Running a Risky Business
Issue 42 - June 08

Like in excercise, No pain No gain.
Many companies are looking at alternative strategies to handle risk when entering into construction projects.

Consider this Consider this. XYZ Co Ltd is offered a tempting proposition. Their partner gives them the opportunity to enter into a contract that requires them to take no financial risk. Everything is paid up front, staff and materials secured and ready, and it turns out this contract might make them more money in the long run as they can get a share of the successful completion bonus. The client is even paying above standard rates. Too good to be true, right? Yes and no. As the project progresses directors at XYZ realise this is going to be a deeply ugly building. Not so ugly they'll never find work again but still unsettling for them to say they've worked on it. In addition there are some slightly unethical dealings going on. Probably no one else knows about it, and it doesn't affect them directly but not having invested financially in the project they can't do much about it. With risk comes an element of power.

so company XYZ is not going to lose money, only control and possibly self-respect. If it wants these things it might have to take financial risks. Therefore taking on financial risk is not something to be avoided per se. This does not mean that contractors and subcontractors should ask to be left out-of-pocket when something messes up. However, a frank assessment of what everyone wants a say in is an important element of determining who should bear financial and non-financial risks at contract promulgation stage. Having power to control the risk elements as they arise is the first step towards reducing and eliminating these risks.

Why Risk vs Reward?
This "larger risk, larger powe" dynamic is often overlooked as people focus on the more immediately attractive 'larger risk, larger reward'. Timothy Hill, Partner, Projects (Engineering and Construction) Practice, Lovells has, apart from a very long job title, a lot of experience in managing the allocation of risk in construction contracts. In a paper entitled "Risk Allocation in Hong Kong Construction Contracts" presented at Lighthouse Club's Construction Risk Seminar he noted that "by accepting the risks inherent in the industry contractors are provided with the opportunity to generate sizable rewards." He goes on to say that the contract is "an attempt to allocate risk between the various parties" before going on to list methods that others have used as justification for where they have allocated these risks.

"The reality of the position was and has been that projects have been built using the new Silver Book would not be built under more balanced forms of contract. This is particularly the case where non-recourse financing is used and the viability of a project company depended upon its ability to pass on construction risk."

In Hong Kong law, unlike in some civil systems or in Chinese construction law, if the contract says that one party is to bear that risk then, regardless of the circumstances, they must do so. So the approach to risk allocation of the parties drawing up the contracts and creating the standard forms of contract imposed by regulators is pretty significant. Hill outlines the standards as described by Jesse B Groves III in a consultancy paper for the HKSAR governments as loosely described as follows:
. The fault standard: you did it, you pay
. The forseeability standard: if you thought it could happen then you should have priced for it at time of tender.
. Management standard: if you have control over it, you deal with it
. Incentive standard: who ever has the most at stake deals with it

Much of the discussion about managing risks talks about what is fair, or obviously avoids being unfair. But if after the contract is signed any concept of fairness or reasonableness goes out the window then perhaps the process has been futile from the outset. Hill suggests that what is considered fair can leave projects as non-starters. For example, people within the industry criticised the new Silver Book for lack of fairness. "The reality of the position was and has been that projects that have been built using the new Silver Book would not have been built under more balanced forms of contract. This is particularly the case where non-recourse financing is used and the viability of a project company depended upon its ability to pass on construction risk" he explains. So taking a broadminded view of fairness might just get you more work and on the happy end of that 'larger risk, larger reward' see-saw.

In view of Hill's conclusion that "we are faced with a growing dichotomy in the approaches being taken to the allocation of risk" a broad minded adaptable standpoint is as good an idea as pressing your clothes before a job interview. Focus on the potential rewards and achievements that could come from what is on offer and look to cleverer ways to handle potential risks that the contract might bring you. Some of the most interesting of these ways do not involve contractual wrangling at all. The first is to insure against the risk and another is to put in a bit of effort at the planning stages so that the expensive, delaying and downright embarrassing mistakes that occur mid project are just less likely to happen.

Insurance
Adrian King, Executive Director, Aon Hong Kong Ltd, an insurance company, says insurance is "a bogey, it is disliked and it is misunderstood". Which seems a pity as he says insurance is "intrinsically part of managing construction risk". Consider, when dealing with these nasty insurance companies that the policy is "actually a contract insuring risk" and yet the company who has issued it doesn't really have any control over how you will treat that risk. The insurer commits its capital in what King says could be seen as a one-sided way.

King asserts that construction contracts give parties greater power and certainty than he can ever hope to get from the policies they issue and that is the reason behind many of their decisions. "The extent of risks which an insurer is to assume are undefined. The period of exposure may extend over many years. The controlling factors are totally fortuitous and unpredictable and the risks are entirely in the hands of another party to control. Contingency is 100 percent unquantifiable. The contract price is jut a small percentage assessed on the known factors." Knowing this makes it easier to understand why insurance companies can be sticklers at times.

King proposes that insurance companies should be viewed not as a "necessary evil" but a collaborative partner in dealing with foreseeable and unexpected project risks. If contractors made open disclosure to their insurers they could bring them on board as "partners in a mutual risk avoidance exercise". If the insurer has a construction or engineering speciality it becomes only more valuable - it has the benefit of having collaborated on other projects and seen how other companies have approached the same types of risks that this project might bring up. If anyone is a construction risk expert, surely it is the insurers who have to shell out every time someone falls off a ladder. No one wants these mistakes to happen - so why couldn't insurers open up their information to accepting employers and contractors to eliminate the risk of this happening.

Other techniques for dealing with insurance risk abound. Some of the more innovative include prefabrication of parts or construction modelling using computer technologies. Not to say that risks will just vanish but if people view the risks as an opportunity not just for reward but for control and power then more successful projects being completed, on time, under budget and without spending the next ten years in court will top-out region wide. RFP

We are faced with a growing dichotomy in the approaches being taken to the allocation of risk.

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