Insurance as a Risk Management Tool for ADR Implementation in Construction Disputes

Abstract

Nowadays, along with the inherent intricacy and magnitude of large-scale construction projects come increasingly complex disputes. Because most projects operate on tight budgets, alternative dispute-resolution (ADR) techniques such as negotiation, mediation, and arbitration are being widely adopted in large-scale construction projects to help handle disputes in more effective and cost-saving ways. However, the risk of incurring uncertain ADR-implementation costs in the dispute-resolution process has become an important issue. The traditional self-insured approach of simply retaining all risks is no longer considered economical. One way to reduce the potential for variations in the dispute-resolution budget is to price ADR techniques as an insurance product, which allows project participants to transfer the risk of incurring unexpectedly high ADR-implementation costs to the insurance company. Despite this advantage, many factors are preventing project participants from investing in ADR-implementation insurance. This paper proposes a model on how to use ADR-implementation insurance as a risk management tool for construction dispute resolution. It first investigates the possibility of using insurance for ADR-implementation and then uses subjective loss to represent the risk-averse attitude of project participants and quantify the effect of ADR-implementation costs in monetary terms. Event-tree analysis (ETA) is used to simulate different dispute-resolution processes and determine the probability mass function of ADR-implementation costs by drawing analogies from seismic risk insurance. These probabilities are employed to calculate the expected ADR-implementation costs and to derive the insurance premium. Finally, the gross premium is compared to project participants’ subjective loss to help them determine whether purchasing ADR-implementation insurance is necessary. At the end, a numerical example is presented to illustrate the application of the methodology.