16 Risk and Contract Management

The Risk Management Process

Risk management is at the core of all projects.  Organizations and individuals must constantly assess and manage risks.  When we look at the delivery of a project, there are many different risks, including the risks associated with errors and commissions during design, risks related to the weather and construction environment, and risks associated with price fluctuation, to name a few.  To manage these risks, a project team should implement a risk management process.

There are many different formalized versions of risk management processes.  There are some commonalities across the processes.  First, the processes tend to start with some form of risk identification, along with defining the impact and probability of the risk if it affects the project.  An example could be the occurrence of a hurricane weather event on a project.  After the risks are identified, potential risk mitigation methods should be identified for each risk that warrants further investigation (e.g., has a large probability of occurring or a high impact if an event occurs). Within our example of a hurricane, this could include having a detailed plan to limit the damage to a project under construction if a hurricane event occurs.  Then, consideration to purchasing third-party protection for the financial impact of events should be considered, especially for risks that may carry significant financial impact.  These third-party protections could include surety bonds and insurance which are discussed in the following sections.  In our example, the contractor or owner may decide to purchase builder’s risk insurance (very typical) to cover damages the constructed items during the construction process and make sure that hurricane damages are covered.  Ultimately, the various parties on a project will need to accept and manage certain risks.  Ideally, the contracts will be set up so that the risks are accepted by the organizations that are able to manage the risk and limit impacts in the event of risk incidents.

Surety Bonds and Their Application in the Delivery Process

Surety Bonds are contractual agreements to reduce risk through a third-party guarentee by a Surety company.  A key aspect of a surety bond is that it is a three-party agreement.  One party (the surety) guarenties that another party (the contractor) will fulfill their contractual obligations to a third party (the owner).  If the contractor defaults on meeting their obligations, the surety company will assume the liability for the costs and impact related to the guarenty as defined in the surety bond agreement.

There are four common types of surety bonds used on construction projects:

1. Payment Bond:  The contractor agrees within the construction contract that they will pay their employees and subcontracts under various terms within the contract.  The payment bond obligates the surety company to make these payments if the construction company fails to pay employees or subcontractors.
2. Performance Bond:  The contractor agrees to complete a project per the original construction agreement.  If the contractor defaults on their obligations, the surety company will assume the liability to fulfill the contractor’s obligations.
3. Bid Bond:  When a contractor submits a bid, they assure the owner that they will sign a contract if awarded the project.  If the contractor does not sign an agreement after being selected by the owner, then the surety company is liable for not signing the agreement.
4. Warranty Bond:  A contractor agrees to various warranties when signing the construction contract.  If the contractor fails to

Other types of bonds may also apply to construction.  This can include a termite bond to ensure that a large financial entity will stand behind a termite warranty or a judicial bond that may be required to guarantee against a mechanics lien placed on a property.  

Insurance and Their Application in the Delivery Process