Construction Risk Analysis and Management

Abstract

Risks associated with construction are numerous, and each of the four main project objectives of scope, time, cost, and quality remains subject to risk, and their effects are considered throughout the project. Construction projects can be unpredictable. Risks start appearing as soon as it is decided to initiate a project and continue to increase as the project moves further.

9.1 Introduction

Risks associated with construction are numerous, and each of the four main project objectives of scope, time, cost, and quality remains subject to risk, and their effects are considered throughout the project. Construction projects can be unpredictable. Risks start appearing as soon as it is decided to initiate a project and continue to increase as the project moves further.

Construction projects can be extremely complex with many uncertainties. In any complex project, there are many things that can go wrong. Risks are therefore inevitable and cannot be eliminated; however, they can be mitigated or distributed with better preplanning. Construction contracts basically carry risks for both the Contractor and the Owner . Unfortunately, some project owners try to allocate the majority of risks to the Contractor satisfying their needs. Whereas contractors consider that they can minimize risk through early completion of the project for less than the contract price, to maximize profits.

In order to achieve project objectives, managing risks in construction projects has been recognized as a very important process. Good risk management practices direct that the distribution of project risks between the various parties shall be made clearly, sensibly, and equitably. Unfortunately, there is a general failure between the construction industry to handle risk issues properly, which mostly results in excessive claims and disputes within the parties. It is therefore important to be prepared for risk occurrences and to handle them timely, through good management and foresight.

9.2 Definition of the Risk

Various definitions have been provided by various professionals. Darnell and Preston (2010) defines risk as “possibility of loss or injury.” Barber (2005) defines risk as “a threat to project success, where the final impact upon project success is not certain”. The National Association of Surety Bond Producers [1] defines construction risk as “any exposure to possible loss”.

Risk is basically the product of severity of hazard and the probability of occurrence. Because every construction project is unique, each offers a multitude of different risks. To ensure the success of an undertaking, the Owner initiating a construction project must be able to recognize, assess, and handle these risks.

9.3 Risk Management

Risk management is concerned with planning , identifying the risks , assessing their likelihood, and deciding how best to manage the project efficiently in the light of this information. An effective risk management method can help properly in identifying risks and how to manage these risks in different stages of a project. Effective risk management increases the likelihood of project success increasing the likelihood of finishing the project on time, within budget and meeting stakeholders’ performance expectations.

For effective management of risks, efforts are required at the early stages of the project to identify all relevant risks by all team members. A key to the success of any construction project is having the right Project Manager, with the right project management model, team, and supporting resources. A Project Manager must be able to recognize and identify the root cause of the risks and mitigate them well. The process of managing contractual risks falls into five main stages.

9.3.1 Risk Management Planning

Risk management planning is the process in which it is decided and worked out how to approach and conduct the risk management activities for a project. Risk management planning should be carried out during the early stages of the project, i.e., at the project planning stage. Risk planning will help earlier identification of high risks , limiting inappropriate changes, rework, cost overruns, time overruns, etc.

To develop a risk management plan , the project team should conduct internal meetings with all related staff. Mainly the risk management plan should include:

• 1. Procedures, means, and methods to be used to perform risk management on the project

• 2. Roles and responsibilities (complete with details of who will do what)

• 3. Budget and time to deal with potential risks

• 4. A process for identifying risks including risk monitoring procedures

9.3.2 Identifying the Risk

The second step in dealing with construction risks is to develop a method for the identification and classification of individual risks related to the particular project. Every construction project carries various different types of risks; however, some risks are common to most of the projects. Examples include differing site conditions , inclement weather, contractor reliability, and the risk of maintaining adequate funds.

A common procedure for risk identification and classification is the development of a risk checklist. For preparing a risk checklist, the past record of risk management for the completed projects is reviewed. This technique allows the user to list common project risks and then to add those risks which are specific to the project in hand.

9.3.2.1 Organizing Checklist

There are several approaches for organizing a risk checklist into a suitable format. One approach proposes that risks should be organized in terms of the nature of the risk itself, like known risks and unknown risks. A second approach proposes to classify the risks upon their effect on the project, like cost risks, schedule risks, or quality risks.

As such, risk is defined in terms of an event, its probability, and the cost and time involved; a suitable way of organizing a construction risk checklist is to divide risks into two broad categories: design and construction risks and financial risks [2]. These risks are most related to the construction projects. Financial risks start affecting the project from the earlier stages of planning and feasibility phases, whereas, design and construction risks appear throughout the life cycle of a project and especially during the construction period.

Most types of risk that occur on a construction project can be summarized using the following checklist, Table 9.1, and can be tailored to a specific project in hand.

Table 9.1 Risk category checklist

9.3.3 Analyzing the Risk

The third step in managing risks is analyzing the risks, i.e., assessing the probability of each risk occurring and severity or impact on main project objectives: cost, time, and quality. Risk assessment methods are formal processes for employing common sense and creative lateral thinking to visualize problems and workout ways to reduce or avoid the likelihood of their occurrence. They depend on good communication, good documentation of ideas and discussions, and agreement about how the whole process will be handled. Risk assessment needs to begin at an early stage and be continuously updated as the project progresses and details are clarified. Risk assessment is an important task, which must be carried out successfully by using reasonable methods of measurement.

Risk assessment should commence in conjunction with the identified risk items in the checklist described earlier. Using the checklist allows the division of risk items according to categories which contributes to a better understanding of how these uncertainties function and affect the project. The risk assessment process involves itemizing the risks into a ranking that will place them in order of importance. To do this, every item in the checklist should be earmarked as high, moderate, or low risks (Table 9.3). For example, if an individual project involves major underground construction, then the risks associated with this activity will become very important and will require extra attention. The checklist can be examined for every project and filled in so as to reflect specific project characteristics. This method is called Qualitative risk analysis.

The second risk analysis method is Quantitative analysis which means numerical analysis of the probability and impact of the project risks. This method is initiated for the highest risks from qualitative risk analysis and is not recommended for a low priority risks. Under Quantitative analysis the most common method of assessing risk is to prepare a fault tree of possible hazards. If the hazards are acceptable, the risk is calculated by using the concept: risk = impact of hazard x probability of occurrence [3]. If this calculated risk is accepted, it is then distributed among the required parties. However, if the hazards are unacceptable, the activity is either rejected or a method is found to mitigate the hazards and carry on further process.

This method can best be understood by an example. Suppose a sewer treatment plant plan to install fire fighting system in the plant. They have come up with the following two options to decide whether to proceed with this item of work or not.

Example 9.1

Scenario 1: Fire fighting system required	Scenario 2: Fire fighting system not required
Set-up cost = $100,000.00	Set-up cost = $0.00
Issues, problems, maintenance = 20% probability and $50,000.00 impact	If not installed then risk chances = 60% probability and $300,000.00 impact
Analysis for this case = 20% × $50,000 + $100,000.00 = $110,000.00	Analysis for this case = 60% × $300,000.00 = $180,000.00

At initial stage looking at the set-up cost against scenario 1, plant authorities might think that there is no need to invest $100, 000.00 for this item in comparison to scenario 2 where the set-up cost is zero, but the analysis proves differently.

The effectiveness of this technique depends on the ability of those engaged to identify all possible events. It is worthwhile to mention that risks having very high probabilities and very low impacts or vice versa are usually not considered important in the construction projects. In fact, it is the combination of probability and impact that matters. Other Quantitative risk analysis methods include Monte Carlo simulation, cost-risk analysis, expected monetary value analysis, etc.

9.3.4 Responding and Allocating Risk

The fourth step is to decide which party is best equipped to manage, control, and assume the risk. Risk response involves procedures to either eliminate a risk before it occurs by proactive approach or mitigate its probability and impact as much as possible. Some risks may be insured, as within most of the standard forms of the contracts, risk is primarily allocated between the parties through indemnity and insurance requirement provisions.

Since funding is provided by the Owner, it is his privilege to assign responsibilities. He has the opportunity to reduce the total project cost through effective allocation of related construction risks. However, as mentioned earlier, the distribution of risks between the parties should be carried out sensibly and equitably because misallocation of risks is not cost-effective. Placing an inequitable risk share on the Contractor should be avoided as it promotes negative working relationships and increases disputes.

Proper and reasonable risk allocation improves efficiency, reduces costs and disputes, and promotes project goals. In the absence of uncertainties imposed by unfairly allocated risks, contractors can avoid the addition of cost contingencies in the pricing of project bids and estimates. By adopting fair risk allocation, the Owner can expect that their projects will have fewer claims, reduced costs, and timely completion. The most common options of responding and allocating risks are risk acceptance , risk sharing, risk avoidance, risk reduction or mitigation, and risk transfer.

Risk acceptance

The most appropriate method to allocate risk is to have the party who controls the risk should accept/retain the risk. For example, a Contractor who is in charge of the construction works, risks arising out of his operations should be allocated to him. Similarly, as the Designer is in control of the design component, he should be allocated the risks pertaining to design, e.g., design errors. Similarly, site selection is the Owner’s responsibility; hence, risks pertaining to site issues such as access, permits, and acquisition should be allocated to the Owner. In the same way, if the risk of fire is to be dealt with by an indemnity from an insurer, the Contractor who is responsible will be tasked with obtaining the insurance coverage and will be considered as having control over the policy; thus, the risk is allocated to him.

Under standard forms of contracts , the Owner will also retain risks that are out of the control of the Contractor, such as acts of God, war, riots, nuclear explosives, strikes, etc. Risk acceptance may be made with contingency. A typical contingency sum will be allowed to the project to address these risks. Contingency is a sum of money or period of time set aside from the general construction funds to pay for losses that actually occur.

The best way to identify the risk assumed by the various parties is to develop a risk matrix. Each party should refer to the matrix and evaluate the extent of risk they are willing to undertake. Parties also should ascertain who is to bear the responsibility for other risks not listed in the matrix. Table 9.2, indicates an example of a risk matrix showing some of the risks and the responsibilities of the parties involved.

Table 9.2 Risk matrix example showing risk and responsibilities of the parties

Risk sharing

Sometimes it is not possible for one party to control a specific risk. The suitable procedure is that it may be then shared and managed by dividing it among two or more parties so as to manage the portion that they are best able to control individually. An excellent example of risk sharing is the development of a joint venture by contractors [2]. A joint venture is the result of the unification of two or more contracting firms to build a single project. Hence all partners share in construction risk in the same way they share in any profit and loss.

Another risk sharing system can be found in the guaranteed maximum price contract. In this contract type , the Owner and the Contractor agree to a project cost guaranteed by the Contractor as maximum. With a guaranteed maximum price contract, amounts below the maximum are typically shared between the Owner and the Contractor, while the Contractor is responsible for costs above the maximum.

Some individual risks are also shared between the Owner and Contractor under standard forms of contract . For example, the risk resulting from the provision regarding “adjustment for changes in legislation” is shared between the Owner and Contractor both under FIDIC Conditions of Contract (Red Book) [4]. FIDIC Sub-clause 13.7 refers to increase or decrease in cost due to changes in Legislation. Accordingly, if a Contractor suffers delay or additional costs, the Owner has to share the burden. However, if there is decrease in cost, then the Owner can submit a claim for a credit.

Risk avoidance

Avoiding a potential risk will reduce a risk’s probability to zero. After the risks are identified and analyzed, some risks may be found unacceptable, e.g., deficiency of funds. Withdrawing a bid by the Contractor or the Owner and not proceeding with the project are two examples of total avoidance of risks. In such case the Owner may redefine (i.e., reduce) the scope of work or even abandon the project for a period of time until the funds are made available to avoid the risk. Some risks that arise early in the project can be avoided by clarifying requirements, obtaining proper information, improving communication, or acquiring expertise.

In addition to risks between the Contractor and Owner, consultants are also subject to risks. Consultants can avoid risks by ensuring that the professional responsibilities are clear and unambiguous.

Risk reduction / mitigation

Risk mitigation involves reducing the probability or impact of the risk to an acceptable level. Actions are taken before the risk is triggered to minimize its probability of occurrence and impact. Taking early action to reduce the probability or impact of a project risk is usually more effective than trying to rectify the damage after the risk has occurred.

The most common risk mitigation efforts include having strong project control, conducting constructability reviews, expediting variations and claims, avoiding late issue of drawings , use of standard items or software, using alternative design and specifications , etc. In short, a well-managed project will have fewer risks.

Risk transfer

Risk transference involves shifting the negative impact of a risk threat, along with ownership of response to a third party. Risk transferring also eliminates the risk from impacting the project. However, when risks are transferred to another party, a premium is paid to compensate the third party to take on the risk.

All parties involved in a construction project can protect their interests via insurance but must accept that not all risks are insurable as described earlier. Many of the standard form contracts insist on certain types of insurance. Insurable risks are generally allocated by contract to the party best able to control, manage, and insure the risk. Standard insurable risks are for works such as, materials, plants and Contractor’s equipment, damage to person and property (third-party insurance), etc.

The consultants usually obtain “Professional Indemnity Insurance ” so as to cover themselves and their clients against the risk of failure to perform their duties with the required level and skills.

The insurance and surety industries provide financial security for parties that incurred legal obligations. Accordingly, forms of financial security and guarantee are available to transfer certain types of risk. For example, the risk of nonperformance on a contract can be addressed by a financial guarantee.

Once the risk assessment and risk response actions are finalized, the Risk Response Matrix can be prepared for proper record and further review during the risk monitoring and control process. Table 9.3 provides an example of a Risk Response Matrix with some of the risk examples.

Table 9.3 Risk response matrix

9.3.5 Risk Monitoring and Control

Risk monitoring and control is the process of tracking all the identified risks , analyzing and reviewing these risks, and identifying and planning for newly arising risks during the life of the project. The progress and performance of risk responses are evaluated, and risk status is updated periodically.

The main objective of the risk monitoring process is to establish a cost performance and schedule management system. The system should be designed to provide early warning of potential problems to allow management action. As the risk approaches, the risk strategies are reviewed for appropriate actions, like choosing alternative strategies, executing a contingency plan, taking corrective action, etc.

As each risk occurs and is dealt with or is avoided, these changes must be documented. Good documentation insures that risks of this type will be handled in a more effective way than before and that the next project manager will benefit from “lessons learned.”

9.4 Standard Forms of Contract

In order to achieve fair distribution of risks, standard forms of contract should be used, which carries appropriate clauses for allocation of risks. For example, clause 17 of FIDIC [4] allocates responsibility between the Contractor and the Employer for damage, to the works. According to this clause, the Contractor is to bear the cost of rectification of loss or damage, which arises from any cause, other than those, which are described as “Employer’s Risk”. Where damage is caused by an Employer’s Risk, the cost is born by the Employer.

Generally, risks that are severe and outside the control of the Contractor, like war, earthquake, riots, nuclear explosives, etc., should be retained by the Employer as is specified by the FIDIC [4] in abovementioned clause.

Construction industry standard forms are produced by construction industry experts and construction law practitioners over a period of many years after receiving suggestions and feedback from owners, contractors, consultants , sureties, and insurers and are also being updated from time to time. Despite all these efforts, standard forms should not be used without modifications as they are drafted for broad applicability. Standard form contracts cannot account for all specific legal and financial terms that the parties need to insert in their agreements. The activity of allocating risks should be carefully evaluated by an insurance professional, contracts specialist, legal counsel, or knowledgeable design professional to assess specific or unique risks and exposures.