Who Owns the Risk?
Six tips for transferring risk and why it’s like Halloween candy
When someone writes a contract, they’re selling risk; when someone else writes a quote, they’re buying it. Transferring risk is one of the main purposes of a contract. In the construction world, the contract makes the bidder responsible for various aspects of the job at a certain price, and if the job costs more than that to build, the responsibility falls mostly on the bidder. If the price of steel doubles between now and when the bridge is being built, too bad.
Why would anyone sign that contract? Well, if the price of steel actually drops 30% between now and when the bridge is being built, the owner’s not seeing a penny back, plus it’s pretty likely that the bidder locked in some kind of agreement with a steel manufacturer immediately before signing. Contractors make their money through being able to gauge and handle risk.
However, there are situations when nobody is really comfortable signing a fixed-price contract. Research and development projects are one example, with their uncertain scope and outcomes. That’s when contract styles like time and materials or even cost-plus are used. Those kinds of contracts mean the owner is on the hook for additional costs, because if it takes longer to finish or if material costs increase, the contractor will just charge more. The choice between a fixed price or time and materials style contract is ultimately about risk: how much risk is there, who owns it, and can they handle it if the risk actually materializes.
So if you’re an owner with a project to build, what is the right amount of risk to keep, and the right amount to transfer?
Trading Halloween Candy
My favorite metaphor for risk transfer is very familiar to anyone who was a kid, has a kid, or knows a kid in the US and Canada. On Halloween night, hordes of costumed trick or treaters roam the streets, knocking on doors and collecting candy. Once the bag gets too heavy, they go back home, sit on the living room floor, dump out the contents, and open negotiations: who will trade two Tootsie Rolls for a fun-size Hersheys? Who will trade a Twizzler for a lollipop? Does anybody actually want this black licorice? (No.)
In this situation, every kid is trying to get the candy they like and give away the candy they don’t like. Ideally, everyone gets as much as possible of the candy they like. There might even be someone who enjoys black licorice, although it’s probably a parent. This is how risk transfer should work: all parties get the risks they want or are best suited for, and it’s a fair trade.
It’s just that in the contract world the trade is usually money instead of Mars bars.
No Such Thing as a Free Lunch
The first rule of risk transfer is that it isn’t free.
With our bridge example, everyone in the supply chain has either added contingency or taken steps to make sure they can keep their commitments. If more risk is being transferred than usual — for example, if the bridge won’t be built for two years but the owner needs a price commitment now — the contractor will need to consider what they need to be comfortable. Conversely, if the owner is retaining more of the risk, they’ll need to keep contingency on hand to cover any price increases.
Carrying the Load
The second rule of risk transfer is give it to the party who can handle it.
This actually has two meanings. First, who is best able to actually control the risk? Is it (a) an execution risk which can probably be best handled by the contractor or consultant actually doing the work? Does it (b) involve a third party that no one has any control over? Or (c) is it a hybrid, where there’s an execution component but also some parts that are uncontrollable? In case (a), that’s a risk to transfer to the contractor; in case (b), that’s a risk for the owner to keep. In case (c), that might be a risk to share.
The second meaning of “handle” refers to what happens if the risk materializes. Some risks are just too great for some parties to be able to deal with; taking on too much risk could mean that the contractor goes bankrupt. It’s important to keep this in mind. Even if it’s possible for an owner to transfer a lot of risk, it may not be wise. The Construction Industry Institute has great resources for recommended ways to share and transfer risk in a way that yields the best long term performance.
Don’t Get Taken to the Cleaners
The third rule of risk transfer is know the cost of risk.
As an owner (or as a contractor), if you don’t have a good idea of where your risks are and how much they might increase costs, you may be unpleasantly surprised by the bids you receive. It’s possible for the risk premium on a project to be a double-digit percentage of the base estimate. This kind of understanding starts with strong risk analysis, but for large or higher risk projects it may be worthwhile to explore more advanced tools like probabilistic cost estimating and joint cost and schedule modeling.
A strong understanding of risk costs also helps to guide decision making around transfer. The decision to transfer or share or retain a specific risk should be just that: a decision. Making time for a discussion of key risks, what their allocation should be, and the mechanism for transfer or sharing is an important part of preparing for procurement.
I’ve Got a Little List
The fourth rule of risk transfer is put it in the contract.
Risks are transferred or shared either through the general style of contract, such as with a Design-Bid-Build contract where the contractor is responsible for all means and methods, or through specific provisions in the contract which deal with one or more risks. Contract language needs to be written carefully to hold up if tested in a dispute. It should be clear where every risk in the register can be found in the contract, whether it’s covered in a general clause or individually called out. This is also an opportunity to explore risk sharing mechanisms, which attempt to set incentives for both owner and contractor to try to control a given risk.
Diamonds are Forever but Risk Transfer is Not
The fifth rule of risk transfer is that not all risks stay transferred.
A contract may not be written well enough to fully transfer all risks, transferring one risk may cause others to materialize, or risks may be inadvertently taken back by the owner during the execution phase. Risks can come back through changes, during disputes, or even in court. It’s important not to take risk transfer for granted; monitoring the status of risks during construction, cross-checking against change requests, and using the risk register as a tool in dispute management are highly recommended.
You Couldn’t Even Pay Someone to Take It
The sixth and final rule of risk transfer is that you can’t transfer everything.
Cost risks can generally be transferred well. However, with schedule risk, while responsibility for delay can be transferred to the contractor or consultant, the project will still be late and stakeholders will still be upset. And some types of risk are practically impossible to transfer, such as reputational risk. Risks frequently have multiple types of impact; a geotechnical risk, for example, could have both cost and schedule implications, and could also result in reputational damage — Seattle’s Big Bertha tunnel boring machine made international news when it was stopped in its tracks after hitting a steel pipe, and regardless of the ultimate responsibility for cost overruns, Washington State had to deal with the outfall in the press.
Transfer Wisely, Transfer Well
According to the Construction Industry Institute, inappropriate risk allocation has the potential for serious consequences to both parties, and the prevailing approach of pushing risk down the supply chain yields an outcome where the parties least able to control risks are the ones made responsible. A thoughtful approach to risk transfer yields better project outcomes, fewer disputes, and better relationships between owners and contractors.
So the next time you’re drafting a contract, think about Halloween candy.
Disclaimer: I am not a lawyer and this is not legal advice.
