10 effective principles for risk allocation in construction contract

Common issues when allocating risks

It is often assumed that one of the main aspects of risk allocation in major projects is the appropriateness and choice of contract delivery type, but CIOB research in 2008 indicated that the type of contract delivery has no material influence on the likelihood of completion on time.

Engineers Australia and the Chamber of Commerce and Industry of Western Australia conducted a study of effective risk allocation in major construction contracts in 2005. It found that risks were not according to which party was best able to manage the risk. Another study by the Queensland University of Technology highlighted that risk reduction is the most frequently used risk response method, with the use of contingencies and contractual transfer preferred over insurance.

The American Society of Civil Engineers (ASCE) has summarised the principles of how the risk of the effect of these variables of cost, time and quality, should be allocated as follows:

1. A risk should be assigned to the party best able to evaluate, control, manage, bear and reduce the cost of, and benefit from the assumption of that risk,
2. Many risks are best shared; and
3. Every risk has an associated and unavoidable cost which must be assumed somewhere in the process.

Similarly, in the UK, Professor Max Abrahamson, has summarised these principles as:

“A party to a contract should bear a risk where:

1. The risk is within that party’s control;
2. The party can transfer the risk (e.g. by insurance), and it is most economically beneficial to deal with the risk in this fashion;
3. The preponderant economic benefit of controlling the risk lies with the party in question;
4. To place the risk upon the party in question is in the interests of efficiency;
5. If the risk eventuates, the loss falls on that party in the first instance and it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by attempting to transfer the loss to another.”

AACEi Recommended Practice 67R-11, Contract Risk Allocation – as applied in engineering, procurement and construction, highlights general risk allocation principles as below:

• Many risks cannot be eliminated but they can be controlled.
• Eliminating one risk may cause another risk to arise.
• Care should be taken to evaluate risk interdependencies and predict the “domino effect” or cumulative impact if one interdependent risk should occur.
• Optimum allocation of risk may only be achieved through cooperation or shared responsibility.
• Ignoring a risk will not eliminate its potential impact.
• Risks that are not contractually allocated will be assumed, knowingly or unknowingly, by one or both of the contracting parties.
• Optimum allocation of risk is likely to vary from project to project.
• Any party may be able to assume a risk if: a) they understand the underlying cause and subsequent consequence of a risk, b) they are granted an appropriate risk premium for taking responsibility or ownership.

With more collaborative type of contracts, e.g. Competitive Alliance or Incentivised Delivery Partner, expected in the next decade, how the risks on a construction project are allocated can be influenced not only by the contract and the parties themselves, but also by judicial interpretations of common law and statute.

10 effective principles for risk allocation

There are many and varied methods of risk apportionment and allocation. But in summary, the following top 10 principles of risk allocation are generally recommended by Risk College International.

1. When discussing ‘risk allocation’ in any type of contract, three critical aspects should be clearly understood, discussed and allocated.
   1. Allocation of responsibilities for ‘controls’ for the risks
   2. Allocation of responsibilities for assessing and managing risks and preventive actions, i.e. to reduce likelihood of occurrence and/or consequences
   3. Allocation of responsibilities for managing recovery actions, i.e. to reduce and manage the magnitude of consequential impacts if risk materialises.   
2. Risks and their controls should be assessed and allocated separately, as the owners might be different parties. For example, while the risk of schedule delay can be allocated to the Contractor to manage, the allocation of one of its controls, i.e. monitoring the schedule confidence level, can be allocated to the Owner.    
3. Risks should be allocated to the party best able to assess and manage them, i.e. the party which is best able to minimise its likelihood of occurrence and/or consequential impacts, if it materialises.
4. Some risks, e.g. insurable risks with very high financial consequences, might be better to be allocated and managed at Program or Portfolio level rather than the Project level.
5. Risk allocation and control allocation should be part of integrated risk management by both parties not a replacement for risk management.
6. When allocating controls, risks or recoveries, try to be as specific and tangible as possible, e.g. clear responsibilities against contractual deliverables, scope items, etc.
7. Both inherent risks, i.e. uncertainty in assumptions, and contingent risks, i.e. possible risk events, should be assessed and allocated.
8. Quantitative risk assessment approaches are recommended as much as practical to support better understanding of risk exposure prior to its allocation.
9. The construction documents should fully disclose all the information known to the Owner and engineering/design party.
10. An independent quantitative risk assessment to be initiated by the Owner, to determine the risk exposure, which the Contractor’s accepted risk can be compared against. Such an independent risk assessment will ensure in addition to contractual risk allocations, further contingency and management reserves being assessed and allocated.  

Please share with us your experiences with successful or failed risk allocations.