The efficient allocation of risk in contracts

This paper considers how project risk should be allocated between clients and contractors, where significant project risk is characterized as uncertainty about project costs requiring explicit attention and policy or behaviour modification. The risk efficiency of cost reimbursement and fixed price contracts given different degrees of client and contractor risk aversion is considered first, using a novel form of model. Then the potential for efficient risk sharing is considered in a mean-variance framework. The concern in both cases is with clarifying the rationale for conventional wisdom and resolving conflicting rules of thumb. Finally, practical application of the analysis with a mixture of controllable and uncontrollable risks is discussed.