FUNDAMENTALS OF CONSTRUCTION RISK MANAGEMENT AND INSURANCE

FUNDAMENTALS OF CONSTRUCTION RISK MANAGEMENT AND

INSURANCE

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Fundamentals of Construction Risk Management and Insurance

Contents Introduction to Fundamentals of Construction Risk Management and Insurance ......... 1

Chapter 1 Introduction to Risk Management ...................................................................... 3 Risk Identification .............................................................................................................................. 4 Risk Analysis ..................................................................................................................................... 8 Designing the Risk Management Strategy ....................................................................................... 10

Risk Control ................................................................................................................................. 10 Risk Finance ................................................................................................................................ 11 Risk Retention ............................................................................................................................. 11 Contractual Risk Transfer ............................................................................................................ 12

Selecting the Right Combination ..................................................................................................... 14 Implementation ................................................................................................................................ 16 Review ............................................................................................................................................. 17 Summary .......................................................................................................................................... 17 Chapter 1 Review Questions ............................................................................................................ 18

Chapter 2 Anatomy of an Insurance Policy ....................................................................... 21 Policy Format ................................................................................................................................... 23

Declarations ................................................................................................................................. 23 Insuring Agreement ..................................................................................................................... 24 Covered Perils .............................................................................................................................. 24 Exclusions .................................................................................................................................... 24 Definitions ................................................................................................................................... 25 Conditions .................................................................................................................................... 26 Endorsements ............................................................................................................................... 26 Insurance Policy Review ............................................................................................................. 27 Construction Insurance Programs ................................................................................................ 27

Chapter 2 Review Questions ............................................................................................................ 28

Chapter 3 Casualty Insurance Survey ................................................................................ 31 Automobile Insurance ...................................................................................................................... 31 Commercial General Liability Insurance ......................................................................................... 32

Personal and Advertising Injury Coverage .................................................................................. 33 Medical Payments Coverage ....................................................................................................... 33

Umbrella Liability Insurance ........................................................................................................... 34 Workers Compensation .................................................................................................................... 35

The Workers Compensation Policy ............................................................................................. 35 Chapter 3 Review Questions ............................................................................................................ 36

Chapter 4 First-Party Insurance Survey ............................................................................ 39 Basic Concepts of First-Party Insurance .......................................................................................... 39

Covered Perils .............................................................................................................................. 40 Covered Property ......................................................................................................................... 40 Valuation ...................................................................................................................................... 40

Insurance to Value Requirements ................................................................................................ 40 Deductibles .................................................................................................................................. 41

Builders Risk Insurance ................................................................................................................... 41 Contractors Equipment Insurance .................................................................................................... 44 Commercial Property Insurance ....................................................................................................... 44 Commercial Crime Insurance .......................................................................................................... 45 Chapter 4 Review Questions ............................................................................................................ 47

Chapter 5 Matching the Insurance with the Exposures .................................................... 51 Direct Damage Loss Exposures ....................................................................................................... 52 Indirect Property Loss Exposures .................................................................................................... 54 Liability Loss Exposures .................................................................................................................. 56 Personnel Loss Exposures ................................................................................................................ 57 Summary .......................................................................................................................................... 58 Chapter 5 Review Questions ............................................................................................................ 58

Chapter 6 Risk Finance ........................................................................................................ 61 The Time Value of Money ............................................................................................................... 61

Loss Payout Patterns .................................................................................................................... 62 Present Value Analysis ................................................................................................................ 62

Guaranteed Cost and Loss Sensitive Rating Plans ........................................................................... 63 Guaranteed Cost Insurance .......................................................................................................... 63 Loss Sensitive Insurance Plans .................................................................................................... 64 When To Consider a Loss Sensitive Plan .................................................................................... 65 Retrospective Rating .................................................................................................................... 66 Dividend Plans ............................................................................................................................. 66 Safety Group Dividend Plans ...................................................................................................... 66 Large Deductible Plans ................................................................................................................ 67 Summary ...................................................................................................................................... 68

Alternative Market Approaches ....................................................................................................... 68 Risk Retention Groups ................................................................................................................. 69 Group Self-Insurance Programs ................................................................................................... 69 Captive Insurance Companies ..................................................................................................... 70

Self Insurance ................................................................................................................................... 71 Conclusion ....................................................................................................................................... 72 Chapter 6 Review Questions ............................................................................................................ 72

Chapter 7 How the Insurance Industry Operates ............................................................. 75 Insurance Distribution Systems ....................................................................................................... 75 Selecting an Agent or Broker ........................................................................................................... 76

Agent/Broker Services ................................................................................................................. 79 Agent/Broker Compensation ....................................................................................................... 79

Arranging Coverage and Determining Premiums ............................................................................ 80 Underwriting Cycles .................................................................................................................... 82

Claims .............................................................................................................................................. 82 The Claims Adjusting Process ..................................................................................................... 83

Chapter 7 Review Questions ............................................................................................................ 84

Glossary ................................................................................................................................. 87

Introduction to Fundamentals of Construction Risk Management and Insurance

This course—Fundamentals of Construction Risk Management and Insurance—provides a general overview of the risk management process, including the loss exposures of most concern to contractors and the risk management tools that are used to treat them. It discusses the common features of property and casualty insurance policies that govern who is covered and what is covered. The property and casualty insurance coverages that contractors typically buy are described along with a review of how they match up with the important exposures. The most commonly used loss sensitive rating plans and risk finance programs are also briefly reviewed. Lastly, the operation of the insurance industry is discussed from an insurance buyer’s perspective to provide insight into the roles and responsibilities of underwriters, agents, brokers, and adjusters.

At the conclusion of each lesson, a chapter Review Quiz is presented to test comprehension of the material presented in the chapter. A response is given to each answer you select to the questions in the quiz, affirming the correct choice or explaining why the choice you selected was incorrect.

There is no required prerequisite or advance preparation for this basic level course; this introductory course will prepare the student to complete the more detailed and technical Construction Risk and Insurance Specialist (CRIS) curriculum.

Students who successfully complete this course will be able to:

1. Identify the primary risks of loss faced by construction companies and apply the risk management process in managing these risks.

2. Identify and explain the various techniques used to manage risk, including risk retention, contractual risk transfer, risk control, insurance, and risk finance.

3. Identify and explain the various provisions in an insurance policy that govern how coverage applies.

4. Explain the essential elements of commercial general liability, commercial auto, workers compensation, umbrella liability insurance, builders risk, contractors equipment, commercial property, and commercial crime insurance.

5. Explain the essential elements of guaranteed cost, deductible, retrospective rating, and dividend plans and of such alternative market risk finance approaches as captive insurance companies and risk retention groups.

6. Explain the processes for procuring property-casualty insurance and adjusting claims.

This fundamentals course was developed to provide an introduction to important terminology and concepts that are explored in significantly more detail in the Construction Risk and Insurance Specialist (CRIS) continuing education program. The CRIS program is a specialized curriculum focusing on the insurance and risk management needs of construction projects and contractors. Those who complete the program and satisfy the annual continuing education requirement are entitled to display the CRISTM designation to certify their knowledge of construction insurance and risk management and dedication to the industry.

Chapter 1 Introduction to Risk Management

Learning Objective

In this chapter, the student will learn how to…

Identify the primary risks of loss faced by construction companies and apply the risk management process in managing these risks and identify and explain the various techniques used to manage risk, including risk retention, contractual risk transfer, risk control, insurance, and risk finance.

Risk management is an approach to cost effectively controlling and financing the risks an organization faces. While this has changed somewhat in recent years with the adoption of “enterprise risk management” by some very large corporations, the risk management discipline has traditionally focused on managing only “pure,” or fortuitous, risks. These are the risks of loss, such as from damage to property by a fire, without the possibility of gain, such as may occur with investment or interest rate risks. The traditional discipline of risk management evolved from a more simple insurance management function, which simply sought to obtain insurance as the primary tool for protecting businesses against the financial loss associated with theft, windstorm, lightning, fire, collision, legal liability, and a multitude of other perils.

A succinct working definition that captures the essence of traditional risk management, has been coined by Dr. E.J. Leverett, professor emeritus of the University of Georgia and risk management consultant: “Risk management” is “pre-loss planning for post-loss delivery.” That is, risk management seeks to mitigate the possibility of losses (or the consequences of those that do occur) while initiating advance planning to assure that adequate funds will be available to cover those losses that occur. Properly conducted, this will assure the company survives and maintains its ability to meet its organizational objectives. The most important goal of risk management, therefore, is to protect the assets and financial viability of the organization. If no plan has been implemented for identifying and dealing with a particular type of risk, any losses that eventually arise from it will be unforeseen and ineffectively handled with the company generally absorbing them out of its own resources. Eliminating this “passive retention” of losses is one key to meeting the goal of protecting the firm’s financial condition.

The secondary objective of risk management is to minimize the “cost of risk.” Cost of risk is typically defined to include all liability, property, surety, and workers compensation insurance premiums; any retained or uninsured liability, property, and workers compensation losses, including any associated financial guarantees; fees and taxes; the costs of administering the risk management program; and the cost of outside services, such as fees paid to agents and brokers, consulting and actuarial fees, risk management information systems costs, and captive management fees. Since these costs are a

substantial element in the costs of construction projects, by reducing its cost of risk below the industry average a contractor can gain a significant competitive advantage.

Soon after the concept of formal risk management programs was developed, practitioners and academics proposed a formal process to follow, which was based on the traditional management problem solving process. The fundamental steps in the now widely accepted “risk management process” are as follows.

1. Risk identification

2. Risk analysis

3. Designing the risk management strategy

4. Implementation

5. Review

Following the steps in this process substantially increases the likelihood that a construction company has anticipated and properly treated its risks. While large contractors often employ a full time risk manager—or even a risk management department—to engage this process, it is not necessary to do so. Anyone can implement the risk management process for a contractor if provided the responsibility, authority, and resources to do so. Thus the risk management process is often initiated by the owners, controllers, CFOs, or business managers of smaller firms—usually with significant assistance from their insurance agents/brokers or consultants.

On any given day or in any given week, a person with risk management responsibility will typically be simultaneously involved in different steps of the process for different exposures. The steps in the risk management process and the risk management techniques utilized to treat the risks are reviewed in the pages that follow.

Risk Identification Risk identification is perhaps the most crucial part of the risk management process because an exposure that is not identified cannot be properly managed. Risk control measures will not have been engaged, and only by chance will there be a source of financial recovery for the loss. (For example, an all risk insurance policy may cover the loss if there was no specific exclusion that would bar payment.) Often, however, no source of recovery is available, and losses must be absorbed by the firm; depending on the size of the loss, this unplanned retention could impair the financial condition of the firm or even threaten its survival.

Loss exposures fall into four broad categories: direct property losses, indirect property losses, liability losses, and injury to personnel. Obviously, direct property losses describe physical damage to or loss of real or personal property, such as by fire, windstorm, or theft. An example would be the collapse of a partially completed parking garage due to high winds. Since they are frequently treated differently, one way to analyze direct property loss exposures for contractors is to consider the types of property exposed. This would include:

Direct damage to the project itself

Direct damage to materials or equipment to be incorporated into the project

Direct damage to the owner’s adjacent property

Direct damage to autos, tools, or contractors equipment

Chapter 1—Introduction to Risk Management

Indirect property losses arise out of direct property losses, to either the contractor’s or some other party’s property, but are not necessarily related to the value of the property loss. Indirect property losses include lost profits when a business is shut down following a property loss (business interruption loss) or, alternatively, the extra expenses associated with restoring operations, such as the cost of renting equipment to replace a contractor’s damaged equipment. Continuing with the previous parking garage collapse example, the inability to open it on time will result in a loss of income for the project owner. Other examples of indirect property losses to which contractors may be exposed include the following.

Cost to remove debris resulting from the direct loss

Cost to expedite replacement of damaged materials or equipment

Costs associated with delayed completion (e.g., additional interest and taxes, refinancing charges, and loan fees)

Efficacy and performance (i.e., failure of the completed project to perform as intended)

The value of an indirect property loss will depend upon the extent of the damage and the time required to repair or replace the property, and in many cases may exceed the value of the damage to the property. When an interruption in operations is unacceptable (e.g., humanitarian concerns prevent hospitals and nursing homes from sending patients out into the streets) the firm may incur substantial expenses in making arrangements to maintain operations. Contractors that face liquidated damages for failing to complete a project on time will probably have a very short period of “acceptable” business interruption.

Liability losses include the cost of defending against and paying damages arising out of third parties’ claims against the contractor. Liability claims usually seek compensation for property damage, bodily injury, or personal injury allegedly caused by the contractor. Note that even if the contractor is found to not be liable, a loss may still be sustained in defending against the claim. The following are typical liability exposures faced by contractors.

Premises and operations bodily injury and property damage—injury or damage to a third party arising on a job site or as a result of the contractor’s operations, including the operations of its subcontractors

Completed operations bodily injury and property damage—injury or damage to either a third party or the project itself arising after substantial completion that is caused by the completed project itself

Contractually assumed liability—liability of another contractor or the owner for injury to a third party imposed on the contractor through the operation of an indemnity or hold harmless clause

Auto, aircraft, and watercraft liability—injury or damage to a third party arising from the ownership, operation, or use of any of these types of conveyances

Other types of liability—unique exposures, such as design liability or environmental liability, may arise from special types of activities

Finally, personnel losses involve risks associated with employees. These include claims for occupational injuries falling within the purview of workers compensation laws, liability arising from employment practices, costs associated with replacing a key employee who is disabled or dies, and lost revenues arising out of the disability or death of a key employee.

Some risks are common to all or most businesses, such as the possibility that an event (e.g., fire, labor strike, or destruction of a key supplier’s facilities) will prevent the firm from operating for a period of time. Different companies will be vulnerable to different causes of loss, but most firms will have some exposure to these types of loss. For example, some contractors rely on key suppliers, and any interruption in the flow of supplies will cause an interruption or reduction in operations. Other firms are more susceptible to interruptions due to labor disputes, and still others are most vulnerable to natural perils such as fire and flood. Obviously the types of construction in which a contractor specializes will have a key influence on the nature and extent of its loss exposures. Exhibit 1.1 provides additional examples of common construction risks.

Exhibit 1.1 Examples of Typical Construction Risks

Direct Property Damage to Contractor’s Property

Automobile damage from collision

Automobile damage from other events, i.e., windstorm, fire, etc.

Damage to contractor’s equipment

Damage to materials to be used in construction

Damage to the project itself, including the contractor’s own work

Damage to the contractor’s office building and contents

Indirect (Consequential) Loss from Damage to Property

Cost to remove debris resulting from direct loss

Rental cost of construction equipment needed to replace damaged equipment

Loss of rents from damaged/destroyed rental property

Business interruption resulting from damage to key construction equipment

Liquidated damages

Increased financing costs

Legal Liability

Bodily injury to the public occurring on job sites

Property damage to another contractor’s equipment from contractor’s negligence

Injury to the public resulting from an auto accident

Damage to a completed project resulting from defective construction

Bodily injury or damage to other property arising from a construction defect

Bodily injury to another contractor’s employee resulting from contractor’s negligence

Failure of project to perform as intended

Liability for environmental damage arising out of the contractor’s work

Personnel

Bodily injury to employees

Expenses necessary to replace an injured key employee

Business lost as a result of death of key employee

Still other risks are unique to the particular organization. For example, within the construction industry, small contractors are more vulnerable than large contractors to an interruption in operations arising out of the death of a key employee; high-rise construction contractors are more susceptible to

fatal falls than road contractors (excluding bridgework); and construction of energy facilities presents technological risks that residential housing construction does not impose.

Contractors have a number of risk identification techniques at their disposal. Some of the common techniques are listed and discussed below.

Interviews with managers and operating personnel

Checklists and surveys

Physical inspections

Financial statement review

Insurer provided loss reports

Contract reviews

Interviews with management and key operating personnel, physical inspections, and analysis of financial statements, current insurance policies, historical loss data, and construction contracts are all important steps in the identification process. Management is uniquely able to provide information about current operations, plans for expansion, and employment practices. Field managers are in the best position to help the risk manager identify dangerous work practices or conditions that could result in employee injuries. Interviewing field managers on site enables the risk manager to simultaneously conduct a physical inspection.

Checklists and survey questionnaires are also popular risk identification aides. One useful survey tool is the IRMI Exposure Survey Questionnaire, and some consultants and brokers have developed their own. Insurance policies can also be used as a risk identification tool as lists of both covered and excluded property and perils delineate many potential types and causes of loss. The exclusions, in particular, (including any exclusionary endorsements) tend to reveal some of the more onerous risks that contractors face.

However, standard questionnaires cannot itemize every potential exposure of every firm. Additional and unique exposures should be added to the list for future reference as they are identified. While checklists should not be relied upon exclusively, a customized version can be a very effective risk identification tool when used in conjunction with other techniques.

Physical inspections of work sites, storage areas, premises, etc., can reveal dangerous conditions or practices that might otherwise be overlooked. The unbiased, “fresh” eyes of an outsider will sometimes see warning signals where those who work on site every day have become so accustomed to their “processes” that they no longer recognize the dangers their methods and operations pose to people and property. Risk managers should try to conduct unannounced inspections of major operating centers or job sites at least once a year to look for new risks and determine whether safety recommendations for previously identified risks are being followed.

Financial statements provide a tremendous amount of risk management information. The balance sheet shows the value of all assets and the income statement shows major sources of revenues and expenses. These documents can help identify events that could cause an interruption in operations, including key suppliers and key customers. For example, what percentage of revenues would be lost if the firm’s biggest client went bankrupt or moved its business elsewhere?

Notes to financial statements will often reveal items such as outstanding lawsuits, unfunded pension liabilities or retiree medical benefits, the nature of the firm’s debt, and the firm’s major outstanding contracts. Publicly-held firms must file a 10-K report that provides even more detail.

Prior losses reveal much about the potential for loss and data of this type is crucial in estimating the expected value of losses. Examining prior loss data is most useful for higher frequency losses, such as collision losses on a fleet of vehicles or minor injuries to workers. Rare or catastrophic losses are less predictable, and the fact that a particular peril, such as a fire or hurricane, has never struck before does not mean it cannot occur in the future.

Contract review is a crucial step in contractors’ risk identification process. Construction contracts specify the contractor’s promises and the conditions under which it can be relieved of certain liabilities. For example, does the contract contain a hold harmless agreement, and if so, just how broad is it? The answer to that question can have major implications on the contractor’s obligation to indemnify the prime contractor or owner for certain losses. Leases, rental agreements, and purchase orders also transfer certain liabilities to the renter or buyer.

Constructing a flow chart of the firm’s operations from start to finish can be particularly helpful in identifying potential losses arising out of events off site, such as an interruption in operations due to a truckers strike or destruction of a key supplier’s manufacturing facility, and the liability and property damage exposures that arise out of the transportation of equipment.

The risk identification tools discussed here are common, but they are not exhaustive. No source of information should be discounted as unimportant. Advertising and marketing materials, company web sites, interviews with legal representatives, published industry loss statistics, risk management information systems, minutes from the meetings of the board of directors, union agreements, employee handbooks, procedure manuals, and corporate bylaws can all reveal potential for loss.

Risk identification tools are complements, not substitutes. No single technique will reveal all of a contractor’s risk exposures, but together they are very effective. As the organization, the industry, the laws, and society change, the loss exposures will change accordingly, which emphasizes the need to be continually alert to new exposures.

Risk Analysis Risks should be evaluated according to their expected impact on the organization’s goals should losses occur. Contractors’ goals will differ somewhat based on management attitudes and philosophies, but typically they will address matters such as employee health and safety, profitability, growth, and legal and humanitarian issues. Exposures should be prioritized based on their potential for interfering with the realization of the organizational objectives.

Risk analysis involves estimating the amount and likelihood of certain types of losses. Estimating the probable value of a loss is more difficult for some exposures than for others. Direct property exposures are probably the easiest to evaluate since property holds a determinable value. For many property losses, however, the damaged property is only the tip of the iceberg. The direct property exposure must be estimated in consideration of potential losses beyond the immediate and obvious property damage. Indirect, or consequential, losses can far exceed the value of the damaged property. This is particularly true when the direct loss delays the opening of an income producing property, which results in business interruption or loss of rents.

The liability exposure is probably the most difficult to estimate because the “rules” are never known with certainty. Unexpected liabilities or standards of care can be established by case law or legislation. Superfund, for example, created retroactive liability for many companies, including owners and contractors, which never actively participated in the dumping or other disposal of hazardous wastes. Damages associated with legal liabilities are also extremely difficult to predict, particularly punitive damages. A number of sophisticated computer models that “trend” on historical

loss data to predict future losses are available. The larger brokers and most consultants can perform these types of analysis, or the systems can be purchased from a variety of vendors. Trending techniques vary, but most utilize some sort of averaging—adjusted for inflation, changes in exposure (i.e., payroll, revenues, etc.), and abnormal losses that would unreasonably skew predictions—to arrive at an expected annual loss.

When analyzing risks, it is important to recognize not only the obvious direct costs of loss but also the indirect costs. The direct costs are those associated with restoring the property, compensating the injured third party or employee, and paying associated related expenses such as medical costs or attorneys fees. Indirect costs are much less obvious and difficult to quantify. Depending on the type of loss they may include such things as lost productivity of a crew following the loss, management time expended in dealing with the loss, overhead cost incurred while work is interrupted, cost of replacing and training a replacement employee, overtime paid to employees attempting to mitigate the project disruption, and production delays. Particularly in the case of employee injuries, these indirect loss costs can far exceed the direct loss—and many of them will not be covered by insurance.

In addition to the expected, or most probable, loss, contractors should estimate the maximum possible loss and probable maximum loss. The maximum possible loss represents the most that could be lost under an absolute worst case scenario. For example, the maximum possible direct property loss for a general contractor involved in construction of an office building would be the total value of the completed portion of the building. The probable maximum loss, however, considers the odds of various loss severities and estimates a “most likely” worst-case scenario. To continue the example above, the contractor estimates that because the building is composed primarily of flame-retardant material and a well-trained and well-equipped fire department is located only a quarter of a mile away, it is unlikely that more than three stories of the building would be lost in a fire. The maximum probable loss, therefore, is whatever percentage of the total value of the building three floors represents. (For example, if the building will be six stories when completed, the maximum probable loss is 50 percent of the total value.)

Developing loss probabilities is equally subjective. While frequency increases predictability, risk management does not deal with purely objective probabilities. For example, even the newest student of statistics can determine that if a fair die is rolled, there is a one-sixth chance that a one will come up on top. Further, if that die is rolled enough times, the number of ones, twos, threes, etc., rolled will become roughly equal. We know that because we know that there are exactly six possible outcomes and they are all equally likely to occur. Conversely, consider the possible outcomes when considering a fire loss range from $0 to the total value of the building. For a liability loss, the possibilities may range from $0 to far in excess of the total value of the firm. The probability of any one outcome is difficult to determine, but clearly they are not all equally likely.

Risk managers need to use their own judgment in considering probabilities. Richard Prouty developed an approach to this task that assigns losses to one of four broad categories, based on the risk manager’s subjective opinion.

Category The Event

Almost Nil Will not occur.

Slight Has never happened before and is unlikely to occur in the future.

Moderate Happens occasionally and is expected to occur again in the future.

Definite Has happened regularly and is expected to occur regularly in the future.

When considered in conjunction with the maximum possible loss, probable maximum loss, and most probable loss, these estimates of likelihood will help the risk manager determine the appropriate risk management strategy for dealing with various loss exposures.

Designing the Risk Management Strategy A risk management program is a combination of risk control and risk finance techniques. Risk control, also commonly referred to as loss control, techniques are designed to reduce the frequency (loss prevention) and severity (loss reduction) of losses. Risk financing involves arranging for funds to be available to pay losses that occur. In choosing an appropriate mix of risk control and risk financing techniques, the risk manager seeks primarily to choose a combination of techniques that is effective, stable, and secure.

Risk Control Risk control measures can be broadly summarized as either loss prevention or loss reduction. Loss prevention and loss reduction measures can be as simple and inexpensive as providing adequate training on how to safely perform work and insisting that safety procedures be followed. For example, use of hard hats and safety harnesses should be required and enforced. While some risk control techniques can be categorized as purely loss prevention or loss reduction (e.g., sprinkler systems cannot prevent fires but they reduce the amount of damage), many measures are capable of producing both desired results.

While such risk control efforts as equipment theft prevention are important for contractors, by far the most important area of risk control is worker safety. Employee injuries typically are the most frequent and costly losses incurred by contractors, particularly when both the direct and indirect costs of these losses are considered. As a result, workers compensation insurance is generally the most expensive coverage that contractors purchase. The cost of this insurance is directly affected by the contractor’s losses. Claims increase the experience modifier in future years and immediately impose direct costs for any retained amounts (e.g., deductibles). A single claim impacts experience modifiers used to calculate premiums in three future years. Since effective safety programs provide competitive advantages to contractors they should be highly motivated to implement them.

The following are considered by many safety professionals as being the four critical elements of an effective safety program:

Top management support and involvement by employees

Hazard identification processes at jobsites

A hazard prevention and control system

Safety and health training programs

The most important element for achieving an effective safety program is top management commitment. All too often, a “production first” mentality, driven by a tight construction schedule, causes safety to take a back seat. Only emphasis and support from the highest levels of the organization can overcome this problem. This support must come from personal involvement in the safety program demonstrated by such actions as setting aggressive safety goals, making safety part of top level meetings, providing the resources needed to implement safety programs, and considering safety in performance reviews at all levels within the organization. Once a company has commitment of this magnitude from the executive suite, huge strides can be made in putting the other critical elements in place to reduce both the frequency and severity of on-the-job injuries.

Another control technique is risk avoidance. This technique entirely eliminates any possibility of loss, and as such represents the ultimate in loss prevention. The only way to ensure that no losses of a given type will occur is to not engage in the activity that creates the risk. Clearly, avoidance restricts a contractor’s business opportunities and potential profitability. This extreme form of loss prevention is appropriate when the potential for loss threatens the firm’s survival or ability to meet some other critical organizational objective, such as maintaining good standing in the community or acting in a socially responsible and humanitarian manner. Avoidance is also the natural strategy when the risk associated with the activity is more than management is comfortable in bearing. For example, some contractors avoid any form of environmental remediation or restoration work because they are unwilling to assume the environmental risks that come with these activities.

Risk control measures should be evaluated in terms of both cost and effectiveness. Inexpensive measures, such as safety education and training, are virtually always worthwhile. Others are more costly and must be evaluated according to the expected reduction in losses they will produce and other organizational objectives. Assuming the contractor has a limited budget for risk control expenditures, those measures that will provide the greatest long-term return on investment should, of course, be selected.

Risk Finance Risk finance techniques are used to fund the losses that a contractor experiences. The primary types of risk financing are risk retention and risk transfer. Losses can be retained through a number of methods, ranging from the simple (e.g., small deductibles or simply deciding not to insure certain identified risks) to the very sophisticated. These include loss sensitive rating plans, qualified self-insurance, captive insurance subsidiaries, and risk retention groups. In essence, risk retention involves exchanging the certainty of insurance protection for a reduced or eliminated premium cost.

In some cases, a contractor may decide not to make any special arrangements to pre-fund or transfer a particular risk to another party, planning to simply absorb any losses of that type that occur. For example, it is common not to purchase collision coverage on older private passenger vehicles, and some large contractors do not insure their mobile equipment. As long as this is a conscious decision, it may constitute a perfectly acceptable risk management decision. However, failure to make arrangements to provide for a loss because the risk went unrecognized or underestimated is unacceptable. Risk management seeks to eliminate this “passive retention” of risk.

While risk retention involves the contractor funding the losses from internal means, risk transfer involves shifting the financial burden of losses to another party. The two prevalent risk transfer techniques used by contractors are contractual risk transfer and the purchase of insurance. Contractual risk transfers are implemented by indemnity provisions and insurance requirements within construction contracts and shift the financial consequences of loss to another contractor (and/or its insurers). Of course, insurance involves buying coverage from a professional risk bearer—an insurance company.

Risk Retention For mid-size and large companies, risk retention is generally more cost effective than purchasing insurance over the long run. This is because of the many frictional costs involved with buying insurance, such as loss of investment income on premiums paid, agent’s commissions, insurer profits, premium taxes, and what not. However, the volatility of losses from one year to the next makes it somewhat more difficult to predict ultimate costs, making it prudent to use a blend of risk retention and risk transfer techniques.

Using this approach, insurance essentially becomes a smoothing mechanism. In some years, the insured will suffer few or no losses, and therefore collect less than it paid for the coverage, while in other years it will suffer large losses and collect much more than it paid. The insurer uses the premiums of those who do not suffer losses to pay the losses of those who do. If the insurer’s prediction of the losses of the group of insureds is grossly understated, it may incur an underwriting loss. The insurer considers this risk along with its overhead costs when determining the rates to charge for insurance. This explains why prudent risk retention can be more cost-effective than insurance—the contractor avoids the part of insurance premiums that go toward insurers’ overhead and profit.

Generally speaking, it is best to use risk retention for the working layers of losses. The working layer is the level of losses that occurs with sufficient frequency to obtain some degree of predictability. Insurance is then purchased for the more catastrophic higher loss levels. This takes advantage of the loss smoothing mechanism offered by insurance while avoiding inefficient dollar trading at the lower loss levels.

If risk retention techniques are to be applied to the lower severity higher frequency exposures—such as auto collision losses, the lower loss layers of workers compensation losses, or lower levels of liability losses—analysis of past loss experience can be very helpful in performing a cost/benefit analysis to determine what level to retain and what level of risk to insure. By analyzing and trending past losses into the future, an estimate of the aggregate expected losses (a “loss pick”) for the next year can be made. Based on the loss pick, an expected-case, worst-case, and best-case scenario of losses that may occur is developed and used in combination with insurance proposals based on varying levels of retention (e.g., deductibles or retrospective rating plans) to perform a net present value analysis of each proposal. The degree of sophistication used in these analyses increases with the size of the program being considered, but the basic approach is the same for any size account: develop net present value cost comparisons of combinations of insurance and risk retention based on the contractor’s expected losses. This type of analysis is invaluable in putting together a cost effective risk retention and risk transfer program.

Contractual Risk Transfer Contractual risk transfer is a technique for allocating the risks associated with the performance of the endeavor governed by a business contract between the contracting parties. At least in theory, the objective for this risk allocation should be to assign the risk to the party with the most control over it. Risks are allocated through the use of various types of contract clauses, including, but not limited to, indemnity (also called “hold harmless”) clauses and insurance clauses.

Indemnity clauses require one contracting party to respond to liability claims made against the other party by third parties who are not involved in the contractual arrangement. For example, Trade Construction might agree to indemnify Gencon Construction for liability arising from Trade’s operations at Gencon’s construction project. If Walter Wounded is injured as a result of Trade’s operations when visiting the site and sues Gencon, Trade would be responsible for paying any awards or settlements Walter receives from Gencon. Indemnity clauses operate without regard to insurance. Thus, Trade would have to make these payments regardless of whether Trade had insurance for the exposure.

It is common practice in construction for project owners to transfer liability risks to the prime or general contractors and for prime or general contractors to transfer them down to subcontractors. Thus, indemnity clauses typically are used to push liability exposures downstream from one tier to the next. In many situations, this is logical as each contractor should be responsible for controlling and

financing the risks resulting from its operations. However, indemnity agreements sometimes result in transfers that are unfair to the downstream parties, as when one subcontractor must fund liability arising at least in part from another contractor’s negligence.

Insurance clauses assign responsibility for purchasing certain types of insurance to the parties to the contract. The objectives of insurance clauses are (1) to assure coverage is purchased for certain mutual exposures of all the parties (e.g., damage to the project during construction) while reducing inefficiencies from multiple parties buying overlapping coverage, (2) to ensure that parties who have agreed to indemnify others have insurance in place to cover liability transferred to them within the indemnification agreement, and (3) to assure that contracting parties have insurance in place to cover liability to one another.

In construction contracts one party, generally the owner but sometimes the prime contractor, agrees to buy builders risk insurance on behalf of all the other parties. This is an efficient way of covering the direct and indirect property exposures associated with the project without creating the coverage overlaps that would occur if each contractor tried to insure only its risk. Each contractor is then generally required to purchase certain casualty coverages, such as commercial general liability, workers compensation, and auto liability.

One caveat to remember about contractual insurance requirements is that rarely do they completely replace the need for the party making the requirement to buy its own liability insurance. Obtaining some protection through another party’s liability insurance should be viewed as a way to insulate the transferor’s liability insurance program from loss rather than as a replacement of its liability insurance program. On the other hand, contract requirements are often used to avoid the necessity of both parties purchasing first party insurance on the same property. Appropriate evidence that coverage has been purchased – usually in the form of an insurance certificate – should always be required and maintained to verify compliance with the contract.

Of course, many other contract provisions may allocate risks to one or more of the contracting parties. For example, it is common for construction contracts to include special provisions related to environmental liability, liquidated damages, and force majeur clauses. Thus, it is necessary to carefully review the entire contract to obtain a clear picture of the risks being transferred.

Since risk allocations in contracts radically alter the risk profile of construction projects, contractors and their insurance advisors must pay careful attention to them and actively negotiate for fair treatment. This involves determining what risks the contractor will accept from others and what risks it will not accept. It also involves knowing what insurance requirements will be acceptable and avoiding contract provisions that require coverages that are not available or are simply unacceptable. Once these determinations are made, a process for reviewing and negotiating these contract provisions should be put in place. This will often require reviews by knowledgeable risk or insurance specialists before contracts are executed.

Insurance Contractors purchase a portfolio of insurance policies that are designed to cover specific risks without overlapping each other. The policies typically purchased by contractors include the following.

Workers compensation and employers liability insurance

Commercial general liability insurance

Business auto insurance

Umbrella or excess liability insurance

Contractors equipment insurance

Property insurance covering the contractor’s real and personal property (e.g., its office and furnishings)

Construction projects also typically require builders risk insurance to cover damage to the project itself. This insurance may be provided by either the owner or the prime contractor, and the responsibility is typically assigned in the construction contract.

Additional policies covering unique exposures arising from the contractor’s operations may also be purchased. Examples include design professional liability, pollution liability, aircraft, and watercraft insurance.

Of course, even the broadest insurance program does not insure all the risks a contractor faces. There are certain risks insurers are unwilling to cover because they feel they are uninsurable or too catastrophic for them to undertake. And some insurers are simply more comfortable with some of the more unique construction exposures than are others. As a result there can be substantial variations in the coverages provided by different insurers. For that reason, contractors need to be aware of the terms of the coverage, and any modifications that are made to the basic policy through endorsements, which can either enhance or restrict coverage. Any potentially catastrophic losses for which coverage cannot be arranged through insurance must be handled through other risk financing or risk control techniques. Insurance will be addressed in additional detail in later chapters.

Selecting the Right Combination Risk control and risk financing measures should be considered complements rather than substitutes. Risk control measures are almost always appropriate when losses occur frequently. Even if individual losses are small, contractors can improve profitability by reducing the number of losses. If insurance has been purchased, exercising risk control will reduce premiums and losses retained through deductibles or loss sensitive rating plans.

Retention is most appropriate for losses that are predictable in nature because these costs can be predicted and the appropriate funds earmarked to cover them. Potentially catastrophic risks (those that threaten the contractor’s ability to meet its most important goals, including, but not limited to, its survival) are normally better handled through other techniques, even if the likelihood of the event occurring is small.

Exhibit 1.2 shows a “risk matrix” that provides broad rules of thumb in selecting the appropriate risk handling techniques for various loss exposures, based on the frequency and severity with which losses are expected to occur. Severity is better defined in terms of the potential of losses to interfere with organizational objectives than as some specific dollar amount, since larger companies can usually absorb more losses than small companies without as severe consequences.

Exhibit 1.2 Risk Matrix

Loss Frequency

Low High

Retain

Retain and implement loss

prevention measures

h Transfer and

implement loss reduction measures

Avoidance

Notice that retention is appropriate when frequency of loss is expected to be high, as long as severity is low. This is true because frequency gives rise to predictability.

For example, if a contractor has experienced between 10 and 20 minor injuries to employees for the past 15 years resulting in annual costs between $8,000 and $14,000, it can be relatively certain that several employees will suffer minor injuries in the coming year as well, and that payments for these injuries will be somewhere between $8,000 and $14,000.

However, suppose this same contractor has had only one fatal injury in those 15 years, and that claim resulted in a payment of $500,000. Payments for serious or fatal injuries in the coming year, therefore, could range from $0 to $500,000 or more. The contractor does not have a comfortable level of certainty as to which outcome will occur. Further, if a fatal injury does occur, it could consume most of the contractor’s profits for that year. This type of low frequency, high severity exposure is most appropriately transferred. This contractor might consider handling its workers compensation exposure by purchasing workers compensation insurance with a deductible of $2,000 per claim. In that way, it earns a premium credit since the insurer will not be responsible for the smaller claims, but it is still protected from the possibility of having to pay a large settlement for a severe injury or fatality. A net present value analysis of the cost of expected deductible payouts at various levels up to $2,000 (e.g., $500, $1,000, and $2,000) and the associated premiums will reveal the most cost effective deductible level to purchase.

Notice in Exhibit 1.2 that risk avoidance is appropriate when both frequency and severity are high. Although this type of exposure may seem ideal for risk transfer (paying someone else to assume the risk), insurance is usually not feasible for these exposures because the cost would be prohibitive. Insurers, when developing premiums, start with expected losses, and add a margin for error, expenses, and profits. Since the contractor’s expected losses are so high and so probable, the contractor is not going to save a lot of money by buying the insurance if it could find an insurer willing to write the coverage. If a loss that has the potential to severely threaten the contractor’s survival or other goals is almost certain to occur, avoidance may be the only alternative.

Notice that when either frequency or severity of loss is high, some form of risk control is appropriate. Only the low frequency, low severity exposures require no risk control measures, as they would produce little if any reduction in losses since these losses rarely happen and are not significant when they do. Contractors should focus their risk control programs on those areas where their efforts can produce savings.

These rules of thumb provide a starting point in determining the optimal risk management plan. Other considerations, including management’s preferences, will influence the final decisions and format of the risk management plan. For example, a highly conservative owner or chief executive officer (CEO) may prefer to insure everything, regardless of the potential savings associated with assuming some of the losses internally.

Implementation For a plan to succeed, the details of the plan must be carried out. The full time or part time risk manager will spend a substantial amount of time implementing the risk management program. Some of the most important implementation functions include the following.

Establishing authority and responsibility for the safety program and assuring that it receives the amount of attention desired by upper management.

Choosing a professional insurance agent or broker with knowledge of construction insurance and who represents insurance markets that focus on the construction industry.

Determining contractual risk transfer strategies and tactics to use and either reviewing the contracts or providing those who will with checklists and guidelines for doing so.

Obtaining and reviewing certificates of insurance from subcontractors to verify compliance with insurance requirements.

Assembling underwriting information for insurers and working with the agent/broker to present a positive picture of the company to underwriters.

Reviewing insurance proposals presented through the agent or broker.

Assuring that losses and claims are promptly and clearly communicated to the proper insurers.

Working with and monitoring claims adjusters to assure that employees and customers are being fairly and properly treated.

Reviewing insurance policies, premium audits, premium invoices, and similar documents to assure they are correct and accurate.

Working with estimators to assure that bids contain appropriate insurance and risk management expense elements.

Communicating special needs, such as for additional insured endorsements and certificates, to the agent or broker.

Working with legal counsel to assure the company is properly defended against liability claims.

Review Finally, risk management is a dynamic field. Contractors must be cognizant of changes in their exposures (e.g., management decides to expand into another type of construction, Congress passes a bill requiring new standards of safety, etc.), and changes in the insurance and financial markets. Insurance markets are cyclical, and wise contractors stay tuned into the market cycle to anticipate changes that may impact costs down the road. Soft (buyers) markets present opportunities to broaden coverage terms, increase insurance limits, and reduce retentions. Hard (sellers) markets, on the other had require creative risk financing approaches, adjustments to contract insurance clauses, reductions in insurance limits, and knowledgeable negotiation of coverage terms.

Of course the results of the program must be monitored. Are the safety programs working? Have the savings justified the cost? By measuring the effectiveness of the risk management program and adjusting accordingly, contractors can most effectively succeed in meeting their goals. Some of the most important monitoring functions include the following.

Obtaining and reviewing loss reports from the insurers to determine loss trends.

Reviewing experience rating promulgations to assure they are correct and properly applied.

Evaluating the claims function through internal review or by commissioning an auditor.

Comparing actual losses to loss picks and reevaluating prior risk retention and finance decisions.

Benchmarking retention levels, premiums, safety programs, and other risk management activities against other contractors.

Benchmarking the company’s OSHA reportable statistics against industry averages.

Summary The risk management process provides a logical approach to managing the risks that a construction firm faces. The basic process is simple enough to allow both business managers with little specialized expertise and experienced risk managers to use it. Thus any contractor, large or small, can use the process to control its cost of risk. The keys to successful implementation of a risk management program are adequate executive suite support to give credibility to the company’s risk management initiatives and recognition that most exposures must be treated with a combination of tactics (e.g., risk control, contractual risk transfer, and insurance) rather than only insurance.

Chapter 1 Review Questions 1. Minimizing the “cost of risk” is a stated goal of AS Contracting’s risk management program.

Which one of the following expenses would typically be considered a cost of risk?

a. Bribes paid to inspectors who affirm that AS’s work complies with building codes.

This answer is incorrect. Bribing inspectors to avoid compliance with building codes is not a cost that is incurred to minimize AS’s risk of loss.

b. Cost of installing an automatic sprinkler system in AS’s storage building.

This answer is incorrect. Although automatic sprinkler systems are a loss control measure, the cost of installing such a system would not generally be included as a cost of risk.

c. Insurance premiums AS pays for liability, property, surety, and workers compensation insurance.

That is correct! Insurance premiums are considered a cost of risk.

d. Liability losses that are covered by insurance.

This answer is incorrect. The cost of risk includes losses that are retained and not covered by insurance.

2. As compared with direct property losses, estimating the amount and likelihood of liability losses is difficult,

a. and computer models can be used to “trend” historical loss data.

That is correct! A number of sophisticated computer models that “trend” on historical loss data to predict future losses are available.

b. and punitive damages are especially predictable.

This answer is incorrect. Punitive damages are especially difficult to predict.

c. although liability holds a determinable value.

This answer is incorrect. Property holds a determinable value, but the value of a liability loss is not limited to anything that is tangible.

d. because clear rules apply, and these rules never change.

This answer is incorrect. The rules are never known with certainty.

3. Risk transfer involves:

a. funding losses from an internal means.

This answer is incorrect. Risk retention involves funding losses from internal means.

b. funding losses from outside sources, such as bank loans.

This answer is incorrect. Since a bank loan must be repaid, it does not transfer risks.

c. outsourcing all risks.

This answer is incorrect. With outsourcing, another organization such as a TPA might process claims, but the risk of loss is not transferred.

d. shifting the financial burden of losses to another party.

That is correct! Risk transfer involves shifting the financial burden of losses to another party such as an insurer

4. Smith Contracting has been engaged to construct a new industrial complex that is owned by James Properties. Smith will hire a number of subcontractors to complete the work, including Shovel Excavation, Short Electricians, and Tarpaper Roofing. If the contract is typical, who responsible for purchasing the builders risk insurance?

a. Each party purchases its own builders risk insurance.

This answer is incorrect. Only one party purchases builders risk insurance.

b. James Properties

That is correct! The owner is generally the party who agrees to buy builders risk insurance on behalf of all other parties.

c. Smith Contracting

This answer is incorrect. As the prime contractor, Smith might, in some cases, be required to buy the builders risk insurance, but that usually is not the case.

d. Shovel Excavation

This answer is incorrect. It would not make sense to require only one of the involved subcontractors to purchase builders risk insurance on the entire project.

5. Because of the nature of its business, Gravel Company must frequently replace its vehicles’ windshields due to stone chips and cracks. Replacing a windshield from time to time is a nuisance because the vehicle must be taken out of service, but the windshield replacement itself is not expensive. Rather than purchase insurance that would cover glass breakage, it would be appropriate for Gravel to retain future windshield losses because:

a. By exercising sound loss control, Gravel can virtually eliminate the risk of future windshield losses.

This answer is incorrect. Low severity, high frequency risks can sometimes be mitigated by the use of loss prevention measures, but that does not seem feasible in this case.

b. Drivers will be more careful if they know the windshields are not insured.

This answer is incorrect. Driver care does not seem to be a factor in these losses.

c. Loss frequency might be high, but loss severity is low.

That is correct! Retention is an appropriate measure for low severity, high frequency losses.

d. Loss frequency might be low, loss severity is high.

This answer is incorrect. Frequency is high; it is loss severity that is low.

Chapter 2 Anatomy of an Insurance Policy

Learning Objective

Identify and explain the various provisions in an insurance policy that govern how coverage applies.

For many lines of property casualty insurance, standard policy forms are promulgated by industry-supported organizations on behalf of all member insurers. The most widely recognized provider of standard forms is Insurance Services Office, Inc. (ISO). ISO prepares standard policy forms portfolios for all major lines of commercial insurance except workers compensation. The only major competitor of ISO in most personal and commercial lines is the American Association of Insurance Services (AAIS), which has a similar product offering to ISO. The National Council on Compensation Insurance (NCCI) promulgates the standard workers compensation policy, and the Surety Association of America (SAA) does so for surety and fidelity (crime) coverages.

Because standard forms are drafted with the needs of the average insured in mind, most of them can be utilized across all industries, with some modification by endorsements to meet specific industry needs. The standard commercial general liability (CGL), business auto coverage (BAC), workers compensation, and commercial crime policies are appropriate for use by most commercial insureds, and are commonly used to insure contractors. There are also other standard forms that focus on the needs of a specific industry. For example, the standard owners and contractors protective (OCP) liability policy is used in the construction industry and the motor carriers liability policy is used instead of the commercial auto policy to insure truckers.

Although the use of standard forms has been criticized by some as anticompetitive, they serve many useful purposes. For example, they allow the use of loss data from many insurers for ratemaking purposes, which is particularly crucial for small insurers. Other advantages of standard policies are summarized in Exhibit 2.1. Keep in mind, however, that even when standard policies are available, there are differences between the AAIS and ISO forms and some insurers will still develop their own nonstandard forms. For this reason, it is important to verify which type of form is being offered by a given insurer.

Exhibit 2.1 Advantages of Standard Policy Forms

Ability to set rates using pooled loss data is enhanced

Increases ability to make generalizations about coverages

Reduces the need to compare numerous insurers’ policies word for word to determine which provides the most favorable coverage

Application of case law to consistent policy terms helps define the scope of coverage

Simplifies the claims-settling process

Standard forms are periodically revised by their drafters in response to changing exposures faced by business, changing underwriting philosophies of insurers, and the development of case law interpreting coverage. As an example of the first scenario, insurers in the late 1990s added policy provisions addressing exposures arising from the increasing use of the Internet. Restrictions incorporated into standard additional insured endorsements in 2004 reflected a change in underwriting philosophy (prompted by a substantial increase in additional insured claims). With respect to the last item, courts may interpret a policy provision as allowing broader or more restrictive coverage than the drafters intended. In this case the standard language will be revised in an attempt to more appropriately codify the intent. An example of this was the inclusion of policy language in the CGL to preclude coverage for losses known to have occurred at the inception of the policy, responding to a California case that had gone the other way.

New editions of standard policies are assigned an edition date to make them identifiable. Since the revisions from one edition to another may be substantial, it is important to ascertain which edition you are reviewing when considering the coverage it applies. It is particularly important to check edition dates when relying on published analyses or court decisions interpreting coverage.

Where no standard forms are available, or where the terms of the standard forms are unacceptable, insurers often develop their own policy forms. Additionally, the large brokerage firms have drafted their own forms for certain lines of insurance, most commonly property. Builders risk insurance is often written on nonstandard forms despite the existence of standard builders risk policies. (Further, most nonstandard builders risk forms provide more favorable terms than the ISO form.). Umbrella liability, contractors pollution liability, contractors equipment, and contractors professional liability are additional examples of coverages that are usually written on insurer forms.

In some cases, particularly when the insured is a very large company with substantial bargaining clout, manuscript policies are used. Manuscript policies are usually drafted jointly by the insurer and the insured. Manuscript policies are used when no existing form is adequate for the insured’s needs. Rather than attempting to piece together the desired coverage by attaching a host of endorsements, many of which would also have to be manuscripted, to modify the terms of the basic policy, a unique policy is drafted for that insured. When they are jointly drafted, or “fairly bargained,” manuscript policies may be subject to different rules of interpretation when a coverage dispute arises than are forms drafted unilaterally by the insurer.

In most states, insurers must place the forms they intend to use for each line they write in that state on file with the state insurance department. (The states vary in regard to whether forms must be approved by the department prior to use. Some lines are exempt from this filing requirement altogether.) Insurers must submit either a standard ISO or other bureau-promulgated form or their own

Chapter 2—Anatomy of an Insurance Policy

nonstandard form. (Most states require that the NCCI form be used by all insurers writing workers compensation insurance in that state.)

Policy Format Whether standard or nonstandard, insurance policies tend to be structured similarly, even when their outward appearance is very different. For example, all insurance policies must have a section where the insured persons or property are identified. Further, the policy must contain a grant of coverage that describes the insurer’s promises under the contract. Sometimes, when more than one type of coverage is provided by the policy, the contract will contain several separate coverage grants. When multiple coverages are included in one policy understanding how to read a policy is even more critical.

Insurance policies contain the following parts.

Declarations (sometimes called the information page)

Insuring agreement

Covered perils (property policies)

Exclusions

Definitions

Conditions

Endorsements

Each component serves a separate and distinct purpose. As stated above, some policies may contain more than one of each type of component. For example, it is common for each separate coverage to have its own insuring agreement, exclusions, definitions, and conditions. However, the policy may also contain a set of “master” exclusions, definitions, and conditions that apply to all coverages (unless otherwise specified). This concept is explained further below.

Declarations The declarations provide information about the insured, the policy, and the insurer. It is here that items such as the name and address of the insured, the type of organization (e.g., partnership, corporation, LLC), the policy period, policy limits, deductible(s), and premium are set forth. Any endorsements attached to the policy are also normally listed in the declarations.

Because the information in the declarations can be binding, it is extremely important that this information is correct. Examine this part of the policy carefully to ensure the information conforms to the specifications used to procure the coverage from the insurer. For each endorsement listed, make sure the corresponding endorsement is actually attached; likewise, make sure no additional and unexpected endorsements are attached.

Insuring Agreement The insuring agreement grants the coverage provided by the policy. Typically very broad in scope, this agreement sets forth the insurer’s basic promises under the policy. For example, the standard commercial general liability insurance policy insuring agreement promises that the insurer will pay for all liability arising from bodily injury or property damage occurring during the policy period and in the policy territory. A builders risk policy might promise to pay for all direct damage to insured property arising from any cause.

The insuring agreement places only a few restrictions on the coverage provided by the policy. The real scope of coverage, therefore, is determined by the policy’s exclusions and definitions.

Where multiple coverages are provided in a single policy, each coverage is likely to have its own insuring agreement. This allows the policy drafters to tailor the insurer’s promise for each coverage area.

Covered Perils Most property policies contain a covered perils section. Some forms include this as part of the coverage grant in the insuring agreement, but it is always addressed somewhere in the policy. All risk policies, also called “open perils policies,” will address this matter by agreeing to cover all causes of loss except those that are excluded. These policies then rely on the exclusions to avoid covering certain perils, such as flood, earthquake, and inherent vice. Named peril policies, on the other hand, agree to cover “the following causes of loss,” and list exactly which perils are covered. They avoid covering certain perils, such as flood, earthquake and inherent vice, by simply not including them in the list of covered perils. Generally speaking, but not in all cases, all risk policies provide the broader scope of coverage.

Exclusions Exclusions limit the coverage granted in the insuring agreement. Exclusions can apply to specified perils (e.g., earthquake or flood), certain types of property (e.g., trees or money) or specified types of losses (e.g., testing losses or intentional losses). For example, the standard workers compensation and employers liability policy excludes bodily injury occurring outside the United States, its territories or possessions, or Canada; however, the exclusion does not apply if the injury is to a citizen of the United States or Canada who is temporarily outside these countries. Most exclusions serve one of the following purposes. They are described in detail below.

Eliminating or reducing overlapping coverage

Removing coverage not needed by typical insureds

Reducing the incentive to create losses and providing the insured with an incentive to try to prevent losses

Removing coverage for uninsurable risks

Eliminating or Reducing Overlapping Coverage Without exclusions, many different policies could easily respond to the same loss. For example, the CGL excludes employers liability losses, except those that are assumed in an insured contract; the workers compensation and employers liability policy, in contrast, covers employers liability losses except employers liability assumed in a contract. (An employers liability claim is a liability claim brought by an injured employee in lieu of accepting workers compensation benefits). Arranging these

policies to “dovetail” instead of overlap avoids charging the insured twice for the same coverage and reduces the number of conflicts between insurers. Similar approaches are taken to coordinate the CGL policy with specific auto, aircraft, and watercraft polices. Likewise, the business auto policy contains exclusions to cause it to coordinate with CGL and workers compensation policies.

Removing Coverage Not Needed by Typical Insureds Sometimes the insurer is willing to provide coverages most insureds are not interested in obtaining because they have no real exposure. Because the rating structure, which is generally based on some general exposure basis, such as payroll or revenues, does not always reflect an insured’s actual exposure, some insureds could end up paying for quite a bit of coverage they do not need. In this case, the standard policy will have an exclusion for the exposure and an optional endorsement will be available to buy back the coverage.

Reducing the Incentive To Create Losses and Providing the Insured with an Incentive To Try To Prevent Losses These motivational factors are often referred to as moral hazards and morale hazards. Moral hazards refer to the insured’s incentive to try to profit from the insurance, often by engaging in an illegal activity. For example, in a highly publicized scandal in Texas, over a dozen vehicles were discovered at the bottom of a swampy pit. All of the vehicles had been reported stolen by the owners, and all of the thefts had been submitted to their insurers as claims. Upon investigation, many of the owners admitted to dumping the vehicles and lying about the theft to collect the insurance. A morale hazard, on the other hand, simply reduces the insured’s incentive to diligently protect against loss because the insurance will pay for it. For example, the CGL policy excludes coverage for property damage to a contractor’s own work to avoid encouraging poor quality workmanship which it would then be required to cover.

Removing Coverage for Uninsurable Risks Some risks, such as general business risks, are considered uninsurable. For example, a company cannot buy insurance to reimburse any expenses it incurs in developing and marketing a product that fails in the marketplace. This is part of the risk of doing business. Other types of risks are uninsurable simply because insurers are unwilling to write the coverage, such as flood insurance in a flood zone. The federal government stepped in to underwrite this coverage because the private market refused to do so.

Definitions Key words and phrases in insurance policies are often assigned precise definitions as they are used in the policy. Undefined terms are assigned their ordinary meaning, such as that found in a regular dictionary. The definitions of key terms should be carefully studied, as they can play just as important a role as exclusions in determining coverage under a policy.

Defined terms are usually marked in some way when they appear in the policy; some policies use bold print, while others use italics or quotation marks to denote defined terms. Most policies define terms in a separate “Definitions” section, but sometimes the same term will be assigned different meanings in different sections of the policy. In that instance, the term may be defined separately in each section, or under each coverage section of the policy.

Conditions The conditions section enumerates both the insured’s and the insurer’s rights and responsibilities under the policy. For example, the terms under which the policy may be canceled are set forth here. Other items typically addressed in the conditions section of an insurance policy include subrogation rights, the insured’s duties in the event of a loss, and how losses will be apportioned between insurers when more than one policy applies to a loss. It is important to make note of the conditions and abide by them, particularly the notice of loss provision, as a violation of a condition can lead to a coverage denial.

Endorsements Because most insurance policies are drafted to meet the common need of a variety of businesses or insureds, some insureds’ needs will not be adequately addressed by the policies. Rather than drafting a manuscript policy for each insured with special needs, insurers use endorsements to tailor the terms of the standard and nonstandard policies to the needs of the individual insured. (Sometimes endorsements are called “riders,” most commonly with contract bonds and in commercial crime insurance.)

Some of the purposes for which endorsements are used include the following.

Granting additional coverage

Restricting or eliminating coverage provided in the basic policy

Changing coverage by changing or adding definitions

Modifying the rights of the insurer or insured by changing or adding conditions

Scheduling covered persons, projects, or property

Standard endorsements exist for many common modifications, such as adding another party as an additional insured on the policy. For example, contractors are commonly required to add project owners and architects as additional insureds on their general liability policies and standard endorsements are available for achieving this.

If no standard endorsement is available for making the desired modifications, a manuscript endorsement can be drafted and added to the policy. For example, until recently, there was no standard endorsement for removing coverage from a contractor’s general liability policy for operations covered by a wrap-up insurance program. (Under a wrap-up, also called owner controlled insurance program (OCIP) or contractor controlled insurance program (CCIP), the owner or prime contractor buys most of the needed insurance for nearly all the involved contractors.) Legal counsel should be consulted in drafting manuscript endorsements to ensure they accomplish the intended purpose, and to avoid making unintended alterations to the policy.

Some endorsements are quite straightforward and brief; others resemble a separate insurance policy, having their own grant of coverage, exclusions, and conditions. Although they may seem to stand on their own, endorsements are attached to the policy, and are thus subject to the same terms and conditions of the policy, except where they specifically declare the terms of the basic policy to be changed or replaced by those in the endorsement.

Endorsements are often added to policies during the policy term. Any such endorsements that are added mid-term should be carefully reviewed to assure their impact is understood and agreeable to the contractor. Insurers have very limited rights to alter the coverage provided by an insurance policy after its proposal is accepted and bound, and any mid-term coverage restrictions may be negotiable.

Once any discrepancies have been explained or corrected, all endorsements should be physically attached to the policy.

Insurance Policy Review When an insurance policy is received, it should be reviewed thoroughly to ensure it complies with the specifications used to obtain proposals (if it is a new policy), or to make sure no unexpected changes have been made from the previous policy (if it is a renewal policy). The information on the declarations page should be verified, and all requested endorsements should be attached (verify these by both name and number). Any questions regarding the policy, such as additional or unexpected endorsements, should be explained by the insurance representative or underwriter before the policy is filed away. In some cases it may be prudent to ask the underwriter for a letter or endorsement clarifying any discrepancies or apparently conflicting policy provisions rather than relying on verbal assurances. (The underwriter may or may not agree to this, but it is worthwhile to ask for it. At a minimum, take detailed notes from conversations with the underwriter regarding questions of coverage, and keep them with the policy.)

Because insurance policies can get very long and complicated, it can be useful to make a photocopy of the policy on which notes can be made in the margins. For example, if the contractors equipment policy includes an endorsement that adds coverage for borrowed property, that fact should be noted in the margin next to the definition of covered property. This makes determining whether a loss is covered much easier, and can help assure important information is not missed when filing a claim or in fighting an insurer’s denial of a claim. Also, make note of coverage available in other policies next to exclusions for those types of losses. For example, the general liability policy excludes employers liability claims, but there may very well be coverage (depending on the circumstances of the loss) under the workers compensation and employers liability policy.

Checklists are a useful tool for verifying coverages, particularly in nonstandard forms, and for identifying necessary coverage modifications. IRMI publishes insurance coverage checklists that can be used for this purpose in its Construction Risk Management reference manual and in IRMI Insurance Checklists. While these can be very helpful, no cookie-cutter document can address all the unique aspects of a particular risk. Therefore, these checklists should be considered only one tool in implementing and managing an insurance program.

Construction Insurance Programs Numerous insurance policies are usually needed to cover the risks presented by a construction project. To a great extent, the coverage provided by these policies are designed to “dovetail”; that is, definitions of covered property and other policy provisions are drafted to create in one policy the exact coverage that was excluded by another policy. For example, the standard ISO automobile liability and general liability insurance policies coordinate the coverage for the use of certain “autos” with permanently attached equipment so that coverage is provided in the auto policy when the vehicle is being used for transportation, and in the general liability policy when it is being used as mobile equipment (e.g., to raise or lower workers). However, in some cases, it is necessary to request standard or manuscript endorsements to prevent gaps in coverage. The next three chapters briefly describe the major lines of insurance purchased by contractors.

Chapter 2 Review Questions 1. All of Hancock Construction’s insurance policies are written on standard forms promulgated

by industry-supported organizations. All but one of Hancock Construction’s property and liability insurance policies were promulgated by Insurance Services Office (ISO), but another organization developed its:

a. business auto policy.

This answer is incorrect. Business auto insurance is one of the major lines of commercial insurance for which ISO prepares standard policies.

b. general liability policy.

This answer is incorrect. ISO provides standard commercial general liability (CGL) forms.

c. property insurance policy.

This answer is incorrect. Commercial property insurance forms are promulgated by ISO and AAIS.

d. workers compensation policy.

That is correct! The National Council on Compensation Insurance (NCCI) promulgates the standard workers compensation policy used in most states.

2. Most commercial insurers in one state use standard insurance policy forms in lieu of drafting and filing their own forms. A new insurance commissioner has experience with consumer affairs, but no experience in the insurance industry. He asks his chief actuary why insurers don’t simply develop their own forms instead of paying fees to others to do it. The actuary tells him that there are many benefits to using standard forms for agents, insurers, and insurance buyers. They include all of the following except:

a. It is easier to determine the scope of coverage when the policy forms to which caselaw applies are consistent with one another.

This answer is incorrect. One advantage of standard policy forms lies in the fact that the application of caselaw to consistent policy terms helps define the scope of coverage.

b. The use of standard forms enhances insurers’ ability to set rates using pooled loss data.

This answer is incorrect. The ability to set rates using pooled loss data is enhanced when an insurer uses standard forms.

c. The use of standard forms increases competition on the basis of coverage rather than price.

That is correct! When all insurers offer the same coverage, insurance buyers will compare insurers on the basis of price, not coverage.

d. With standard forms, it is easier to make generalizations about coverage.

This answer is incorrect. Standard forms increase one’s ability to make generalizations about coverages.

3. Jeremy & Dilys Excavators is legally a partnership. Where in their commercial general liability policy would this information be found?

a. Conditions

This answer is incorrect. The conditions enumerate the insured’s and the insurer’s rights and responsibilities under the policy.

b. Declarations

That is correct! The type of organization (e.g., partnership, corporation, etc.) is set forth in the policy’s declarations.

c. Definitions

This answer is incorrect. The definitions assign precise meanings to key words and phrases that are used in the policy.

d. Insuring agreement

This answer is incorrect. The insuring agreement sets forth the insurer’s basic promise to grant coverage.

4. Hancock Contractors’ commercial property insurance policy contains many exclusions. Which of the following is one of the reasons for these exclusions?

a. To give Hancock an incentive for preventing losses.

That is correct! Contractors are more likely to control losses that they have to pay for because they are excluded by the contractor’s insurance.

b. To increase the likelihood of duplicate coverage for major exposures.

This answer is incorrect. Many exclusions are designed to eliminate or reduce coverage overlaps.

c. To provide specific coverage for uninsurable risks.

This answer is incorrect. Exclusions typically remove coverage for risks that are deemed to be uninsurable.

d. To remove coverage needed by typical insureds.

This answer is incorrect. Exclusions often remove coverage for an exposure that could be insured when most insurance buyers do not have that exposure.

5. One section of Grave Excavation’s general liability policy includes a series of Conditions. Which of the following would most likely be included in the Conditions section of this policy?

a. Definition of subrogation.

This answer is incorrect. The conditions only describe the insurer’s subrogation rights.

b. Insurance company’s name and address.

This answer is incorrect. The insurer is identified in the declarations.

c. Insurer’s responsibilities in the event of a loss

That is correct! The conditions section of an insurance policy typically set forth the insured’s duties in the event of a loss, as well as the insurer’s rights and responsibilities under the policy.

d. Insuring agreement

This answer is incorrect. The insuring agreement is a different section of the policy.

Chapter 3 Casualty Insurance Survey

Learning Objective

Explain the essential elements of commercial general liability, commercial auto, workers compensation, and umbrella liability insurance.

This chapter provides a brief summary of the basic lines of casualty insurance that contractors typically purchase. “Casualty insurance” is a name for the types of insurance that cover the insured for claims made against it by third parties as opposed to property, or first-party insurance, which reimburses the insured for losses it suffers when its property is damaged, destroyed, or stolen. The types of casualty insurance described in this chapter include the following.

Automobile Insurance

Commercial General Liability Insurance

Umbrella Liability Insurance

Workers Compensation Insurance

These are the casualty insurance lines purchased by virtually all contractors, and they form the bedrock of a contractor’s liability insurance program. However, there are also some other types of liability policies that some contractors need to buy. The most notable of these are contractors pollution liability insurance (to fill in gaps created by the commercial general liability policy’s pollution exclusion) and contractors professional liability (when the contractor employs design professionals). Other types of liability insurance that may be needed by contractors, depending on their operations, include directors and officers liability, employment practices liability, fiduciary liability, aircraft liability (and hull), and watercraft liability insurance. Since this course covers only the fundamentals of construction insurance, none of these policies are addressed further.

Automobile Insurance Automobile insurance policies provide two types of coverage. They insure liability for injuries to others and/or damage to their property (“bodily injury liability and property damage liability”) and damage to the insured’s own vehicles. The liability coverage is generally referred to as automobile liability insurance, while damage to owned vehicles is referred to as automobile physical damage coverage. Most contractors are covered under a policy called the business auto policy (BAP), or the business auto coverage (BAC) form.

Besides covering exposures associated with owned vehicles, liability insurance may cover liability arising out of operation of nonowned vehicles in cases such as when an employee uses a personal car to run an errand. It can also cover liability arising from a hired auto—one that the contractor leases, hires, rents, or borrows.

There are two basic types of physical damage coverage usually provided for owned autos: collision and comprehensive. The collision coverage insures against damage from collision with another vehicle or object as well as from overturning. The comprehensive coverage provides protection against damage from other types of perils such as hail, fire, vandalism, and flood. Additionally, there are several secondary coverages such as medical payments, personal injury protection (PIP), and towing.

Automobile liability insurance is subject to a per accident limit of liability. The specified per accident limit is the most it will pay for liability arising out of a single accident regardless of how many people are injured or claims made. The physical damage coverage does not provide for a specific limit of liability for the insured vehicles. Instead, physical damage coverage covers the lesser of the cost to repair the vehicle, the cost to replace the vehicle with a like vehicle, or the actual cash value of the vehicle at the time of the loss. Actual cash value is the cost to replace the vehicle with a new vehicle less a deduction for depreciation.

The policy automatically applies with respect to liability for all owned vehicles and, subject to certain conditions, for auto physical damage. Thus, while some insureds report fleet additions and deletions during the year, it is usually necessary to report changes only at the end of the year with the insurance company making the necessary premium adjustment at that time. This saves substantial administrative costs for the insured, the insurance agent, and the insurance company.

Commercial General Liability Insurance The commercial general liability (CGL) policy protects the insured against lawsuits alleging bodily injury or property damage. Think of it as lawsuit insurance. In other words, the policy covers defense costs, awards, or settlements associated with lawsuits brought by third parties who are injured by the insured’s premises, operations, products-completed operations, or independent contractors. The policy also automatically includes contractual liability insurance, meaning that it provides protection to other parties whom the insured agrees in a construction or other business contract to “hold harmless and indemnify.” The CGL policy does not cover liability arising from aircraft, most watercraft, or automobiles. Separate policies must be purchased to cover these risks.

The policy covers the named insured contractor as well as the contractor’s officers, directors, and employees with respect to their liability as such. Owners and other contractors can be added as additional insureds by endorsement, subject to concurrence of the underwriter and, sometimes, an additional premium.

Some of the important exposures for which coverage is excluded or limited in CGL policies include the following.

Many types of pollution liability, especially if the contractor owns, transports, or handles the pollutant

Financial loss not involving bodily injury or property damage resulting from breech of contract (e.g., delay in completion)

Property damage to the work of the insured arising from that insured’s work (i.e., construction defect) once the project is completed

Chapter 3—Casualty Insurance Survey

Liability to an employee for discrimination or other employment practices

Endorsements excluding coverage for design error are often attached to contractors CGL policies

Separate policies can be purchased to cover some of these excluded liability exposures. In particular, contractors should consider purchasing contractors professional liability or contractors pollution liability insurance if their operations present design or environmental liability exposures. Also, employment practices liability insurance (EPLI) is available to cover suits by current or former employees alleging discrimination, wrongful termination or other employment related wrongs.

The CGL policy’s premises-operations bodily injury and property damage coverage is subject to an each occurrence limit and a general aggregate limit. The each occurrence limit is the most the policy will pay for all bodily injury and property damage claims arising out of a single accident or event. The general aggregate limit is the most the policy will pay for all premises-operations claims during the policy period. For example, if the policy has a $1 million each occurrence limit and a $2 million general aggregate limit, it could pay the each occurrence limit twice during the policy period, which is usually a year. The general aggregate limit can be amended by endorsement to apply separately to each of a contractor’s projects, and this is a worthwhile coverage extension to request.

A separate each occurrence and aggregate limit applies to the CGL policy’s products-completed operations coverage. Thus claims paid under products-completed operations coverage will not affect the limit available under the premises-operations coverage and vice versa.

Personal and Advertising Injury Coverage In addition to coverage for bodily injury and property damage liability, the CGL policy also provides “personal injury and advertising injury” liability coverage. The personal injury portion of CGL insurance protects against suits brought by others alleging libel, slander, defamation of character, false arrest, disparagement of goods, and similar allegations. The advertising injury coverage insures against disparagement of goods, slander, copyright infringement, and similar allegations that may arise in connection with the contractor’s advertising activities. This coverage is subject to an each person limit, and claims paid under the coverage are deducted from the general aggregate limit discussed above.

Medical Payments Coverage A CGL policy also provides a type of “no fault” medical payments coverage. This coverage will reimburse the contractor for medical bills paid on behalf of others who are injured on the contractor’s premises or by the contractor’s operations, subject to a $5,000 per person limit. Taking this approach to medical expenses is thought to reduce the likelihood that injured parties will bring a lawsuit.

Umbrella Liability Insurance Umbrella policies provide excess coverage over the limits of the underlying, or primary, liability policies. The applicable primary coverages generally include the commercial general liability (CGL) policies, the liability coverage of the business auto policy, and the employers liability coverage of the workers compensation policy. Sometimes an umbrella can be arranged to provide excess coverage over professional liability or pollution liability insurance as well. In those areas where the umbrella provides broader coverage, the policy would drop down to a self-insured retention of usually $10,000 or $25,000. In other words, the contractor would be required to pay the first $10,000 or $25,000 of a loss not covered by the primary insurance (but covered by the umbrella) and then the umbrella would pay amounts in excess of this self-insured retention.

The application of the umbrella policy is fairly simple. Assume that the liability limit of an insured’s auto policy is $1 million, and the umbrella provides a $3 million limit. An automobile loss occurs that involves an ultimate claim of $2 million. The auto policy would exhaust its per accident limit by paying $1 million and then the umbrella would pay the $1 million of loss that exceeds the first $1 million. But if a $1 million loss occurred that was not covered by a primary liability policy, the insured would be responsible for the first $25,000 (a self-insured retention) and the umbrella policy would pay the next $975,000.

The scope of coverage provided by umbrellas generally parallels that afforded by the primary CGL, auto, and employers liability policies. Unlike the standard commercial general liability, business auto, and workers compensation policies, most insurers do not utilize an industry standard umbrella policy form. Instead they develop their own forms as well as special endorsements to tailor coverage with respect to contractors. As a result, there is a tremendous amount of variation in umbrella forms. In fact, IRMI has identified more than 180 types of variations in the wording of umbrella forms used in the current marketplace. Therefore, these forms must be carefully reviewed and compared when they are purchased.

When reviewing an umbrella pay particular attention to the “contractors limitation endorsement.” Most insurers have one or more forms of this endorsement, which is designed to address significant nuances of construction exposures. These endorsements will exclude all or part of the exposures related to design or construction defect and claims arising from projects insured under wrap-up (OCIP) programs or joint ventures. Since there can be substantial variations in these endorsements—and some insurers have more than one with differences in the extent of their restrictions—they should be carefully studied and the subject of negotiation.

In summary, the primary function of umbrella policies is to provide high limits of liability above general, auto, and employers liability insurance for catastrophic losses. They also usually “drop down” to become first-dollar insurance if the aggregate limits of these primary policies are exhausted because of loss frequency.

Most contractors should purchase at least $1 million in umbrella coverage over their primary policies, and many should purchase much higher limits than that. In fact, many insurance professionals believe that $5 million is the least that any commercial enterprise should buy. Unfortunately, there are no formulas to help select the appropriate limit for a company. However, in making this decision, consider such things as the following.

Net worth of the company

Size of the largest project

Annual revenues

Value of the most valuable structure in which the contractor performs operations

Litigiousness of the communities in which the contractor operates

Typical contract requirements

Workers Compensation At the beginning of this century, the United States was emerging as an industrialized nation while society was developing a social conscience. In those days, employees who were injured on the job had to sue their employer under common law to obtain benefits. Employers had basic common law defenses that were very difficult to overcome in court and, since many employees had very little, if any, savings, it was virtually impossible for them to hire an attorney. As a result, injured employees and their families often ended up in the poorhouse.

Starting in 1911 with Wisconsin, each state began to pass workers compensation statutes that amounted to a trade-off between the employer and the employee. Under these statutes, the employers agreed to give up their common law defenses and, in return, enjoyed a limitation on their liability for weekly indemnity and medical benefits. Employees gained by receiving “no fault” benefits if injured on the job. Each state individually passed its own workers compensation statute and, in 1927, Congress passed the U.S. Longshore and Harbor Workers Compensation Act, providing benefits to longshoremen, who were not covered under the individual states’ statutes.

The United States is the only major industrialized nation that has a private workers compensation system. In most countries, workers compensation is part of a social security program. There are five U.S. states that do not allow the private insurance industry to fund benefits. Instead, monopolistic state funds have been established in North Dakota, Ohio, Washington, West Virginia, and Wyoming. When contractors have operations in these states, they must purchase coverage from the monopolistic state fund. In Arizona, California, Colorado, Hawaii, Idaho, Kentucky, Louisiana, Maine, Maryland, Minnesota, Missouri, Montana, New Mexico, New York, Oklahoma, Oregon, Pennsylvania, Rhode Island, Texas, and Utah, competitive state funds compete in the open marketplace with private industry.

The Workers Compensation Policy Benefits provided to employees are covered by the standard workers compensation and employers liability policy in most states. This standard form was drafted by the National Council on Compensation Insurance (NCCI) and filed with most states on behalf of insurers. Today’s workers compensation policy has three basic coverage parts.

Part One provides coverage for the statutory liability of the employer under the specified state statutes. Rather than insuring a specific individual or a class of individuals, the employer insures the liability created by state statutes. However, some employees—such as domestic help and agricultural employees—as well as sole proprietors/partners are often excluded under the law and have to be specifically added to the policy for coverage to apply. Since the state statute establishes how much injured workers receive in benefits, there is no limit of liability applicable to this coverage.

Part Two provides coverage for any liability to an employee presented to the employer under common law. Such coverage is known as employers liability insurance. It applies in those few situations where the employee can elect not to come under the workers compensation statute. In most states, if the employee decides to press a common law liability suit, benefits under Part One are forfeited. This coverage does have limits of liability. There is an each accident limit which applies to all claims arising from a single accident, a bodily injury by disease limit applicable to each ill employee, and a bodily injury by disease aggregate limit which is the maximum payable under the policy for all ill employees.

Part Three provides for statutory benefits when employees can press claims in states other than those where they are working. This other states coverage may come into play when, for example, an employee is injured while traveling in a state that provides higher benefits than the state in which he or she normally works. This coverage should be structured to apply to all states except those specified in Part One and the monopolistic fund states listed above. It is important to understand, however, that this coverage is only intended when there is incidental exposure in a state not scheduled for coverage under Part One. When a contractor begins to operate in a state not scheduled for coverage under Part One, this information should be provided to the insurer.

Chapter 3 Review Questions 1. Franklin Contracting’s auto insurance policy includes automobile physical damage

coverage. Which of the following is an example of a loss to which this coverage would apply?

a. A bolt of lightning sets Franklin’s truck on fire.

That is correct! Physical damage coverage covers damage to an owned auto that is covered under the policy.

b. A gasoline leak from Franklin’s truck damages a customer’s asphalt driveway.

This answer is incorrect. The gasoline leak would produce an auto liability claim.

c. Franklin’s truck driver dumps a load of gravel at a work site without realizing a small car had just parked right behind the truck.

This answer is incorrect. The property damage to the small car would be a property damage liability claim.

d. Franklin’s truck strikes and injures a jaywalker.

This answer is incorrect. This incident would probably result in a bodily injury liability claim.

2. Hancock Contracting owns a number of vehicles which it insures under a business auto policy. Which of the following losses would not be covered under the policy’s collision coverage?

a. A foreman arrives at a construction site one morning and discovers that one of the company’s trucks has been vandalized.

That is correct! Comprehensive coverage applies to vandalism.

b. A foreman is driving one of the vehicles on his way to a meeting with an architect for a project when he loses control on a slick road and overturns the vehicle.

This answer is incorrect. Overturn losses are covered under the collision coverage.

c. A foreman is driving one of the vehicles to a construction site when he has a minor collision with another vehicle.

This answer is incorrect. Damage to Franklin’s vehicle from this collision (but not damage to the other vehicle) is covered by Franklin’s collision coverage.

d. A foreman is driving to a construction site early one morning and is rear ended by a hit-and-run driver.

This answer is incorrect. Collision coverage applies even when another driver, who might ultimately be held liable, causes the collision.

3. Adams Contracting has a CGL policy with a $1 million each occurrence limit and a $2 million general aggregate limit. Three suits pertaining to three separate premises-operations bodily injury incidents that occurred during the policy term are filed against Adams. They are settled for $300,000, $1 million, and $2 million respectively. What is the total amount that Adams’s CGL will pay for these three settlements?

a. $300,000

This answer is incorrect. The $300,000 claim is not large enough to consume all available limits.

b. $1 million

This answer is incorrect. $1 million is the maximum amount that will be paid for a single claim, but more than one claim was incurred.

c. $2 million

That is correct! The insurer’s total liability is limited to the annual aggregate.

d. $2,300,000

This answer is incorrect. Adams’s liability limits are not adequate to pay all claims incurred that year.

4. Washington Builders has a CGL policy and an umbrella policy. The CGL policy has a $2 million limit. The umbrella policy has a $5 million limit with a $10,000 self-insured retention. If a $100,000 loss occurs that is not covered by the CGL but is covered by the umbrella, how much would Washington Builders be required to pay towards this loss?

a. Nothing

This answer is incorrect. Washington’s insurance would not cover the entire loss.

b. $10,000

That is correct! Washington would be required to pay $10,000 of any loss not covered by the primary insurance but covered by the umbrella.

c. $90,000

This answer is incorrect. $90,000 is what one of the insurers would pay.

d. $100,000

This answer is incorrect. Washington’s insurer would not cover the entire loss.

5. Lehigh Builders is going to construct a tunnel in Virginia, a state that has neither a monopolistic nor a competitive state fund. What does this mean in regards to workers compensation insurance?

a. Lehigh does not have to purchase workers compensation insurance.

This answer is incorrect. Lehigh will have to purchase workers compensation insurance from an available source.

b. Lehigh will have to purchase workers compensation insurance from a private insurer.

That is correct! When a monopolistic or a competitive state fund is not available, workers compensation insurance is provided in the open marketplace by private industry.

c. Lehigh will have to purchase workers compensation insurance from another state’s fund.

This answer is incorrect. Each state fund operates within a single state.

d. Lehigh’s employees will have to sue Lehigh should they want workers compensation benefits.

This answer is incorrect. Workers compensation insurance provides statutory coverage on a no-fault basis which eliminates the need to sue to obtain benefits under the common law.

Chapter 4 First-Party Insurance Survey

Learning Objective

Explain the essential elements of, builders risk, contractors equipment, commercial property, and commercial crime insurance.

This chapter provides a brief summary of the basic lines of first-party insurance that contractors typically purchase. First-party insurance indemnifies the insured for loss it sustains when its property is damaged, destroyed, or stolen. The insurance company, the second party, covers the policyholder, the first-party, against damage. This is as opposed to “casualty insurance” or “third-party insurance,” in which the insurer (the second party) covers the insured (the first party) for liability claims made against it by third parties. The types of first-party insurance described in this chapter include the following.

Builders Risk Insurance

Contractors Equipment Insurance

Commercial Property Insurance

Commercial Crime Insurance

Before delving into these specific types of first-party insurance, however, a few basic concepts of first-party insurance are addressed.

Basic Concepts of First-Party Insurance There are a number of basic elements common to all types of first-party insurance. Regardless of the type of property insurance being reviewed, it is important to consider them. These include the following.

Covered perils

Covered property

Valuation

Insurance to value requirements

Deductibles

Covered Perils A peril is something that causes a property loss. This includes such events as fire, flood, earthquake, windstorm, vandalism, collapse, smoke, vehicle or aircraft collision, hail, riot, or explosion. Obviously, the scope of perils covered by a property insurance policy is a key element affecting the quality of the coverage provided. Most policies take one of two approaches. The first is to specifically list all of the covered perils—if a peril is listed, the policy covers it; if not it doesn’t. The other approach is for the policy to apply on an “all risks” or “open perils” basis. A property policy written on this basis doesn’t list the covered perils; rather, it indicates that it covers loss from any cause except those perils that are specifically excluded. It then lists the perils that are not covered. Generally speaking—but certainly not in every case—the all risk or open perils policies provide a broader scope of coverage than do named perils policies.

Covered Property Most property insurance policies specifically list the types of property they insure and/or the types of property they do not insure. Therefore, it is very important to review these items to assure that all the key property that may be exposed to loss is covered.

Valuation There are various approaches used to determine the value of property that has been damaged or destroyed, but the two most common are replacement cost and actual cash value. Replacement cost value is generally defined as the cost to replace new today with materials of like kind and quality. Although the term “actual cash value” is seldom defined in the policy, most courts have upheld the insurance industry’s traditional definition: the cost to replace new today with materials of like kind and quality, less depreciation. Choosing a replacement cost policy will result in a higher premium because the limit of insurance, which is multiplied by the rate to derive the premium, is higher. However, it will provide for a larger insurance recovery following a total loss.

Insurance to Value Requirements The rates used to calculate premiums for property insurance are developed with the assumption that the insured will fully insure the value of its property. If insureds routinely purchased only partial limits to cover their property, much higher rates would be necessary to develop the premiums needed to cover losses. For this reason, property insurance policies often have provisions that provide an incentive to insure to value by penalizing the insured if, at the time of loss, the amount of insurance is not above a specified percentage of its total value. Generally, the amount insured must be 80 percent of the value when the policy is written on an actual cash value basis and 90 percent of value when written on a replacement cost basis.

The mechanism used to initiate this penalty is called a coinsurance clause. Thus, it is common for a policy to have an 80 percent or 90 percent coinsurance clause. An 80 percent coinsurance clause would, in effect, require a building valued at $100,000 to be insured for at least $80,000, and a 90 percent clause would require $90,000. The coinsurance clause provides a formula for calculating whether a penalty applies and the extent of the penalty if it does. The formula is the amount purchased divided by the amount required multiplied by the amount of the loss.

As an example of a coinsurance clause, assume a contractor’s office building has an actual cash value of $500,000 and an 80 percent coinsurance clause applies. The required minimum amount of insurance would then be $400,000, but let’s assume the contractor only purchases $300,000 of coverage. The building suffers $100,000 of damage in a fire. The contractor would recover only

Chapter 4—First-Party Insurance Survey

$75,000 for this loss. This would be calculated as $300,000/400,000 X $100,000. Thus, the contractor suffers a $25,000 penalty as a result of the inadequate insurance to value. This is called a coinsurance penalty.

There is really no reason to experience a coinsurance penalty. The first step is to ascertain the value of the property being insured, and contractors are particularly capable of this. The second step is to demonstrate to the insurer that the property is insured to value and request that the coinsurance clause be waived in the policy. Most insurers will consent to this request if they believe the property values are correct. The endorsement used to accomplish this is usually called an “agreed amount endorsement.” The third step is to periodically update the reported values of the insured property.

Deductibles Virtually all property insurance policies will have one or more deductibles applicable to recoveries under the policy. The deductible serves the purpose of eliminating the need to run smaller claims through the insurance mechanism, which is inefficient for insured and insurer alike. In return for taking the deductible, the insured pays a reduced premium.

Commercial property forms vary somewhat with respect to how deductibles are applied. Some policies impose a single deductible to be subtracted from the total amount of loss claimed under the form, which is a very favorable approach for the insured. Other forms apply the stated property damage deductible separately to each building, to the contents of each building, and to property in the open. It is also common to have separate deductibles applicable to certain catastrophic perils, such as earthquake, flood, and windstorm on coastal properties.

When securing property insurance proposals it is wise to obtain quotes at several different deductible levels and evaluate the reduced premium against the additional assumption of risk. Of course, it is also important to take into account any differences in the application of the deductibles as discussed above.

Builders Risk Insurance The first-party insurance covering a construction project during the course of construction may be the most important insurance protecting the contractors on the project and the project owner. If there is a property loss that isn’t covered by this insurance, costly litigation between the parties is very likely. Thus, this insurance should be considered the foundation of a construction insurance program—poorly arranged property insurance on the project can lead to collapse of the entire insurance program.

Construction projects involve unique risks not contemplated by the coverage forms, underwriting approaches, and rating methods used to insure existing buildings and contents. Structures under construction are much more subject to damage from the elements—windstorms, earthquakes, rain, hail, etc.—than completed structures. Also, construction project property values do not remain stable throughout the policy period. Instead, the insurable value of a construction project is minimal at the beginning of the job and continually increases until completion—often beyond the originally anticipated completed value. During the project, property to be used in the construction may be owned by many different parties, namely the general contractor, subcontractors, and the owner. Property may be located at the job site, at off-site storage locations, or in transit.

It is sometimes possible, although usually inadvisable, to obtain at least partial coverage for construction projects under the property forms used to insure existing building(s). However, coverage limitations in standard property insurance forms make this approach undesirable for all but the most modest construction or renovation projects. The most obvious drawbacks are the lack of coverage for property off premises and in transit, and potentially inadequate limits. In addition, commercial property policies typically have considerably more exclusions than inland marine policies do—and most builders risk policies (certainly most good builders risk policies) are inland marine forms.

Aside from coverage limitations, a number of other considerations make standard commercial property coverage forms inappropriate for insuring property under construction. The underwriter for the insured’s permanent property insurance program may have neither the knowledge nor the experience to properly underwrite, rate, and structure coverage on a construction project.

Lastly, any adverse loss experience on the construction project may affect the marketability of the owner’s overall property insurance program in the future. This disadvantage is frequently overlooked until a large loss occurs as a result of the negligence of one or more contractors. The owner then feels that the responsible party should pay the loss rather than the owner’s property insurance. In such a situation, the owner is unlikely to cooperate with the contractor in settling the claim and may even work against the contractor.

Builders risk policies are specialized “inland marine” policies designed to cover the property loss exposures that are associated with construction projects. Inland marine is a specialized category of first-party insurance designed to cover mobile property. Inland marine insurance is less heavily regulated by insurance regulators to give underwriters more flexibility in writing these types of policies. These policies also specifically address coverage for such things as materials in transit, materials stored off site, and special construction perils, such as collapse resulting from construction defect. Since they are written separately from the owner’s permanent property insurance program, losses under the builders risk policy will not affect the owner’s property insurance premiums in the future.

The construction contract should specify in its insurance clause who should buy the builders risk policy. Most of the time this is the owner, but the prime contractor is also often assigned the responsibility of procuring it. Regardless of who purchases the policy, it should include all contractors involved in the project as insureds and contain a waiver of subrogation provision applicable to all the insureds. A waiver of subrogation precludes the insurer from bringing a suit against the contractors to recover claims it paid when the losses resulted from the contractor’s negligence. This provision will preempt otherwise expensive and time-consuming litigation.

Sometimes a contractor will be required to provide an installation floater covering its work. An installation floater is essentially a builders risk insurance policy written to cover a specific type of property during its installation. Installation floater coverage is normally purchased by a subcontractor installing highly valued equipment or materials (such as compressors, generators, or other machinery) that are not covered by a builders risk policy. If there is a broad builders risk policy including all involved contractors as insureds, individual installation floaters are usually not necessary. But if there is no builders risk coverage in place, they should be considered. Most insurers use the exact same form to provide both builders risk and installation risk coverage.

Builders risk insurers typically use their own policy forms rather than an industry standard form. Although there are some standard builders risk forms, they contain coverage limitations that make them less desirable than most insurer forms. Since each insurer drafts its own form, there may be substantial variations from one to another. For this reason they should be carefully reviewed.

The broadest builders risk forms are generally written on an “all risks” or “open perils” basis. The excluded perils can vary from policy to policy and should be carefully examined, paying particular attention to how flood, earthquake, collapse, and construction defect are treated.

The property covered under a builders risk policy can vary significantly from one form to another, depending on the wording of the “Property Insured” and “Property Excluded” sections of the policy. Consequently, both sections warrant close examination.

Builders risk policies can be written to reimburse the insured for either the actual cash value or the replacement cost of the property. The only difference between the two valuation methods is the deduction of any physical depreciation or economic obsolescence from the replacement cost in the determination of actual cash value. Usually, physical depreciation and economic obsolescence in connection with new construction would be minimal, or even nonexistent. Nevertheless, replacement cost valuation is recommended, if only as a precaution, since it is readily available and costs no more than the same amount of actual cash value coverage.

While the basic forms insure only direct losses from covered perils, builders risk policies can be endorsed to also insure certain indirect or “time element” losses. These are losses that, while they stem from the damage to the insured property, are not directly related to repairing or replacing the insured property. “Time element” losses may occur when there is a delay in the completion, and therefore the anticipated revenue stream, of a construction project. As these losses can be quite substantial, coverage should be considered whenever a builders risk policy is purchased. Of course, this time element coverage will only apply when the delay results from an insured peril, such as a windstorm, fire, or explosion. Delays from other causes, such as inclement whether, are not covered.

Builders risk time element loss coverage is generally referred to as “delayed opening” (or “delay in completion” or “delayed start-up”) coverage or “soft costs” coverage. “Soft costs” is the term used by developers, lenders, and others in the construction industry to refer to all of the costs associated with a construction project other than the cost of labor and materials, which they refer to as “hard costs.” There are two basic types of delayed opening coverage: loss of earnings coverage and specific delay cost coverage. The “loss of earnings” delayed opening coverage is essentially business interruption coverage adapted for losses to property under construction. Coverage applies to the income (e.g., revenues or rents) that would have been received had there been no delay in completion. Generally, the loss of earning coverage will insure only the owner’s loss and not any loss of earnings experienced by the contractor.

Specific delay cost of delayed opening coverage covers the additional costs made necessary by the delayed completion, regardless of anticipated earnings and regardless of the extent of the insured’s actual income loss. It applies only to the particular types of additional costs that are specified in the endorsement as covered. Covered soft costs that may be listed and defined include additional interest expense, additional real estate taxes, and, sometimes, additional advertising and promotional expense.

Contractors Equipment Insurance Contractors equipment policies are inland marine forms designed to provide insurance against physical damage to the mobile equipment used by contractors in construction projects. Most builders risk policies do not cover this type of equipment; they generally provide coverage only for equipment that is destined to be incorporated into and become part of the project. Commercial property policies, on the other hand, usually do cover this type of equipment (provided it is not licensed for road use), but there are two major problems with the coverage provided: the in-transit coverage is usually very limited or nonexistent, and often there is little or no coverage for property away from scheduled locations.

Contractors equipment policies don’t tie coverage to particular locations at all; as long as it is within the policy territory—usually the United States and Canada—the equipment is covered regardless of its location. And since they are inland marine forms, they also typically have fewer exclusions than commercial property forms. However, there is no standard contractors equipment form, so it is important to review the provisions of each coverage form being considered.

These policies may be written on either an open perils or named perils basis, and there may be substantial differences between the coverage offered by various insurers. Regardless of which type of policy is purchased, however, these forms usually cover theft of the equipment (except theft by employees), which of course is a very important exposure to insure with this line. The valuation is usually on an actual cash value basis, because insurers are reluctant to agree to replace older equipment with new equipment. However, replacement cost coverage can sometimes be arranged on newer equipment.

Coinsurance provisions are also typically included in these policies. While underwriters will sometimes agree to provide coverage on an agreed valuation basis, they are usually reluctant to do so. It will usually be necessary to have excellent documentation demonstrating that the equipment is properly valued to obtain their consent.

Commercial Property Insurance If a contractor’s facilities are damaged or destroyed by a fire or a tornado, the physical damage to the buildings and contents is said to be a direct damage loss. Direct damage property insurance provides funds to pay for the repair or replacement of the damaged property.

An organization that suffers a direct damage loss also may suffer a loss of income or an increase in operating expenses as a result of not being able to use the damaged property while it is being repaired or replaced. These losses are called time element losses, because the amount of the income loss or expense increase depends on how long it takes to repair or replace the damaged property. Time element property insurance pays for the loss of income or the increase in operating expenses that results from suspended or makeshift operations while the damaged property is being repaired or replaced.

Many contractors will not suffer a measurable business interruption loss from loss or damage to their office buildings, and may have little need for this form of time element coverage. However, they are likely to incur substantial extra expenses in resuming their office functions at temporary facilities while their office is being repaired or rebuilt. Extra expense coverage should be considered in these situations.

Both types of commercial property coverage can be written on standard, insurer, or manuscript forms. The commercial property insurance forms drafted by the Insurance Services Office, Inc. (ISO) are

generally recognized as the industry standard forms. Many insurers use ISO forms in issuing at least some of their policies, and most insurers that have their own forms use ISO forms as a basis for developing them. Individual insurer forms usually offer somewhat broader coverage and are used as a competitive tool in attracting especially desirable property insurance business. Manuscript forms are custom-designed forms written especially for a particular business; these forms are generally available only to very large companies. Direct damage and time element coverage are usually provided in a single commercial property policy.

These policies may be written on an open perils or named perils basis with an actual cash value or replacement cost valuation provision. Regardless of whether a named perils or open perils form is chosen, it will generally be necessary to add certain other coverages if the property is exposed to these perils. In particular, the need to cover earthquake, flood, and increased costs of construction from the operation of building codes should be considered as these are not automatically covered under most policy forms.

Commercial Crime Insurance Most organizations need crime insurance of some kind. While commercial property policies written on an all risks basis do cover most types of theft, money and securities do not qualify as covered property, and employee theft—of money or any other type of property—is virtually always excluded. Theft via transfer of property on the basis of unauthorized instructions is usually excluded as well. Finally, some contractors elect to purchase named perils (rather than all risks) property insurance, and named perils forms seldom provide coverage for theft losses.

The need for separate crime insurance, then, can be summarized as follows.

Most contractors need crime insurance to cover employee theft losses, since property policies universally exclude employee dishonesty as a cause of loss.

Any contractor that handles a significant amount of money and securities needs crime insurance, since money and securities do not qualify as covered property under a property policy.

Any contractor purchasing named perils property coverage, whose personal property (other than contractors equipment) is susceptible to theft, needs crime coverage even if little or no money is exposed to loss, since named perils property policies do not cover theft as a cause of loss.

Crime insurance that is designed to meet the needs of contractors and most other businesses is written on what are typically referred to as commercial crime coverage forms. At present there are four different commercial crime programs in use, developed by three different insurance advisory organizations.

The ISO commercial crime program, developed by Insurance Services Office, Inc. (ISO)

The SAA crime protection policy, developed by the Surety Association of America (SAA)

The American Association of Insurance Services (AAIS) commercial crime program

The ISO/SAA commercial crime program. This joint program has been replaced by separate ISO and SAA programs, but its forms are still used by some insurers. The forms promulgated by ISO show an ISO copyright. The forms promulgated by SAA may or may not show an SAA copyright.

Insurers may elect to use the forms in any of these programs, or they may develop their own versions of them.

The key commercial crime coverages available to contractors are shown in Exhibit 4.1. Contractors may choose which of these coverages they wish to purchase, and of course the premium will be adjusted accordingly. By far the most important of these for most contractors are the employee dishonesty and forgery or alteration coverages. The other five available coverages will only be necessary when the contractor has specific exposures, such as large amounts of cash, securities, or money orders on hand, substantial electronic transfers of funds, or a high profile (or travel to foreign countries) that may present an exposure to kidnap and ransom.

Employee dishonesty coverage insures against loss by employee theft of money, securities, and other tangible property. Other tangible property can include such things as office furniture and equipment or even construction equipment. This insurance usually applies on a blanket basis to all employees of the contractor.

Forgery or alteration coverage protects an insured against loss due to the forgery or alteration of checks, bank drafts, promissory notes, and similar documents drawn on the insured’s bank account. While banks are held liable for accepting forged or altered checks, there are circumstances in which a bank will not be held liable for forgery losses, such as when the depositor’s negligence plays a substantial role in allowing the loss to happen. Another reason for carrying forgery or alteration coverage is that it makes a possible confrontation between the insured and its bank unnecessary. This consideration can be important to a business that enjoys a good relationship with its bank and wants to avoid jeopardizing that relationship in a dispute over responsibility for a forgery loss.

Exhibit 4.1 Key Commercial Crime Coverages

Employee dishonesty coverage

Forgery or alteration coverage

Money and securities coverage

Money orders and counterfeit paper currency coverage

Coverage on property other than money and securities

Computer fraud coverage

Kidnap, ransom, or extortion coverage

Chapter 4 Review Questions 1. McDonnell discovers that property insurance for the full insurable value of his building will

cost less under an actual cash value policy than under a replacement cost policy. Why is this the case?

a. The current actual cash value of the building is lower than its replacement cost value.

That is correct! McDonnell will purchase less insurance to insurer the building for its full insurable value on an actual cash value basis, but he will also recover a smaller amount in the event of a major loss.

b. The current replacement cost value of the building is lower than its actual cash value.

This answer is incorrect. The actual cash value is lower than the replacement cost value because depreciation is subtracted.

c. The premium rate for actual cash value insurance is lower.

This answer is incorrect. The premium rate is the same whether coverage is purchased on an actual cash value basis or a replacement cost basis.

d. The rate is based on the building’s insurable value.

This answer is incorrect. The rate is multiplied by the limit of insurance to arrive at the premium.

2. An agreed amount endorsement is attached to the property insurance policy covering Harrison Electric Contractors’ building and personal property. Because this endorsement is attached to the policy,

a. Harrison will not experience a coinsurance penalty in the event of a property loss.

That is correct! The policy’s coinsurance clause is waived when an agreed amount endorsement is in effect.

b. Harrison’s property insurance limits will automatically be updated periodically.

This answer is incorrect. Harrison should make sure its property limits are up-to-date before requesting an agreed amount endorsement. (For automatic updates Harrison might consider inflation guard coverage.)

c. Harrison’s property values will automatically be updated periodically.

This answer is incorrect. The endorsement does not affect the property’s value.

d. It indicates that Harrison and the insurer could not agree on the property’s insurable value.

This answer is incorrect. The endorsement is issued to indicate that the insurer and the insured agree on the property’s value.

3. Skyreach Towers is building a new high-rise building. The project, which will take approximately 2 years, is insured by a builders risk policy. During the construction period, the insurable value of covered property:

a. is equal to approximately one-half the completed value.

This answer is incorrect. If construction proceeds at a completely linear pace, the average insurable value will approximate one-half the completed value, but the actual insurable value at any given time is not the average value.

b. will continually increase.

That is correct! When the job begins, the insurable value is minimal, but the insurable value increases as the construction process progresses, culminating in a completed value that often exceeds the value originally anticipated.

c. will go up and down as various construction phases are completed.

This answer is incorrect. The insurable value would not normally decrease as a building moves toward completion.

d. will gradually decrease.

This answer is incorrect. The closer a building under construction gets to completion, the more valuable it becomes.

4. Under which of the following circumstances might Chaser Boilermakers be required to provide an installation floater covering its work?

a. A builders risk policy covers all contractors on the project where Chaser is installing a boiler.

This answer is incorrect. Individual installation floaters are usually not necessary; a builders risk policy includes all involved contractors as insureds.

b. Chaser has installed a boiler that has never been tested.

This answer is incorrect. An installation floater is not normally required after property has already been installed.

c. Chaser is installing an expensive replacement boiler in an old industrial plant.

That is correct! A contractor maybe required to provide an installation floater when installing high-value equipment that is not covered by a builders risk policy; the old plant is unlikely to be covered by a builders risk policy.

d. Chaser is manufacturing an expensive boiler on Chaser’s own premises.

This answer is incorrect. The floater addresses the installation process rather than the manufacturing process.

5. Tyrone Builders is constructing a resort hotel for Rooney Enterprises. Tyrone’s builders risk policy includes “soft costs” coverage or “delayed opening” coverage which might include all of the following except:

a. additional real estate taxes that Rooney will have to pay if the manufacturing facility is not completed on time as a result of damage caused by an insured peril.

This answer is incorrect. Additional real estate taxes may be listed and defined as covered soft costs.

b. additional interest expenses on the loan that Rooney will pay if the hotel is not completed on time as a result of damage caused by an insured peril.

This answer is incorrect. Additional interest expenses may be listed and defined as covered soft costs.

c. loss of revenue because of a delay caused by inclement weather which kept Tyrone from being able to work on the project.

That is correct! Delays not caused by an insured peril are not covered.

d. loss of revenue that Rooney will experience if the manufacturing facility is not completed on time as a result of damage caused by an insured peril, such as a windstorm.

This answer is incorrect. Builders risk coverage applies to a delay in completion because of an insured peril that results in a delay in revenue.

Chapter 5 Matching the Insurance with the Exposures

Learning Objective

Explain the concepts of risk allocation via contract and the manner in which the various insurance policies coordinate with each other with respect to construction projects.

Chapter 1 identified the major types of direct property, indirect property, liability, and personnel loss exposures faced by contractors and explained how a combination of the various risk treatment techniques, such as contractual risk transfer, risk control, and insurance, can be used to manage them. The purpose of Chapter 5 is to illustrate and further clarify the concepts of risk allocation via contract and the manner in which the various insurance policies coordinate with each other with respect to construction projects. These discussions will also point out some of the problems encountered in insuring complex construction exposures.

It is important to note that this discussion focuses on the construction project risks rather than the full array of risks that a construction company may face. For example, such risks as directors and officers liability and fiduciary liability (arising from the management of retirement accounts) are not considered here.

As explained previously, the various insurance policies that contractors purchase rely on their insuring agreements and exclusions to coordinate with each other. For example, this approach keeps the commercial general liability (CGL) policy from insuring most losses covered by auto, watercraft, aircraft, and workers compensation insurance. Likewise, each of these policies has exclusions that, for the most part, avoid overlaps with the CGL policy and each other.

Nevertheless, there are circumstances when two policies may cover the same loss. When this occurs, a provision known as the other insurance clause dictates which of these policies applies on a primary basis and which applies on a secondary basis. It is also possible for one type of policy to fill in a coverage gap resulting from an exclusion or other limiting provision in another policy. In the charts that form the basis for the discussions in this chapter, these types of insurance are referred to as “secondary insurance.” Please understand, however, that this nomenclature is not a standard in the insurance industry.

Direct Damage Loss Exposures Exhibit 5.1 lists most of the key types of property exposed to direct damage loss on a construction project, how this risk of loss is usually allocated in the construction contract, and the prime and secondary insurance coverages that would apply to the exposure.

Exhibit 5.1 Direct Damage Exposures, Risk Allocation, and Insurance

Exposure Contract Allocation Prime Insurance

Secondary Insurance

The Project All Contractors Builders Risk Contractor’s Builders Risk DIC and/or CGL

Materials to Be Used in Construction

All Contractors Builders Risk and Ocean Cargo

Contractor’s Builders Risk DIC

Owner’s Existing/Adjacent Property

Owner or All Contractors

Owner’s Property Insurance

Contractor’s CGL

Autos, Tools, Equipment

Owner of the Property Auto Insurance, Equipment Insurance

Note that the contract usually makes the contractors responsible for damage to the project and materials to be incorporated into the project. Builders risk insurance is the first-party coverage used to insure this exposure, and the contract should specify whether the owner or the contractor will purchase this insurance. Many contractors feel that, since they are responsible for risk of loss or damage to the property, they should have the right to manage their own risk. For example they should have the right to negotiate and purchase the insurance to cover it. Nevertheless, it is common for the owner to retain this responsibility.

If the project builders risk insurance contains deficiencies that result in no coverage for a particular type of loss, there are two possible secondary insurance programs that may come into play: DIC builders risk insurance and general liability insurance. Many general contractors buy blanket builders risk policies that can be used as the primary builders risk insurance on those projects where they are charged with procuring the insurance and as a type of back-up insurance on projects where the owner retains the right to procure the insurance. This latter type of approach is called difference-in-conditions (DIC) coverage because the broad policy purchased by the contractor can fill in coverage gaps created by more restrictive coverage conditions in the owner’s policy. A DIC builders risk policy can also be used to “buy down” the deductible in a policy purchased by the owner on behalf of the contractor. Reflecting the insurer’s reduced exposure, the rate used to calculate the premium for the DIC coverage is much lower than the rate used when the policy is the primary builders risk insurance on a project.

There are two advantages to using a DIC builders risk policy to back up the owner’s policy. One is that any losses are paid without the expensive litigation that would be necessary in an attempt to obtain coverage under the contractor’s liability insurance. The second is that claims will be paid directly to the contractor, thus relieving the contractor of the need to finance the loss during the period in which the owner is awaiting proceeds from its own builders risk policy.

Chapter 5—Matching the Insurance with the Exposures

The other insurance that could become involved if the builders risk insurance has a deficiency leading to no coverage for a loss (or if no builders risk insurance was purchased) is the contractors CGL and umbrella liability policies. However, there is no underwriting intent for these policies to apply to most types of course of construction direct damage losses, and many obstacles will stand in the way of collecting liability insurance for them. To start with, these policies insure liability, and it will be necessary for the owner to have a cause of action alleging negligence for them to apply; this means that there will be expensive and time-consuming litigation. Since the liability insurance will only apply if the contractor’s negligence plays a substantial role in causing the loss, the insurer will often be successful in defending the contractor. If, for example the loss is caused by flood, earthquake, windstorm, fire resulting from lightening, or some other act of God, the contractor will not be legally liable and the insurance will not pay.

Thus, for the liability insurance to apply to a direct damage course of construction loss, it will be necessary for the owner to prove negligence on the part of the contractor. This will generally require an allegation of defective workmanship. If construction defect was the proximate cause of the loss, standard CGL policies and most umbrella policies will exclude the particular part of the contractor’s work that caused the loss and cover resulting damage to other work. The coverage arguments in this case will center on just how much of the work constituted “that particular part.”

Another problematic exposure is treatment of the owner’s existing/adjacent property. This would be, for example, an existing plant in which the contractor is doing work or an existing building next to the one the contractor is constructing. The owner will usually have permanent property insurance on this property that will cover on a no-fault basis damage resulting from all causes, including damage resulting from the contractor’s negligence. However, the owner’s insurer will sue (i.e., subrogate against) the contractor to recover the loss it paid. Providing the existing/adjacent property is not deemed to be in the care, custody, or control of the contractor, the contractor’s CGL and umbrella liability polices will cover the claim. However, this is a potentially huge liability exposure—perhaps exceeding the contractor’s liability insurance limits. This huge exposure can be avoided if the owner will agree to include a provision in the construction contract that that releases the contractor from such damage and waives the property insurer’s right of subrogation against the contractor. Unfortunately, many owners are unwilling to do this for fear that claims paid will adversely affect their future property insurance costs. Nevertheless, contractors should be cognizant of this loss exposure and attempt to treat it through this contractual risk transfer technique or consider the exposure when determining what to bid on the project.

When the owner is unwilling to provide the contractor a full release for damage to existing or adjacent property, the contractor should consider negotiating both a time and dollar limitation for this exposure. For example, the contractor might assume the risk of loss for damage to owner’s existing property (1) to the extent such loss or damage is caused by contractor; (2) provided such damage occurs during the performance of contractors’ work; and (3) subject to a limit of $ 25,000 per occurrence and $50,000 over the course of the project .

Indirect Property Loss Exposures Exhibit 5.2 lists most of the key types of indirect exposures that may result from a direct property loss on a construction project, how this risk of loss is usually allocated in the construction contract, and the prime and secondary insurance coverages that would apply to the exposure.

Exhibit 5.2 Indirect Exposures, Risk Allocation and Insurance

Exposure Contract Allocation Prime Insurance Secondary Insurance

Debris Removal Prime Contractor Builders Risk Insurance

Contractor’s DIC Builders Risk

Expediting Costs Prime Contractor Builders Risk Insurance (Soft Cost Coverage)

Contractor’s DIC Builders Risk

Delayed Completion Prime Contractor or Owner

Builders Risk Insurance (Delay in Start Up Coverage)

Business Interruption on Owner’s Existing/Adjacent Property

Owner or All Contractors

Owner’s Property Insurance

Contractor’s CGL

Efficacy and Performance

Designer, Prime Contractor, or Owner

Usually Isn’t Insured (System Performance Coverage)

Indirect or consequential loss exposures of construction projects can be very difficult to predict, measure, manage, and insure. Debris removal involves the clean up of damaged property following a major loss, and these costs can be substantial. Builders risk policies usually cover these costs, but it is important to assure that any applicable sublimit is adequate to cover the true exposure. Expediting cost and most costs associated with delayed completion resulting from direct loss (e.g., additional financing costs, loss of rents) can be covered by adding the optional delayed completion (soft costs) coverage endorsement to the builder risk policy. If the contractor purchases a blanket builders risk policy providing coverage on a DIC basis as discussed previously, this policy can back up the owner-provided builders risk policy.

On the other hand, business interruption or other similar consequential losses resulting from delayed completion are more difficult to insure because the loss exposure is very difficult to quantify. For this reason, many contractors will attempt to use contract provisions to allocate the risks to the owner. This may be achieved with a waiver of consequential damages provision or a liability limitation provision in the contract. The first provision absolves the contractor from any responsibility to the owner for consequential loss while the second limits the contractor’s liability to either a maximum amount or a specified sum. A type of delayed completion coverage, often called “delay in start up” (DSU) coverage, can be added to the builders risk policy to insure the owner’s loss exposure. Of course, coverage will apply only to loss from delays resulting from insurable perils. Additionally, the contractor is usually not insured under this coverage.

Business interruption caused by direct damage to the owner’s existing or adjacent property presents a very difficult loss exposure. If the contractor is working within or in close proximity to an income producing plant or facility, damage to that property from the contractor’s negligence could cause a substantial interruption in the owner’s income stream. In some cases, this loss could far exceed the cost to repair or replace the owner’s property. The owner’s direct damage and business interruption insurer will subrogate against the contractor. In most cases the CGL and umbrella policies will respond to this claim. However, depending on the amount of the direct property damage and the business interruption loss, the limits could prove insufficient.

Because consequential damages from damage to the owner’s existing property can be so substantial, savvy contractors will attempt to use contract provisions to eliminate or greatly limit the contractor’s exposure to them. This exposure can be addressed contractually in various ways. One is with a waiver of subrogation with respect to the owner’s business interruption insurance. A second is with an even broader waiver of consequential damages provision. A third possibility is a compromise in which the contractor accepts the liability, but subject to a contractually specified maximum amount—this is called a limitation of liability provision.

Efficacy and performance refers to the project performing as intended. This concept applies primarily to industrial projects where the contractor is providing engineering and construction services. In these cases, the contract will specify certain minimum production standards that the completed project must meet. If it does not meet those standards, the contractor may be legally liable to the owner or obligated to pay specified liquidated damages. Coverage for this exposure is sometimes available in the specialty marketplace for very large projects. However, it is subject to careful underwriting scrutiny and the premium is substantial.

Liability Loss Exposures Exhibit 5.3 lists broad categories of liability exposures on a construction project, how these risks of loss are usually allocated in the construction contract, and the prime and secondary insurance coverages that would apply to each exposure.

Exhibit 5.3 Liability Exposures, Risk Allocation And Insurance

Exposure Contract Allocation Prime Insurance Secondary Insurance

Premises & Operations Bodily Injury and Property Damage

Prime Contractor and Below

Contractors’ CGL and Umbrella Policies

Owners Insurance (for Owner Only)

Completed Operations Bodily Injury and Property Damage

Owners Insurance (for Owner Only)

Contractually Assumed Liability

Upper Tier Contractors’ Liability Polices

Auto, Aircraft, & Watercraft

Auto, Aircraft, Watercraft, and Umbrella Policies

Design and Pollution Owner, Prime Contractor or Below

CGL/Umbrella, Professional, or Pollution Liability

The most common scenario in construction is for the owner to require the prime contractor to hold harmless and indemnify the owner and to provide CGL, auto, umbrella, and any specialty liability coverages dictated by the nuances of the project to back up the indemnity agreement. The owner also usually requires the prime contractor to add the owner as an additional insured on its CGL and umbrella liability policies. The prime contractor then makes similar requirements of each of its subcontractors and they do the same of their subcontractors. As a result, it is common for multiple liability policies written by different insurers to be triggered for complex construction losses.

Another approach sometimes used on very large projects (e.g., $100 million or more) is the controlled insurance program (CIP)—also called a consolidated insurance program (CIP), an owner controlled insurance program (OCIP), contractor controlled insurance program (CCIP), or wrap-up program. With a CIP, one party, usually either the owner or prime contractor, purchases the liability insurance (and usually the workers compensation insurance) for all the contractors involved in the project. The contractual allocations of risk usually remain the same as with the traditional procurement approach, but there is a single consolidated liability insurance program in place rather than a host of separate contractor-purchased insurance programs. Contractors need to carefully review coverage under these programs to determine if and to what extent the coverage is the equivalent of the contractor’s own insurance program and take steps to coordinate their insurance program with the coverage afforded under the CIP.

Personnel Loss Exposures Exhibit 5.4 lists the broad categories of personnel loss exposures existing on construction projects, how this risk of loss is usually allocated in the construction contract, and the prime and secondary insurance coverages that would apply to the exposure.

Exhibit 5.4 Personnel Exposures, Risk Allocation, and Insurance

Exposure Contract Allocation Primary Insurance Secondary Insurance

Workers Compensation Laws

Each Employer Workers Compensation Insurance

Employers Liability Each Employer Workers Compensation Insurance

Third-Party-Over Actions

Employer of Injured Worker

Contractor’s CGL and Umbrella Policies

“Negligent” Owner’s or Contractor’s CGL and Umbrella Policies

Employment Practices Liability

Employer of Injured Worker

Employment Practices Liability (EPL) Insurance

Loss of revenue or extra expenses incurred from loss of key person

Not Addressed Specifically

Key person life insurance

Workers compensation insurance is the primary approach for insuring the exposure of worker injury. With most projects, each contractor is responsible for procuring its insurance. However, a controlled insurance program (CIP) is sometimes used for very large projects wherein the owner or prime contractor purchases workers compensation insurance for all (or most) of the contractors.

One of the thorniest risk and insurance problems in construction is third-party-over actions, also called “action overs.” This occurs when a contractor’s employee is injured, collects workers compensation benefits, and sues an upstream (e.g., prime) contractor and/or the owner alleging its negligence contributed to the employee’s injury. Often the allegation is simply failure to provide a safe workplace. Unfortunately, the exclusive remedy doctrine—which keeps the employee from suing its own employer—does not apply to these other entities in most states. In this situation, the contract indemnity clause and/or the additional insured status of the upstream contractor and owner will pass responsibility for this liability back to the injured employee’s employer. That contractor’s (i.e., the employer of the injured worker) liability insurance will then cover the upstream contractor and/or project owner in spite of the protection provided to the contractor by the exclusive remedy doctrine. Thus, this is an area where the intent of workers compensation laws—to make workers compensation benefits the exclusive remedy of injured workers—has been circumscribed by the legal system.

If for some reason the contractor’s liability insurance does not respond on behalf of the upstream contractor or owner involved in an action over, the CGL and umbrella policies of the upstream contractor and owner will protect them. If the employer of the injured worker was a subcontractor of the prime contractor, the prime contractor’s CGL and umbrella would likely protect both the prime contractor and the owner as an indemnitee or additional insured.

Summary This chapter demonstrates how contractual allocation of risk and insurance programs operate together in addressing the exposures presented by construction projects. It also exposes some of the most problematic risks to allocate and insure. Of course it is important to remember that this discussion addresses these issues from the 30,000-foot level. There are many nuances of insurance coverage dictated by the details of the various insurance policies that may cause certain types of losses falling within the broad exposure categories discussed above not to be covered. It is up to risk managers, agents/brokers, and underwriters to work through the details of these insurance policies to shape the coverages that will apply.

This discussion also overlooks other important risk management techniques, in particular risk control. Avoiding the occurrence of losses and reducing the severity of those that do occur mitigates the problems pointed out in this chapter.

Chapter 5 Review Questions 1. After a loss occurs, it appears that two of Ted Contracting’s property insurance policies cover

the same loss. What will determine whether one of these policies applies on a secondary basis?

a. Cause of the loss

This answer is incorrect. Two policies would not appear to cover the same loss unless the cause of the loss is insured under both policies.

b. Date of the loss

This answer is incorrect. Two policies would not appear cover the same loss unless they were both in force at the time of the loss.

c. Other insurance clause

That is correct! The other insurance clause dictates which of the policies applies on a primary basis and which applies on a secondary basis.

d. Type of property damaged or destroyed

This answer is incorrect. Two policies would not appear to cover the same loss unless the type of property that was damaged or destroyed is covered under both policies.

2. Even though the project owner has purchased builders risk insurance, Ted Contracting’s insurance broker suggests Ted purchase builders risk DIC coverage to fill any coverage gaps. In this case, DIC stands for:

a. difference in conditions.

That is correct! The broker has recommended using a difference in conditions approach.

b. difference in contracts.

This answer is incorrect. Although the difference in insurance contracts might create coverage gaps, the DIC acronym does not stand for difference in contracts.

c. different insurance conditions.

This answer is incorrect. Gaps in coverage between the two policies might be covered because the insurance policies contain different conditions, but that is not what the DIC acronym stands for.

d. differential insurance contract.

This answer is incorrect. The term “differential insurance contract” is not commonly used.

3. Falcon Hospital hires Gamma Contracting to build a new parking garage that is adjacent to its existing hospital. Falcon’s existing hospital is insured by a property policy, but Gamma Contracting realizes that its construction activities could damage the existing structure. How can Gamma manage this potential liability exposure it faces?

a. Gamma could ask Falcon Hospital to cancel its property policy for the existing facilities and replace it with a CGL.

This answer is incorrect. Falcon needs property insurance to cover any damage; moreover, a CGL in Falcon’s name would not protect Gamma against liability claims.

b. Gamma could buy a contractors equipment policy to insure the existing building.

This answer is incorrect. Contractors equipment insurance does not cover buildings.

c. Gamma could persuade Falcon Hospital to include a provision in the construction contract that releases Gamma from such damage and waives the property insurer’s right of subrogation against Gamma.

That is correct! A release and a waiver of subrogation can avoid this huge exposure.

d. Gamma could require Falcon Hospital to buy an umbrella liability policy.

This answer is incorrect. An umbrella policy would protect the hospital against major liability claims, but it would not protect Gamma.

4. Hancock Commercial Property Inc. is going to build a $175 million office complex with eight buildings. Although multiple contractors will be employed for this project, they will all be overseen by UNO General Contracting. If the project is to be insured under a typical controlled insurance program (CIP):

a. All contractors involved in the project will purchase liability and workers compensation insurance policies to protect both Hancock and Uno.

This answer is incorrect. The contractors do not purchase separate insurance policies.

b. Both Hancock and UNO will purchase liability and workers compensation insurance for all contractors involved in the project.

This answer is incorrect. Only one party purchases insurance.

c. Either Hancock or UNO will purchase liability and workers compensation insurance for all contractors involved in the project.

That is correct! With a CIP, one party—usually the owner or prime contractor—purchases liability and usually also workers compensation insurance for all involved contractors.

d. Hancock and UNO will jointly purchase liability and workers compensation insurance for all contractors involved in the project.

This answer is incorrect. The purchase is made by either the owner or the prime contractor.

5. Shortz Electric’s employee is injured and collects workers compensation benefits. The employee then sues Benjamin General, an upstream contractor, alleging that Benjamin’s negligence contributed to the employee’s injury. This scenario is referred to as a:

a. first-party-under action.

This answer is incorrect. First-party-under action is not a commonly used term.

b. third-party loss.

This answer is incorrect. Although the injured employee is a third party from Benjamin’s perspective, this is not a typical third-party loss.

c. third-party-over action.

That is correct! A third-party-over action occurs when a contractor’s employee is injured, collects workers compensation benefits, and sues an upstream (prime) contractor alleging its negligence contributed to the employee’s injury.

d. violation of the exclusive remedy doctrine.

This answer is incorrect. The exclusive remedy doctrine would not apply in most states.

Chapter 6 Risk Finance

Learning Objective

Explain the essential elements of guaranteed cost, deductible, retrospective rating, and dividend plans and of such alternative market risk finance approaches as captive insurance companies and risk retention groups.

The term “risk finance” is the broad moniker for the financial aspects of risk management, primarily related to the cash flow, tax, and other implications of risk retention and insurance purchasing decisions. As discussed in Chapter 1, risk retention is a key risk management tool that can substantially reduce a contractor’s cost of risk, and risk retention is the key ingredient in any risk finance program. Risk finance concepts apply predominantly to casualty exposures, most commonly workers compensation, though they may apply to first-party (property) exposures for very large organizations. There are many types of risk financing alternatives ranging from the very simple to the extremely complex. While the number of choices increases as organizations grow larger, there are alternatives even for fairly small contractors. Examples of risk finance techniques, from simplest to more complex include the following.

Monthly premium payments in lieu of payment in advance

Deductibles

Retrospective rating plans

Self-insurance

Captive insurance subsidiaries

The Time Value of Money Most organizations attempt to implement risk financing programs that complement their cash management. Firms generally have a limited amount of money available and multiple uses to which the money can be allocated. The money available includes money the firm has internally (e.g., money derived from the firm’s operations) and money generated externally (i.e., borrowing and the sale of equity interests in the firm). The firm must make choices between the alternative uses and sources of funds. Because of these choices, money has a “time” value. Dollars held now are valued more highly than dollars expected at some time in the future. The time value of money concept is integral to understanding the implications of loss payout patterns and therefore loss funding needs. It is also central to evaluating risk financing plans based on their cash flow patterns.

Loss Payout Patterns Under conventional insurance programs for large contractors paying significant premiums, the insurer charges premiums based on its estimate of incurred losses for the insured firm. Small contractor’s premiums are not pegged to individual loss projections. “Incurred losses” include both the actual payments as well as an estimate of future costs and payments, called “case reserves,” on known losses. However, profiles of historical loss payout patterns have illustrated that, on average, less than 30 percent of each dollar of incurred workers compensation losses is paid during the first year of coverage. This is because the values of the future payments included in the reserves are much greater than the amounts actually paid in the first year. As a result, large firms have found ways to allow the firm itself, rather than an insurer, to take advantage of the delayed loss payments by having use of the funds used as claims reserves (i.e., the difference between losses incurred during the year of coverage and their ultimate payout).

A study by Insurance Services Office, Inc. (ISO) analyzed the property/casualty insurance industry’s loss and loss adjustment expense reserves at the end of 1988. The results of the study are published in the book, Analysis of Loss and Loss Adjustment Expense Reserves at Year-End 1988.

It showed that automobile liability losses are paid more quickly than other liability coverages since bodily injury and property damage claims associated with auto liability coverage are not as likely as other liability claims to get stranded in the legal system. Over 30 percent of incurred losses are paid during the first 12 months after policy inception. By the completion of the fifth year, a cumulative total of over 93 percent of all losses has been paid out.

General liability losses are the slowest to be paid out, which often extends well beyond 10 years. This is a result of the nature of general liability claims. They frequently require detailed investigation, drawn-out litigation, and a long time lag between the date of occurrence and the report of the actual claim. This study shows that less than 10 percent of all general liability claims incurred during the policy period are paid during the first year. By the second year, almost 20 percent of incurred losses have been paid. Even after 5 years, less than 60 percent of incurred losses have been paid.

The payout pattern of workers compensation losses increases steadily over time. Workers compensation benefits are statutorily defined and, therefore, are known. What is not known, however, is the duration of the injury and the amounts and duration of medical treatment. Because of the unknowns, by year 5, only 75 percent of the workers compensation insured losses have been paid.

Payout profiles vary from state to state and from organization to organization, depending on the legal climate and the nature of a particular organization’s claims. While industry-wide averages can be used to make specific risk finance decisions, a more accurate payout profile can be computed for large organizations by charting their actual losses and determining the actual length of time to closing. From this, an average payout profile for that particular organization can be computed.

Present Value Analysis Present value analysis is a way of quantifying the time value of money by determining today’s value of a future income stream. It takes into account the period of time over which the income stream will take place as well as the interest rate that would be applicable on money during that period of time. The net present value of an income stream is calculated using a simple formula and published net present value tables that can be found in most basic finance textbooks or through other sources.

Net present value analysis is an integral component in determining funding levels for risk retention programs. Since, as demonstrated above, casualty losses are usually paid over long periods of time, it

Chapter 6—Risk Finance

is not necessary to fully fund incurred losses at inception. Instead, they can be partially funded with reliance on investment income to make up the difference over time. Calculating the net present value of the payments of, for example, a year of workers compensation incurred losses will establish the amount of funds needed to pay those losses as they come due.

Net present value analysis is the only way to fairly compare different risk financing plans with varying payment. This is generally performed by using a forecast of incurred losses for the period and the organization’s payout profile to determine the payments that will be made under each program in the future. A net present value calculation then converts each of these payment streams into a single net present value amount. The program with the lowest net present value is the least expensive program.

Guaranteed Cost and Loss Sensitive Rating Plans Risk finance alternatives generally involve the retention of risk by the insured in return for reduced premiums and cash flow benefits. These can involve specialized insurance rating plans that adjust costs in relation to the insured’s losses or some form of sophisticated self-insurance or alternative market program. The most commonly used insurance programs are briefly summarized below, and the alternative market plans are described in the next section.

Guaranteed Cost Insurance Guaranteed cost insurance is a common insurance rating plan for workers compensation, commercial general liability, and auto liability, and it is often the only option for employers with relatively low premiums. Guaranteed cost rating is prospective in nature, meaning the premium is derived using rates that are based on expected losses, and the premium is not subject to change based on the employer’s actual loss experience during the policy period. The final premium determined at the end of the policy period will be adjusted only to account for any difference between the estimated exposure (e.g., estimated payroll) and the actual exposure (e.g., actual payroll), and for midterm rate changes if they apply to policies already in force.

For purposes of this discussion, “guaranteed cost insurance” is defined as any insurance policy in which the premium for the current period is not affected by the individual insured’s loss experience during the current period. It may, however, be affected by prior loss experience, current loss experience of a class of insureds, or the retention by the insured of some part of individual losses.

While guaranteed cost insurance premiums are not sensitive to losses incurred during the current policy period, workers compensation premiums usually do have an experience rating component. Experience rating involves generating a factor based on 3 years of past losses that modifies the premium used to develop the current year’s premium. If losses during the 3-year experience period are worse than would be expected for similar types of contractors, a debit modifier results from the calculation. This would be an experience modifier greater than 1.0, for example 1.25. If the insured’s losses were less than expected for similar types of contractors, a credit modifier would result, .90 for example. The modifier is multiplied by the preliminary premium (which was calculated by multiplying the rates by the exposure base) to determine the premium to be charged. Consequently, an employer’s losses in previous years affect the premium paid in the current period, and losses in the current period affect the premium it pays for coverage in future years. Since three years of losses are included in the calculation, a single loss will be included in the modifier and affect premiums in three future years; this should be considered when evaluating the cost and benefits of safety initiatives.

While guaranteed cost plans are not “loss sensitive” and do not require the insured to retain risk, they can still have some risk finance elements. The most common is to defer the premium payment without charging interest on it. For example, insurers will sometimes agree to accept premiums in monthly or quarterly installments for credit-worthy insureds.

Loss Sensitive Insurance Plans Insurance plans that are classified as “loss sensitive” operate exactly as the name implies. In contrast to guaranteed cost plans, the final premium is dependent on the ultimate loss experience during the period a plan is in effect. This approach is quite different from a guaranteed cost program, for which the final premium amount is fairly predictable at the inception of the coverage period. For example, a reasonable estimate of the final premium for a guaranteed cost workers compensation policy can be determined based on projected payrolls. Conversely, the final premium for a loss sensitive insurance plan cannot be determined until after the end of the coverage period. In fact, it is often many years before all claims under the plan have been closed, the loss totals are reported, and the exact final cost is known.

Some loss sensitive plans come with the risk of much higher costs when loss totals exceed expectations. Usually, plans with a risk of very high costs also come with the opportunity for substantial savings when loss totals are very low. This represents one of the main reasons why loss sensitive insurance plans are chosen over guaranteed cost plans. They afford contractors the opportunity to directly and immediately affect their final insurance premiums and related expenses. In return for retaining a greater share of the risk under a loss sensitive plan, an insured receives a credit in the fixed components of the insurance premium. It is the same principle behind the reduction in premium for a policy insuring physical damage when the deductible level is increased. A higher deductible results in a lower premium, but also involves a transfer of some risk back to the insured.

Another important benefit of loss sensitive insurance plans is that they provide rewards for those insureds that emphasize safety and loss control efforts. They can be used as a part of an insured’s strategy to focus more attention on reducing losses. For many plans, losses are factored directly into the final premiums or the final total cost. The calculations are usually quite straightforward, so the effects of losses on the bottom line are obvious. Making loss costs so apparent in an organization can stir up strong support at all levels for holding losses to a minimum.

Another reason why some insureds move away from guaranteed cost programs into loss sensitive insurance programs is that they provide a natural first step toward an ultimate goal of becoming self-insured. Small to midsize insureds frequently start down this path by choosing loss sensitive programs as they grow out of guaranteed cost programs. Loss sensitive programs allow insureds to retain more risk and reduce insurance costs while staying within a risk financing program that does not exceed their tolerance for accepting risk. Lastly, for many insureds with extremely poor loss experience, some form of loss sensitive plan may be the only available alternative. Insurers are loath to write guaranteed cost insurance if they perceive a possibility that losses will ultimately exceed the premium.

When To Consider a Loss Sensitive Plan In general, insureds consider loss sensitive plans when they reach a point where:

The premium level of guaranteed cost insurance is high enough to make other options competitive strictly from a financial standpoint.

The loss experience is expected to be very low relative to the premium for guaranteed cost insurance.

There is a desire to create a financial incentive to control losses.

There is a desire to reduce dependency on the insurance industry.

Of course, all of these points do not have to apply to an insured for a loss sensitive plan to make sense. Sometimes insureds purposely enter into such plans to create a higher degree of urgency for their safety and risk control efforts. Their hope is that the added financial incentive will encourage management and other employees to make the safety programs more effective. Others simply have a higher tolerance for risk, and they prefer a loss sensitive arrangement under almost any scenario.

Loss sensitive plans do not make sense for all insureds. The relatively high cost of administration makes them reasonable only when the costs can be spread out over a large exposure. Insureds with only a few employees may not have an adequate spread of risk to maintain an acceptable degree of stability in losses. One large loss could dramatically skew an insured’s total loss experience and result in large year-to-year variations in premiums. In general, insurers establish underwriting guidelines with minimum premium levels for loss sensitive plans (significantly higher than those required for experience rating) to be eligible. Consequently, small insureds will not qualify for some of the loss sensitive rating plans available to large insureds.

Many contractors are reluctant to become involved in loss sensitive plans due to the uncertainty of the costs they will be including in their project bids. If adverse loss experience on a project results in an increase in the premium associated with a project bid on a fixed-price basis, the contractor’s profit is reduced accordingly. For this reason many contractors prefer the known costs of a guaranteed cost program. While this is understandable, there are some potential flaws in this rationale. First, guaranteed cost programs are only in place for a year, and large price increases on renewal will generally not have been contemplated in the bids for jobs already under way. Second, most loss sensitive programs have known maximum premiums, and these can be considered when determining how much insurance cost to include in a bid. Lastly, contractors of any size will generally have predictability of workers compensation losses that will enable them to develop a reasonable estimate of the workers compensation premium to charge when a loss sensitive program is in place.

For those that do qualify, there are many types of loss sensitive programs commonly used. There is also a wide variety in the terminology that insurance companies, brokers, agents, and others use to refer to loss sensitive rating plans. Different names are used to differentiate one company’s products from another’s, usually for no better reason than gaining a competitive advantage. However, many of the plans with different names share the same characteristics, and many new plans simply involve combinations of features from existing plans. To be consistent, the following discussions of the plans that have historically been labeled “loss sensitive” will not deviate from the terminology used elsewhere in this course.

Before electing to enter into any type of loss sensitive insurance arrangement, an insured should consider all reasonable options that might be available. Brief descriptions of the most common types of plans are provided below.

Retrospective Rating Retrospective rating refers to an insurance plan for which the final premium is determined retroactively after the end of the coverage period. The losses that were incurred during the coverage period go directly into the premium calculation. It is referred to as a cost-plus approach. The premium for a retrospectively rated plan is based on a simple formula that includes the ratable losses plus a charge for loss adjustment expenses, a basic premium charge, a charge for any special loss limitations, and premium taxes. The final premium is subject to a maximum (and/or a minimum) charge, expressed as a percentage of the standard premium.

Depending on the specifics of the plan, retrospective rating can lead to a wide range of final premiums. The maximum premium can be much higher than the premium for an equivalent guaranteed cost plan. Maximum premium factors of 150 percent (1.50 x standard premium) are not unusual. As a trade off, the minimum premium can be very low. A retro plan with a maximum premium factor of 150 percent might have a corresponding minimum premium factor of 30 percent (0.30 x standard premium). Even for a midsized insured, the possible difference in outcomes can be substantial. Of course, retro plans are available with narrower ranges of potential outcomes (lower maximums and higher minimums) as well.

The traditional retrospective rating plan (or retro) is based on incurred losses. That is, the actual paid losses and loss reserves go into the premium calculation as ratable losses. In the late 1980s, the insurance industry began to offer a variation of the traditional retro plan called a “paid loss” retro. Ratable losses under a “paid loss” retro plan do not include loss reserves. This allows an insured to retain the use of more of its funds until losses are actually paid. A paid loss plan usually requires a smaller initial payment, so it offers some cash flow benefits not available with an incurred loss retro.

Dividend Plans A dividend plan is usually written on the same basis as a guaranteed cost plan with one exception. It offers the opportunity for the insured to receive a dividend at the end of the coverage period based on loss experience. Dividend plans are also referred to as participating plans, because they include an opportunity for an insured to participate in the risk with the insurer. The payment and size of a dividend can be tied to either the loss experience of a particular insured, or to the loss experience of an insurance company as a whole, depending on the type of plan.

Safety Group Dividend Plans A safety group dividend plan is a program organized for the members of a professional or trade association. In essence, it leverages the potential volume of the group to use as a bargaining factor with an insurer from whom coverage will be purchased and creates the potential for greater returns from a dividend plan. The concept is to organize and coordinate the efforts by similar organizations to isolate and solve common safety problems and negotiate terms with an insurer, thereby lowering losses and reducing overall insurance costs.

The lines of coverage available under a safety group dividend plan can include workers compensation and other kinds of coverage such as general liability, commercial auto liability, and sometimes property insurance. An insurer’s normal underwriting standards apply based on the combined experience and safety capabilities of the members of the group as a whole. Each member of the safety

group receives individually written policies subject to its own experience modifications. A premium discount may be applied on the basis of the premium volume of the entire group. All members’ policies will generally have a common expiration date.

Safety group dividend plans are based on the pooling of all group members’ premiums and losses. The total audited earned premiums are pooled, from which the following are subtracted.

Incurred losses

Allocated loss adjustment expenses

Acquisition and other expenses such as premium taxes

Loss limitation charges, if applicable

Underwriting and auditing costs

Loss prevention costs

The result is the safety group’s net cost. The difference between the earned premium and the group’s net cost is available for dividends. Dividends are normally allocated in the proportion of a member’s premiums to the total premiums of the group as a whole.

Since losses are a major variable controlling a safety group’s net cost, the key to lower costs lies in the prevention and reduction of losses. Therefore, safety becomes an important factor in each insured’s ultimate insurance costs.

Large Deductible Plans Since the early 1990s, large deductible plans have been one of the most popular types of loss sensitive risk financing arrangements chosen by insureds. For the most part, this was because of the market conditions existing at the time. Larger insureds that could afford to retain more risk chose to take advantage of the many competitive large deductible plan options offered by insurers. Essentially, the plans allowed large insureds to self-insure their workers compensation risks without having to satisfy the filing requirements for self-insurance programs in the states where they operated.

Large deductible plans can be written with a per occurrence deductible alone, or with an occurrence deductible and an aggregate deductible to cap an insured’s out-of-pocket loss payments in any one coverage period. The premium credit for accepting a large deductible on a workers compensation insurance policy can be more than 75 percent of the standard premium.

Under a large deductible arrangement, the insured pays the workers compensation deductible plan premium. It is based most often on the total payroll and subject to a year-end premium audit. Many insurers offer to let insureds pay the premium in monthly installments with no finance charges. The costs of claims adjusting expenses are included in the premium, with the exception of allocated claims adjusting expenses. Insureds must also provide funds for losses usually in the form of an escrow fund with a letter of credit as security for the credit risk. The amount to be maintained in escrow is negotiable. Typically, it is based on an insured’s estimated average losses for 2 or 3 months.

Summary Loss sensitive insurance plans come in many different varieties and take on many different names. A recent offering by one insured was labeled a “metro retro.” Basically, the plan was an incurred loss retro with negotiated factors and with a superimposed dividend. Many insurance plans combine cash flow features with the features of loss sensitive plans to allow an insured to benefit from both. For example, many insurers offer premium installment plans for their insureds with loss sensitive plans without any type of finance charge. Regardless of the terminology or specific plan features, the final premium for any type of loss sensitive insurance plan is dependent on the losses during the coverage period.

Alternative Market Approaches Many contractors with sufficient capital resources use alternatives to traditional insurance markets and their inevitable cycles. Although these methods of funding losses may require more resources when traditional insurance is cheap, they bring an element of predictability and stability to a company’s expenses that most financial managers value enough to make it worthwhile. In many instances, costs may actually be lower over the long run.

The term “alternative market” is somewhat vague, but it is generally used as a catchall term for any form of policyholder-owned insurance mechanism in which the insureds are the ultimate bearers of the losses sustained by the alternative market facility. Participation in the facility usually requires an initial contribution to capital, as well as a commitment to tender additional monies if the company is unable to meet its claim payment obligations. There is no minimum or maximum number of participants required—an alternative risk financing facility could have as few as one policyholder or thousands of policyholders. Accordingly, captive insurance companies (hereinafter referred to as “captives”), risk retention groups, and group self-insurance pools fit the definition of an alternative risk financing facility. Together, these nontraditional forms of risk financing make up what is commonly referred to as “the alternative market.” Qualified workers compensation self-insurance programs are also generally considered part of the alternative market because, as opposed to large deductibles, no insurance company is involved with the working layer losses. (A qualified self-insurance program is one that has been approved by the state of domicile as meeting its regulatory requirements for self-insuring workers compensation).

Alternative risk financing facilities (ARFFs) can take a variety of forms. Some specialize in certain lines of coverage, such as workers compensation or basic casualty lines. Some provide primary coverage, while others are purely excess programs. Many of these facilities are formed to meet the needs of a specific industry that traditional markets are shunning or that has unique coverage needs not available in traditional markets. Frequently, ARFFs are established and operated by industry associations for the benefit of their members. For example, 13 state chapters of the Associated General Contractors (AGC) of America operate workers compensation group self-insurance funds under the laws of their respective states.

Getting involved in the alternative market requires a commitment of time and resources and should only be done with a full understanding of these requirements, as well as the associated risks. Whether a particular alternative market concept is right for a given contractor will depend on a number of factors such as the company’s size, risk profile, loss experience, management objectives and tolerance for risk, risk financing goals, etc. Virtually all alternative market programs require a long-term commitment, as many impose penalties on members who do not participate for a specified minimum period of time.

Additionally, any type of group facility will contain an element of financial risk since its ongoing financial viability is dependent on successfully underwriting members of the group. Conflicts of interest can arise when the board and management have dual motives of properly managing the facility while reducing the cost of risk of their own organizations. Thus, it is important to carefully review the capitalization, underwriting policies, and corporate governance of any group program being considered.

Some of the most common types of alternative market facilities are briefly reviewed below.

Risk Retention Groups Simply stated, a risk retention group (RRG) is a policyholder-owned insurance company operating under the auspices of the Liability Risk Retention Act of 1986. Since the act only applies to liability exposures, property and workers compensation cannot be covered by a RRG. The primary purpose of the group is to spread the liability risk of its member-owners.

Members of a given RRG must be engaged in similar businesses or activities that result in similar liability exposures. The requirement that group members be engaged in the same business or activity allows them to pool their resources to develop and implement more effective risk management and loss control programs than what could be arranged by most individual members. Ideally, this leads to more favorable loss experience for the group than for the industry as a whole. The resulting savings can then be passed on to group members in the form of dividends or premium credits.

From a practical standpoint, they can be described as groups of similar entities coming together to self-insure their losses, much like a group captive insurance company. Many of the same characteristics of group captives are also relevant to risk retention groups, such as prerequisites for formation, advantages and disadvantages, feasibility, implementation, and domicile selection.

Group Self-Insurance Programs Self-insurance is generally not feasible for small firms. The only realistic method they have of satisfying the various states’ financial responsibility laws regarding workers compensation is through the purchase of a large deductible plan or any of the conventional insurance policy options. Individually, a small firm lacks the clout and loss predictability to negotiate very favorable loss-sensitive cash flow plans, and it does not have the financial resources to qualify for self-insurance. However, by combining their buying power, small firms can enjoy the leverage, as well as the benefits, of loss and expense control of a group self-insurance program.

Group self-insurance is a premium and risk pooling arrangement through which entities with similar exposures join together to cover their workers compensation exposures. Group self-insurance can be a viable alternative to traditional workers compensation insurance for many contractors in states where it is allowed. Group self-insurance is regulated by the states, and each state that allows this form of risk pooling has its own criteria for qualifying such programs. All states require the group to file a plan of operation for approval by the state’s governing jurisdiction. As with other types of group insurance (e.g., safety groups in which insureds participate in a group dividend plan), these operational business plans must include the following.

A description of the method for administering the group

Guidelines for determining premium payments

Descriptions of safety plans

Self-insured workers compensation groups are similar in format and purpose to risk retention groups and captives. However, workers compensation groups differ in the following three respects.

They require substantially lower, and, in some instances, no initial capitalization.

They operate in a single state.

They insure workers compensation exposures.

In fact, risk retention groups are specifically prohibited from covering workers compensation risks in any jurisdiction, pursuant to the Risk Retention Act of 1986.

Captive Insurance Companies A captive insurance company is an entity created primarily to insure the exposures of its parent organization(s). As in self-insurance, captives are generally formed with the goals of reducing the parent company’s ultimate cost of risk by controlling losses, minimizing expenses and taxes, and escaping the influence of loss subsidization that is present in traditional insurance.

Although interest in captives always peaks during a hard insurance market, statistics show that the growth in captive insurance companies remained surprisingly steady throughout the extended soft market of the 1990s. Although hard markets generate interest in captives, the time to be doing the work is before the hard market begins, as it can take several years to form, capitalize, and begin writing business through a captive.

Captives can be formed as wholly owned subsidiaries of a single company or as a joint venture between several companies (i.e., group captives). Obviously, forming a wholly owned captive involves a greater commitment of resources (e.g., investment, personnel, etc.) than simply joining an existing group captive. However, contractors will obviously have greater control over a captive of which they are the sole owner.

Captives can be structured in variety of ways. They most frequently operate as reinsurers, but can operate as primary insurers in some circumstances. When operating as a reinsurer a domestic insurance company, called a fronting company, issues policies and performs most of the other normal services that insurers provide. It then cedes all or a portion of the premium to the captive and is reimbursed by the captive for losses it pays out, just as with any other reinsurance arrangement.

Generally speaking contractors’ captives are set up as reinsurers for a variety of reasons. First and foremost, as a reinsurer, the captive avoids the need to meet the regulatory requirements of each state in which the contractor operates. Second, its existence is transparent to owners or other contractors, since insurance certificates are issued by the front company instead of the captive. This makes it easier to comply with contract insurance requirements. Third, it is easier to domicile a reinsurer outside of the United States than it is a primary insurer.

Captives may be domiciled in an offshore location, such as Bermuda or the Cayman Islands, or domestically. Some states, such as Vermont, South Carolina, and Hawaii have passed special legislation to facilitate locating captives within their boundaries. A number of issues, such as taxes, regulations, needed infrastructure, and perception objectives will influence the choice of domicile.

Group captives and association captives make captives a viable option for organizations that do not have adequate capital resources to form their own captives. They offer the same key benefits of pricing, coverage stability, and improved services. One disadvantage of group captives, compared to single parent captives, is the inevitable differences of opinion that will exist among participants. For this reason, group captives are more likely to encounter decision-making difficulties that can result in

delays in formation and capitalization, rating and cost allocation controversies, earnings distribution conflicts, owner withdrawals, and potential tax problems. Premiums paid to group captives are generally considered to be deductible from the owners’ federal income taxes, depending on a variety of variables. However, in order for a group captive to be deemed a bona fide insurance company by the Internal Revenue Service, there must be a considerable amount of risk sharing between the members. Sharing risk means that the premiums of the many pay the losses of the few, an arrangement than can cause concern for members that effectively control their losses.

Another type of captive that allows participation by companies too small to form their own captives is the rental captive. These are captive insurance companies owned by an organization that is not one of the policyholders, such as a broker, a reinsurer, or a fronting insurance company. The fees to enter one of these facilities are much less than the initial capital requirements of a single-owner or most group captives. However, they usually do not offer as much flexibility. These programs are often set up using “protected cells” which are segregated accounts for each insured. This reduces financial risk from participating by protecting each participant from the liabilities of other participants within the captive.

Self Insurance Self-insurance is an option for some contractors with the ability to obtain some spread of risk and the financial wherewithal to absorb unexpected losses. This is an arrangement in which an organization consciously retains at least a portion of a specific, identified risk, usually workers compensation. Sometimes organizations may claim to be “self-insured” when the more appropriate way to describe them is “uninsured.” Uninsured losses can either be the result of exposures that fall outside the realm of coverage provided by an insurance policy, or they can be the result of simply failing to recognize a loss exposure. Self-insurance, however, involves a much more conscious decision to retain risk, to estimate expected losses, to set aside funds for the payment of losses, to purchase excess insurance if a catastrophic exposure is present, and to make arrangements for the handling of claims. In other words, the self-insured entity performs (or contracts for) many of the same functions an insurer would perform.

The most common form of formal self-insurance is with workers compensation. By meeting certain financial prerequisites and arranging for security to guarantee payment of losses to injured workers, an employer can become a qualified self-insurer in most states. The employer will generally contract with a third-party administrator (TPA) to handle the claims. Excess workers compensation insurance is usually purchased to protect against catastrophic occurrences, above $250,000, $500,000, or $1,000,000, for example.

One problem with workers compensation self-insurance for contractors, however, is that construction contracts almost always require contractors to have insurance for this exposure. While many owners and prime contractors will make exceptions for financially stable contractors, some are reluctant to do so, and the additional time, effort, and energy in negotiating this point is a major drawback for self-insuring the exposure. For this reason, workers compensation qualified self-insurance is not as common in the construction industry as it is in many others.

Conclusion An important final note in this discussion is to recognize the importance of risk control to the success of a risk financing program. When a contractor retains more risk, reductions in losses provide an immediate reduction in costs—and increase in profits. Conversely, when loss experience worsens, even the best risk financing plan will not keep the cost of risk from increasing. Additionally, since losses account for as much as 80 or 90 cents of every premium dollar, success in controlling losses can yield much greater cost savings than virtually any other risk management activity. Thus, safety programs work hand in hand with risk finance programs in reducing the cost of risk.

Given that proper attention is paid to safety, by carefully choosing and negotiating a risk financing program, a contractor can substantially reduce its cost of risk and obtain an advantage over competitors with higher costs. These programs will seek to use an optimum blend of risk retention and insurance protection that reduces fixed costs and provides cash flow benefits to the contractor while avoiding unacceptable and detrimental fluctuations in earnings.

As a word of caution, this chapter provides a brief overview of the risk finance plans commonly used by contractors today. Its purpose is only to introduce important basic concepts and terminology. Each of the programs discussed has many advantages and disadvantages as compared to the others that are not discussed above and should be considered, especially when becoming involved with sophisticated loss sensitive insurance plans or alternative market programs.

Chapter 6 Review Questions 1. According to a recent report from its insurer, Taylor Builders’ incurred losses during the

past 12 months were larger than its incurred losses during any preceding 12-month period. In tallying Taylor’s incurred losses, the insurer would have included both paid losses and:

a. an estimate of future costs and payments on known losses.

That is correct! Incurred losses include not only actual payments, but also an estimate of future costs and payments (case reserves) on known losses.

b. losses occurring during the 12-month period that were closed without payment.

This answer is incorrect. Losses that occurred during the reporting period would not have a case reserve at either the beginning or the end of the period.

c. paid premiums.

This answer is incorrect. Although premiums are a cost of risk, they are not counted as incurred losses.

d. reported losses.

This answer is incorrect. Incurred losses have obviously been reported; otherwise, the insurer would not have paid for them.

2. After considering a loss sensitive rating plan for its workers compensation insurance, Cherokee Construction decides to continue its current guaranteed cost insurance program under which its workers compensation premium for the current period is affected by its:

a. auto liability loss experience.

This answer is incorrect. An insured’s auto liability loss experience would not directly affect its workers compensation premium.

b. general liability loss experience.

This answer is incorrect. Workers compensation premiums are based on workers compensation experience.

c. loss experience during previous policy periods.

That is correct! With experience rating, prior loss experience might affect the current period’s premium under a guaranteed cost plan.

d. loss experience during the current period.

This answer is incorrect. With guaranteed cost insurance, the premium for the current period is not affected by the individual insured’s loss experience during the current period.

3. Lorenzo Plumbing has a retrospective rating insurance plan for the period January 1, 2010 to January 1, 2011. When is the amount of the final premium for this policy determined?

a. As of the retroactive date.

This answer is incorrect. A retroactive date is a feature of claims-made insurance, not retroactive rating plans.

b. During 2009, when the policy is sold.

This answer is incorrect. Although a deposit premium is collected up front, it is not the final premium.

c. During 2010, while the policy is in force.

This answer is incorrect. The retroactive premium cannot be determined while the policy is still in force.

d. After the coverage period has ended.

That is correct! With retrospective rating, the final premium is determined retroactively after the end of the coverage period.

4. Sixty paving companies decide to form a policyholder-owned insurance company operating as a risk retention group (RRG) that operates under the auspices of a law passed in 1986. Because all members of the group have similar operations, an RRG can provide its members with a specially tailored program of:

a. liability insurance.

That is correct! The Liability Risk Retention Act of 1986 applies to liability exposures only; however, some have recently proposed that the act be expanded to include other lines of coverage.

b. property insurance.

This answer is incorrect. The Liability Risk Retention Act of 1986 does not permit an RRG to sell property insurance.

c. workers compensation insurance.

This answer is incorrect. Workers compensation insurance must be arranged separately.

d. workers compensation and employers liability insurance.

This answer is incorrect. An RRG cannot cover workers compensation.

5. Because they are fed up with traditional insurance companies, eight large paving contractors wish to form their own captive insurance company which will be known as Captiv8. Captiv8 is not:

a. a group captive.

This answer is incorrect. As a joint venture between several companies, Captiv8 is, in fact, a group captive.

b. likely to be a primary insurer.

That is correct! Contractors’ captives are usually set up as reinsurers.

c. legally permitted to be domiciled outside the continental United States.

This answer is incorrect. A captive that operates as a reinsurer can be domiciled outside the United States with relative ease.

d. unlike a fronting company.

This answer is incorrect. A fronting company is a domestic insurance company that issues policies and performs most other insurer services but cedes some or all premium and losses to a captive reinsurer.

Chapter 7 How the Insurance Industry Operates

Learning Objective

Explain the processes for procuring property casualty insurance and adjusting claims.

On the surface, the process for obtaining insurance is simple. A salesperson, typically called an “agent,” “broker,” “producer,” or “account executive,” works with the contractor to assemble the underwriting data needed to secure proposals from insurers. The producer provides this information to underwriters at one or more insurance companies, and they issue proposals or quotes to write the insurance. The producer then helps the contractor select the optimal quote for each coverage line and coverage is “bound” with the winning insurer(s).

When the contractor experiences a loss, it is reported to the insurer, and a claims adjuster is assigned to handle the claim. The adjuster investigates the claim and determines if the loss falls within the coverage parameters of the contractor’s insurance policies. Assuming coverage applies, the adjuster will determine how much to pay the insured to resolve the loss for property insurance claims or coordinate the defense of liability insurance claims.

This chapter explores the insurance procurement process and claims adjusting process in more detail. Its objectives are to provide an overview of the insurance distribution system, discuss the roles of the important personnel involved with underwriting and servicing contractor accounts, make some suggestions as to how to choose a professional agent or broker, and review some of the important aspects of the claims adjusting process.

Insurance Distribution Systems In the United States, property and liability insurance is distributed by three types of systems: the direct writer system, the exclusive agency system, and the independent agency system. The direct writer and exclusive agency insurance companies market insurance through salaried salespeople or commissioned agents who sell only the insurance products of a particular company. Examples of direct writer and exclusive agency companies include Farmers Group, Liberty Mutual, Nationwide, and State Farm. The independent agency system insurance companies, on the other hand, depend on independent insurance agents and brokers to sell their products. These agents or brokers often represent many insurance companies. A few examples of the many independent agency system insurance companies are ACE, American International Group (AIG), CNA, Chubb, The Hartford,

Travelers/St. Paul, Safeco, and Zurich. In a few instances, certain companies such as Liberty Mutual are represented by both exclusive and independent producers.

From the standpoint of the insurance buyer, each of these alternatives for marketing insurance offers both advantages and disadvantages. The principal advantages of the direct writer/exclusive agency system over the independent agency system are higher quality claims, risk control, rehabilitation, and similar services typically provided by these companies. Another key advantage of most direct writers is lower expense ratios, a fact that should ultimately be reflected in lower premiums. On the other hand, the sales representatives of direct writers and exclusive agency companies may not be as skilled and knowledgeable as independent agents and brokers. In addition, direct writers and exclusive agency companies’ representatives can offer only the services and products that their employer provides. However, both segments are making improvements in their deficient areas, and, consequently, the advantages of one system over another in a particular area are diminishing.

Probably the most important advantage of using independent agents and brokers—as compared to direct writers and exclusive agents—is that agents and brokers can place insurance with any one company or a combination of many insurance companies with which they do business. An independent agency generally has contracts with the insurers it represents. Not being employees of the insurance company, some independent agents and brokers are more oriented toward representing the buyer of insurance than the insurance company.

The insurance buyer should keep in mind, however, that an insurance agent is legally an agent of the insurance company and not of the insurance buyer. In contrast, a true insurance broker is legally an agent of the insured and not of the insurance company. In practice, the legal distinctions between insurance agents and brokers probably make little difference in the level of service provided to insurance buyer and should not be an important consideration in choosing an insurance representative.

An insurance buyer can have success using either the American agency system or the direct writer/exclusive agency system. The main point to remember is that the agent/broker or insurance company representative is the primary interface/supplier of insurance protection and risk management advice, and it is therefore important to choose a knowledgeable and professional representative. Because construction risks and the insurance policies needed to cover them are unique and complex, it is wise to choose a representative who understands the construction industry and has experience writing construction accounts

Selecting an Agent or Broker The most visible function of an insurance representative—i.e., an agent, broker, or direct sales representative—is to procure coverage for clients. Most contractors, however, look to their agent or broker for a variety of additional services. For example, most contractors rely on their broker to perform certain risk management functions, such as identifying coverage gaps and advising them on loss control and risk financing matters. As the commercial insurance market becomes more specialized, contractors’ need for knowledgeable and experienced insurance advisers has grown accordingly.

Because the agent or broker plays such an important role in the risk management program, contractors should exercise considerable diligence in selecting a representative. A common approach to selecting an insurance representative is to invite a limited number of agents and brokers to submit proposals outlining their recommendations for the program and the markets they would use in arranging the coverages. The participants are then evaluated on the quality of their proposals,

Chapter 7—How the Insurance Industry Operates

including their demonstrated knowledge, creativity in the areas of risk financing and handling unusual or hazardous exposures, access to markets, and level of commitment. This competitive process may or may not include actually obtaining price quotes from insurers. The evaluation process should encompass all personnel who will work on the account, including assistants and anyone involved in providing ancillary services. More often than not, assistants (often called Customer Service Representatives or “CSRs”) will handle much of the day-to-day activity on the account and will have some authority and responsibility to act alone.

Unfortunately, some contractors choose a representative without careful consideration of the perils of engaging an inexperienced or incompetent representative. For example, many agents and brokers are engaged because of social or family relationships with the insured. Others are retained based purely on the price quoted. While cost and comfortable relationships are important, they are not the only criteria on which the selection should be based. Construction firms need insurance advisers who understand the industry’s unique loss exposures, such as contractual, environmental, and completed operations exposures, who know what is and is not covered by the applicable insurance policies, and who can make valid recommendations for covering those losses that are not within the scope of the standard policies.

Naturally, contractors want to minimize their insurance costs. However, until all other factors are equal, price should not be the determining factor in selecting a representative. More important are the agent’s or broker’s knowledge, access to reputable and specialized insurance markets, education, experience in dealing with construction-related accounts, and service capabilities. These and other important criteria for selecting an insurance adviser are listed in Exhibit 7.1.

Exhibit 7.1 Selection Criteria

Demonstrated expertise in construction industry

Creativity and flexibility in designing coverage and pricing programs

Access to insurance markets committed to the construction industry

Risk management orientation

Size of account relative to other accounts

Length of time in business

Education and experience of everyone who will be working on the account

Staff assistance

Reputation in the construction community

Service capabilities

Ability to assist in estimating insurance costs for inclusion in contract bids

Location of branches and correspondent offices

Adequate errors and omissions insurance

Ability to handle surety bonds

While knowledge cannot be measured directly, contractors can look at a number of other factors for evidence of the representative’s knowledge. Most agents and brokers would agree that the majority of what they know is learned “in the trenches.” Therefore, length of time in the insurance business is one measure of a representative’s overall familiarity with the markets (e.g., what a particular insurer’s policy form does and does not provide) and experience in negotiating coverage. The amount and types of education, particularly continuing education, also shed light on the representative’s commitment to getting the proper background and staying current on developments in loss exposures, coverages, and markets. Designations such as the CPCU, CIC, and ARM (Chartered Property Casualty Underwriter, Certified Insurance Counselor, and Associate in Risk Management respectively) demonstrate that the agent or broker has completed a rigorous course of study in general insurance and risk management. The CRIS (Construction Risk and Insurance Specialist) designation demonstrates that the insurance representative has embarked upon a course of study focusing on the risk management and insurance needs of contractors and shows a true commitment to the construction industry.

Other than holding the CRIS designation, the best measure of a representative’s construction knowledge is his or her experience in handling similar accounts. A proven track record is very important, and the agent’s or broker’s past performance with other construction-related clients should be evaluated. Asking for references of other contractors is absolutely acceptable, and resistance to providing such references should be viewed as a red flag for further dealings with that agent or broker.

Any licensed insurance agent is legally permitted to handle contract bonds (surety). In reality, many insurance agents are not qualified to adequately serve a contractor’s bonding needs, because suretyship and insurance are very different. However, most agencies or brokers that focus on construction accounts have bond specialists on staff who can perform this function. Other firms specialize in surety credit. The important thing is to make sure that whoever is handling this important responsibility is qualified to do so.

How the size of a contractor’s account compares to an agent’s or broker’s other accounts can have an impact on the service the contractor receives. A common theory on this matter is that the representative’s commitment to an account will be greater if it is the firm’s largest, or one of its largest, accounts. Believers in this theory contend that because the account represents a large portion of the agency’s revenues, it will receive better service and the agent or broker will work harder to obtain favorable coverage at favorable prices.

Another theory holds that an agent or broker that has no other accounts of comparable size may not have the market access or service capabilities that a larger firm would be able to offer the client. For example, if most of a firm’s clients are small, they are very likely purchasing workers compensation insurance on a guaranteed cost basis; a larger firm with more capacity to retain risk may prefer a loss sensitive plan of some type. The agent in this example may be unable to perform the necessary analysis or offer knowledgeable recommendations on how to structure this plan because he or she has no experience in that area. The contractor might thus be better served by choosing a representative that has several accounts of similar size and operations as the contractor in question.

An ideal situation might exist where the client is the largest account at a small office of a large broker. The account is thus highly important to that office, and they have the resources of the national office to call upon. For example, many of the regional and national insurance brokers have centralized research and consulting divisions that support the regional offices.

At the end of the day, the issue of which strategy is better is a matter of preference. The issues of market access and service capabilities can be addressed separately to determine whether the agent in question can meet the contractor’s needs. As for the level of commitment, references and performance during the interview or proposal process usually reveal much about a representative’s professionalism and commitment.

Risk management expertise can be assessed by looking for evidence of risk management education (such as the ARM designation), experience in handling other construction accounts, and by talking with other clients who have worked with the same account executive or team that will be servicing their account. Also, creativity in solving risk financing or insurance problems reveals much about a representative’s overall understanding of market capabilities and alternatives.

Agent/Broker Services Most agents and brokers perform a host of services beyond simply delivering an insurance policy. These may include risk management program reviews, alternative risk finance feasibility studies, policy reviews, construction contract reviews for insurance implications, and assisting in getting claims settled and paid. These types of services are often referred to as “value-added” services because they are performed as part of a general agreement between the representative and the insured, and they do not carry extra charges. The term “value-added services” describes any services the agent or brokers perform as part of their role as adviser, over and above delivering a policy, such as performing risk analysis, maintaining a database, assisting with project bid calculations, calculating test modifiers for workers compensation insurance rating, etc.

Agent/Broker Compensation The compensation paid to independent agents or brokers by the businesses for which they procure insurance is usually in the form of commissions paid by the insurance company (and passed through as part of the premium). In some cases, a fee is paid directly to the agent/broker by the insured business, and in some cases a combination of these two approaches is used.

Commissions vary from insurance company to insurance company, agent to agent, and region to region. They are also different for different lines of insurance. They are, to some extent, a function of the size of an account, with larger ones generating lower commission percentages. In general, however, insurance companies will pay a commission of around 8 to 15 percent of the premium on commercial auto insurance, 10 to 15 percent on commercial fire insurance, 8 to 10 percent on commercial general liability, 10 to 15 percent on commercial package policies, and 3 to 10 percent on workers compensation. Risk managers of larger businesses may have the bargaining power to negotiate the commission percentage with their agent or broker. And sometimes an agent or broker will initiate reduced commissions from the insurance company to compete on medium size accounts against other agents and brokers in a competitive bidding situation.

In addition to commissions, it is common for agents/brokers to derive additional income known as “contingent commissions.” These commissions stem from agreements the agents/brokers enter with insurers called “placement service agreements” (PSAs). These are payable, usually on a preset, sliding scale, when the agent’s book of business with an insurer generates especially favorable loss experience during a given year. Contingency commission plans have been criticized by the risk management community and have received increased scrutiny by regulators and state attorneys general with concerns that they create conflicts of interest. While the future of this system may be in question, it remains in place today. Insurance brokers will disclose the existence of these agreements upon request, and many now proactively disclose them without being requested to do so. It also is likely that many states will pass legislation requiring the voluntary disclosure of these commissions by agents and brokers.

Large contractors may be able to negotiate with their agent or broker to operate on a fee basis. This could be a negotiated flat fee or a fee based on time and expense. Since income to the agent or broker computed in this manner is not a function of the insurance premium, possible disincentives to reducing premiums that are inherent in the commission system are eliminated. This approach can also smooth out the income of the agent/broker rather than having it subject to the cyclical nature of the insurance business. One problem in attempting to place agents/brokers on such a system, however, is that they are not accustomed to accounting for their time and expenses and frequently do not have the systems in place to efficiently do so.

Regardless of the compensation system(s) used, full disclosure of compensation benefits both the agent/broker (by removing the mystery from the process for the client) and the contractor (by facilitating an assessment of the agent’s/broker’s performance). It is a good practice for the agent to provide an annual stewardship report reviewing the services provided during the year and the compensation received for this work. This practice is very common with large accounts and much less so for small accounts. However, it is a good practice regardless of the size of the account, and there is a general trend in this direction as agents/brokers take a more professional approach to their work.

Arranging Coverage and Determining Premiums The process generally used to purchase insurance is illustrated in Exhibit 7.2. The insured asks an agent or broker to obtain a quotation. Underwriting data necessary to determine whether or not the risk is insurable is assembled by the insured and the agent. The agent may or may not then ask a surplus lines broker (a “wholesaler”) to assist in approaching insurers. Surplus lines brokers are most often used for specialty coverages (professional liability, umbrella liability, aircraft insurance, and marine insurance, for example) or for insureds who are in very high-risk businesses (like environmental contractors and homebuilders in some states). The independent agent and surplus lines broker are usually paid commissions that are included in the insurance premium.

Exhibit 7.2 Insurance Distribution and Claims Process

An underwriter at the insurance company reviews the underwriting data and determines whether the company wants to write the policy. In some cases, particularly in professional liability or other specialty lines, the underwriter will be an employee of a managing general agency (MGA) or managing general underwriter (MGU) with authority from the insurer to underwrite on its behalf.

The underwriter who agrees to write the policy also decides how the premium will be determined. Sometimes, particularly with large accounts, the local branch office underwriter must seek home office approval of a decision.

Rating technicians generally perform the actual mechanics of rating the policy based on the underwriter’s instructions. For workers compensation, general liability, and auto insurance, the initial premiums are derived using an exposure base, such as payroll or number of vehicles, that will change during the policy year. Since the initial premiums are based on estimates of the contractor’s exposure bases at policy inception, a premium audit is conducted at the end of the policy period to determine actual exposures and premiums.

Note that the underwriter does not become involved in paying claims. For this reason, all understandings related to the insurance coverage should be put in writing. This will greatly facilitate any necessary negotiations with claims adjusters with respect to special arrangements made with the underwriter. However, it is important that any changes in the coverage provided by the policies issued be implemented by endorsement to the policies rather than through side agreements. Side agreements may not be enforceable in court should there be a claims dispute.

Often, the insurer wants to write a particular policy but does not want to bear the responsibility of paying all the losses. In such a situation, the insurer may arrange with one or more reinsurers to share a portion of the premium and of the insured losses. Usually the insured will not know whether or not its risks are reinsured or the identities of any reinsurers on the risk. The primary insurer is the only party to the insurance contract with the insured and bears all responsibility for insured losses, whether or not the reinsurer(s) pays.

Underwriting Cycles The property and casualty insurance industry is cyclical in nature. It cycles through periods of being a buyer’s market (usually called a “soft market”) and seller’s market (usually called a “hard market”). There are many factors affecting these market cycles. Some of the most important include the following.

Industry competition

Investment returns

Occurrence of catastrophic losses

Overall loss trends

Until the early 1980s, the industry’s cycles seemed to change every 5 years or so. However, the dynamics changed following the very hard market of the mid-1980s, and the industry was in an extended soft market cycle from 1986 until 2001. A number of factors caused the extended soft market, including the ability to earn substantial investment returns, relatively low occurrence of catastrophic events (e.g., hurricanes) in most years, and substantial industry competition. However, the stock market’s downward spiral teamed with rising loss costs eliminated profits for many insurers and the marketplace swung back towards a hard market in the first half of 2001. Then came the horrible events of September 11, 2001, which caused more than $35 billion in insured losses (they were thought to be much higher at the time). The substantial losses of September 11 put the overall insurance industry results for that year in the red for the first time in recent history.

The resulting hard market began to ease for many types of insureds during 2004. However, the risks and complexities of construction caused the market to remain difficult for many types of contractors for an even longer period of time.

During hard markets, contractors will see their premiums rise substantially, insurers will require higher deductibles and retentions, and insurers will pare back the scope of the insurance coverages offered. Some types of insurance will be difficult or even impossible to obtain. In these markets, it is important to be proactive and creative, and to have a very knowledgeable and experienced insurance representative. It takes longer for insurers to respond with proposals, and additional time should be built into the renewal process. Alternative ways to finance risks, such as with loss sensitive plans or industry-owned insurers, pools, or risk retention groups must be considered.

It is much easier to manage an insurance program in soft insurance markets. Underwriters have much more flexibility to negotiate coverage terms, deductibles, and premiums. It is usually possible to broaden the scope of coverage provided in the policies purchased, reduce deductibles, and secure lower rates. Insurers also respond to competitive proposal processes with more attractive terms.

In summary, insurance cycles are not very predictable in the long run, but they there are usually advance signals when a change is imminent. An experienced risk manager or agent/broker will recognize these signs and forewarn of the impending change. By proactively managing the insurance and risk management program, the affects of market swings can be mitigated.

Claims When losses occur, insurers are expected to respond in a professional manner to rapidly settle the resulting claim or claims. Claims are the major cost component of insurance premiums and the reason contractors purchase insurance. Depending on the line of insurance, claims costs generally consume between 50 and 90 percent of the premium dollar.

For all but the very smallest commercial insureds, insurance is simply a cost-stabilizing device. Most insureds will eventually pay all of their losses back to insurance companies in the form of premium dollars. This becomes most obvious in the liability lines (workers compensation, auto, and general liability) wherein experience rating, retrospective rating, deductibles, and other loss-sensitive rating programs make the impact of claims on ultimate premiums quite obvious. However, this general rule is also true in other lines of insurance, such as property insurance.

The Claims Adjusting Process When an insured contractor suffers a loss, a claim should be made to the insurer. It is important to promptly report losses (and in some cases even potential losses) to insurers because failing to do so will violate the claim notice provision of most policies and may result in a denial of the claim.

Except for very small claims, in which agents are sometimes given settlement authority by insurers, a claims adjuster is assigned to the case by the insurer. The adjuster may be an employee of the insurer, or the insurer may contract with an outside company to perform this service. Outside companies that provide these services are called third-party administrators (TPAs). Whether an employee of the insurer or TPA, the adjuster’s primary allegiance is to the insurer.

As illustrated in Exhibit 7.2, the adjuster investigates the loss and compares the facts of the case to the terms of the insurance policy. If the adjuster determines that the policy does not cover the loss, the claim is denied. If the adjuster determines that the loss is covered, the adjuster will negotiate with the insured to settle a property claim or with the claimant to settle a liability or workers compensation claim. In the case of potentially severe liability or workers compensation claims, the adjuster may retain a law firm to investigate, defend, and/or settle.

In some cases, it may not be clear to the adjuster whether or not the claim is covered by the policy. This most often happens with very complex liability claims that have elements that may be excluded and elements that may be covered. For example, construction defect claims often fall into the gray areas of insurance coverage. In these cases, the insurer will usually send a “reservation of rights” letter indicating that it will undertake a defense of the liability claim but reserves its rights to later deny coverage as additional facts become known. Contractors should consult with their legal counsel to determine their options when a reservation of rights letter is received.

The agent/broker will usually work with their contractor client to present the claim to the insurer. However, the agent or broker ordinarily cannot commit the insurer to a particular response. Likewise, the underwriter who negotiated the insurance policy does not normally become involved in the claims adjusting process.

One of the responsibilities of adjusters is to estimate the amount for which open claims are likely to be settled or adjudicated. This estimate is called a “case reserve.” Workers compensation and liability insurance claims costs include not only the amount actually paid on claims but also the case reserves. When the portions of a claim that have been paid are combined with the case reserve, the resulting number is called the “incurred loss.” Incurred losses are used in many ways affect the amount of premiums paid by insured contractors. They are given to competing insurers quoting on the insured’s account, used to calculate workers compensation experience rating modifiers, and used in calculating premiums under standard retrospective rating plans (as opposed to paid loss retrospective rating plans, which don’t include case reserves). Therefore, these estimated case reserves have a substantial effect on premiums, and any “over-reserving” by the insurer will cause undeserved, often unrecoverable, premium increases.

Because claim costs are such a large percentage of the insurance premium, they should be monitored, evaluated, and managed. In property insurance, claims recoveries are also negotiable with the insurer, and the insured’s goal when presenting your case to the insurance company is to maximize a recovery following a loss. Since paid claims in workers compensation and liability insurance will directly affect premium costs in the future, it is important to monitor the loss adjustment activity of the insurance company to ensure that only legitimate claims are paid, that unpaid claims are not being over-reserved, and that claim costs are accurately recorded.

One last key point to recognize concerning claims administration is the close correlation between the quality of claims handling and adjuster file counts. This fact affects both insureds and self-insureds. On one hand, insurance companies have been cutting the size of their adjusting staffs in recent years. On the other, the claims administration business is extremely competitive, and firms sometimes slash prices to “buy business.” The net effect is that whether a contractor self-insures or purchases coverage from a commercial insurer, it is wise to monitor the average file counts of its adjusters. This statistic is perhaps the single most important factor affecting the quality of the claims handling that a contractor will receive.

Chapter 7 Review Questions 1. Angel Contracting has purchased insurance through an independent insurance agency in the

past, but its new manager feels strongly that Angel should be getting its insurance through an insurance broker because an insurance broker is legally:

a. an agent of the insurance company.

This answer is incorrect. An independent agent, but not a broker, is a legal representative of the insurance company.

b. an agent of the insured.

That is correct! An insurance broker legally represents the insured.

c. permitted to bind coverage on behalf of the insurance company.

This answer is incorrect. In representing an insurance buyer, a broker is not permitted to make coverage commitments on behalf of an insurer that can provide the coverage.

d. required to hold a CPCU professional designation.

This answer is incorrect. Both agents and brokers may become CPCUs, but neither is legally required to do so.

2. Harold Construction wants to know how to select an insurance representative that will meet its challenging and complex insurance needs. Which of the following is least likely to be a reliable indicator of an insurance representative’s abilities?

a. His or her gender

That is correct! An agent’s or broker’s gender does not per se indicate whether he or she is competent.

b. Holding a CPCU designation

This answer is incorrect. The CPCU designation demonstrates that the agent or broker has completed a rigorous course of study in general insurance and risk management.

c. Holding the CRIS certification

This answer is incorrect. The CRIS certification demonstrates that the insurance representative has embarked upon a course of study focusing on the risk management and insurance needs of contractors, which shows a true commitment to the construction industry.

d. Track record in handling similar accounts

This answer is incorrect. One good measure of a representative’s construction knowledge is his or her experience and past performance in handling similar accounts, as indicated by other contractors’ references.

3. As a homebuilder, Fein Homes is considered a high-risk business. Ace’s agent is asked to obtain competitive proposals from several insurers who offer coverage for homebuilding contractors. The agent does not have relationships with the insurers who specialize in this line. What type of broker is likely to be able to assist the agent?

a. Liability lines broker

This answer is incorrect. Insurance brokers are not usually categorized in this way.

b. Property lines broker

This answer is incorrect. Although some brokers may specialize in unusual property coverages, this is not a common broker category.

c. Real estate broker

This answer is incorrect. A real estate broker sells homes, not homebuilders insurance.

d. Surplus lines broker

That is correct! Surplus lines brokers are often used for specialty coverages or for insureds who are in very high-risk businesses, like homeowners in some states.

4. Which of the following factors would not contribute to a soft insurance market?

a. High occurrence of catastrophic events

This answer is incorrect. When catastrophic losses erode insurers’ policyholders surplus, they tend to increase premiums to rebuild their equity.

b. Little industry competition

This answer is incorrect. Competition drives prices down, but a lack of competition does not.

c. Low investment returns

This answer is incorrect. If an insurer’s investment returns are down, it tends to compensate by taking steps to increase its underwriting returns.

d. Low loss costs

That is correct! Low loss costs exert a downward pressure on insurance premiums.

5. After submitting a construction defect claim to its insurer, Calamity Construction received a reservation of rights letter from its insurer. What should Calamity do after receiving a reservation of rights letter?

a. Consult its own legal counsel to determine Calamity’s options.

That is correct! A contractor that receives a reservation of rights letter should explore its options with its own legal counsel.

b. Inform the claimant that its claim against Calamity might not be paid.

This answer is incorrect. If insurance does not cover a valid claim against Calamity, Calamity might need to pay the claim with its own resources.

c. Institute a lawsuit against the insurer to enforce its rights.

This answer is incorrect. It would be premature to take action against an insurer at this point, since the insurer has indicated it might pay the claim.

d. Sign and return it.

This answer is incorrect. A reservation of rights letter is a unilateral document signed only by the insurer, although the insured might acknowledge its receipt.

Glossary

additional insured—A person or organization not automatically included as an insured under an insurance policy of another but for whom the named insured desires or is required to provide a certain degree of protection under its insurance policy.

adjuster—One who settles insurance claims.

agent—An insurance agent is a person or organization who solicits, negotiates, or instigates insurance contracts on behalf of an insurer and are the legal representatives of insurers, rather than policyholders, with the right to perform certain acts on behalf of the insurers they represent, such as to bind coverage.

aggregate—A limit in an insurance policy stipulating the most it will pay for all covered losses sustained during a specified period of time, usually a year.

agreed amount endorsement—A property insurance provision that suspends the coinsurance clause.

all risks coverage—Insurance covering loss arising from any cause except those specifically excluded.

alternative market—Risk funding techniques (e.g., self-insurance, captive) or facilities that provide coverages or services not usually provided by most traditional property-casualty insurers.

automobile liability insurance—Insurance that protects the insured against financial loss because of legal liability for automobile-related injuries to others or damage to their property by an auto.

automobile physical damage insurance—Coverage for perils such as collision, vandalism, fire, and theft to the insured’s vehicle.

avoidance—A risk management technique whereby risk of loss is prevented in its entirety by not engaging in activities that present the risk.

bodily injury (BI)—Liability insurance term that includes bodily harm, sickness, or disease.

breach—Failure to live up to the conditions or warranties contained in a contract.

broker—An insurance intermediary who/that represents the insured rather than the insurer.

business auto policy (BAP)—A commercial auto policy that includes auto liability and auto physical damage coverages; other coverages are available by endorsement.

business interruption coverage—Insurance covering loss of income suffered by a business when damage to its premises by a covered cause of loss causes a slowdown or suspension of its operations during the time required to repair or replace the damaged property.

captive—An insurance company that has as its primary purpose the financing of the risks of its owners or participants.

causes of loss—The perils that can bring about or trigger loss or damage.

claim—a demand by an individual or corporation to recover for loss that may come within an insurance policy.

collision insurance—A form of automobile insurance that provides for reimbursement for loss to a covered automobile due to its colliding with another vehicle or object or the overturn of the automobile.

commercial crime policy—A policy that typically provides for employee dishonesty coverage; forgery or alteration coverage; computer fraud coverage; funds transfer fraud coverage; kidnap, ransom, or extortion coverage; money and securities coverage; and money orders and counterfeit money coverage.

commercial general liability (CGL) policy—A standard insurance policy issued to business organizations to protect them against liability claims for bodily injury (BI) and property damage (PD) arising out of premises, operations, products, and completed operations; and advertising and personal injury (PI) liability.

commercial property policy—An insurance policy for businesses that insures against damage to buildings and contents due to a covered cause of loss, such as a fire and may also cover loss of income or increase in expenses that results from the property damage.

comprehensive auto coverage—Coverage under an automobile physical damage policy insuring against loss or damage resulting from causes such as fire, theft, windstorm, flood, and vandalism, but not loss by collision or upset.

conditions—The section of an insurance policy that identifies general requirements of an insured and the insurer on matters such as loss reporting and settlement, property valuation, other insurance, subrogation rights, and cancellation and nonrenewal.

consequential loss—A loss that arises as a result of direct damage to property—for example, loss of rent.

contractual liability—Liability imposed on an entity by the terms of a contract.

contractual risk transfer—The use of contractual obligations such as indemnity and exculpatory agreements, waivers of recovery rights, and insurance requirements to pass along to others what would otherwise be one’s own risks of loss.

declarations—The front page(s) of a policy that specifies the named insured, address, policy period, location of premises, policy limits, and other key information that varies from insured to insured.

deductible—An amount the insurer will deduct from the loss before paying up to its policy limits.

definitions—Terms and phrases that have specific meanings in defining the scope of coverage.

direct damage—Physical damage to propertythat results from the inability to use the damaged property.

direct writer—An insurer who is involved in the direct selling system.

dividends—A partial return of premium to the insured based on the insurer’s financial performance or on the insured’s own loss experience.

event—An occurrence that may or may not become a claim.

Glossary

excess—Insurance to cover unanticipated or catastrophic losses.

exclusion—A provision of an insurance policy referring to hazards, perils, circumstances, or property not covered by the policy.

exposure—The state of being subject to loss because of some hazard or contingency.

extra expense coverage—Time element insurance that pays for expenses in excess of normal operating expenses incurred to continue operations while property is being repaired or replaced after having been damaged by a covered cause of loss.

frequency—The likelihood that a loss will occur.

guaranteed cost insurance—Any insurance for which the insured pays a fixed premium for the policy term, regardless of the number and amount of losses that occur during the policy term.

hazard—Conditions that increase the probability of loss.

incurred losses—The total amount of paid claims and loss reserves associated with a particular time period, usually a policy year.

indemnify—To make compensation to an entity, person, or insured for incurred injury, loss, or damage.

independent adjuster—A claims adjuster who provides services on a contract basis to insurance companies, self-insured firms, and governmental entities.

indirect damage loss—Loss resulting from direct damage to property—for example, income and expense loss resulting from inability to use damaged property.

inland marine coverage—Coverages designed to insure exposures that cannot be conveniently or reasonably confined to a fixed location or insured at a standard rate under a standard form.

insurable interest—An interest by the insured person in the value of the subject of insurance.

insurance—A contractual relationship that exists when one party (the insurer) for a consideration (the premium) agrees to reimburse another party (the insured) for loss to a specified subject (the risk) caused by designated contingencies (hazards or perils).

insured—The person(s) protected under an insurance contract.

insurer—The insurance company that undertakes to indemnify for losses and perform other insurance-related operations.

insuring agreement—That portion of the insurance policy in which the insurer promises to make payment to or on behalf of the insured.

liability insurance—Insurance that pays for loss arising out of legal liability to others.

limit—The total amount of losses to be paid under an insurance policy.

loss—The basis of a claim for damages under the terms of a policy.

loss control—See risk control.

loss of income coverage—A type of business interruption coverage that does not include a coinsurance clause but limits recovery to loss incurred during a specified period after the direct damage loss.

loss reduction—A loss control activity focusing on reducing the severity of losses.

loss sensitive plans—An insurance rating plan for which the final premium is dependent on the actual losses during the period the plan is in effect.

medical payments—A coverage that reimburses others, without regard to the insured’s liability, for medical expenses incurred as a result of bodily injury (BI) sustained by accident.

mobile equipment—A term that refers to equipment such as earthmovers, tractors, forklifts, etc., that, even when self-propelled, are not considered automobiles for insurance purposes.

morale hazard—A subjective hazard that tends to increase the probable frequency or severity of loss due to an insured peril. It implies a certain indifference to loss simply because of the existence of insurance.

moral hazard—A subjective hazard that tends to increase the probable frequency or severity of loss due to an insured peril. It is measured by the character of the insured and the circumstances surrounding the subject of the insurance, especially the extent of potential loss or gain to the insured in case of loss.

named insured—Any person, firm, or organization, or any of its members specifically designated by name as an insured(s) in an insurance policy.

named perils coverage—A property insurance term referring to policies that provide coverage only for loss caused by the perils specifically listed as covered.

negligence—A tort involving failure to use a degree of care considered reasonable under a given set of circumstances.

nonadmitted insurance—Insurance written by an insurance company not licensed to do business in a certain state or country.

occurrence—An accident.

personal injury—A category of insurable offenses that produce harm other than bodily injury.

policy—A written contract of insurance between the insurer and the policyholder, typically composed of a declarations page, policy form, and endorsements that amend the policy form.

probable maximum loss (PML)—A property loss term referring to the maximum loss expected at a given location in the event of an occurrence at that location.

products-completed operations—Hazards arising out of the insured’s products or business operations conducted away from the insured’s premises once those operations have been completed or abandoned.

property damage (PD)—Physical injury to tangible property including resulting loss of use and loss of use of tangible property that has not been physically injured.

property insurance—First-party insurance that indemnifies the owner or user of property for its loss, or the loss of its income-producing ability, when the loss or damage is caused by a covered peril.

public adjuster—A claims adjuster who represents the interests of an insured in a property loss.

reserve—An amount of money earmarked for a specific purpose. Insurers establish unearned premium reserves and loss reserves indicated on their balance sheets.

Glossary

retention—Assumption of risk of loss by means of noninsurance, self-insurance, or deductibles. Retention can be intentional or, when exposures are not identified, unintentional.

retrospective rating—A rating plan that adjusts the premium, subject to a certain minimum and maximum, to reflect the current loss experience of the insured.

risk—Uncertainty arising from the possible occurrence of given events.

risk control—The technique of minimizing the frequency or severity of losses with training, safety, and security measures.

risk financing—The technique of providing for the payment of losses after they occur through retention, noninsurance transfers, and commercial insurance.

risk identification—The qualitative determination of risks that potentially can impact the organization’s achievement of its financial and/or strategic objectives.

risk management—The practice of identifying and analyzing loss exposures and taking steps to minimize the financial impact of the risks they impose.

risk management process—The process of making and implementing decisions that will minimize the adverse effects of accidental business losses on an organization.

risk management techniques—Methods for treating risks, including risk retention, contractual or noninsurance risk transfer, risk control, risk avoidance, and insurance transfer.

risk manager—An individual responsible for managing an organization’s risks and minimizing the adverse impact of losses on the achievement of the organization’s objectives.

risk retention group (RRG)—A group self-insurance plan or group captive insurer that can cover all the liability exposures, other than workers compensation exposures, of its owners.

self-insurance—A system whereby a firm sets aside an amount of its monies to provide for any losses that occur—losses that could ordinarily be covered under an insurance program.

self-insured retention (SIR)—A dollar amount specified in an insurance policy that must be paid by the insured before the insurance policy will respond to a loss.

severity—The amount of damage that is (or that may be) inflicted by a loss or catastrophe.

surety bond—A contract under which one party (the surety) guarantees the performance of certain obligations of a second party (the principal) to a third party (the obligee).

surplus lines broker—A broker who is licensed to place coverage with nonadmitted insurers (insurers not licensed to do business in a given state).

third-party claims—Liability claims brought by persons allegedly injured or harmed by the insured. The insured is the first party, the insurer is the second party, and the claimant is the third party.

time element insurance—A property insurance term referring to coverage for loss resulting from the inability to put damaged property to its normal use.

time value of money—Refers to the ability to invest money and earn income or interest over a period of time.

transit coverage—Inland marine coverage on the insured’s property while in transit over land from one location to another.

umbrella liability policy—A policy designed to provide protection against catastrophic losses.

workers compensation—The system by which no-fault statutory benefits prescribed in state law are provided by an employer to an employee due to a job-related injury or occupational disease.

FUNDAMENTALS OF CONSTRUCTION RISK MANAGEMENT AND INSURANCE

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