Cost Allocations for Construction Insurance and Risk - Charlie Woodman and Caroline Koenraad

7/28/2019 Cost Allocations for Construction Insurance and Risk - Charlie Woodman and Caroline Koenraad

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Cost Sensitivity, Recognitionand Allocation for Construction

Insurance & Risk

C2 : Cost of Risk Dynamics in 60

Minutes or Less

Charlie Woodman, CPA

Caroline Keonraad, CPCURisk Finance Advisory

Willis National Construction

2012 Willis Construction Risk

Management Conference

September 20, 2012


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2

Intro

With increased competition, the dynamics of the bidding process is

becoming more critical as are the recovery of costs where allowed

Insurance and risk management costs are a significant and, often, highlyvariable element in project profitability, especially where loss retentionsare assumed and insurance rates are in specific or cyclical flux

Establishing realistic risk cost ranges provides greater flexibility in jobcosting / traditional costing to aggregate levels erodes competitiveness

Components to always consider and factor into a costing rate:

Program costs with ultimate expected and adverse loss performance

Un(der) insured high severity adverse loss risk margins

Insurance renewal fluctuations especially where projects are long-term

Insurance program minimums and exposure-based premium adjustments

Administrative and internal risk management costs


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Construction Industry Somewhat Unique

All value is added to the engineering and construction process by

managing risk Two broad categories of risk

Fortuitous: Insurance Costs

Commercial/Technical

Managing commercial and technical risk is what engineers andcontractors do best

Design / Cost / Schedule / Quality

Subcontractor performance

Some engineers & contractors also manage fortuitous risk well andincrease their margins at both the corporate level and the project level


4/32

Risk Transfer + Risk Retention + Admin = Insurance Costs

Risk Transfer: ContractualInsurance

Property

Fixed Property

Builders Risk

Equipment

Casualty, including Legal Defense

Workers Compensation

General Liability / Casualty

Umbrella

Professional and PollutionLiability

Subcontractor Default

Risk Retentions

Deductibles

Self-insured Retentions

Un(der) insurables: Rework / Rip & Tear,

etc.

Business Risk

Legal Defense

Administration

Safety Operations

Claims and Defense Management

Compliance

Time

Transaction Costs

All These Can Exhibit Variability To Some Extent


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Discussion

Financial Recognition of Losses and Contingencies (Expenses)

Costing Dynamics

Expected Losses & Retentions

Adverse Loss Sensitivities

Severity Exposures

Insurance / Risk Transfer Costs

Internal Costs

Issues and Considerations

5


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Basic Elements of Cost of Risk: Not To Proportional Scale6

Insurance Premiums

Brokerage Commissionsor Fee

Expected Losses within

Deductible

Cost ofReinsurance,

Imbedded

Uninsured Losses

Administrative

Costs

Risk Control

Legal Expenses

Adverse Losseswithin Retention

Loss Adjustment

Expense

Taxes

Regulatory

Compliance


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7

Economics of Insurance: Typical Commercial Insurance 1st

Dollar / Guaranteed Cost

Fixed (25%-35%) Insurance Company

Overhead, Taxes,Reinsurance Cost,Commission

Profits & Investment Income Underwriting Profit and

Investment Income Accrued byInsurance Company and orReinsurer

Profits & Losses55 -75% Components of Traditional

Insurance:

Expected loss and ALAE

Taxes and regulatory fees

Overhead andadministration

Insurer selling anddistribution expense

Reinsurance andIntermediary charges

Risk Margins Surplus charges

Risk Based Capital offsets

Odd VariableRisk MarginsSurplus & RBC


8/32

8

Insurance Program Risk Costs with Large Deductibles /

Retentions

Fixed Risk Transfer Taxes Safety & Claims

Mgmt Loss ControlAdmin & Compliance

FixedCosts

Incurred Losses: The Variable Stuff65% 90+%


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Losses: the 800 Pound Gorilla Sitting In The Corner

Make up the vast majority of insurance cost uncertainties

In Guaranteed Cost: Standard Premium including Experience Mods

In Loss-sensitive Programs : Deductibles and Retentions

Losses = Pure Loss (claimant satisfaction costs) + Loss AdjustmentExpense (loss reconciliation activity costs)

Losses and their uncertainty broken down into two (2) types

Frequency / Burning Losses: Actuarially Predictable WC / GL / AL

Admin vs Self-perform GC

Severity / Adverse / Catastrophic Losses: Tougher to Predict - PL / Comp Op / SDI Generally, loss intensity grows with time

We can measure outcomes / pose what ifs / Apply Portfolio

Approaches 9


10/32

First: Financial Reporting of Losses for Contractors

Financial Reporting is expense recognition which is a reactive activity

Costing is a rationalization activity which is a proactive activity

Financial reporting is the responsibility of Owners, CFOs, Management,Controllers and Independent CPAs - all share the risk

Reliance by various users on financial statements:

Sureties

Banks and finance companies

Regulatory boards - licensing

Owner and prime contractor prequalification

Suppliers

Stockholders (owners)

Joint venture partners

Costing is the responsibility of various technical areas combining to

establish reasonable expectations of project costs10


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Intro To Losses

A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-But-Not-

Reported (IBNR)

What is a Loss Reserve?

Amount necessary to settle unpaid claims

Case Reserves

Claim reported but not yet paid

Assigned a value by a claims adjuster or by formula

IBNR reserves include: Most difficult to measure and justify

Reserves for claims not yet reported (pure IBNR)

Claims in transit

Development on known claims

Reserves for reopened claims


12/32

Loss Characteristics by Line

Emergence (E) vs. Settlement (S)

A E S

A E S

Completed Ops / Defect / Statute of Repose (Included in SDI)

Workers Compensation

Automobile Liability

A

A E S

E S

Builders Risk


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Basic Loss Measurement Techniques:

Definitions

Sometimes solely Industry-based

Composite to Insurer Expectations

Loss Development Method using Historical Patterns

Triangles

Compiled to measure the changes in cumulative claim activity over time in orderto estimate patterns of future activity.

Loss Development Factor

The ratio of losses at successive evaluations for a defined group of claims (e.g.

accident year).

Loss Sensitivity Simulation (discussed later): Not Used in ConstructionThat much


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Basic Reserving Techniques:

Application of Paid LDM: Land of Actuaries.

Evaluation Interval in Months72 to

12-24 24-36 36-48 48-60 60-72 Ultimate

LDFs 1.800 1.235 1.134 1.085 1.052 1.070

Cumulative Paid Losses ($000 Omitted) Final

Accident Development Stage in Months Total

Year 12 24 36 48 60 72 Cost

1995 3,780 6,671 8,156 9,205 9,990 10,508 11,244

1996 4,212 7,541 9,351 10,639 11,536 12,136 12,985

1997 4,901 8,864 10,987 12,458 13,517 14,220 15,215

1998 5,708 10,268 12,699 14,401 15,625 16,437 17,588

1999 6,093 11,172 13,797 15,646 16,976 17,859 19,109

2000 6,962 12,532 15,477 17,550 19,042 20,032 21,435

Sample Calculations for Accident Year 2000:

At 24 Months : 12,532 = 6,962 x 1.800

At 36 Months: 15,477 = 12,532 x 1.235

or 15,477 = 6,962 x 1.800 x 1.235

Cumulative Development Factors

12 to Ult 24 to Ult 36 to Ult 48 to Ult 60 to Ult 72 to Ult

3.079 1.710 1.385 1.221 1.126 1.070


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15

Recognition of Losses: Rule

A loss or group of losses is recorded only when (FAS 5):

The likelihood of actual loss is probable, AND

The amount of the loss is reasonably subject to estimation.

If reasonable estimates of loss or losses produces a range of equally likelyoutcomes (FIN 14) book the minimum.

Treat the tail of claims-made expected losses as unlimited loss(es) regardless ifa new policy will likely be purchased.

Importance

A company cannot set aside reserves for a loss it believes might occur before it actually

happens.

If a loss occurs, a company must recognize the full value of the loss as an expense on itsfinancials in the accounting period in which it knows of the event

Actual payment reduces a reserve; should not effect earnings.


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Probability

Remote the chance of the future event

or events occurring is slight Reporting Action: Do nothing or

ID as a Risk of Business, if large,

in MD&A

Reasonably Possible the chance of the

event or events occurring is more thatremote but less than likely

Reporting Action: Disclose in

Notes

Probable the future event or events

are likely to occur

Reporting Action:

If Measurable: Book to Financials:Disclose in Notes

If Immeasurable: Disclose inNotes under Claims, Lawsuits

and Other Contingencies

16

Potential FASB changeRemote, ifsignificant, must be disclosed.


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17

Now Costing: Why Cost Accounting is So Important

It Helps In:

Bidding

Determining problem projects

Supporting change order pricing

Claims process

Reconciling job costs to financial reports

Making better decisions

Making expansion less frightening

Supporting Audits Commercial

Governmental

Tax


18/32

Risk & Insurance Costing - Current Trends and Observations

Meet The Somes

Some contractors only include the cost of insurance premiums in their accrualmodels without loss consideration.

Some include the aggregate of total costs and loss exposure (even beyond).

A contractors Total Cost of Risk can include the following:

Insurance premium costs

Safety & loss control costs

Cost of having risk management staff

Claim costs within deductible layers

Un-recovered legal expenses

Uninsurable or self-insured risks

This trick is developing a methodology for quantifying your cost of riskwhile validating those costs for owners

And provide you a competitive advantage or wiggle room when bidding

or negotiating projects 18


19/32

Loss(es) Severities

Expected

Losses

Unexpected Losses

Stress Losses

Costing Tolerance

Profitability At Risk

Effects of Adverse Losses on Project Profits

Loss

Probabilities


20/32

Insurance Cost (including Loss Costs) Allocation

Project #1

Ins Cost

Allocation

Fixed ExpensesRisk Transfer PremiumsProgram Administration

SafetyBrokerage Fee

Variable ExpensesRetained Losses

Loss Adjustment Expenses

Actuarial

Expected Loss

Maximum/

Aggregate Loss

Potential Profit

Loss

Project #2

Project #3Current

Loss

Accruals

Expected

Losses


21/32

Typical Practice: Internal vs Market-Based Costing

21

INTERNAL COST OF RISK

Risk/Coverage Insurance Allocation

Description Program Cost Cost

Workers Comp Statutory 3.2390% $1,133,639 Premium w/ $250k ded. 12.5200% $4,382,003 1st Dollar Standard Policy Premium

Deductible Funding 8.1429% $2,850,000 Deductible Loss Pic

Primary CGL $2MM/$5MM 1.3192% $461,736 Premium w/ $250k ded. 6.0083% $2,102,910 First Dollar Cost

Deductible Funding 4.1429% $1,450,000 Deductible Loss Pic

Primary Auto Liability $1MM 0.5685% $198,980 Premium w/ $250k ded. 2.1968% $768,878 First Dollar Cost

Deductible Funding 1.4286% $500,000 Deductible Loss Pic

Umbrella

1st Layer $50MM 1.7000% $595,000 Policy Premium 1.7000% $595,000 Policy Premium

2nd Layer (Excess) $25MM xs $50MM 0.3743% $131,000 Policy Premium 0.3743% $131,000 Policy Premium

3rd Layer (Excess) $25MM xs $75MM 0.2250% $78,750 Policy Premium 0.2250% $78,750 Policy Premium

4th Layer (Excess) $25MM xs $100MM 0.1589% $55,619 Policy Premium 0.1589% $55,619 Policy Premium

5th Layer (Excess) $200MM xs $125MM 0.0000% $0 Self Insured 1.0000% $350,000 Market Indications

Professional & Pollution Liab. $10MM 0.9221% $322,742 Premium w/ $100k ded. 1.1342% $396,973 First Dollar Cost

Deductible Funding 0.5590% $50,000 Deductible Loss Pic 0.1429% $50,000 Deductible Loss Pic

Professional Excess $25MM xs $10MM 0.0000% $0 Included in 2nd Layer (Excess) 0.0374% $13,100 Market Indication

Builders' Risk/DIC 0.0000% $0 Risk Transfer-Per Job 0.0000% $0 Risk Transfer-Per Job

Contractors Equip. 0.2032% $71,103 Premium w/ $25000ded. 0.2032% $71,103 Premium w/ $ 250000ded.

Deductible Funding 0.0714% $25,000 Loss Pic 0.0714% $25,000 Based on historical experience

Fiduciary Liability $1MM 0.0000% $0 Self Insured 0.0214% $7,507 Actual Cost for $1mm

Excess Fiduciary 9xs1 0.0243% $8,500 0.0243% $8,500 Market Cost for $9mm xs $1mm

Directors & Officers Liab. $10MM 0.0000% $0 Self Insured 0.2143% $75,000 Market Cost Indication for $10mm

Employee Dishonesty $1MM 0.0000% $0 Self Insured 0.0155% $5,437 Actual Cost for $1mm

Excess Employee Dishon. 4xs1 0.0189% $6,600 0.0189% $6,600 Market Cost IndicationEmployment Practices Liab. 10 0.2100% $73,500 0.2100% $73,500 Market Cost Indication

Excess Layer 65xs10 0.3429% $120,000 0.3429% $120,000 Market Cost Indication

Deductible Funding 0.2143% $75,000 0.2143% $75,000 Loss Pic

Risk Management 0.8388% $293,580 0.8388% $293,580 Department Costs

Safety Administration 2.4314% $850,999 2.4314% $850,999 Department Costs

Claims Administration 0.4514% $158,000 0.4514% $158,000

Brokers Fee 0.7971% $279,000 Per Contract with Willis 0.7971% $279,000 Per Contract with Willis

Auto Physical Damage 0.0000% $0 Self Insured $89,900 Market Cost Indication

Total: 28.3840% $9,788,748 Total Internal Cost 31.3527% $10,973,459 Total Market Cost

MARKET COST OF RISK

LimitsNotesNotes


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Lets Get Back to Cost Volatility or Uncertainty

The traditional definition of cost of risk has four basic components:

Insurance purchased

Retained losses, including claims management costs

Risk reduction initiatives Administration

= Costs to be divided by Exposures (Project Values / Total Revenues / Total Payroll)

= Assumed Insurance Rate

End of Story?

This traditional definition ignores a key component of cost of risk: thecost ofvolatility.

22

L t L k t L Ch t i ti i R t ti L l A


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Lets Look at Loss Characteristics using Retention Levels As

Illustrations

Pr o p e r t y - P r o b a b ilit y Dis t r ib u t io n

0%

2%

4%

6%

8%

10%

12%

14%

-

750,

000

1,50

0,00

0

2,25

0,00

0

3,00

0,00

0

3,75

0,00

0

4,50

0,00

0

5,25

0,00

0

6,00

0,00

0

6,75

0,00

0

7,50

0,00

0

8,25

0,00

0

9,00

0,00

0

9,75

0,00

0

10,500

,000

11,250

,000

12,000

,000

12,750

,000

13,500

,000

14,250

,000

15,000

,000

Losses / (Gains)

Probability

Unlimited $500K Retn $1MM Retn

$500,000Retention

$1,000,000Retention

UnlimitedRetention


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Multi-Risk Comparison

Pr o b a b ilit y D is t r ib u t io n s - In d ivid u a l R is k s

0%

2%

4%

6%

8%

10%

12%

14%

0

750,

000

1,50

0,00

0

2,25

0,00

0

3,00

0,00

0

3,75

0,00

0

4,50

0,00

0

5,25

0,00

0

6,00

0,00

0

6,75

0,00

0

7,50

0,00

0

8,25

0,00

0

9,00

0,00

0

9,75

0,00

0

10,500

,000

11,250

,000

12,000

,000

12,750

,000

13,500

,000

14,250

,000

15,000

,000

15,750

,000

16,500

,000

17,250

,000

Losses / (Gains)

Probability

Prop. @1MM W.C. @1MM Prod. @1MM Auto @1MM

Auto Liability

Builders Risk

Workers Comp

Professional Liab.


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Portfolio Effect

Pr o b a b ilit y Dis t r ib u t io n s - All Lin e s

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

15,000

,000

16,500

,000

18,000

,000

19,500

,000

21,000

,000

22,500

,000

24,000

,000

25,500

,000

27,000

,000

28,500

,000

30,000

,000

31,500

,000

33,000

,000

34,500

,000

36,000

,000

37,500

,000

39,000

,000

40,500

,000

42,000

,000

43,500

,000

45,000

,000

46,500

,000

48,000

,000

49,500

,000

Losses / (Gains)

Probability

All Lines- Treated as Combined All Lines- Treated as Separate

Retained Risk @ 85th Percentile -

Risks Treated In Combination

Retained Risk @ 85th Percentile -

Risks Treated In Isolation


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Loss Sensitivity Simulation

26

Outputs Item Losses at $250,000 per Occurrence

Simulation# 1

Statistics / Cell NA

Minimum 3,264,992Maximum 8,585,279

Mean 5,297,963

Standard Deviation 680,733

Variance 463,397,165,442

Skewness 0.259430

Kurtosis 3.028987

Number of Errors -

Mode 4,837,020

5% 4,231,13710% 4,427,777

15% 4,584,207

20% 4,710,057

25% 4,825,061

30% 4,916,320

35% 5,009,401

40% 5,098,429

45% 5,182,846

50% 5,271,78355% 5,356,573

60% 5,454,766

65% 5,543,744

70% 5,636,479

75% 5,738,704

80% 5,859,217

85% 5,997,048

90% 6,193,518

95% 6,475,948

Expected Losses

Aggregates usually > 95%


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Insurance Costs / Fixed Components

27

Cost elements Base case $k Minimum Most Likely Maximum Minimum Most Likely Maximum Sampled

WC Fixed 2,000 90% 100% 125% 1,800 2,000 2,500 2,050

GL / Comp Ops Fixed 5,000 90% 100% 125% 4,500 5,000 6,250 5,125

CPPI Fixed 4,000 90% 100% 125% 3,600 4,000 5,000 4,100

Builders Risk 2,000 90% 100% 125% 1,800 2,000 2,500 2,050

Umbrella 1,000 90% 100% 125% 900 1,000 1,250 1,025

TPA and 3rd Party Admin 500 90% 100% 125% 450 500 625 513

Loss Control & Safety 1,500 90% 100% 125% 1,350 1,500 1,875 1,538

Other general overhead 2,500 90% 100% 125% 2,250 2,500 3,125 2,563

Total 18,500 16,650 18,500 23,125 18,963

Use of @RISK statistics for key outputs (run simulation for these to be valid):

Probability of meeting value of 18500 15.0% 18,500

Total budget required for 95.0%confidence

19,675 95.0%

Contingency required for 95.0%confidence

1,175


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Graphic Output

28


29/32

Dynamic Financial Modelling with Cost of Risk

I can now take

Expected Losses

Loss Variability

Severe Loss Probability and

Tolerances

Fixed Cost Variability over Time

And Combine Them Into a Range

of Reasonable Insurance Cost

Rates

C2 Process

29


30/32

30

Special Consideration: Federal Contracting

Key regulation* for accounting for insurance costs:

Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs

Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs

FAR 31.205-19, Insurance and Indemnification

FAR 31.201-5, Credits

FAR 28.3, Insurance

When to evaluate your current accounting practices for insurance costs?

Contracts will be CAS covered

Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification

*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html

Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html


31/32

31

Special Considerations & Challenges

Profitability offsetting between projects

Contract where deductibles are borne contractor; language clarity is essential

Use of insurance quotes to support insurance costs Basis Risk

Use of Loss Exposure Aggregates limits as costing levels

Multi-state differences in retentions or limits / sub-limits

Monopolistic states Incurred and Paid Loss Retrospectively-rated Insurance

CCIP minimums and insurance cost timing

CPPI where contract allows Pollution but limits Professional

Project-specific coverage cost reimbursement disallowances Workers Compensation costs General Conditions (Auditable Labor Burden)

and Admin / Fees (Profit Eroding)

Defect / Completed Operations /DIC

Subguard / SDI


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Questions & Thank

You

Charlie Woodman, CPA

Caroline Keonraad, CPCURisk Finance Advisory

Willis National Construction

2012 Willis Construction RiskManagement Conference

September 20, 2012

Cost Allocations for Construction Insurance and Risk - Charlie Woodman and Caroline Koenraad

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