Methods for Reducing Claims
Summary of a Presentation by Paul Barshop
Chief Operating Officer, Independent Project Analysi, Inc.
One in four projects in the construction industry has a claim. Claims are costly, lead to delays and damaged relationships, but they are avoidable. Strategies and practices can be used to reduce the frequency of claims, because a number of claims appear to be unwarranted.
I make that statement based on a recent study completed by my organization, Independent Project Analysis (IPA), Inc. The study objective was to identify practices that reduce claims by understanding the main drivers of claims so that performance of capital projects improves. The study found a significant difference between the amount submitted for a claim versus the amount actually paid at settlement (Figure 8.1). Even disregarding the skew caused by several projects with very large claims, the difference between the claim and settlement amounts is as much as half.
In a formal survey owners identified the following as primary drivers of claims:
Increased profit pressures on contractors: 30 percent,
Poorly developed or executed contracts: 20 percent,
Increasing risk allocated to contractors: 20 percent,
Inadequate owner involvement: 10 percent,
Overly aggressive schedules: 10 percent, and
All of the above: 10 percent.
The good news is that there are strategies to address each of these issues.
A claim is a request for compensation not anticipated in the terms of the original contract. A change order that is written, negotiated, and accepted without going outside the project team is not a claim. A disputed change order is a claim. Disputes can arise over schedule targets, performance guarantees, or any deviation from the original contract terms that has significant commercial consequences. Claims also include owner requests for compensation for the contractor’s failure to meet contractual terms.
IPA obtained data for the claims study using a 100-question survey that covered claims drivers, contractor practices, owner practices and contract clauses, and claim and settlement value. This information was supplemented by a subset of data from IPA’s database. Thus we combined claims survey data with existing project data (Figure 8.2).
IPA’s findings are based on 122 projects in more than 21 companies and span diverse industries including energy, chemical, pharmaceuticals, steel, consumer products, and other specialty chemical manufacturers. The average cost of projects in the database is $163 million and ranges from $4 million to approximately $1.4 billion. The database is therefore broad enough to facilitate study of claims and risks.
Risk is one of the biggest drivers of claims. Projects that transfer more project risk to the contractor are much more likely to have a claim. The drivers of risk are fast-track projects, aggressiveness of contractors’ bids, and the contracting strategy.
Fast-track or schedule-driven projects have significantly more claims than conservatively scheduled projects. An aggressive schedule is defined as one that is 70 percent faster than the industry average (we were able to benchmark how long a project should take based on industry experience). We found that 33 percent of aggressively scheduled projects have claims as compared to 7 percent of conservatively scheduled projects. This is not surprising since meeting the schedule depends on equipment delivery and other external factors.
Projects with aggressive costs—projects using costs per square meter or for materials processes that are significantly lower than industry norms—tend to have more claims. This finding is qualified because the result is only significant to about a ten percent confidence level, meaning there is a ten percent chance that the aggressive cost projects and the conservatively scheduled projects have the same frequency of claims.
The data support the finding that competitive contractor bids are more likely to result in a claim (Figure 8.3). There is a clear trend that for projects where the contractor significantly underbids the competition, there is a significantly higher frequency of claims: 70 percent of projects that fit that category will have a claim (Figure 8.4).
These data indicate either that contractors are purposefully being aggressive in their bid and attempting to make up the profits later with a claim, or they did not understand the scope of work and submitted a low bid. In the case of a low bid, contractors will still submit a claim to recoup their costs or restore profitability to a job.
IPA groups contracting strategies or practices into three categories:
Lump-sum EPC is detailed engineering, procurement, and construction performed on a fixed-price basis by the same firm or consortium. This is the design/build strategy.
Reimbursable under which essentially all work is performed on a cost-plus fee or cost-plus incentive fee basis. Reimbursable contracts include those where both the engineering and construction procurements are done on a reimbursable basis. Also included are projects that are incentivized, i.e., where the contractor’s profit fluctuates based on project overruns or cost savings.
Mixed is engineering and procurement performed on a reimbursable basis with predominantly fixed-price construction. Design/bid/build is in this category.
When we look at the frequency of claims associated with risk, there is a clear distinction. Lump sum EPC, which transfers the greatest amount of risk to the contractor, has a much higher frequency of claims. In contrast, the mixed strategy has the lowest frequency of claims because the owner transfers risk to the construction contractor at a point when design is 80 or 90 percent complete, drawings are highly detailed, the site conditions are known, and the scope is well-defined. In this case, the construction contractor enters the process understanding the project environment and has every incentive to do a good job.
SHARED RISK CONTRACTS
In theory, there should be fewer claims in shared risk contracts where contractors are rationally assigned the risks they can manage and the owner retains some of the risk. However, the data show no difference between the frequency of claims on shared risk versus predominantly contractor-allocated risk contracts. In our view, this means that the process of risk allocation is not working properly.
When risk is shared, some ambiguity is created about who owns the risk and when they assume the risk; this creates a situation that generates claims. One reason for this is that when owners evaluate project risk, although they nominally want to keep some of the risk, in actuality they tend to push that risk to the contractors. This is not to say that shared risk contracts can’t work, only that the methods being used today are not resulting in fewer claims.
Other strategies to reduce claims have mixed results. Contracting alliancing does not reduce claims. Contract alliances are established to incentivize groups of contractors to meet a single project cost target by sharing project profits and losses and managing interfaces effectively. In reality, these alliances deteriorate quickly when the gain-share targets are unachievable and contractors realize they
will not reap the profits they expected. By this point in the process, the owner has lost leverage and is forced to renegotiate the target price or dissolve the alliance and return to a reimbursable arrangement to proceed with the project.
No-reservation-of-rights clauses are not correlated with fewer claims. These clauses state that once a party submits a claim, that party cannot come back at the end of a job to claim hidden costs. Owners have difficulty getting these clauses into some contracts and generally the clauses are not used when the owner accepts risk as part of a project. On the other hand, contractual releases from claims do reduce the likelihood of claims. If there is a waiver of a claim for a specific risk, that does tend to reduce claims on a job.
OWNER PRACTICES THAT REDUCE CLAIMS
There are better alternatives owners can use to reduce claims. Functionally integrated teams—those that include not only engineers but also people with expertise in business, operations, maintenance, construction management, and project controls—give owners the resources they need to better monitor contractors’ performance to prevent problems and, when problems do arise, to avoid escalation to disputes and litigation. Only 15 percent of projects using functionally integrated teams had claims compared to 35 percent of the projects using non-integrated teams. Further, all of the projects valued at 1 billion dollars or more that did not use integrated teams had claims.
A good understanding of site conditions also reduces claims by enabling the contractor to mitigate risk or the owner to accept the risk from the contractor.
The frequency of clams is also lowered when there is an expectation of future work (Figure 8.5). Indeed, some claims between owner and contractor were settled with the promise of future work. Looking at projects where the contractor had a very high expectation of future work, the frequency of claims was less than 10 percent. For contractors, the guarantee or likelihood of a steady stream of work is important because the contractors do not have to invest as much time or resources into marketing for their next job.
Involvement from the project team in the contracting process also mitigates claims. When corporate lawyers control the contracting process, claims are more frequent. Lawyers are important in the dispute management process, but the project team’s involvement is necessary for balance.
There is a correlation between claims and an owner’s satisfaction with contractor controls and reporting. That may seem obvious: If the owner is satisfied with the information being provided by the contractor, claims are less frequent. However, if the owner is happy with the contractor’s controls but the reporting suddenly slows down or the quality of the information deteriorates, that should serve as a “red flag” to the owner that a problem is brewing and action may be necessary to prevent the problem from escalating into a claim.
EFFECT OF ALTERNATE FORMS OF DISPUTE RESOLUTION ON CLAIMS
IPA has also studied alternate forms of dispute resolution. In terms of reducing claims, arbitration is not effective. Seventy percent of projects with arbitration clauses had claims, and claim-to-settlement value ratios were much higher than normal. The use of arbitration encourages inflated claim values and presents minimal risk for opportunistic claimants. Other forms of dispute resolution such as claims review boards and mediation did not increase the frequency of claims. Of course, resolution costs are less than litigation costs, so these methods appear to be good strategies for reducing claims or at least resolving claims more effectively than arbitration and litigation.
In summary, owners need a multifaceted approach to reduce claims. Such an approach should include strategies and practices to optimize risk allocation, mitigate claims, and address unwarranted claims. To achieve this, owners should
Prepare for projects with aggressive targets and bids.
Use contracting strategies, such as design-bid-build, to manage contractor risk.
Refrain from using the contracting process as a means of shifting risk to the contractor.
Use functionally integrated teams to oversee contractor work and act when problems arise.
Understand site conditions.
Establish limits on value of claims that can be settled at arbitration.
Use strong owner scheduling and controls resources to ensure an evidentiary trail as a basis for deciding whether a claim is warranted or not.
Increase the burden of proof by requiring contractual releases and detailed, frequent status reports.