Cost Sensitivity, Recognition and 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

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, 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

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

• Builder’s Risk

• Equipment

• Casualty, including Legal Defense

• Workers’ Compensation

• General Liability / Casualty Umbrella

• Professional and Pollution Liability

• 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

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

Basic Elements of Cost of Risk: Not To Proportional Scale6

Insurance Premiums

Brokerage Commissionsor Fee

Expected Losses withinDeductible

Cost ofReinsurance,

Imbedded

Uninsured Losses

AdministrativeCostsRisk Control

Legal Expenses

Adverse Losses within Retention

Loss AdjustmentExpense

Taxes

Regulatory Compliance

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 by Insurance Company and or Reinsurer

Profits & Losses55 -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

Odd VariableRisk MarginsSurplus & RBC

8

Insurance Program Risk Costs with Large Deductibles / Retentions

Fixed• Risk Transfer• Taxes• Safety & Claims

Mgmt• Loss Control• Admin & Compliance

“Fixed Costs”

Incurred Losses: The Variable Stuff65% – 90+%

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 Approaches

9

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-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

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

Builder’s Risk

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 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 Cost1995 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 1.800At 36 Months: 15,477 = 12,532 x 1.235

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

Cumulative Development Factors12 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

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 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.

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”

16

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

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

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 or negotiating projects

18

Loss(es) Severities

Expected

Losses

Unexpected Losses

Stress Losses

Costing Tolerance

Profitability At Risk

Effects of Adverse Losses on Project ProfitsLoss P

rob

ab

ilit

ies

Insurance Cost (including Loss Costs) Allocation

Project #1Project #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 #2Project #2

Project #3Project #3Current

LossAccruals

Expected

Losses

Typical Practice: Internal vs Market-Based Costing

21

INTERNAL COST OF RISKRisk/ Coverage Insurance Allocation

Description Program Cost CostWorkers 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 PicPrimary 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 PicUmbrella 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 JobContractors 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 experienceFiduciary Liability $1MM 0.0000% $0 Self Insured 0.0214% $7,507 Actual Cost for $1mmExcess Fiduciary 9xs1 0.0243% $8,500 0.0243% $8,500 Market Cost for $9mm xs $1mmDirectors & Officers Liab. $10MM 0.0000% $0 Self Insured 0.2143% $75,000 Market Cost Indication for $10mmEmployee Dishonesty $1MM 0.0000% $0 Self Insured 0.0155% $5,437 Actual Cost for $1mmExcess 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 PicRisk Management 0.8388% $293,580 0.8388% $293,580 Department CostsSafety Administration 2.4314% $850,999 2.4314% $850,999 Department CostsClaims Administration 0.4514% $158,000 0.4514% $158,000Brokers Fee 0.7971% $279,000 Per Contract with Willis 0.7971% $279,000 Per Contract with WillisAuto Physical Damage 0.0000% $0 Self Insured $89,900 Market Cost IndicationTotal: 28.3840% $9,788,748 Total Internal Cost 31.3527% $10,973,459 Total Market Cost

MARKET COST OF RISK

LimitsNotesNotes

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

Property - Probability Distr ibution

0%

2%

4%

6%

8%

10%

12%

14%

Losses / (Gains)

Pro

bability

Unlimited $500K Retn $1MM Retn

$500,000 Retention

$1,000,000 Retention

Unlimited Retention

Multi-Risk Comparison

Probability Distr ibutions - Individual Risks

0%

2%

4%

6%

8%

10%

12%

14%

Losses / (Gains)

Pro

bability

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

Auto Liability

Builders Risk

Workers Comp

Professional Liab.

Portfolio Effect

Probability Distr ibutions - All Lines

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

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

Loss Sensitivity Simulation

26

Outputs Item Losses at $250,000 per Occurrence

Simulation# 1

Statistics / Cell NA

Minimum 3,264,992

Maximum 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% 4,231,137

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

3 5 7 9

5% 90% 5% 4.23 6.48

Mean=5297963

Distribution for 250K Per Occ/B239

Val

ues

in 1

0 ̂-

7

Values in Millions

0

1

2

3

4

5

6

Mean=5297963

3 5 7 9

Expected Losses

Aggregates usually > 95%

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

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

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

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

Questions & Thank You

Charlie Woodman, CPA

Caroline Keonraad, CPCURisk Finance Advisory

Willis National Construction

2012 Willis Construction Risk

Management Conference

September 20, 2012