Transcript 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
5,
25
0,
00
6,
00 0
0,
00
6,
75 0
0,
00
7,
50 0
0,
00
8,
25 0
0,
00
9,
00 0
0,
00
9,
75 0
0
10 ,00
0
,5
00
11 ,00
0
,2
50
12 ,00
0
,0
00
12 ,00
0
,7
50
13 ,00
0
,5
00
14 ,00
0
,2
50
15 ,00
0
,0
00
,0
00
0
0
4,
50
0,
00
0
3,
75
0,
00
0
3,
00
0,
00
0
0,
00
2,
25
0,
00
1,
50
0,
00
-
0
0%
75
Probability
10%
Losses / (Gains)
Unlimited
$500K Retn
$1MM Retn
0
0,
1, 00
50 0
0
2, ,00
25 0
0
3, ,00
00 0
0
3, ,00
75 0
0
4, ,00
50 0
0
5, ,00
25 0
0
6, ,00
00 0
0
6, ,00
75 0
0
7, ,00
50 0
0
8, ,00
25 0
0
9, ,00
00 0
0
9, ,00
75 0
10 0,0
,5 00
0
11 0,0
,2 00
5
12 0,0
,0 00
0
12 0,0
,7 00
5
13 0,0
,5 00
0
14 0,0
,2 00
5
15 0,0
,0 00
0
15 0,0
,7 00
5
16 0,0
,5 00
0
17 0,0
,2 00
50
,0
00
75
Probability
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%
12%
6%
Auto Liability
10%
8%
Workers Comp
Builders Risk
Prop. @1MM
Professional Liab.
4%
2%
0%
Losses / (Gains)
W.C. @1MM
Prod. @1MM
Auto @1MM
,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
15
Probability
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%
7%
Retained Risk @ 85th Percentile -
6%
Risks Treated In Combination
5%
4%
Retained Risk @ 85th Percentile -
3%
Risks Treated In Isolation
2%
1%
0%
Losses / (Gains)
All Lines- Treated as Combined
All Lines- Treated as Separate
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