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Adding Value through Risk Management – Part 1

Risk management is a dilemma. If you tried to cover every risk that you could think of on the prospective project, you might never win another bid. On the other hand, if you do not adequately plan for risk, you may lose your shirt on every job. The value you bring to the table is finding the balance.

Jeremy Laurance, health editor for The Independent, captures this dilemma very succinctly: “Risk is unavoidable in life; no human activity is free from risk, and those who insist that ‘safe’ must mean ‘zero risk’ are deluding themselves. The correct approach when risks are uncertain—to paraphrase Lord Phillips—is to ensure the public is properly apprised of them. People are then free to dig their own graves, as it were.”The basic components of risk management are defined by your ability to be proactive in defining risks, making a plan to avoid and/or mitigate them, and having a recovery action plan in place. Risk management is the value you can bring to a project. It can be the difference between success and failure.

Andy Patron from FMI recently spoke with Karen Schwartzkopf, senior vice president of Zurich North America, and Tom Miller,  senior vice president of Lockton, Inc., about their thoughts on risk management.

Patron: What are we talking about when we talk about risk in the construction industry?

Miller: We go by the standard Webster’s definition of risk, which is the possibility of loss or injury; a variable that leads to uncertainty in the final cost of the project, vis-à-vis construction. The issue is that people are compensated based on different types of risks they take, and if they are not taking any risks, there is not much opportunity for profit. In order to make more profit, you need to be willing to undertake risks and manage the risk properly.

Patron: So there is a risk reward equation to consider as well?

Miller: Yes, the better contractors are at identifying, evaluating, accepting and controlling the risk, the more profit or higher reward they may gain on a project.

Patron: What are some of the risks that typically need to be managed?

Schwartzkopf: There is financial risk, operational and business risk, and risk associated with safety, the environment, subcontractors and suppliers. There is reputational risk to firms that do not manage all of these things as a common course of their business.

Patron: What indicators would show that companies have a good handle on their operational risk management?

Schwartzkopf: When I think about operational risks for contractors, the first thing that comes to mind is managing contractual risk. Tom spoke earlier about being able to retain more risk by managing it with the appropriate technique or strategy within the contract. Favorable contracts provide organizations with additional revenue opportunities or possibilities to prevent revenue loss. When we think about contractual risk and risk transfer, we see that it has changed in the environment that we are in today for many of our companies. Risks that they once could have avoided by adjusting the contract terms are now accepted in order to get the job. They are in a position today of accepting more risk. Liquidated damages are more prevalent; where it was a negotiation point 18 months ago, today it’s more a part of our contractors’ risk profiles.

Patron: So if contractors are not able to deliver operationally, the result is having to pay liquidated damages.

Miller: The possibility exists, and I think in today’s economic environment with people bidding projects at slimmer profit margins with less than optimal float available within the schedule, it becomes a very big issue. It is much more difficult to get a sufficient contingency to help you manage the risks that are apparent on a construction site. Much of profitably building the project involves setting aside appropriate contingencies, so that when an event happens during the course of construction you have a built-in safety mechanism to deal with at least part of that event. It could be having standby equipment ready or additional time built into your schedule, whether it’s a cost component that you’ve built in because you’re concerned about an individual subcontractor’s financial standing and ability to complete in accordance with your schedule or some other individual item that you identified at the outset of the project. Contractors assume a lot of risk in what they do by signing contracts. What we look at as an optimal “risk management strategy” is having the contractors, whether via their general counsel, senior management or risk manager, identify that the contracts they are signing are allocating risks to the party that is best able to handle these risks. This may be something that is in that party’s scope, or perhaps it is a risk that from a monetary standpoint is better handled by the owner or by the contractors, such as the risk of subcontractor failure.

Patron: Say a contractor asks: “We just won this job and the margins are very tight — what can you help me with?” What are some of the typical things you would walk that contractor through to make sure he or she is thinking ahead to mitigate some of the risks?

Miller: I would focus on the cost you have built into the project. How comfortable are you with your internal estimates, labor availability, labor productivity and workforce relations? How comfortable are you with the cost of materials you included in your bid? Do you have a materials escalation clause built within the contract? If it is tight on profit margin, do you at least have an appropriate schedule duration to give you some level of comfort? Where are you building? What is it going to take for you to get labor and materials to the site?

Patron: Certainly that process drives a contractor to some sort of decision-making and some action. What type of person should an organization look for to manage risk well?

Schwartzkopf: I think it is somebody who has the broadest understanding of the company’s goals and its risk profile and risk appetite. This person serves as a consultant to the project team, so he or she is considered part of that whole process of acquiring work and not just as risk management as an afterthought. Thus, the company is really looking at providing its risk management capabilities as if it is responding to an RFP. A few companies we work with really have risk management represented as part of the project team.

Miller: We know of one company where risk management is not a position, but rather really a company philosophy, from the CEO on down. Personnel know which types of contracts will not be undertaken. And when a project is brought in by a business development manager, it undergoes a review by its executive review board or a proposal review board. Essentially, this company attempts to identify as much risk as it can based on experience. It has learned to identify more risk and develop an approach that allows it to focus on delivering the projects in a profitable manner and on time. In a broad forum, companies like this are developing a formal method of identifying and evaluating both contractual and commercial risks that they will face for any given upcoming project. We assume successful construction managers and contractors have a never-ending focus on safety. The reality is sometimes bad things happen and when they do, it’s a difficult work environment.

Reprinted with permission from FMI Corporation. For more information, call (919) 787-8400 or visit http://www.fminet.com. Part II of this Q&A will cover safety, risk engineering and how risk affects the industry as a whole.

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