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

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
Fixed (25%-35%)
Insurance Company Overhead, Taxes, Reinsurance Cost, Commission
Profits & Investment Income
Underwriting Profit and Investment Income Accrued by Insurance Company and or Reinsurer
Profits & Losses
55 -75%
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. Insurance Program Risk Costs with Large Deductibles / Retentions
Incurred Losses: The Variable Stuff
65% – 90+%
Fixed
Risk Transfer
Taxes
Safety & Claims Mgmt
Loss Control
Admin & Compliance
“Fixed Costs”

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 10

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 A E S
Automobile Liability A E S
Completed Ops / Defect / Statute of Repose (Included in SDI) A E S
Workers Compensation A E S

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. Probability
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”
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 18

19. Effects of Adverse Losses on Project Profits
Loss(es) Severities 
Expected
Losses 
Unexpected Losses 
Stress Losses
Costing Tolerance
Profitability At Risk
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
Current
Loss
Accruals 
Expected
Losses
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. Let’s Look at Loss Characteristics using Retention Levels As Illustrations
Unlimited Retention

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

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

26. Loss Sensitivity Simulation
Outputs Item
Losses at $250,000 per Occurrence
Simulation# 1
Statistics / Cell NA
Minimum
3,264,992
Maximum
8,585,279
Mean
5,297,963
Standard Deviation
680,733
Variance
463,397,165,442
Skewness
Kurtosis
Number of Errors -
Mode
4,837,020 5%
4,231,137
10%
4,427,777
15%
4,584,207
20%
4,710,057
25%
4,825,061
30%
4,916,320
35%
5,009,401
40%
5,098,429
45%
5,182,846
50%
5,271,783
55%
5,356,573
60%
5,454,766
65%
5,543,744
70%
5,636,479
75%
5,738,704
80%
5,859,217
85%
5,997,048
90%
6,193,518
95%
6,475,948
Expected Losses
Aggregates usually > 95%

27. Insurance Costs / “Fixed” Components
Cost elements
Base case $k
Minimum
Most Likely
Maximum
Sampled
WC Fixed
2,000
90%
100%
125%
1,800
2,500
2,050
GL / Comp Ops Fixed
5,000
4,500
6,250
5,125
CPPI Fixed
4,000
3,600
4,100
Builders Risk
Umbrella
1,000
900
1,250
1,025
TPA and 3rd Party Admin
500
450
625
513
Loss Control & Safety
1,500
1,350
1,875
1,538
Other general overhead
2,250
3,125
2,563
Total
18,500
16,650
23,125
18,963
Use statistics for key outputs (run simulation for these to be valid):
Probability of meeting value of 18500
15.0%
Total budget required for 95.0% confidence
19,675
95.0%
Contingency required for 95.0% confidence
1,175

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 , Insurance and Indemnification
FAR , 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 , Insurance and Indemnification
*Full text of FAR clauses can be found at
Full text of Cost Accounting Standards can be found at

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