the most effective way.

Conclusion and recommendation

As the risk is an inevitable aspect of a construction contract, it is quite important for the project owner to take some important steps to mitigate risk. In this direction, allocation of entire risks of the project among different related parties involved within a construction contract can be understood as an important measure adopted by project owners. In relation to this, the paper has shaded lights over different types of risks and their allocation within a construction contract. On the basis of the entire findings of the paper, it can be concluded that there are a number of risks embedded with a construction project which are quite necessary to be managed. These risks are having different nature and impact over the contract. Owing to this reason, different parties involved within the contract such as project owner, contractor, subcontractor, employees and external parties like Insurance Company, can handle or mitigate different types of risks in a better way. In this context, in a contract, allocation of risk in a contract is done on the basis of frequency of the occurrence of risk in a project and severity of the impact of the risk over the project. For the purpose of allocating risk in a project, there is a need of including a disclaimer within the construction contract which is designed for the purpose of shifting risk from one party to another in the legal manner.

Recommendation

Allocation of risks among different parties can be proved quite critical in a contract as it can lead to enhance dispute and adverse relationship among different parties involved in the contract. In this direction some of the crucial recommendations can be given for undertaking risk allocation effectively within a contract.

  • The proper assessment and prioritization of different risks should be done effectively before allocating risk. For this purpose, past data and experience should be used.
  • All the norms and terms related with risks allocation should be mentioned in the disclaimer presented within the contract.
  • Proper and adequate compensation should be given to the party to which, a particular risk is transferred or allocated so that its interest in the contract can be secured (Best, and Valence 2002).