As contractors grow and increase their overall contract revenue, they must evaluate different methods to finance their overall risk exposures. This is referred to as “risk financing.”
Risk financing programs involve a trade-off between cash flow and risk, and hence many of them are called “cash flow” plans. Most risk financing programs are based upon the premise that there is a time lapse from the date of loss and the actual payment of claims. Effective risk financing can result in lower ultimate insurance expenses for a contractor.
Contractors who are capable of assuming substantial amounts of risk can put in place risk financing options that allow them to hold all or a portion of the funds ultimately needed to pay claims. On the other hand, contractors who are not willing or able to assume risk must transfer most risk to the insurance companies, including the premiums to pay the losses.
There are various types of risk financing plans available from the commercial insurance market— guaranteed cost, retrospective rating, large deductible programs. All are examples of the risk financing plans available from the insurance industry. A large deductible program is a risk financing option that combines commercial insurance and direct retention of risk by the contractor up to a given loss assumption level. A self-insurance program, however, is a type of risk financing plan that is largely independent of the insurance industry. In addition, contractors can consider group or association programs, group captives and single company captive programs.
The objective of a contractor during the selection of a risk financing program is to maximize the cash flow benefits without subjecting the firm to more risk than it can safely afford to assume based upon its financial condition and overall risk appetite. A contractor should balance the economic rewards of the risk retained with the insurance premium reductions available to the contractor. The following are some important variables that affect the choice of plans:
- Contractor size —The larger the contractor, the more predictable and credible will be its overall losses, allowing higher risk retention levels. The higher premiums typically paid by large contracting firms also enhance their ability to negotiate with the insurance company providing a greater degree of flexibility in risk financing alternatives.
- Contractor financial strength —A contractor with an overall strong balance sheet allows the contractor the ability to fund more of its risk exposures without experiencing adverse financial impact. Therefore, financially strong contractors can assume larger amounts of risk.
- The attitude of management toward risk —The level of retained risk should correspond with the philosophy of the construction firm’s top management. Some managers are risk averse while others are risk takers. For this reason, many small- to mid-size contractors prefer to insure heavily rather than retain significant amounts of risk.
- Overall risk management program —An effective risk management program increases a contractor’s ability to assume risk. Particularly important are superior loss control programs, claims management processes that are fully supported by top management, effective contract risk management and information systems that provide the timely and accurate data needed to analyze alternative risk financing programs while monitoring results.
- Tax position —Insurance premiums are fully deductible in the year in which they are paid, but loss reserves established to pay future deductible or retained losses are not. Such losses can be deducted only in the year they are actually paid. Therefore, the creation of an aggressive risk retention program, such as self-insurance, should be balanced with the tax deductibility of reserves for future claims. There are several methods available to mitigate the tax effects of some cash flow plans.
Risk Financing Plans
There are a number of rating plans used by contractors for financing losses. The following represent some of the more readily used plans:
Guaranteed Cost
Guaranteed cost insurance is a prospective rating plan where premiums in a policy year are simply a function of the contractor's estimated exposures (payroll
