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Three Perspectives on Risk Management In the Construction Industry

All construction projects have a defined set of risks—from bad weather, non-payment and schedule delays to safety, permitting and regulations—but how those risks are mitigated and distributed among all parties varies greatly. Construction Executive set out to determine the strategies three industry stakeholders—a small subcontractor, a mid-size general contractor and a large self-performing developer—use for distributing risk as fairly as possible, as well as mitigating their own risks.  

Brian Allison
CEO and President, Sentry Electric
  • 35-year-old electrical contracting firm
  • Performs service work in Nebraska, Kansas and Iowa
  • Annual revenue: $3.25 million 
  • Based in Lincoln, Neb.
Mike Kolakowski
CEO and President, KBE Building Corporation
  • 55-year-oldcommercial contracting firm
  • Specializes in federal government, municipal, retail, private institution and senior living market
  • Annual revenue: $300 million 
  • Offices in Farmington, Conn., and Columbia, Md.
Rick Morris
Senior Vice President of Construction, AvalonBay Communities, Inc.
  • 20-year-old real estate investment trust
  • Develops hundreds of apartment buildings with nearly 80,000 housing units on the East and West coasts; self-performs 99 percent of the work
  • Annual revenue: $2.5 billion 
  • Based in Arlington, Va., with 11 regional offices

Do owners and developers understand the risks that go along with their projects?
Allison: Depending on how sophisticated they are, owners typically don’t understand the risk and are just going to try to pass down as much as possible. But a construction manager and developer probably does. We usually see them pass risk off to the general contractor, which passes it off to subcontractors.

Kolakowski: Some owners understand risk more than others. Owners that understand risk seem to be open and receptive to appropriate risk allocation. Those that do not understand it often have unreasonable expectations when it comes to risk allocation.

Morris: Depending on how they execute construction, developers look at risk differently than a construction company. They understand it better if they act as their own general contractor, but developers that use third-party general contractors aren’t as in tune to the risk, especially in regard to worker safety and subcontractor failure because they are insulated from it. If a contractor fails or fails to pay a sub-tier supplier, it shows up on our balance sheet very quickly. We have a better understanding of what that risk is and we are better able to mitigate and identify it. Many developers get blindsided by risk because they don’t have deep construction knowledge like those that self-perform their projects.

KBE Building CorpWhat are some of the most challenging risks you typically face?

Allison: We risk the general contractor defaulting and not paying us, and we usually have 10 percent retainage tied up in projects. We’re working to pass legislation to limit the amount of retainage a general contractor and owner can hold to 5 percent. When people started using retainage in 1970, they were able to make a10 percent margin; now we’re lucky if we get a 2 percent to 3 percent margin. 

Kolakowski: Contractors are accustomed to taking on typical risks associated with construction, such as the means and methods of performing the work, the integrity of the workmanship, following the plans and specifications, and remaining within an agreed to budget and schedule. The most challenging risks are those the contractor has limited or no ownership over, control of or knowledge about, or for which they have no risk management options available. While we want to accommodate clients whenever reasonably possible, negotiations often revolve around certain non-traditional terms such as no-damages-for-delay clauses,responsibility for unforeseen or unknown conditions, provisions that attempt to make a contractor responsible for traditional design risk and overbroad indemnification provisions. Legislative and regulatory initiatives also create risks for a contractor that are difficult to control or manage. In addition, with the current economic climate, one of the most challenging risks is ensuring owners and subcontractors are adequately capitalized, which transfers financial risk to the contractor if not responsibly monitored and managed.

Morris: To mitigate the risk of contractor default, we have pretty stringent standards for vendor prequalification. We make sure they can get insurance, can fund the job, are a well-run company, have good balance sheet management, are creditworthy and have bonding capacity. We also look at their safety programs and OSHA records.

Sentry ElectricHow do you determine what goes into a contract and what you accept in a contract?
Allison: Some contractors have presented us with contracts that so unfairly transferred risk that we won’t even meet with them anymore. We love to see AIA Contract Documents or ConsensusDocs because we know they are fair. But typically, general contractors use their own contracts that include a lot of risk for subcontractors. I did not even read contracts until I was made aware of the risks at an education conference sponsored by Associated Builders and Contractors. I would bet that a majority of subcontractors don’t even read their contracts because they just aren’t educated on the risks that could be included.

We rely primarily on industry norms to gauge contract terms. In our opinion, the AIA documents between owners and contractors are the most widely accepted and unbiased form of agreements. When those documents form the basis of a contract (without significant modification), negotiations are relatively smooth, and the parties can focus on business terms and the unique aspects of the project. It is important for all parties to proactively cooperate and collaborate on contract documents to prevent future disagreements. We strive for balanced and appropriate risk allocation. Our in-house general counsel works with us and our clients to make sure the project agreements are consistent with that objective.

Morris: We use good business judgment and get as much data as we can prior to contracting. It really comes down to how much information we have and how much risk a contractor is willing to take on. We use the same standard contract for all our projects; it only changes per regional or state requirements. That way we’re not getting policies and contracts that are inconsistent.

How do you determine the amount of risk you will accept?
Allison: The contract manager, foreman and I review all contracts. If the contract is proprietary from a general contractor, we have our attorney and insurance carrier review it as well. If we don’t want to accept all the risks in the contract, we send it back to the general contractor to see if it will negotiate changes. We negotiate a lot of projects now; owners are more willing to work with us and accept their share of risk.Negotiated and service work has been growing for us. I don’t want to fight the race to the bottom, and in service work I can name a fair price and get a reasonable margin. I started in construction and will go back to that type of work as soon as there are good margins and risks I can mitigate. 

We thoroughly review all key elements of a project, which typically include specifications and drawings, the availability of subcontractors and materials, special licenses or permitting, logistical challenges, long-lead considerations, schedule constraints, and the needs and resources of the client. Then we assess the risks of the project and we assemble our proposal accordingly. If we can’t reasonably cover a risk, we discuss appropriate ways of addressing the situation with our clients and have found that most clients are receptive to finding mutually agreeable solutions. Most experienced owners do not ask the contractor to take on unreasonable risk because it can have an adverse effect on the contractor’s ability to perform.

AvalonBay CommunitiesHas risk management always been handled this way?

Allison: We’ve been in business for more than 30 years. In the old days, construction was managed with a handshake; these days we won’t even start a project without a letter to proceed. There’s a real lack of trust. A lot of it is due to the economy. General contractors are forced to use the lowest-price subcontractors they can, and a lot of them are not sophisticated or financially sound. General contractors assume those subcontractors will be able to finish the job, but they might not.

Kolakowski: Construction is a risky business, and contractors are accustomed to traditional risk.  Contractors must be smart about managing the risk to remain healthy. Traditional risk management historically included simply doing good work and having a reasonable level of insurance coverage; today’s industry is much more complex. Risk management starts with having highly skilled employees, a strong commitment to safety, good communication,and a fair working relationship with clients and subcontractors. If risk is not reasonable or too great, it is best to avoid the risk in the first place. Sometimes a project, for whatever reason, is a bad risk and should be avoided.  

Morris: Everything changed during the recession. We had a lot of general contractors and subcontractors that ran their businesses very well, but no longer had a bank to deal with or their credit lines were restricted. We self-fund many projects though, so we were in an advantageous position to step in and help some of the contractors complete projects.

What can be done to make construction risk management fairer?
Allison: A strong economy is the only thing that will fix it. Contractors were able to make a good margin when there was a strong economy in the early 2000s. But it won’t get better until we get a strong market where there is a lot of work relative to the amount of contractors in the area. 

Kolakowski: Risk allocation starts with contractors and owners being open and honest about the unique risks of a project and addressing those risks in a contract that makes sense. Allocating the risk to the wrong party leads to an imbalance and puts parties and the project at risk, which is not good for anyone. All issues should be proactively addressed upfront through prompt communication. As economic conditions improve, I suspect there will be a transition away from purchasers of construction services asking for unreasonable risk transfer, as well as contractors willing to accept it.

Jessica Porter is assistant editor of Construction Executive. For more information, visit www.constructionexec.com or follow @ConstructionMag

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