as announced by NAHB
Integrated Risk Mgmt
Since I started in the insurance industry in 1989, I have never had a builder or contractor tell me I charged too little for insurance. At the same time, I have rarely been accused of offering insurance that covers too much. Construction is a risky business and as builders grow larger, they need to consider next level risk management.
We see larger builders experiencing tremendous growth and profitability, both of which pose increased risks. However, the strategy of buying more insurance to cover the increased risk does not always make sense as a builder grows past a certain point. Often the newly gargantuan builder will realize their commercial insurance does not make the same kind of sense it did five years ago. Who wants to pay $500,000 for a $1,000,000 policy? Every month now I am seeing different builders have this realization. Many of these builders have few claims. However, they are wrestling with more important, non-insurance-related problems like labor shortages, supply chain delays and bankers who want to tighten terms. These builders need to understand that effective risk management is not just about what your agent can sell you or what insurers are willing to provide. Substantial builders can certainly control what they insure and how they insure it. That is what this article is about. However, this next level of risk management requires education, planning, and a full commitment to best practices. No builder wants to self-insure a bad situation.
Treacy Duerfeldt began his commercial insurance career in 1989 as a one-year trainee for a large corporation studying all aspects of insurance before computerization, from the ground up. After serving in corporate capacities, including and not limited to association relationships, loss control, marketing, programs and underwriting, he moved on to the independent insurance agency world. Realizing a knack for programs while with a large regional retail agency, he parlayed his program experience and ownership into his own wholesale brokerage organization with an emphasis on construction. Shortly afterward, Treacy formed his first captive for his own program and has since formed more for himself and his clients.
1. Conventional Commercial Insurance Risk
2. Builder Business Model Risk
Both are insurable, but not necessarily by way of traditional Insurance
Conventional Commercial Insurance includes General Liability, Excess/Umbrella Risk, Fleet Risk, Workers Compensation, Builder's Risk and much, much more. Banks and investors require adequate insurance with rated carriers, so many consider it a necessary evil, especially when there are few if any claims.
The answer may be captive insurers.
Captives have been around and misunderstood for generations. For the purposes of this article captive insurers are the mechanism by which the builder can self-insure their risks, both conventional and business model. These captives are not designed to be a “tax haven” or “piggy bank,” but rather a risk management tool whereby the builder can most efficiently manage risk in general.
Captives can be more efficient than commercial insurance in several ways. Consider expense ratio: a commercial insurer's expense ratio can include things like commissions, underwriting expense, overhead and so on. For many lines of construction insurance, the expense ratio exceeds 30% of the premiums paid. By comparison, a builder's captive insurer can eliminate some of those costs thereby keeping the expense ratio well below 10%. That's a form of efficiency.
Another form of efficiency can be found in claims handling. In many instances claims can be handled better by the builder than the insurer. For instance, an insurance defense attorney is no substitute for a builder's customer service team. Add to that a dedicated, specialized construction defect attorney when the builder is of substantial size, and there is plenty of efficiency without the commercial insurer getting involved. Builders with these and other risk management resources are positioned to self-insure using a Self-Insured Retention (SIR) for reduced commercial insurance rates. SIRs allow the builder to control a claim and report it only when certain thresholds are realized. Once an insurer is involved, the builder loses control and can risk reputation.
A captive may provide additional efficiencies when a commercial insurance policy with an SIR is utilized by creating an SIR recovery policy to set money aside to cover the commercial insurance policy’s SIR. In this case, tax deductible premiums would be paid to the captive insurer. In the same way claims paid by commercial insurers are received tax free, so are claims paid by the captive.
This approach is different from just setting a reserve at the builder which is not tax deductible and likely not accurate since builders don't employ actuaries. The risk of inadequate reserving is mitigated by using a properly set up and operated captive insurer. By the way, a number of substantial builders with low losses are using captives to accurately and entirely self-insure their general liability and excess programs. A-rated “fronting carriers” are available to make this happen at substantially reduced cost compared to commercial insurance carriers.
Third party companies have been insuring warranties for generations and the data is readily available. Interestingly, many sophisticated builders have better loss ratios than the third-party warranty providers. Both of these facts make setting up a captive for the builder warranty one of the most profitable opportunities for the builder and can be key to satisfying various compliance needs. Furthermore, the builder does not lose the document and risk management advantages of a properly written warranty when they change from a commercial insurer to the captive.
Given sufficient scale and size, warranty can be a perfect component for a captive and reflects what can be done with business model risk. But let's not stop there: in recent years builders have suffered shortages, whether it be financing, labor, materials or supply chain issues. The vast majority are not effectively prepared, and the problem is simply allowed to impact the bottom line. A few builders, though, were prepared. After having paid a substantial, tax-deductible premium into their captive, when such a shortage hit they simply made a claim, with proof of loss. In those cases, the impact on the bottom line was mitigated with tax free claims dollars. This is just like commercial insurance, with the primary difference being what is insured.
The impact of these business model problems (and many more) is very insurable and should be given the efficiency of a captive. The efficiency emerges because large insurance companies tend to have much larger expense ratios than captives.
Business model risk can be affordable to insure when using a captive. The captive can provide significant efficiency compared to commercial insurance companies due to their larger expense ratios. Utilizing captives properly can also improve the portfolio aspects of the captive with better compliance. The impact of the business model problems we’ve described, along with many others, are very insurable. Given the efficiencies they offer, well informed, large builders should be utilizing captives to do so.
The ability to selectively place inefficient commercial insurance into a captive gives both benefit and leverage in the marketplace. While a properly constructed captive efficiently provides profit protection and various other advantages, a builder must be careful not to place what seems to be less affordable insurance into a captive if the underlying problems being insured are not resolved.
Insurance agencies by themselves are poorly equipped to set up proper captives. Should an agent have the actuarial, accounting, captive management, regulatory and tax law support under one roof, then who is the client...the builder or the agency? All of these functions should be independent and offered by best of class providers who each individually recognize the builder as the client. A captive/risk management coach familiar with each of the expert segments and an unbiased eye as to what is possible may help keep all the pieces moving efficiently together. In fact, teamwork in these multiple disciplines is crucial to success and sustainability while each independently serves the client. Per one of my team, Gary Harden: “By leveraging a team approach that draws upon the strengths of collaborating professional firms on a national platform, we are able to design and implement value-added legal, tax and business strategies for clients ranging from start-up ventures to Fortune 100 companies.”
Even effective builders who are working to fix the underlying problems recognize that some underlying problems can’t be completely solved. While good use of warranty can manage customer expectations and provide for exclusive remedy, a home is typically sold after less than six years and the second and subsequent owners have no privity with the builder. This means the benefits of the warranty are limited.
Another example is Third Party Quality Assurance (QA). QA can have an impact, but by no means solves general liability loss problems on its own. Most insurer-required QA programs only focus on construction defect issues, suffer English only language limitations, and rarely emphasize job site safety. Like with the warranty, QA provides a measurable impact, but is still not a complete solution.
The proper transfer of risk to the appropriate subcontractors and vendors is a key to solving many underlying general liability problems. Doing so requires accountability and transparency combined with claims expertise. However, for many builders, the management and implementation of this are often done incorrectly. They hire certificate tracking companies that do not use the phone and are too automated to perform adequate document procurement. Those cert tracking companies often rely on certificates and endorsements rather than fully reviewing all policies. They do not have integrated claims expertise, so the builder's general liability policy does not get involved, whether in a captive or not.
The key to having an impact with a certificate tracking or similar service is moving the builder to “the back of the line” so the appropriate subcontractor’s general liability provides initial defense and settlement. When this does not happen, the builder’s policy suffers those expenses with only hope of contribution or recovery from the subcontractors' insurers, usually for pennies on the dollar. The builder’s loss ratio unnecessarily suffers, resulting in higher premiums and potential uninsurability. Selecting the right certificate tracking service, structuring the general liability properly, and structuring the claims tendering correctly with the support of properly worded subcontract documents is vital to moving the builder “to the back of the line”.
While captives can be vitally important for the large builder for many lines of coverage, there are some that are best left to commercial insurance policies due the expertise they offer. For example, cyber coverage is probably best addressed by commercial insurers. Even the most sophisticated builders are not well equipped to fully handle a data breach and all the corresponding communication, compliance and disaster management aspects. The same could be said for pollution or professional coverage. In these cases, the captive can still play a role by acting as an Excess policy. The captive would be equipped to pay if the lower limits best managed by commercial insurers weren't enough for a blue moon, high limits claim.
Insurance and efficiency are not two words commonly found together. However, if captive insurance is properly integrated into the risk management context, it's a winner. Builders sometimes tend to put off improvements in best practices if there's a commercial insurer willing to pick up that cost of an accident or failure. By being proactive and solving key problems a builder can enjoy the fruits of their labor instead of just reducing premiums.
Improving best practices requires the builder to know what to implement and how it will work. Effective best practices means more than improved documentation. Builders need to consider contracting or employing risk management experts that are independent of their insurance agent's agency or insurer. In many cases the builder does not enjoy the agency’s or carrier’s highest loyalty or first priority. Outsourcing independent risk management expertise can alleviate that concern.
Some of the key areas to consider outsourcing:
In my opinion, builders achieve their best value by an approach I call “Integrated Risk Management”. Not a one trick pony, like purchasing a commercial insurance policy, Integrated Risk Management reviews and evaluates actual business risks, determines the layers of risk best covered by available commercial insurance, and those better addressed in another way. Active management of business risks, intentional retention of risk diligenced by an actuary, captive insurance, Reg. 114 Trusts to fund high deductibles when a commercial policy is required by third parties, are just some of the non-conventional methods to address risk, enhance business profits and assure business continuity with Integrated Risk Management.
I could write a detailed article on each of the above, but that wouldn't be efficient. What is efficient is fixing the problems causing conventional insurance claims rather than “financing” them with elevated premiums or cancellation risk. Fortunately, both Conventional Commercial Insurance Risk and Builder’s Business Model Risk are both insurable. To do so with the greatest efficiencies, the well-informed large builder needs to put the right independent team in place that will help them identify how to fix any underlying problems through proper risk management & risk transfer, and then effectively integrate both commercial insurance along with captive insurance to their greatest possible benefit.
Efficiencies in Risk Management for Builders is written by NAHB member Treacy Duerfeldt, who has served many years on the NAHB Committees for Construction Liability/Building Materials and Construction Health and Safety. His belief in education for the construction industry has been demonstrated by the audiovisual on-demand offering “Construction Insurance and Risk Education” found at www.cirelearning.org. Treacy has authored articles in the Insurance Journal and designed various coverages and tools for contractors throughout the insurance industry. Treacy has been a part of the insurance industry since 1989 and first joined NAHB in 1992 as part of the Elkhart, Indiana HBA.
Efficiencies in Risk Management f M. Harden of Harden Law and Tax