A successful construction project depends on how well project participants manage project risks. Risks are managed through sound business and construction practices and through careful preparation and review of the project contracts. A significant component for successful risk management begins with the careful allocation of risk during the contract development stage. Ideally, the project documents will allocate responsibility for certain risks to the party best situated to bear them, and in doing so minimizing the likelihood and the cost of each risk. Following are five key risk allocation and management concepts that should be considered during the preparation of the contracts
1. Risk Allocation to Appropriate Professionals
Owners and contractors should anticipate potential project risks and determine whether it is more advantageous to retain or transfer them. From a risk management perspective, it is crucial to spread the project risks to the parties most able to manage them. Owners, especially those not well-versed in the nuances of the construction industry, should strive to limit the number of parties with whom they contract. The owner should engage a project architect, and then place responsibility for engagement and oversight of all other design professionals on the architect, who is in a much better position to oversee these consultants’ services than the owner. The same is true for the project’s construction activities; the owner should enter into a contract with the contractor, who will engage all subcontractors. Subcontractors should, in turn, engage sub-subcontractors, materialmen, and suppliers. In this fashion, the overall project risks may be spread to those with the greatest ability to control them.
2. Allocate Risk Through Indemnity Provisions
An indemnity provision generally is a section in a contract that requires one party to pay for losses incurred by the other party (and, often, to defend the other party against claims for such losses) as a result of claims made by third parties. Following up on the risk allocation example set forth above, a construction contract indemnity provision often requires the contractor to indemnify and defend the owner from and against claims for bodily injury and property damage that arise from the negligence of the contractor or one of its subcontractors while performing the work. Another indemnity clause may require the owner to indemnify and defend the contractor from and against claims based on the existence of hazardous materials on the project site over which the contractor has no control.
3. Use Insurance to Support Indemnity Provision
Contractual indemnity provisions included in contracts are only as good as the indemnitor’s ability to honor them. Because it is often difficult to adequately vet a contractual partner’s finances and work/safety history, requiring the proper amount and type of insurance is a crucial risk management component. When transferring risk through indemnity, it is important to ensure that the transferee has, or is able to procure in a cost-effective manner, insurance coverage sufficient to handle the assumed risk. One caveat at is that some risks included in an indemnity agreement, such as liability arising out of an indemnitor’s intentional misconduct, are not insurable. Do not let lack of insurability for such conduct serve as a valid argument for negotiating responsibility for it out of an indemnity agreement.
4. Require Additional Insured Requirements
The owner should require all contractors and/or subcontractors to add them as an additional insured under their liability policies. Additional insured status adds a layer of protection to an owner’s or contractor’s indemnity requirements. A key advantage is that an insurer has an upfront duty to defend claims made against additional insureds, whereas most indemnity provisions require only that the indemnitee provide reimbursement of any defense costs. Include a requirement in your contract that the additional insured endorsement be broad enough to cover both ongoing and completed operations, as well as your liability arising out of the work, on a primary and non-contributory basis.
5. Include Waivers of Subrogation
Where applicable, proper transfer of many project risks from the contracting parties to their insurers is achieved through the inclusion of waivers of subrogation. These waivers prevent insurers from passing risk back to other project participants by impeding insurers from seeking reimbursement from other project participants for amounts paid on claims. When bringing a subrogation claim, an insurer cannot bring such a claim if its insured has waived this right in its contract with the allegedly responsible party. For this reason, waivers of subrogation ensure that transferred project risk stays with the insurers.
And above all, there is no substitute for reading each contract very carefully before signing it. Beyond the obvious problems of errors and inaccurate information that creep into negotiated contracts, careful review may reveal additional risks, improperly allocated risks, and other issues. No agreement is perfect, but vigilant contract review is one of the most crucial steps in the risk management process.