Learning the Limits of Risk

March 15, 2013

“We are definitely in a changing insurance market, however short-lived it might be” -Aon Risk Solutions 2012 Construction Industry Report

The biggest challenge for the construction industry in terms of insurance and bonding is truly understanding what is needed and the consistency of what’s available in the marketplace. So says Seth Hausman, senior vice president and head of operations in construction practice for Zurich Insurance.

“Owners and organizations they’re working for are changing their requirements, and there is uncertainty in the changes, whether they are more or less stringent,” Hausman points out. “A second challenge is how contractors think about their business and what insurance to buy-the risk/tolerance issue.”

Ed Smith concurs. He’s the executive vice president at SIA Group, an independently owned commercial insurance risk management company with offices throughout North Carolina and Virginia. Smith says the biggest issue his company encounters with contractors is the way they view risk.

“They focus on hazard risk-buying insurance and transferring the risk to an insurance company,” he says. “That’s not the most cost-effective way to do that. They need to consider strategic operation risk; most companies tend not to do that.”

One way of approaching that is by implementing an enterprise risk management program from the top down, says Smith. That will drive insurance costs down, he adds.

“The key is partnering with a company that not only can represent the right carrier, but someone who can evaluate the risk, help them fully understand the risk, quantify the risk and help develop a proactive plan to control the risk.”

By doing that, a contractor looks more attractive to insurance carriers, Smith says.

Contractors often don’t understand why the cost of their insurance increases when they haven’t made any claims.

“Those two factors are a lot less related than they often think,” Hausman says. “Insurance is going up or down because the cost of the product goes up and down-it’s no different than the cost of steel or a car they buy. It goes up and down to much extent whether or not they use it.”

Perhaps the greatest challenge that site contractors face is striking a balance between having sufficient quantities of quality equipment and working capital, says Zachary Mendelson, a sales executive specializing in surety for Wells Fargo Insurance Services.

“Their lifeblood is equipment and how they make their living is by having sufficient equipment,” he adds. “Site contractors always love to invest in new equipment and our challenge from the bonding standpoint is to be able to evaluate their equipment schedule. They may always be a little light on the working capital side because of that.”

Dan Weedin is a Seattle-based insurance consultant with more than 25 years’ industry experience as an underwriter, agent, and now a consultant. He works with insurance buyers and insurance companies to help them improve crisis leadership, risk management, and overall strategy in the insurance industry.

Weedin, whose experience includes working with the commercial and residential contractor sector in insurance and surety issues since 1989, says insurance options available to grading and excavation companies aren’t much different than that for other artisan contractors.

Needs include commercial general liability, property, business income, commercial auto, cyber liability, workers’ compensation, and inland marine. Those in grading and excavating also may have additional needs for professional liability to cover errors and omissions and pollution.

In terms of insurance needed, a company needs a minimum of $1 million per occurrence for general liability, says Weedin.

“Having less is negligent,” he says. “The rest is based on what they actually have in property or exposure.”

A contractor also has to look at a maximum level, says Hausman.

“The minimum they need to purchase is what they’re going to need to conduct business in terms of limits and coverage,” he says. “The maximum is what I call a risk tolerance issue. There’s not an answer that says if you build this kind of project, you should buy this amount of insurance, and if you build this project, you should buy this kind of insurance. You should buy insurance relative to the risk tolerance that you have in your individual organization.”

Every contractor has a number of uninsured risks-that’s the nature of construction, Hausman points out.

“The question for the contractor is how much of that do they want to insure? There’s a risk and reward component to that. The more they buy, the more risk they transfer, the less reward they have in their business,” he says.

“Contractors may have a huge profit margin, but there are also contractors who might be taking on huge amounts of risk and have a risk tolerance in their organization. Every contractor has to find their own balance.”

If contractors insured every risk that could happen in their business, “that would effectively mean they have no profit. If they choose to insure nothing or buy very little, they may have a huge amount of reward, but also have a huge amount of risk in the business.”

It’s important for businesses to recognize what they need not only for their business, but also to meet contract requirements.

“There are cases of contractors buying less than what is required by the contract,” Hausman says. “Owners are getting more savvy in terms of making certain that the contractors are buying what they’re looking for. Just because a contractor buys a general liability policy for $1 million doesn’t mean they’re all the same. In fact, they’re not.”

Can one buy too much insurance?

“The answer for that is how much do you want to sleep at night? It’s no different than any kind of insurance purchase,” Hausman says. “Do you mind thinking you might have a professional liability claim that’s uncovered because you chose not to purchase professional liability? If you don’t mind that, then you’re not over- or underinsured.

“If you go home at night worrying about the fact you may have a professional liability claim and elected not to purchase insurance, then you’re underinsured.”

The answer to such questions is different for each contract and each project, he adds.

To ascertain whether one’s company is underinsured or overinsured requires that one review the limits of insurance annually and comprehensively with an agent, says Weedin.

“Too many contractors leave this to chance by being too busy to really review it,” he says. “That’s where becoming underinsured happens. The emphasis is on the relationship with the agent. This is so important.”

As for gaps in coverage, Smith notes that many companies focus on hazard risk and third-party liability with respect to construction defects, pollution, and worker injuries.

“They don’t emphasis the financial risk, the lack of funding capacity, the increased cost of insurance, the asset valuation of the company,” he says. “They are not looking at return on human capital, productivity issues, compliance issues, changes with government requirements, loss of contracts, and disqualifications.”

Hausman says the biggest gaps that contractors may have in their insurance coverage focus on liability programs.

“Contractors can buy a liability policy that meets contract requirements but without the details may or may not know what they’ve actually purchased,” he says. “We’ve seen contractors buy general liability policies in the marketplace that basically provides them no complete operations coverage. As soon as that project is done, they’ve got limited or no coverage.”

Another question for contractors to consider when looking for gaps is if there is coverage for work completed prior to putting a policy in place.

“There are coverages out there that contractors buy that limits that option,” Hausman says.

Other areas in which insurance gaps may occur include cyber liability, pollution, professional liability, and employment practices liability, says Weedin.

While insurance protects against losses, surety bonding addresses performance on contracts.

Sureties are seeing losses and negative cash flow on the contractor’s balance sheet and financial reports, notes Drew Brach, the US surety practice leader for Marsh.

“It’s making the underwriters very cautious,” he says. “There have been a number of contractor losses throughout the United States in the past 18 months, and it is increasing.”

Therefore, over the next 18 months, sureties see loss ratios continuing to increase. That’s not applicable only to the largest 10 companies, but the smallest ones as well, with many having to leave the marketplace as a result.

“Most contractors right now are really trying to expand their relationship with their surety and provide them with more details about projects, including a breakdown of labor, materials, subcontractors, contingencies, and gross profit-get more details on the project so that they continue to build that relationship,” Brach notes.

“Surety underwriting is based upon metrics because we’re all financial individuals and we do ratios and benchmarks and analysis, but then there is the other element, which is a subjective view of the entire organization and the people running it, so that relationship becomes very important,” he adds. “Sureties are most concerned with what we call surprises. The contractor has a major loss and has not discussed this with the surety.”

Many sureties will stay with accounts through “thick and thin” but need to have trust build up over a period of time, Brach says.

“Sureties know that stuff happens in the construction marketplace, but they’ve got to be part of the process, so continuing to build that surety relationship for us is a key element during this time,” he adds.

Brach says one of the most significant components Marsh is discussing with clients is ensuring their financial reporting maintains certain standards.

“One of the most important things is that they have a CPA who understands the construction industry and that the balance sheet, the income statement, and the cash flow contain all the necessary information,” he says.

“But there are also other reports that a surety company wants, including a work-in-progress report: How much of it is completed, what kind of a profit they’re seeing, and a completed contract schedule of all of the jobs they completed during the year that contains similar types of information.”

Such detailed financial reporting helps contractors build additional capacity, Brach points out.

In addition to having a CPA who understands the construction business, it’s also important to have a banker who understands the construction business.

“We’re seeing banks pull out,” Brach says, pointing out one case in Indianapolis where the bank pulled out and the company went out of business.

In working with subcontractors, Smith says he believes the key is to transfer risk to them, rather than retain it.

“Managing that process can be pretty complicated, and going through the contractual arrangements is the key with their subcontractors,” he says.

The insurance needed by subcontractors is contingent upon what the upstream contractor requires, points out Hausman.

“General upstream contractors assume lots of risks for the owners and choose to pass as much of that on to their subs as they can,” he says. “The subcontractor is going to expect to get paid for assuming that risk. If the general contractor expects the subcontractor to take on very little risk, the subcontractor is not going to expect to get paid to assume those risks.”

There are many successful ways to manage that relationship, Hausman says.

“You can manage your subcontractor completely differently from the way that your owner manages contracts with you,” he adds. “However, if you elect to require certain coverages from your subcontractor, it is important to look at those policies. Certificates of insurance are not enough because they don’t provide the details of exactly what’s covered in the underlying policy.”

Mendelson says it’s important for contractors make sure subcontractors have the wherewithal to finish the job.

“They may use the same subcontractor for the last 10 years, but what they don’t know is whether that subcontractor’s financial picture could have changed in the last six months, and although on the last job they participated on they performed well and completed it as specified, any contractor is one hiccup away from a claim or a loss.

“I suggest to our contractors that they stay in touch with how their subs are doing, what they’re working on and always get reassurance that they’re financially sound. A bad subcontractor can bring a contractor down easily.”

Marsh has a service that reviews subcontractors for its clients.

“In some cases, we’re seeing losses, negative cash flow, and we’re seeing them run out of their bank line of credit,” says Brach. “Once they run out of cash, they’re out, so it’s important to do that financial analysis or benchmarking and scoring that particular subcontractor in some fashion so that it can be determined if they’re acceptable or not and also determine whether they need to bond them or not.”

In most cases, Marsh is seeing its contractors take a more conservative approach to subcontractors.

Contractors are intent on controlling costs on every expense item, including insurance.

Weedin points out that insurance costs depend mostly on the type of work performed and also are dictated by payroll and materials costs. The bottom line in controlling costs is to avoid claims, control labor costs, and ensure the insurance agent markets the company’s insurance on a regular basis, he says.

At Zurich, “we spend a lot of time talking about not only a safety management program, but a culture around zero accidents,” says Hausman. “Some of our customers do a very good job of managing their business.”

Regarding general liability, quality control programs are important.

“Record retention is an enormous area of concern when you have a claim,” says Hausman. “It’s unfortunate how often, when there is a claim in the construction industry, when we go back to our customer and look for project’s records, contracts, change orders, photographs, and videotapes, they may not have kept them in the first place. A lot of that helps bring down claim costs. Claim costs continue to be the largest component of our insurance costs for contractors.”

Less discussed but equally important is contractual risks.

“Contractors are assuming contracts every day with lots of risk that is insured or required to be insured or not required to be insured,” Hausman says. “They may elect not to insure it, or they may elect to insure it, but at the minimum they need to understand the risk before they make that decision.”

That directly reduces the cost, because contractors can make informed decisions about what they want to buy and what they don’t want to buy, Hausman says.

“But if they don’t understand exactly what risks they’re assuming in their contract, it’s hard to make that decision,” he adds.

Contractors today are facing risks that previously had not been on the insurance radar and an increasing number of specialty-type coverage issues.

“There are many environmental risks the contractors are assuming every day that they may not necessarily think about and may not be required to purchase-issues such as stormwater runoff that are common around environmental issues,” Hausman says. “It could lead to an environmental problem if they’ve got a runoff problem.”

Employment practices liability also is gaining more attention.

“It’s not something that’s required by contract, and you wouldn’t put it in the minimum standards,” Hausman says. “It goes beyond the construction industry, but we’re seeing a lot of employee-related lawsuits against employers, and the construction industry is not immune to that.”

Scott Stevens, vice president of captive and specialty programs at The Hartford, which includes programs for excavation contractors, agrees that the fewer losses incurred by a contractor typically results in lower costs.

“The existence and enforcement of a formal safety program and proper contractual controls are two high-impact items that can also help reduce costs,” he says. “These are signs of a better than average risk.”

A formal safety program is the prime way to control losses, Stevens says.

Such a program should encompass plans to protect the public, employees, and subcontractors as well as physical assets of the contractor.

“This can include, among other items, a driver selection and monitoring program and regular safety meetings as well as written policies on personal protective equipment, return to work for injured employees, ergonomics, and accident reporting,” he says.

Contractual controls are also important, Stevens adds.

“By effectively transferring risk appropriately to subcontractors, a contractor can minimize their risk while not putting undue pressure on their subcontractors,” he says. “Conversely, accepting risk from a general contractor that is limited to the exposure generated by the subcontractor helps minimize risk and can help prevent coverage issues.”

Workers’ compensation is another area contractors view closely when looking for ways to curb costs.

“Workers’ compensation continues to be one of the loss leaders in this industry despite all of the work we think we’ve done in the industry over the last five to 10 years,” says Hausman.

Drug and alcohol tests continue to be the top way of addressing those costs, Hausman says. Another effective approach is focusing on return-to-work programs, he adds.

“It’s cheaper and more efficient for a contractor to work proactively with their injured worker,” he says. “Not every injured worker has the opportunity to come back to work because they’re not able. When you’ve got a worker who is willing and able, contractors who work proactively in managing that process are going to eventually have a much healthier safety culture and reduce costs at the same time.”

While workers’ compensation issues vary from state to state, “the commonality is that all workers’ compensation rates are driven to a large part by experience,” says Weedin. “The fewer claims you have, the less you will pay. That is the one area where the contractor has a modicum of control. The issue is safety and the more savvy and sophisticated the contractor is with safety training, the more likely they will pay less.”

Smith says such weather events as Hurricane Sandy have an undoubtedly huge effect on the insurance market, an effect that will eventually run back to the contractors.

Weather events can present unique challenges-as well as opportunities-relating to construction, with accompanying insurance impacts.

“Anytime there is a disaster, while it’s unfortunate for those affected, it presents opportunity for those that work in that area, whether that’s supplying goods, rebuilding, or being needed to help clean up,” Mendelson says.

“There are those contractors who are affected by this-their buildings, their equipment was damaged, destroyed-while other contractors that may have been on the cusp of it and not had their equipment affected are presented with the opportunity to go in and help clean it up. I think that’s what you have in any type of situation like this.”

The impact of severe weather events also present problems and opportunities for contractors and surety companies.

“A number of our clients were not able to get to their job sites,” Brach says. “They were looking closely at the contractual language to determine if they had a way to get extra delay time, and deal with extra cost.”

Many contractors had a good emergency response planned during Hurricane Sandy and did a stellar job moving their equipment to a secure area during the weather event, Brach points out.

“Another area that was important is knowing what is insurance really going to cover,” he says. “If you’re building a project and it’s the builder’s risk, is it going to be considered a hurricane or a storm or a flood? What’s covered and what’s not covered in their insurance policies?”

There is also the opportunity for new work in repair and rebuild.

“A number of our clients were immediately talking to different departments of transportation,” Brach says. “A lot of them could be on a list where they are prequalified so they can get work immediately.”

Ultimately, making the right choices about insurance and bonding comes down to choosing the right agent or broker.

Weedin emphasizes that contractors need to find a broker/agent who is knowledgeable and specializes in contractors’ insurance.

Weedin is a firm believer in working with an insurance professional.

“Contractors need to use an agent or broker,” he says. “There is a difference. Agents are contractual “˜agents’ of the insurance company. They represent the carrier, not the insured. Brokers represent the insured and do not have a contractual representation with companies.

“These terms have become muddled over the years, and in most cases, insured work with agents. There is no advantage to working without an agent. This is simply too complex of a topic to go at it without one. Even though the agent is contractually bound to the insurer, they generally do a great job of advising and representing the insured.”

Weedin says contractors also need to consider requirements that they will have for additional insureds and policy language, the financial strength of the insurer, how long has insurer been insuring contractors, breadth of coverages that can be obtained through an agent or insurer, and the premium.

Contractors should interview brokers to determine if they fully understand all of the risks, says Smith, adding they should look for an agent or broker who can quantify the risk and has the ability to bring in specialists who can help them with claims, loss control and with the training of their employees or writing policies.

Hausman concurs that contractors use an agent or broker who understands the construction industry and the markets well enough to be able to render the best input on what’s important in making insurance decisions.

Hausman points out that liability claims-not so much workers’ compensation-take time to develop in the construction sector.

“It could be up to 10 years after the project is complete before we’re working on those claims,” he says. “Understanding the financial strength and ability of the company you’ve been in business with and their ability to pay claims long-term is something that continues to be important for contractors,” he says. “Many are doing a much better job at looking at those details when they’re making their decisions.”

He also points out that the companies that are most successful in managing their insurance relationships have the same level of relationship with their property and casualty underwriters as they do with their surety underwriters in understanding every step of their business and are ultimately the most successful in managing their entire risk portfolio.