Cost Sensitivity, Recognition and Allocation for Construction Insurance & Risk

1. Charlie Woodman, CPA Caroline Keonraad, CPCU Risk Finance Advisory Willis National Construction 2012 Willis Construction Risk Management Conference September 20, 2012 Cost Sensitivity, Recognition and Allocation for Construction Insurance & Risk C2 : Cost of Risk Dynamics in 60 Minutes or Less

2. 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

3. 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

4. Risk Transfer + Risk Retention + Admin = Insurance Costs • Risk Transfer: Contractual Insurance • Property • Fixed Property • Builder’s Risk • Equipment • Casualty, including Legal Defense • Workers’ Compensation • General Liability / Casualty Umbrella • Professional and Pollution Liability • Subcontractor Default • Risk Retentions • Deductibles • Self-insured Retentions • Un(der) insurables: Rework / Rip & Tear, etc. • Business Risk • Legal Defense • Administration • Safety Operations • Claims and Defense Management • Compliance • Time • Transaction Costs All These Can Exhibit Variability To Some Extent

5. 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

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 Administrative Costs Risk Control

7. Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost Profits & Losses 55 -75% • Fixed (25%-35%) • Insurance CompanyOverhead, Taxes,Reinsurance Cost, Commission • Profits & Investment Income • Underwriting Profit and Investment Income Accrued by Insurance Company and or Reinsurer • 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 • Odd Variable • Risk Margins • Surplus & RBC

8. Incurred Losses: The Variable Stuff 65% – 90+% “Fixed Costs” • Fixed • Risk Transfer • Taxes • Safety & Claims Mgmt • Loss Control • Admin & Compliance Insurance Program Risk Costs with Large Deductibles / Retentions

9. 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 Approaches

10. 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

11. Intro To Losses • A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-But-Not-Reported (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

12. Loss Characteristics by Line • Emergence (E) vs. Settlement (S) Builder’s Risk S A E Automobile Liability S A E Completed Ops / Defect / Statute of Repose (Included in SDI) A S E Workers Compensation S A E

13. 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

14. Basic Reserving Techniques:Application of Paid LDM: Land of Actuaries.

15. 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.

16. 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” Probability • Potential FASB change – “Remote”, if significant, must be disclosed.

17. 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

18. 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 or negotiating projects

19. Costing Tolerance Profitability At Risk  Expected Losses  Unexpected Losses  Stress Losses Loss(es) Severities Effects of Adverse Losses on Project Profits Loss Probabilities

20. Insurance Cost (including Loss Costs) Allocation Fixed Expenses Risk Transfer Premiums Program Administration Safety Brokerage Fee Project #1 Project #2 Maximum/ Aggregate Loss Ins Cost Allocation Variable Expenses Retained Losses Loss Adjustment Expenses Project #3  Expected Losses Current Loss Accruals Actuarial Expected Loss Potential Profit Loss

21. Typical Practice: Internal vs Market-Based Costing

22. 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.

23. $500,000Retention $1,000,000Retention UnlimitedRetention Let’s Look at Loss Characteristics using Retention Levels As Illustrations

24. Auto Liability Workers Comp Professional Liab. Builders Risk Multi-Risk Comparison

25. Retained Risk @ 85th Percentile - Risks Treated In Combination Retained Risk @ 85th Percentile - Risks Treated In Isolation Portfolio Effect

26. Loss Sensitivity Simulation Expected Losses Aggregates usually > 95%

27. Insurance Costs / “Fixed” Components

28. Graphic Output

29. 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

30. 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

31. 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

32. Charlie Woodman, CPA Caroline Keonraad, CPCU Risk Finance Advisory Willis National Construction 2012 Willis Construction Risk Management Conference September 20, 2012 Questions & Thank You