Allocating risk

It is crucial for entities involved with construction projects to protect themselves
through risk allocation. The most effective way to allocate risk is by properly utilizing both insurance and indemnification.

“The ultimate financial risk is borne by an
insurance carrier with the identity of the
insurance carrier being determined and controlled by the various indemnification and
insurance provisions in the contract documents,” says Robert Chaklos, executive partner of Secrest Wardle’s construction practice

Smart Business spoke with Chaklos about
risk allocation, the importance of insurance
protection and indemnity provisions, and
other methods that can be deployed to mitigate risks.

Why should a construction company use risk

To fully comprehend the concept of risk
allocation, one must understand the structure inherent in construction projects where
the financial risks exist. The construction
entities or companies involved in construction projects all face some level of financial
risk, not only during the course of the project, but for many years subsequent to its
completion. These risks vary, and are a function of the construction entities’ position
within the hierarchy or chain of command
common to most construction projects.
These entities typically include the owner of
the project, the architectural team in place
to design the project, the management team
in place to manage the project, and finally
the contractors and/or subcontractors contracted by the owner and/or the management team to perform the actual construction work. Not surprisingly, the financial
risk is most significant at the top of the hierarchy, but risk allocation is used to shift
those financial risks down the chain of command as contractual leverage decreases.

What role does insurance play in risk allocation?

The first level of risk allocation is through
insurance protection afforded either directly
to the construction entity by its own insurance carrier outside the contract documents or indirectly through insurance requirements within the contract documents.
Therefore, insurance coverage is provided
either by the insurance carrier contracted
directly by the construction entity or by
insurance carriers contracted by construction entities down the chain of command,
who are contractually bound to provide
insurance coverage for the protection of
those entities up the chain of command.

For example, the owner of the project will
typically have its own insurance policy in
place, but will also require that the management team and contractors provide insurance protection to the owner, as well.
Likewise, the management team will allocate risks to its own insurance carrier, as
well as to those insurance carriers of its contractors through insurance clauses in the
contract documents. Typically, the language
in the contract documents and in the insurance policies will provide that the contractor’s insurance coverage is primary.

Why is indemnification such an important

Indemnity provisions will allocate the
financial risks down through the chain of command so that the construction entities
with the most financial risk, i.e., the owner
and the management team, allocate their
financial risk to the contractors. This is justified as simply a cost of doing business; the
contractors have very little, if any, contractual leverage. The strength of the indemnity
provision and the effectiveness of its use in
risk allocation is determined by the precise
language of the indemnity clause. The entity
bearing the risk through an indemnity provision is typically the contractor most directly
responsible for the work that caused the
financial risk that must be allocated.
Fortunately, if each contractor has its own
insurance policies in place, then even
though the contractor bears the financial
risk between construction entities, it is the
insurance carrier that ultimately bears the
financial responsibility.

What other steps can be taken to mitigate

In addition to allocation, risks can also be
mitigated or eliminated. This can be accomplished by the owner through provisions in
the contract documents, or through due diligence performed both before and during the
project. Since the financial risk typically
results from the work performed by construction companies, control over the company and its work force by the owner can
mitigate or eliminate the risk. These steps
would include the owner’s due diligence in
selecting the members of its construction
team, which ensures that a qualified and
experienced work force will complete the
project. The contract provisions can also be
used to ensure that the work being performed is monitored directly by each
employer and is supervised by the management team. Focusing on safety and quality
of work will typically reduce and potentially
eliminate property damage and personal
injury or improper workmanship and the
use of defective materials. The owner may
also require that all work be performed and
all materials be used pursuant to government and safety standards.

ROBERT CHAKLOS is executive partner of Secrest Wardle’s construction practice group. Reach him at [email protected]
or (248) 539-2824.