Cost Allocations for Construction Insurance and Risk

Cost Sensitivity, Recognition and Allocation for Construction Insurance & Risk

C2 : Cost of Risk Dynamics in 60 Minutes or Less

Charlie Woodman, CPA Caroline Keonraad, CPCU Risk Finance Advisory Willis National Construction

2012 Willis Construction Risk Management Conference September 20, 2012

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, highly variable element in project profitability, especially where loss retentions are assumed and insurance rates are in specific or cyclical flux • Establishing realistic risk cost ranges provides greater flexibility in job costing / 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 2

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 and contractors do best • Design / Cost / Schedule / Quality • Subcontractor performance • Some engineers & contractors also manage fortuitous risk well and increase their margins at both the corporate level and the project level

Risk Transfer + Risk Retention + Admin = Insurance Costs • Risk Transfer: Contractual Insurance • Property • Fixed Property

• Risk Retentions • Deductibles • Self-insured Retentions

• Builder’s Risk

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

• Equipment

• Business Risk

• Casualty, including Legal Defense • Workers’ Compensation • General Liability / Casualty Umbrella • Professional and Pollution Liability • Subcontractor Default

• Legal Defense

• Administration • Safety Operations • Claims and Defense Management

• Compliance • Time • Transaction Costs

All These Can Exhibit Variability To Some Extent

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

6

Basic Elements of Cost of Risk: Not To Proportional Scale Insurance Premiums Taxes

Brokerage Commissions or Fee

Expected Losses within Deductible

Uninsured Losses

Loss Adjustment Expense

Regulatory Compliance

Adverse Losses within Retention

Cost of Reinsurance, Imbedded

Legal Expenses Risk Control

Administrative Costs

Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost

•

Profits & Losses 55 -75%

Components of Traditional Insurance:  Expected loss and ALAE  Taxes and regulatory fees  Overhead and administration  Insurer selling and distribution expense  Reinsurance and Intermediary charges  Risk Margins  Surplus charges  Risk Based Capital offsets

Fixed (25%-35%)  Insurance Company Overhead, Taxes, Reinsurance Cost, Commission

Profits & Investment Income  Underwriting Profit and Investment Income Accrued by Insurance Company and or Reinsurer

Odd Variable Risk Margins Surplus & RBC 7

Insurance Program Risk Costs with Large Deductibles / Retentions Incurred Losses: The Variable Stuff 65% – 90+%

“Fixed Costs”

Fixed • Risk Transfer • Taxes • Safety & Claims Mgmt • Loss Control • Admin & Compliance

8

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 Adjustment Expense (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 9 Approaches

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 costs 10

Intro To Losses • A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-But-NotReported (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

Loss Characteristics by Line

• Emergence (E) vs. Settlement (S)

Builder‟s Risk S E Automobile Liability

A

S A E Completed Ops / Defect / Statute of Repose (Included in SDI) A Workers Compensation A

E

E

S

S

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 order to 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 Construction That much

Basic Reserving Techniques:

Application of Paid LDM: Land of Actuaries. Evaluation Interval in Months 12-24 LDFs

Accident Year 1995 1996 1997 1998 1999 2000

24-36

1.800

1.235

36-48 1.134

48-60

60-72

1.085

1.052

Cumulative Paid Losses ($000 Omitted) Development Stage in Months 24 36 48 60 6,671 8,156 9,205 9,990 7,541 9,351 10,639 11,536 8,864 10,987 12,458 13,517 10,268 12,699 14,401 15,625 11,172 13,797 15,646 16,976 12,532 15,477 17,550 19,042

12 3,780 4,212 4,901 5,708 6,093 6,962

72 to Ultimate 1.070

72 10,508 12,136 14,220 16,437 17,859 20,032

Sample Calculations for Accident Year 2000: At 24 Months: At 36 Months: or

12 to Ult 3.079

12,532 = 6,962 x 1.800 15,477 = 12,532 x 1.235 15,477 = 6,962 x 1.800 x 1.235

Cumulative Development Factors 24 to Ult 36 to Ult 48 to Ult 60 to Ult 1.710

1.385

1.221

1.126

72 to Ult 1.070

Final Total Cost 11,244 12,985 15,215 17,588 19,109 21,435

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 likely outcomes – (FIN 14) book the minimum. • Treat the tail of claims-made expected losses as unlimited loss(es) regardless if a 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 its financials in the accounting period in which it knows of the event • Actual payment reduces a reserve; should not effect earnings.

15

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 that remote 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 in Notes under “Claims, Lawsuits and Other Contingencies”

•Potential FASB change – “Remote”, if significant, must be disclosed.

16

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 17

Risk & Insurance Costing - Current Trends and Observations • Meet The “Somes” • Some contractors only include the cost of insurance premiums in their accrual models without loss consideration.

• Some include the aggregate of total costs and loss exposure (even beyond). • A contractor‟s 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 risk while validating those costs for owners • And provide you a competitive advantage or wiggle room when bidding 18 or negotiating projects

Effects of Adverse Losses on Project Profits

Loss Probabilities

Costing Tolerance

Profitability At Risk

 Expected Losses





Unexpected Losses

Stress Losses

Loss(es) Severities

Insurance Cost (including Loss Costs) Allocation

Fixed Expenses Risk Transfer Premiums Program Administration Safety Brokerage Fee

Project #1 Project #2

Ins Cost Allocation

Variable Expenses Retained Losses Loss Adjustment Expenses

Maximum/ Aggregate Loss

Project #3 Actuarial Expected Loss

Potential Profit Loss

Current Loss Accruals

 Expected Losses

Typical Practice: Internal vs Market-Based Costing Risk/Coverage Description Workers Comp Deductible Funding Primary CGL Deductible Funding Primary Auto Liability Deductible Funding Umbrella 1st Layer 2nd Layer (Excess) 3rd Layer (Excess) 4th Layer (Excess) 5th Layer (Excess) Professional & Pollution Liab. Deductible Funding Professional Excess Builders' Risk/DIC Contractors Equip. Deductible Funding Fiduciary Liability Excess Fiduciary Directors & Officers Liab. Employee Dishonesty Excess Employee Dishon. Employment Practices Liab. Excess Layer Deductible Funding Risk Management Safety Administration Claims Administration Brokers Fee Auto Physical Damage Total:

Limits Statutory $2MM/$5MM $1MM

INTERNAL COST OF RISK Insurance Notes Program Cost 3.2390% $1,133,639 Premium w/ $250k ded. 8.1429% $2,850,000 Deductible Loss Pic 1.3192% $461,736 Premium w/ $250k ded. 4.1429% $1,450,000 Deductible Loss Pic 0.5685% $198,980 Premium w/ $250k ded. 1.4286% $500,000 Deductible Loss Pic

MARKET COST OF RISK Allocation Notes Cost 12.5200% $4,382,003 1st Dollar Standard Policy Premium 6.0083%

$2,102,910

First Dollar Cost

2.1968%

$768,878

First Dollar Cost

$50MM $25MM xs $50MM $25MM xs $75MM $25MM xs $100MM $200MM xs $125MM

1.7000% 0.3743% 0.2250% 0.1589% 0.0000%

$595,000 $131,000 $78,750 $55,619 $0

Policy Premium Policy Premium Policy Premium Policy Premium Self Insured

1.7000% 0.3743% 0.2250% 0.1589% 1.0000%

$595,000 $131,000 $78,750 $55,619 $350,000

Policy Premium Policy Premium Policy Premium Policy Premium Market Indications

$10MM

0.9221% 0.5590% 0.0000% 0.0000% 0.2032% 0.0714% 0.0000% 0.0243% 0.0000% 0.0000% 0.0189% 0.2100% 0.3429% 0.2143% 0.8388% 2.4314% 0.4514% 0.7971% 0.0000% 28.3840%

$322,742 $50,000 $0 $0 $71,103 $25,000 $0 $8,500 $0 $0 $6,600 $73,500 $120,000 $75,000 $293,580 $850,999 $158,000 $279,000 $0 $9,788,748

Premium w/ $100k ded. Deductible Loss Pic Included in 2nd Layer (Excess) Risk Transfer-Per Job Premium w/ $25000ded. Loss Pic Self Insured

1.1342% 0.1429% 0.0374% 0.0000% 0.2032% 0.0714% 0.0214% 0.0243% 0.2143% 0.0155% 0.0189% 0.2100% 0.3429% 0.2143% 0.8388% 2.4314% 0.4514% 0.7971%

$396,973 $50,000 $13,100 $0 $71,103 $25,000 $7,507 $8,500 $75,000 $5,437 $6,600 $73,500 $120,000 $75,000 $293,580 $850,999 $158,000 $279,000 $89,900 $10,973,459

First Dollar Cost Deductible Loss Pic Market Indication Risk Transfer-Per Job Premium w/ $ 250000ded. Based on historical experience Actual Cost for $1mm Market Cost for $9mm xs $1mm Market Cost Indication for $10mm Actual Cost for $1mm Market Cost Indication Market Cost Indication Market Cost Indication Loss Pic Department Costs Department Costs

$25MM xs $10MM

$1MM 9xs1 $10MM $1MM 4xs1 10 65xs10

Self Insured Self Insured

Per Contract with Willis Self Insured Total Internal Cost

21

31.3527%

Per Contract with Willis Market Cost Indication Total Market Cost

Let’s 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: the cost of volatility. 22

Let’s Look at Loss Characteristics using Retention Levels As Illustrations P r o p e r t y - P r o b a b ilit y D is t r ib u t io n 14% 12%

$500,000 Retention

8% 6%

$1,000,000 Retention

4% 2%

Unlimited Retention

Los s e s / (G ains ) Unlim ite d

$500K Re tn

00 ,0

00 15

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00

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50

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00 13

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12

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11

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0 9,

75

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0 9,

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25

0,

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6,

75

0,

00

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0 6,

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25

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50

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75

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00

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00 3,

00

0,

00 25 2,

1,

50

0,

0,

00

0

0

-

0% 75

Probability

10%

$1M M Re tn

Multi-Risk Comparison

P r 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 14%

Auto Liability

12%

Workers Comp

8%

Professional Liab. 6%

Builders Risk

4% 2%

00 ,0

00 17

,2

50

,0

00 16

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00

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00 ,7

50

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15

15

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75

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9,

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5,

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00 3,

3,

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1,

50

0,

0,

00

0

0

0% 75

Probability

10%

Los s e s / (G ains ) Pro p . @ 1M M

W.C . @ 1M M

Pro d . @ 1M M

Auto @ 1M M

Portfolio Effect P r o b a b ilit y D is t r ib u t io n s - All Lin e s 10% 9% 8%

Retained Risk @ 85th Percentile -

Probability

7%

Risks Treated In Combination

6% 5% 4%

Retained Risk @ 85th Percentile -

3%

Risks Treated In Isolation

2% 1%

15

,0

0 16 0,0 ,5 00 0 18 0,0 ,0 00 0 19 0,0 ,5 00 0 21 0,0 ,0 00 0 22 0,0 ,5 00 0 24 0,0 ,0 00 0 25 0,0 ,5 00 0 27 0,0 ,0 00 0 28 0,0 ,5 00 0 30 0,0 ,0 00 0 31 0,0 ,5 00 0 33 0,0 ,0 00 0 34 0,0 ,5 00 0 36 0,0 ,0 00 0 37 0,0 ,5 00 0 39 0,0 ,0 00 0 40 0,0 ,5 00 0 42 0,0 ,0 00 0 43 0,0 ,5 00 0 45 0,0 ,0 00 0 46 0,0 ,5 00 0 48 0,0 ,0 00 0 49 0,0 ,5 00 00 ,0 00

0%

Los s e s / (G ains ) All Line s - Tre a te d a s C o m b ine d

All Line s - Tre a te d a s Se p a ra te

Loss Sensitivity Simulation Outputs Item

Losses at $250,000 per Occurrence

1

Simulation#

NA

Statistics / Cell Minimum

3,264,992

Maximum

8,585,279

Mean

5,297,963 680,733

Standard Deviation

463,397,165,442

Variance Skewness

0.259430

Kurtosis

3.028987 -

Number of Errors

4,837,020

Mode 5%

4,231,137

10%

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%

5,271,783

55%

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% 26

Insurance Costs / “Fixed” Components

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

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

16,650

18,500

23,125

18,963

TPA and 3rd Party Admin

Total

18,500

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

27

Graphic Output

28

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

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 30

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 31

Charlie Woodman, CPA Caroline Keonraad, CPCU Risk Finance Advisory Willis National Construction

Questions & Thank You

2012 Willis Construction Risk Management Conference September 20, 2012