Risk Allocation in Construction Contracts

Introduction

Risk allocation in construction contracts is a complex and crucial aspect of contract negotiation and drafting. There is no one-size-fits-all rule for risk allocation and it largely depends on the circumstances of each project. Drafters of standard forms of contract, made up of industry experts, give consideration to industry best practices in risk allocation when drafting these contracts.

Risk Categories

There are many categories of risk in a construction project. Some examples of the risk categories include the following:

• Safety risks.
• Non-payment or late payment.
• Delays caused by one of the parties to the project or caused by an event beyond the control of the parties.
• Political and economic risk.
• Environmental risks.
• Regulatory risks.
• Supply chain risks.

General Principles of Risk Allocation

It is important to highlight that risk allocation in standard form contracts is often amended in special conditions of contract. The intention of this article is to provide some general guidelines on risk allocation in a construction contract.

• Allocate the risk to the party best equipped to manage it: The fundamental principle is to allocate the risk to the party that is in the best position to manage or control the risk. For example, design risks are allocated to the Employer who has appointed the Engineer or Architect whereas the construction-related risks would fall on the Contractor. Usually, the Employer would hold the Engineer or Architect responsible in their contract directly with the Employer. Industry standards and practices have revolved around this principle. For example, it is common for Engineers and Architects to carry professional indemnity insurance.
• Risk transfer through insurance: Many contracts rely on insurance to transfer risks. For example, the term of the contract will require the party carrying a certain risk to ensure that there is an adequate insurance policy in place to ensure that the party is protected by their insurance for the risk.
• Liquidated Damages: The parties to the contract may specify liquidated damages in their contract which is payable when a contract is breached. For example, the penalty clause states the amount that the Contractor is responsible for paying in the event of a delay to a project that the Contractor is responsible for. The damage is usually predetermined instead of negotiated later on.
• Performance Guarantees and Payment Guarantees: These protect the Employer and Contractor respectively in the event of breach through non-performance by the Contractor or non-payment by the Employer.
• Force Majeure: Contracts often include force majeure clauses that allocate the risk of unforeseen events, for example natural disasters, by determining which party is responsible for delays and costs associated with these events.
• Changes and Variation Orders: These should be clearly defined in the Contract including the process of how changes or variations to the project scope of work should be facilitated as well as who will be responsible for the costs.
• Contractual Provisions: The contract itself should clearly define the allocation of risks. This includes the use of indemnity clauses, limitation of liability clauses, and warranties that specify who is responsible for what and to what extent.

General Risk Management Strategies

Effective risk management requires proactive measures to identify, assess and mitigate risks. Some key strategies include:

• Comprehensive Risk Assessment: At the outset of the project, conduct a thorough risk assessment and identify potential hazards and vulnerabilities. This is imperative, especially from a safety perspective and some projects may require a risk assessment of each task before it is executed.
• Contractual Risk Allocation: As highlighted above, risks should be allocated to the party that is in the best position to manage them. The terms of the contract must be reviewed with a view that it clearly identifies the responsibilities and liabilities of the parties.
• Risk Mitigation Plans: Develop contingency plans to manage identified risks and regularly monitor them throughout the project life cycle.
• Stakeholder collaboration: Regular collaboration and engagements with all project stakeholders on the project risks lead to effective management of these risks. Communication is key.

The role of insurance in managing risks

Insurance plays an important role in managing risks. The following are common examples of insurance that is used on construction projects:

• Contractor’s All Risk (CAR) insurance: CAR includes third-party liability and is essential for physical loss and destruction to the construction works, plant and equipment.
• Professional Indemnity Insurance (PI): PI cover is essential for professionals on the project and includes engineers and architects. PI covers negligence or errors in design.
• Public Liability Insurance: This insurance covers claims for bodily injury or harm or damage to property raised by third parties resulting from the construction project.
• Workman Compensation Insurance: This is a legal requirement and covers workplace accidents and injuries.

Risk management is a vast landscape and specialist advice may be required on a case-by-case basis. Members may contact the Association for any further advice or guidance.

Bilaal Dawood

Head: Membership Services