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 insurance is a prospective rating plan where premiums in a policy year are simply a function of the contractor's estimated exposures (payroll and revenue) multiplied times the rate that an insurance company is charging to transfer the risk to the insurer. The premiums paid for that period are not a function of the losses that occur during that given year. For this reason, the term “guaranteed cost insurance” is applied.
Advantages of guaranteed cost insurance include the following:
- Accounting for insurance premiums on projects is easier.
- Adverse losses that occur during the premium year do not affect the current premium levels.
- A premium discount is guaranteed.
- The insurer is motivated to be aggressive in loss control and claims handling activities as these will directly impact their underwriting profits.
Disadvantages of guaranteed cost insurance include the following:
- Typically, guaranteed cost insurance is the most expensive method of financing risk.
- Rewards for an effective contractor safety program are not optimized as there is no current period premium savings.
- Excess premiums collected during the year that exceed the losses and expenses of the insurance company are not refunded to the contractor.
- Cash flow benefits are limited, if any.
Deductible insurance programs allow a contractor to assume some risk in exchange for lower premiums. The risk transfer portion or the amount of insurance paid to the insurance company for the risk transferred is a guaranteed amount based upon overall payroll and revenue. The contractor would assume some level of losses per occurrence for each line of coverage. Dependent upon size and financial strength, this could vary between $2,500 per occurrence for automobile liability to $250,000 per occurrence for worker's compensation. There are many options available. The level of deductible should reflect the economic rewards and the risk retention philosophy of the given contractor.
Advantages of a deductible program include the following:
- There are lower insurance costs during the year, if losses are favorable.
- The contractor is allowed to pay for small, frequent losses.
- The contractor is rewarded for maintaining an effective safety program.
- Cash flow benefits can be significant.
- Plan design is flexible.
- Some tax relief is available on premiums.
- Extended loss payments allow longer ultimate expense deferrals and increases investment income.
Disadvantages of a deductible program include the following:
- Financial security or collateral is typically required, depending upon the amount of retention.
- Final costs are uncertain and not determined until future periods.
- There is some risk of large losses.
- The timing of reimbursements can be unpredictable.
Retrospective rating programs are basically a cost plus program, subject to maximum and minimum premiums. These types of plans come in a variety of rating methods. For instance, the two most popular methods are incurred loss retrospective rating and paid loss retrospective rating.
Retrospective rating programs plans provide for an evaluation of losses six months following expiration of a policy term, with an adjustment in premium based upon actual incurred or paid losses. Additional adjustments will be made annually until all claims are either closed or an agreement is reached with the insurance company on final settlement values.
Advantages of retrospective rating plans include the following:
- Maintaining effective loss control and safety programs is rewarded.
- When losses are low, the contractor's insurance costs are usually lower than with other funding alternative.
- The maximum premium prevents a single catastrophic loss from eliminating possible savings from the plan.
- Flexible plan design is provided.
Disadvantages of retrospective rating plans include the following:
- The final premiums are uncertain.
- The maximum premium may be in excess of pay-in premiums.
- The insurer is not motivated to control losses.
- Premium adjustments usually occur over several years and have a financial statement impact in each fiscal year.
- Premiums are a function of incurred losses, and therefore, subject to the insurer’s reserving practices.
Self-insurance is largely independent of the insurance industry, except for the excess coverage or stop loss coverage. This type of program involves the contractor retaining most of their risk and not putting claims through the commercial insurance market at all. Claims are investigated and settled by the contractor’s staff or by an outside third party (claims administrator) hired to provide this service. The contractor holds all funds until claims are actually settled and paid.
The excess insurance or stop loss coverage is typically purchased from an insurance company that may or may not offer claims handling services as well. The level at which the excess coverage attaches is a function of contractor size, financial strength, risk philosophy and other factors.
Because of the significant amount of risk retained, self-insurance programs are viable only for larger construction firms. Self-insurance of worker's compensation exposures requires regulatory approval in the involved states. Each state has their individual requirements, which must be met before permission is granted to the self-insurer. Most of these requirements relate to the size and financial strength of the contractor, and typically, financial security is required.
Advantages of self-insurance include the following:
- Cash flow benefits
- Immediate reduction in short-term expenses
- Greater control of claims
- Elimination of insurance company expenses
Disadvantages of self-insurance include the following:
- Cost fluctuations as losses may vary.
- Tax issues as loss reserves are not deductible for tax purposes creating a timing effect on costs.
- Greater management responsibilities are assumed because the firm must oversee claims investigations, defense, administration, loss control and regulatory compliance.
- There are increased collateral requirements due to letter of credit requirements or self-insurance bonds.
- Regulatory approval must be obtained.
- Potential catastrophic liability is assumed, unless excess insurance coverage is purchased.
Captive Insurance Programs
A captive insurance company is effectively a self-insurance program that has been formalized into a separate corporate entity for payment of premiums and losses. A very large contractor may wish to establish their own insurance captive, which is referred to as a “single parent” captive. Mid-size to larger contractors who have similar exposures and risk philosophies may have an interest in forming or participating in a group-owned captive insurance company. There are also association captives and rental captive programs available.
Group owned captives have increased substantially during the past fifteen years, and have become an effective risk financing vehicle for many contractors. In a group captive, individual contractors are responsible for their own losses up to some predetermined level, with losses excess of that amount shared among the captive participants. Typically, the actual insurance policies are provided by substantial insurers (fronting companies) who also provide “excess” insurance to the captive to insure large severe losses.
The feasibility of establishing a “single parent” captive or participating in a group captive, requires significant evaluation and consideration of many factors. Professional assistance in the evaluation process is highly recommended.
Advantages of a captive insurance company program include the following:
- Avoids the cyclical nature of the insurance industry
- Provides cost stabilization
- Offers broader coverages
- Reduces expenses due to capture of underwriting profit and investment income
- Allows for unbundled services for claims and loss control
- Provides direct control of claim reserves and settling of cases
- Offers wide access to reinsurance market place
- Provides coverage stability
- Offers potential tax advantages
Disadvantages of a captive insurance company include the following:
- Increases administrative costs
- Requires capital
- Increase the uncertainty of final insurance expenses
- Allows possibility for under-reserving of claims
- Requires long-term budgeting
- Requires collateral on outstanding reserves
It’s vitally important for a contractor to select a risk financing plan that is compatible with the contractor's overall goals, objectives, financial capabilities and cash flow requirements. Not all financing plans are created equal; each has its own uniqueness in satisfying a contractor’s risk management and operational goals. A key in that decision process is to compare the program “cost of risk” thoroughly and completely. Here are a few suggestions:
- Analyze the “cost of risk” on a net present value basis, taking into consideration taxes.
- Evaluate the cost of funds and your company’s internal rates of return for retaining certain levels of risk.
- Look beyond the first year and consider future collateral requirements for the selected risk financing program.
- Match loss retentions and deductibles to the company’s financial ability to assume losses.
Despite insurance market cycles, contractors who retain significant exposures via deductibles or retentions will reduce their long-term cost of risk much more effectively than those who elect to transfer most of their risk exposures to insurance companies via guaranteed cost programs. Selecting the proper program and adjusting as you grow will benefit your company near and long-term.
Construction Business Owner, May 2007