Presentation on theme: "C2 : Cost of Risk Dynamics in 60 Minutes or Less"— Presentation transcript:
1 C2 : Cost of Risk Dynamics in 60 Minutes or Less Cost Sensitivity, Recognition and Allocation for Construction Insurance & RiskC2 : Cost of Risk Dynamics in 60 Minutes or LessCharlie Woodman, CPACaroline Keonraad, CPCURisk Finance AdvisoryWillis National Construction2012 Willis Construction Risk Management ConferenceSeptember 20, 2012
2 IntroWith increased competition, the dynamics of the bidding process is becoming more critical as are the recovery of costs where allowedInsurance 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 fluxEstablishing realistic risk cost ranges provides greater flexibility in job costing / traditional costing to aggregate levels erodes competitivenessComponents to always consider and factor into a costing rate:Program costs with ultimate expected and adverse loss performanceUn(der) insured high severity adverse loss risk marginsInsurance renewal fluctuations especially where projects are long-termInsurance program minimums and exposure-based premium adjustmentsAdministrative and internal risk management costs
3 Construction Industry Somewhat Unique All value is added to the engineering and construction process by managing riskTwo broad categories of riskFortuitous: Insurance CostsCommercial/TechnicalManaging commercial and technical risk is what engineers and contractors do bestDesign / Cost / Schedule / QualitySubcontractor performanceSome 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 InsurancePropertyFixed PropertyBuilder’s RiskEquipmentCasualty, including Legal DefenseWorkers’ CompensationGeneral Liability / Casualty UmbrellaProfessional and Pollution LiabilitySubcontractor DefaultRisk RetentionsDeductiblesSelf-insured RetentionsUn(der) insurables: Rework / Rip & Tear, etc.Business RiskLegal DefenseAdministrationSafety OperationsClaims and Defense ManagementComplianceTimeTransaction CostsAll These Can Exhibit Variability To Some Extent
5 DiscussionFinancial Recognition of Losses and Contingencies (Expenses)Costing DynamicsExpected Losses & RetentionsAdverse Loss SensitivitiesSeverity ExposuresInsurance / Risk Transfer CostsInternal CostsIssues and Considerations
6 Basic Elements of Cost of Risk: Not To Proportional Scale Insurance PremiumsTaxesBrokerage Commissionsor FeeExpected Losses withinDeductibleUninsured LossesLoss AdjustmentExpenseRegulatory ComplianceAdverse Losses within RetentionCost ofReinsurance, ImbeddedLegal ExpensesAdministrativeCostsRisk Control
7 Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost Fixed (25%-35%)Insurance Company Overhead, Taxes, Reinsurance Cost, CommissionProfits & Investment IncomeUnderwriting Profit and Investment Income Accrued by Insurance Company and or ReinsurerProfits & Losses55 -75%Components of Traditional Insurance:Expected loss and ALAETaxes and regulatory feesOverhead and administrationInsurer selling and distribution expenseReinsurance and Intermediary chargesRisk MarginsSurplus chargesRisk Based Capital offsetsOdd VariableRisk MarginsSurplus & RBC
8 Insurance Program Risk Costs with Large Deductibles / Retentions Incurred Losses: The Variable Stuff65% – 90+%FixedRisk TransferTaxesSafety & Claims MgmtLoss ControlAdmin & Compliance“Fixed Costs”
9 Losses: the 800 Pound Gorilla Sitting In The Corner Make up the vast majority of insurance cost uncertaintiesIn Guaranteed Cost: Standard Premium including Experience ModsIn ‘Loss-sensitive Programs’ : Deductibles and RetentionsLosses = Pure Loss (claimant satisfaction costs) + Loss Adjustment Expense (loss reconciliation activity costs)Losses and their uncertainty broken down into two (2) typesFrequency / Burning Losses: Actuarially Predictable – WC / GL / ALAdmin vs Self-perform GCSeverity / Adverse / Catastrophic Losses: Tougher to Predict - PL / Comp Op / SDIGenerally, loss intensity grows with timeWe 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 activityCosting is a rationalization activity which is a proactive activityFinancial reporting is the responsibility of Owners, CFOs, Management, Controllers and Independent CPAs - all share the riskReliance by various users on financial statements:SuretiesBanks and finance companiesRegulatory boards - licensingOwner and prime contractor prequalificationSuppliersStockholders (owners)Joint venture partnersCosting is the responsibility of various technical areas combining to establish reasonable expectations of project costs10
11 Intro To LossesA Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-But-Not-Reported (IBNR)What is a Loss Reserve?Amount necessary to settle unpaid claimsCase ReservesClaim reported but not yet paidAssigned a value by a claims adjuster or by formulaIBNR reserves include: Most difficult to measure and justifyReserves for claims not yet reported (pure IBNR)Claims in transitDevelopment on known claimsReserves for reopened claims
12 Loss Characteristics by Line Emergence (E) vs. Settlement (S)Builder’s RiskAESAutomobile LiabilityAESCompleted Ops / Defect / Statute of Repose (Included in SDI)AESWorkers CompensationAES
13 Basic Loss Measurement Techniques: Definitions Sometimes solely Industry-basedComposite to Insurer ExpectationsLoss Development Method using Historical PatternsTrianglesCompiled to measure the changes in cumulative claim activity over time in order to estimate patterns of future activity.Loss Development FactorThe 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, ANDThe 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.ImportanceA 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 eventActual payment reduces a reserve; should not effect earnings.
16 ProbabilityRemote – the chance of the future event or events occurring is slightReporting Action: Do nothing or ID as a Risk of Business, if large, in MD&AReasonably Possible – the chance of the event or events occurring is more that remote but less than likelyReporting Action: Disclose in NotesProbable – the future event or events are likely to occurReporting Action:If Measurable: Book to Financials: Disclose in NotesIf 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:BiddingDetermining problem projectsSupporting change order pricingClaims processReconciling job costs to financial reportsMaking better decisionsMaking “expansion” less frighteningSupporting AuditsCommercialGovernmentalTax
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 costsSafety & loss control costsCost of having risk management staffClaim costs within deductible layersUn-recovered legal expensesUninsurable or self-insured risksThis trick is developing a methodology for quantifying your cost of risk while validating those costs for ownersAnd provide you a competitive advantage or wiggle room when bidding or negotiating projects18
19 Effects of Adverse Losses on Project Profits Loss(es) SeveritiesExpectedLossesUnexpected LossesStress LossesCosting ToleranceProfitability At RiskLoss Probabilities
20 Insurance Cost (including Loss Costs) Allocation Fixed ExpensesRisk Transfer PremiumsProgram AdministrationSafetyBrokerage FeeProject #1Project #2Maximum/Aggregate LossIns CostAllocationVariable ExpensesRetained LossesLoss Adjustment ExpensesProject #3CurrentLossAccrualsExpectedLossesActuarialExpected LossPotential 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 purchasedRetained losses, including claims management costsRisk reduction initiativesAdministration= Costs to be divided by Exposures (Project Values / Total Revenues / Total Payroll)= Assumed Insurance RateEnd 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 LiabilityBuilders RiskWorkers CompProfessional Liab.
25 Portfolio Effect Retained Risk @ 85th Percentile - Risks Treated In CombinationRisks Treated In Isolation
26 Loss Sensitivity Simulation Outputs ItemLosses at $250,000 per OccurrenceSimulation#1Statistics / CellNAMinimum3,264,992Maximum8,585,279Mean5,297,963Standard Deviation680,733Variance463,397,165,442SkewnessKurtosisNumber of Errors-Mode4,837,0205%4,231,13710%4,427,77715%4,584,20720%4,710,05725%4,825,06130%4,916,32035%5,009,40140%5,098,42945%5,182,84650%5,271,78355%5,356,57360%5,454,76665%5,543,74470%5,636,47975%5,738,70480%5,859,21785%5,997,04890%6,193,51895%6,475,948Expected LossesAggregates usually > 95%
27 Insurance Costs / “Fixed” Components Cost elementsBase case $kMinimumMost LikelyMaximumSampledWC Fixed2,00090%100%125%1,8002,5002,050GL / Comp Ops Fixed5,0004,5006,2505,125CPPI Fixed4,0003,6004,100Builders RiskUmbrella1,0009001,2501,025TPA and 3rd Party Admin500450625513Loss Control & Safety1,5001,3501,8751,538Other general overhead2,2503,1252,563Total18,50016,65023,12518,963Use statistics for key outputs (run simulation for these to be valid):Probability of meeting value of 1850015.0%Total budget required for 95.0% confidence19,67595.0%Contingency required for 95.0% confidence1,175
29 Dynamic Financial Modelling with Cost of Risk I can now takeExpected LossesLoss VariabilitySevere Loss Probability and TolerancesFixed Cost Variability over TimeAnd 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 CostsCost Accounting Standard (CAS) 403, Accounting for Home Office CostsFAR , Insurance and IndemnificationFAR , CreditsFAR 28.3, InsuranceWhen to evaluate your current accounting practices for insurance costs?Contracts will be CAS coveredContracts subject to Federal Acquisition Regulation , Insurance and Indemnification*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.htmlFull text of Cost Accounting Standards can be found at
31 Special Considerations & Challenges Profitability offsetting between projectsContract where “deductibles” are borne contractor; language clarity is essentialUse of insurance quotes to support insurance costs – Basis RiskUse of Loss Exposure Aggregates limits as costing levelsMulti-state differences in retentions or limits / sub-limitsMonopolistic statesIncurred and Paid Loss Retrospectively-rated InsuranceCCIP minimums and insurance cost timingCPPI where contract allows Pollution but limits ProfessionalProject-specific coverage cost reimbursement disallowancesWorkers Compensation costs – General Conditions (Auditable Labor Burden) and Admin / Fees (Profit Eroding)Defect / Completed Operations /DICSubguard / SDI
32 Questions & Thank You Charlie Woodman, CPA Caroline Keonraad, CPCU Risk Finance AdvisoryWillis National Construction2012 Willis Construction Risk Management ConferenceSeptember 20, 2012Questions & Thank You