Managing Insurance Costs in Today's Marketplace

Editor's Note: This is part one of a two-part article. To read part two, click here.

The construction industry has come to recognize the relationship between managing risk and return on investment.

Now considered a serious profit initiative, risk management in today's insurance market requires beyond-the-edge thinking if a contractor is to maintain a competitive advantage. The risk management technologies outlined here offer contractors the means to generate additional earnings while leveling out losses.

It is apparent that lean and fit organi­zations represent a platform for long-term survival. Yet, many contractors have also recognized the importance of imagination, vision, and competitive information if they are to succeed in a competitive market. In this respect, risk management has emerged as an additional source of creativity and vision that is enhancing the competitive edge of many contrac­tors despite the softness of the construc­tion insurance market. At last, managing risk has been transformed from a once-a-year insurance bidding frenzy with the local agent into a serious profit initiative, having the ability to boost returns, create equity, reduce costs and permanently change the way con­struction firms are managed.

This shift of recognizing and managing risk has occurred due to the construction industry's enlightened perspective on "risk" and its integration with the overall cost to fund losses. This cost is no longer viewed as an expense item but as an opportunity to make a reasonable return on risk dollars that are currently being consumed to protect and preserve the assets of the construction firm.

The risk management technology available today has long passed the traditional insurance policy buyer in favor of sophisticated construction firms that are astute enough to put each and every risk dollar to work for the compa­ny, generating additional earnings while leveling out the losses on bad projects. The following represents a few risk management technologies that need to be reinforced in a contractor's business.

Contract Documents

Allocating risk on construction projects continues to be an often-over­looked area in analyzing risk profiles for contractors. The effective use of hold harmless and indemnification agreements can reduce, and oftentimes manage, specific types of losses (par­ticularly "action-over" lawsuits) that would have been otherwise absorbed into the contractor's operations or insurance program. The following list provides some ideas for capitalizing on this technology:

1. A standard subcontract document and purchase order should be re­viewed for enforceability and insur­ability; this document should also be updated, when necessary, to incorpo­rate recent case law on indemnifica­tion wording. Traditionally, indemni­fication agreements have been classified into three types: Broad Form, Intermediate Form and Limited Form. Whatever form is chosen, this agreement should serve as the basis for distributing risk within projects.
2. This standard subcontract/purchase order should contain specific lan­guage with respect to types of poli­cies/coverages required, minimum limits of liability and endorsements that protect the interest of the con­struction entity seeking indemnity. For example:
   
• Additional Insured-adding the name of the general contractor to a subcontractor's general liability policy as an additional insured. Due to the new forms from ISO, this is becoming a more difficult issue with regard to completed operations, residential restrictions and indemnity agreements.
• Insurance Considered Primary-the liability program of the subcontractor or sub­-subcontractor shall be considered primary in the event of a loss.
• Cancellation Notice-usually as much as 60 days for cancella­tion and/or non-renewal is desired.
• Waiver of Subrogation-to avoid subrogation proceedings on losses by the subcontractor's insurer. It must be noted that these recom­mendations apply to all contractors.
3. As a rule, coverages should include general liability, automobile liability, worker's compensation, umbrella and certain types of property poli­cies, such as builder's risk/installa­tion floater for work to be installed or erected. Coverage areas need to be quite specific and include limits endorsement language and specific reference to the indemnification agreement signed by the parties.
   
4. Each project file should contain a standard certificate of insurance specifying coverages, limits and endorsements maintained throughout the project and continued for a given period after substantial completion.
5. An audit of the certificate process should be conducted annually on major projects and on subcontractors to verify that the administration of the contract area is being monitored properly.
6. A contract checklist should be drafted for review between the contractor and the owner of the project, noting specific areas such as limits required and special coverages (e.g., Owner's/Contractor's Protec­tive, Railroad Protective). This checklist can be given to the project bid team for cost analysis.
7. Other contract control techniques include the following:
• Route all contracts, purchase orders and agreements that require certificates of insurance to a centralized department where an insurance coordinator, risk manager or contract coordi­nator oversees the documents.
• Use form letters when requesting the standard certificate of insur­ance to be completed.
• Suspend the request and follow­-up within thirty to sixty days from the date of request.
• Develop a database of third-party certificates, based upon renewal dates for easier retrieval and follow-up each month.

Hold harmless clauses are only as good as the indemnitor's ability to respond to assumed liabilities, and waivers of subrogation apply only to insurance that is in force. Certificates of insurance are an important control system and should be monitored as such. Remember, contractual transfer is nothing more than an additional risk-financing tool. The certificate represents the method by which such losses will get paid.

Rating Plans

The insurance marketplace has undergone some improvements during the past year. There are some classifications of work that continue to be difficult, such as residential construction. However, it's important to realize that most contractors are enjoying the benefits of a more competitive market and are realiz­ing rate reductions over last year by as much as 10 percent. Remaining a competitive, yet profitable, force in the market requires contractors to focus on true cost and how it might compare in best-of-class benchmarking from an insurance per­spective.

It's important to match the risk-financing plan with your company's goals, objectives, financial capabilities and cash flow needs. Not all financing plans are creat­ed equal; each has its own uniqueness in satisfying a contractor's risk manage­ment goals. Choosing the right program is step one. Key in that decision process is to compare the program cost of risk thoroughly and completely. A few hints:

1. Always analyze the cost of risk on a net present value basis, taking into consideration taxes and the effect that certain rating plans, such as self­-insurance, might have on deductibili­ty of premiums or loss reserves.
2. Evaluate the cost of funds and your company's internal rates of return for retaining certain levels of risk dollars in-house.
   
3. Look beyond the first year and obtain commitments, or at least an understanding, from the insurance company on how future premiums will be determined, focusing on the long-term rather than just the short­-term aspects of the negotiation.
4. Develop an understanding of the method used by the insurance com­pany in calculating projected losses.
5. Match specific and aggregate loss retentions to the company's financial ability to assume losses, either through formal or informal funding.

Despite the more receptive insurance market cycle, contractors continue to retain significant dollars in the form of deduct­ibles, retro limits and aggregate expo­sures in their operations. In most cases, they are convinced that their ability to prevent and control losses, as well as fund for losses, is far more economically rewarding than simply delegating the entire responsibility to an insurance company, which may have a very different agenda.

Construction Business Owner, September 2006