Allocating risk Featured

8:00pm EDT October 26, 2008

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 group.

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 allocation?

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 consideration?

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 risks?

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 rchaklos@secrestwardle.com or (248) 539-2824.