Determining the Optimal Premium for ADR Implementation Insurance in Construction Dispute Resolution

Abstract

In most of today’s construction projects, disputes are almost inevitable, and the implementation costs associated with dispute resolution are becoming increasingly expensive. One approach to deal with the risk of dispute-related cost overruns is by pooling the risk using alternative dispute resolution (ADR) implementation insurance. This innovative insurance product is designed to allow the insurance company to compensate any ADR implementation cost that project participants incur during the construction phase. In return, the insurance company will receive a premium for bearing the risk of excessive ADR implementation costs. Similar to commercial medical and auto insurance, the ADR insurance policy specifies a deductible limit (DL) and a maximum payment limit (MPL) on project participants to prevent both moral and morale hazards. In this case, project participants must bear part of the future ADR implementation costs before their insurance is activated. Based on the basic framework of ADR implementation insurance previously developed by the writers, this paper proposes an advanced model with the two additional insurance limits to help determine the optimal point on the project participants’ subjective loss curve. The objective is to provide a mutually advantageous insurance policy and minimize project participants’ total expected subjective loss. An example is provided to illustrate the benefits of the proposed methodology. The results show that project participants’ subjective loss function (SLF), DL, MPL, and the expense loading factor