What it means
Every project carries risks, such as delays, price rises, faulty materials, regulation changes or a customer failing to pay. If the contract is silent, arguments about who pays will arise at the worst possible moment.
A common principle is to place each risk with the party best able to manage it at the lowest cost. A contractor can manage site productivity, so delays within its control sit with the contractor, while a change in law is outside either party's control and may be shared or assigned to the owner.
Parties use several tools to allocate risk. These include fixed-price clauses that put cost overruns on the supplier, cost-plus clauses that put them on the buyer, indemnities (promises to cover another's loss), liability caps, warranties and insurance requirements.
Allocation has a price. A supplier asked to take on more risk will add a contingency to its price, so a buyer that pushes every risk onto the other side usually pays for it in the quote.
The aim is a balance in which the total cost of the project is lowest. In finance, risk allocation underpins project finance, joint ventures, mergers and supply contracts.
Lenders will often lend only if the risks that could stop repayment sit with parties that can withstand them. Lenders will often lend only if the risks that could stop repayment sit with parties that can withstand them.
Contracts should be clear about both the risk and the trigger. A vague term such as "unforeseen conditions" invites disputes, so well-drafted agreements describe the event, who bears the cost and what notice must be given.
In practice
Real-world examples
Example 1
A software client and a developer agree a fixed price of $400,000 for a project. The developer bears the risk of overruns, and the client bears the risk of changes it requests later. Each change is priced separately. Both sides sign a short change form before any extra work starts.
Example 2
A wind farm developer and its lender agree that the lender is repaid from electricity sales, while a separate maintenance firm bears the risk of turbine breakdowns under a guarantee. The lender accepts the deal because each risk sits with the party able to manage it. The structure also lets the developer borrow at a lower rate.
Example 3
A retailer signs a supply contract with a manufacturer in another country. The contract states that the manufacturer bears the risk of loss until the goods are loaded on a ship, and the retailer bears it afterwards. The retailer buys cargo insurance for the voyage. The cost of the insurance is added to the landed cost of the goods.
Think of it
Think of risk allocation like sharing a car journey with a friend. Before you set off, you agree that if you get a flat tyre, your friend pays for the repair because they chose the scenic route through the sharp stones.
Formula
Calculation
Expected loss = Probability of the event x Cost if it happens
Suppose a building contract has a 10% chance that ground conditions will add $1,000,000 of cost. The expected loss is 0.10 x 1,000,000 = $100,000. If the contractor takes the risk, it may add a $100,000 contingency to its price, but if the owner keeps the risk, the price falls by that amount and the owner pays only if the event occurs.Case study
Seen in the real world
Harlow Civil Works is an illustrative, fictional contractor that agreed to build a road for a fixed price of $8,000,000. The contract said nothing about rock found under the surface, so a dispute arose when 1,200 cubic metres of rock were uncovered.
Excavating the rock cost $450,000 more than planned, and the owner refused to pay. The two sides spent six months in negotiation and legal fees of about $120,000 before they split the extra cost.
For its next contract, Harlow insisted on a clause that allocated ground risk to the owner, with a price per cubic metre for any rock. In this illustrative story, its tender price rose by only $50,000 but it avoided a large and uncertain exposure. The board now requires a risk allocation review before any bid is submitted.
Watch out
Common mistakes
- Pushing all risk to the other party, which usually raises the price or leads to the supplier refusing the deal.
- Leaving risks undefined in the contract, which almost always leads to disputes.
- Allocating a risk without checking whether the party can afford the loss, since a small supplier may not survive a large claim.
Questions
People also ask
What is the best way to decide who bears a risk?
Give the risk to the party that can best control it, insure against it or absorb it at the lowest cost. The decision should be recorded in the contract.
What is a risk register?
It is a list of identified risks, their likelihood, their impact and who is responsible, which is a starting point for allocation.
How do insurance and indemnities help?
They move the financial cost of a loss to an insurer or another party, but the contract must say who buys the insurance and who is covered.