Construction Project Risks How to Estimate Insurance Costs

Frustrations with the Allocation Process of Risk Management Costs

To ensure that a project runs smoothly, coordination among all parties regarding allocation of insurance costs should be a priority of the management teams.  The terms and conditions of the prime contract should allow for a starting point of discussion in properly allocating costs to the benefit of the owner, general contractor, and subcontractors. If proper coordination does not take place, frustration will ensue, including the following:

Owner Frustrations

The changing costs of insurance from one project to another and from one region of the country to another and the general contractor’s seeming inability to procure “typical” insurance terms and conditions with reasonably high limits are common owner frustrations.  Contractors trying to push risk of subcontractor’s inability to secure proper insurance coverage back to the owner will frustrate owners.  An unclear response from the general contractor or their broker regarding back-up or validation of the general contractor’s insurance rates also causes owner frustrations.  Many owners are frustrated by the belief that the general contractor is using the cost of insurance as another “profit center.”

General Contractor Frustrations

Erosion of broad coverage within the insurance marketplace is a general contractor’s frustration.  Old projects giving rise to new insurance claims, namely the proliferation of completed operations claims especially relating to construction defects, is also a current general contractor frustration.  Subcontractors’ position that they “just can’t get” the required insurance, or that there is a significant up-charge to procure the required insurance is compounded by the seeming failure of those same subcontractors’ insurers to stand up to claims when presented, and their seemingly constant foot-dragging on coverage determinations for tenders of defense/indemnity. The owners’ enthusiasm for pushing risk back onto the contractor by way of the Prime Contract with broad-brush statements of “it’s your risk” also compounds the risk frustrations for general contractors.  Additionally, the owner architect/engineer’s lack of adequate coverage and/or limits, effectively pushing risk back to the general contractor, and owners truly thinking that insurance is a profit center, both add to general contractors risk management frustrations.  (Personal conversation with Chris Heaney, Executive Vice President, Berglund Construction Company, on December 11, 2005.)

Subcontractor Frustrations

Subcontractors’ are frustrated with the erosion of broad coverage within the insurance marketplace along with general contractors and owners not being flexible in consideration of this reality, while being fixed into a subcontract price which does not capture market price escalation.  Subcontractors are frustrated with being held responsible for risks that they cannot meaningfully control without receiving commensurate compensation, creating insurance risks for subcontractors.  Being pulled into completed-operations claims with diffuse statements of “bad-work” before any meaningful investigation has taken place; general contractors and owners demanding defense/indemnity response and threatening a lawsuit without providing a tangible connection between the alleged problems and the subcontractor’s work are examples of unfair frustrations for subcontractors. Being told that they are accountable for insurance requirements (at their own expense) that they had not been made aware of prior to bid, or that they cannot reasonably comply with, commonly frustrates subcontractors.  Subcontractors wish they had enough influence with the insurance marketplace to make insurance a profit center as they think the general contractors and owners do.

Market Changes Impacting Insurance Programs and Pricing Models

Market changes impact insurance programs, along with legislative issues.  The insurance industry, like most other industries, is cyclical.  Dramatic changes in construction insurance have been commonplace in the industry over the past 5-8 years.  Impacting changes include insurance company insolvency, long-term effects of 9/11, greater level of owner sophistication, emerging insurance companies, and fluctuations in pricing by geographic area. Some of the major issues are mentioned here.

Issues Common to the Construction Industry

Major issues common to the construction industry include cost fluctuation for various lines of insurance which, at times, can be influenced more by market factors than by loss experience.  Additionally, Deductibles and Retentions have increased--both as insurer expectations, and as necessitated to keep the net cost of insurance low--it then becomes the responsibility of the contractor to determine the charge-out rate, manner of financing, managing, and/or risk transfer for this “burning layer.”

Exclusions on general contractor and subcontractor policies, such as erosion of coverage within the general liability form itself including EIFS (Exterior Insulated Finish System), subsidence, silica, CCA-C (chromated copper arsenate), and residential construction (very broadly defined), make long-term interpretation of the coverage uncertain.  Insolvency of insurers on prior projects and on wrap-up programs is an issue: (1) Reduced number of quality insurers as rated by AM Best that can adequately serve the construction industry’s unique insuring needs.  (2) Cost to defend claims is increasing, thereby causing a corresponding erosion of available limits.  Another concern common to the construction industry concerns limits or coverage available in the market for some contractors that are often not commensurate with the risk of the work that they are performing.

Legal/Legislative Environment

Complex litigation pertaining to construction defects has quickly become a market-influencing force. The statute of repose in many jurisdictions outstrips reasonable performance expectations (and warranty) of some of the systems integrated within the structure.  Some “right of repair” laws in various jurisdictions have begun to address this inequity.

The case law/statute in some jurisdictions limits the practical ability of the general contractor to transfer risk-financing obligations (additional insured endorsements) and hold-harmless obligations to the subcontractor, putting a heavier financial burden on the general contractor’s own program when it was not originally priced to carry that risk.  The American Subcontractor Association is actively lobbying for restrictions to limit downstream indemnity transfers and insurance requirements on subcontractors. (Personal conversation with Pat Wielinski, Attorney-at-Law, Cokinos, Bosien & Young, on January 4, 2006.)

Wrap-up Programs

Wrap-up programs hold varied benefits when it comes to insurance pricing.  The biggest value of a wrap-up program is the coordination of coverage, which allows for consistent pricing among all contractors.  This coordination stems from the fact that wrap-ups are under one insurance program, written by one insurance company--all contractors and subcontractors are under one umbrella of insurance--thus the term “Wrap-up.”  This consistent approach allows the pricing of coverage and proper allocation in the construction bid for all parties.  Some of the major issues are mentioned here.

Historical rationale for purchasing wrap-up programs

The historical rationale for purchasing wrap-up programs is that a wrap-up program will likely provide higher limits for the participating contractors than what they could provide on their own through insurance credits back from contractors (for insurance provided under the Owner Controlled Insurance Program) which off-set the cost of the program.

Benefits of wrap-up programs in light of current marketplace

A properly structured wrap-up program can address thin limits within contractors’ programs if the limits provided are project specific, and are not eroded by other dissociated projects.  Another benefit is that a wrap-up program may provide broader coverage within the policy form than what the general contractor or subcontractor might otherwise be able to obtain.  For the most part, a wrap-up program eliminates the difficulties contractors often have in complying with additional, insured endorsement requirements and the related tracking of certificates and endorsements.  Also beneficial is that a wrap-up program addresses “residential” insurance coverage issues when project details are accurately communicated to the underwriter.

Disadvantages of Wrap-up Programs

Disadvantages of wrap-up programs vary according to the carrier and types of coverage provided.  One example concerns when high hazard operations are typically excluded, and these include demolition and blasting.  Other disadvantages include enrollment procedures, and follow-up.  If a contractor fails to enroll and subsequently incurs a loss on the project site, will that claim be a covered loss?  One of the biggest disadvantages is that most wrap-up programs do not provide completed operations coverage out to the state’s statute of repose.

Owner Controlled Insurance Programs (OCIP)

In a typical OCIP, the general contractor is the controlling contractor and is the party that normally is identified to coordinate insurance coverages of the subcontractors on behalf of the owner.  With this in mind, the following insurance provisions are discussed in brief.

Challenges for the contractors

Challenges for the contractors include the following four concerns:

EIFS--Exterior Insulated Finish System--exclusions can extend to exterior systems beyond the EIFS system itself.

Subsidence--often includes any movement of earth, such as a trench collapse, which would not intuitively be thought of as subsidence.

Residential--the term residential may be defined so broadly as to actually exclude coverage for the structure (or parts of the structure) under construction.

Program limits may be applicable to other owner projects unknown to the contractor participants.  Initially, the owner may not know how many projects they intend to roll into a wrap-up program.  

Limits wasting away because of defense costs on claims for one or multiple projects, when the defense costs are inside the limit.

Negotiating from Standardized Contract Form

Construction insurance budgets for insurance costing typically stem from one of the following standard forms of contracts:

Budgets initially set using standardized industry forms taking into account risk issues and predetermined insurance requirements

AIA 1997 A101 / A201 (Lump Sum)

AIA 1997 A111 / A201 (Guaranteed Maximum Price)

AGC 200 (Lump Sum)

AGC 250 (Guaranteed Maximum Price)

Cost Identification Issues by Line of Insurance

Insurance deductibles are probably the one provision that pose the most difficulty for contractors’ to price.

Common Issues

A determination must be made as to what “price” should be charged within the cost of risk for the deductible exposure in each policy.  The higher the selected deductible, the less the related insurance premium will be.  So, the deductible must be accounted for.  A policy’s deductible aggregate provides a gauge as to the contractor’s ultimate deductible exposure.  If there is no deductible aggregate, a reasonable estimate must be made regarding that exposure.  Contractors typically will rely on their insurance broker to assist them in pricing-out their respective deductibles.  The model is an outline of key considerations regarding this important provision.

Past-loss analysis or actuarial projections can be made.

Alternatively, an estimate can be made based on the potential number or “expected” number of events.

Proper consideration must be made with regard to defense costs and how they interact with the deductible and the limits of insurance, and how the type of work and jurisdiction may influence the cost of defense.

Although a flat premium may be originally developed based on total construction volume or other metric, the most accurate metric to use must be determined when allocating out that cost to the projects.  The contractor may wish to use a method to allocate that premium that best takes into account the risks involving that coverage.  Insurance that is maintained, but not necessarily required by every owner contract, needs to be determined.  Examples may be pollution, professional, or equipment coverage.  All such insurances benefit the owner directly or indirectly, but a decision about how to allocate those charges needs to be made.

General Liability

There are a number of notable exclusions within most common policy forms, which now must be addressed with different insurance or internal funding mechanism.  They are:

Equipment

Coverage is typically rated against insured values and anticipated rental expenditures, subject to maximum per item loss limit.  Actual value of rented or leased item must be reviewed against this per item limit.

Tower crane value, for example, may exceed loss limit or may not be insured unless specifically scheduled.  In this instance, premium may be most properly allocated to the specific project utilizing the crane or scheduled item.

Workers’ Compensation

Workers’ Compensation insurance is typically a contractor’s most expensive line of insurance coverage, especially, if a contractor self-performs a majority of its work.  The experience modifier or (EMR) is an insurance calculation that adjusts a contractor’s workers’ compensation premium based on their historical payrolls and losses.  It is the key index in pricing workers’ compensation coverage.  In simplified form, it is a contractor’s actual losses divided by their expected losses.

The experience modifier may change (up or down) between the time the work is originally bid and when the work is actually put into place.

Should the contractor bid the work with its published modifier?  Should the current owner receive the benefit of past internal cost of risk investments made by the contractor?

Schedule credits, which are granted in one year, may not be made available in subsequent policy years even though there may be no change in the contractor’s workers’ compensation experience.  Composite rating may be used to blend the cost of all employees’ workers’ compensation rates to create better predictability of workers’ compensation costs.

Builder Risk Insurance

The Prime Contract must be reviewed carefully to determine which party has responsibility for procuring the important coverage of Builder Risk Insurance.  If the Prime Contract is silent regarding this obligation, the general contractor should include the price for the coverage in its budget, as the “responsibility for the work” clauses could be argued in such a way as to hold the contractor responsible for loss or damage, regardless of the existence of the necessary coverage.  The pricing can be removed from the budget if the owner ultimately provides the coverage.  If in a hard-bid situation, the question should be clarified for the benefit of all bidders prior to the bid date.  If the owner is intending on providing the coverage, the general contractor should be sure that the details of the required coverage are listed fully in the Prime Contract.  Builders Risk insurance should be reviewed very carefully by contractors prior to purchase.  Every coverage form is different.  Deductibles, limits, perils, and all other additional coverage provisions will vary.  Many times, the owner is not in a good position to purchase the Builders Risk insurance based on the owner not having the expertise in construction operations.  If, in the prime contract, this is delegated to the owner, the contractor should try to negotiate this provision. (Personal conversation with Bill McIntyre, CEO, ACIG, on November 20, 2005.)  The 1997 AIA A201 Section 11.4 is one potential guide to memorializing coverage points.  Be clear on a number of key points as follows:

The “All Risk” policy form.

Coverage for any existing structure in which the construction will take place (such as a renovation).  The selected limit must be sufficient to cover a catastrophic loss and the parties must agree that the insurance limit selected is the sole source of recovery to the owner in the event of a property damage claim.  In other words, the general contractor and subcontractor(s) should not be held responsible for an underinsured loss to the existing structure.

Inclusion of earthquake and land movement coverage, especially in high risk areas.

Inclusion of flood, windstorm, and water damage coverage.

Coverage for materials stored offsite, intended for incorporation in final structure.

Inclusion of coverage for any owner-provided furnishing, fixtures, and equipment which the general contractor or subcontractors will be asked to install or move in.

Delay in opening / loss of use / soft costs coverage; or the general contractor, subcontractor(s) and materials suppliers are provided with waiver of rights of action against them for such damages.

Subcontractor Default Insurance (SDI)

Subcontractor Default Insurance (SDI) is procured by the general contractor as a replacement for subcontractor bonds.  It is designed to cover the financial impact associated with a subcontractor default of its subcontract obligations.  Advantages to the owner and general contractor include providing higher limits that are available to respond to a subcontractor default and a much-simplified claims process, helping the construction process stay on track.  SDI also potentially broadens the pool of bidding subcontractors, creating work opportunities for those subcontractors unable to currently provide payment and performance bonds.

Premium is developed as a rate against anticipated construction volume making it easily translatable into a per-project charge.

Rates may vary by contractor, by the type of construction risk, and by region.

Price Modeling for Assumed Risks

While there are innumerable approaches for developing charge-out rates for the cost of risk and insurance for projects, we have put together a model of potential costs to consider.   We have also provided a few sample models designed to distribute the cost of risk between similar business units, or business units performing different types of construction services.  While no single approach is without flaws, these models are intended to provide the rationale behind allocating the cost of risk and insurance premiums to the project.

Table 1

Sample table for developing cost of risk

Legend

Rate:  Dollar amount per unit charged

Exposure base:  Depending on the line coverage, the exposure base typically is payroll for WC and GL, Receipts for GL, Builder Risk and SDI, Number of auto units for auto liability.

Sample Models

Even though there are innumerable approaches for developing charge-out rates for the cost of risk and insurance for projects, the following three models for charging-out risks to projects are outlined below.  While no single approach is without flaws, these models are intended to provide the needed rationale behind allocating the cost of risk and insurance premiums to a project.  The designations A, B, C, D, E, and F, refer to the items in Table 1.

Model 1, Simplified:

Useful when contractor is providing primarily general contracting services between all of its business units.

_______% of Contract Value [A/B]

Alternatively:

_______% of Payroll [A/C]

Model 2:

Provides risk adjustment between business units.  In the following example, one unit does self-performed work (industrial) and the other does very little self-performed work (general contracting/construction management).  In the example below, the Cost of Risk is equally weighted between the two factors.  Actual weighting may vary depending on evaluation of the risks.

______% of Contract Value [(A/2)/B]

______% of Direct Craft Payroll [A/2)/D]

______  Cost of Insurance/Risk

Model 3:

Provides risk adjustment between business units that directly manage work (general contracting) and units without privity of contract with site contractors (construction management).  Below, the Cost of Risk is equally weighted between the two factors.

 ______% of CM Fee [(A/2)/E]

______% of Total CM Construction Value [(A/2)/F]

______  Cost of Insurance/Risk

Contract Wording

In any of the above examples, it is prudent for the parties to agree to the rate(s) at the time the Contract is executed and memorialize that understanding in the Agreement wording.  This benefits the parties by excluding the issue from audit, by negotiating and resolving any issues at the time of the project negotiation.  Below is sample wording that can be added to Section 7.6.1 of the 1997 AIA A111 to memorialize the agreement between parties.

Sample Wording

Insurance shall be reimbursed for each pay application at the agreed-upon rate of  ________________ and shall be adjusted in accordance with the ___________ Index upon _______________

Coordination with Estimating

Internally, within a contractor’s organization, communication with the estimators will play a vital role in determining a properly structured bid.  The following considerations should be key objectives.

Proposals should be submitted with the budgeting based on standard contract forms.

The types of projects should be clarified for which a wrap-up program should regularly be considered, such as for projects with residential exposures.  The risk manager who is typically responsible for and held accountable for a contractor’s insurance program should ensure that proper communications are established with all levels of management and other operational disciplines that will affect how the insurance program is structured and budgeted.  Some of the key considerations should include quarterly staff meetings to include project managers, key operational managers, and the manager of estimating.  The backlog of projects, projected bids, and any bids going in into new markets or new states need to be carefully evaluated regarding the risk to the contractor.

Commonly Asked Questions

Why, as an owner, am I being charged for insurance coverages not required in the Prime Contract?

There are two primary reasons for being charged for insurance coverages not required in the Prime Contract.  First, the indemnity agreement holds the contractors responsible for risks which they largely are unable to self-fund because there is typically no stated dollar cap to that obligation.  So, while the insurance requirements may be silent on a number of key coverages, the indemnity obligation to the owner necessitates that the insurance be purchased and maintained in order to uphold that obligation.  Second, over time, some coverage under the general liability policy form has eroded due to case law interpretations and changes to the policy form itself.  This has brought about the need to purchase other policies--pollution being perhaps the best example of this.  Also, equipment coverage is necessary because of the use of various types of equipment for the project by the general contractor.  If the coverage could not get reimbursed in the budget, the only alternative would be to have all such equipment provided through subcontractors. Subcontractors would naturally include the cost of the insurance in their subcontract price (so the owner would pay for it anyway), but the process of subcontracting the rental of such items may make the project less cost-efficient.

Why do general contractors believe it is “equitable” to require subcontractors to sign broad hold-harmless agreements?  Doesn’t it make more sense for everyone to pay for losses in accordance with their share of the “fault?”

The long-stated purpose, and in theory, equitable practice, of express-indemnity or hold-harmless agreements was and is to allocate responsibility for a loss before the loss actually occurs.  Then, there would be proper funding pre-arranged for the loss as well as a “road-map” for determining responsibility.  This prevents finger-pointing, puts all of the indemnitee parties on the “same side of the table” and focuses the parties on mutually resolving the claim from the plaintiff party.  This pre-set manner of resolving claims is to ensure that claim disputes do not interrupt the progress of the work or interfere with the relationship between the parties--keeping the relationship favorable for the next potential project together.  In theory, such an arrangement is equitable since all the parties have had the opportunity to establish their price at the time of bid for the work and including the indemnity obligations as outlined in the Contract.  The definition of “insured contract” within the general liability policy form upholds these types of hold-harmless agreements.

As a general contractor, do I even need to carry professional liability coverage if I’m not doing design/build work?

There are many trades under contract to the general contractor which perform professional services, such as engineering, in order to properly execute their work (HVAC/Mechanical being notable examples).  To the extent that there is an error in the execution of those services, there may be a resulting professional liability claim.  The subcontractor may or may not have broad enough coverage or sufficient limits to pay for the claim.  Therefore, many general contractors have opted to purchase such “contingent” professional liability insurance which sits as excess to any professional liability coverage maintained by its subcontractors.

Conclusion

Pricing insurance into a general contractor’s and subcontractor’s bid is becoming more difficult in today’s construction marketplace.  There are many variables that are in a constant flux of change in the insurance industry that makes the contractor’s job much more difficult in establishing the correct charge for a particular bid.  There are many models available to allow for these changes.  Indeed, many contractors try to use past-loss experience and even actuarial projections from consultants to assist in making these charges into the bid. 

Proposals and budgets should assume that standard contract terms and conditions will be utilized.  Any projects that meet the cost scope of a potential wrap-up should be identified early, as well as ensuring inclusion of inflationary figures or indexes for projects that extend past the current policy year.

A contractor’s risk manager and the estimators must work diligently in communicating all the key insurance components for bid preparation.  Important considerations include insurance company insolvency, coverage erosion, and in some instances, unreliable subcontractor’s insurance coverage to name a few.

It is vitally important that both the general contractor and subcontractors remain vigilant in conducting the appropriate follow-up in securing the required information regarding insurance coverage and bid pricing due to the ever-changing construction insurance landscape.

Bibliography

A. M. Best Company.  (Study from 1969-2002.)  Leading cause of insolvency was inadequate reserves for claims; Rapid growth also has played a major role;  Most insolvencies relate to some form of mismanagement.

American Subcontractors Association. (January 2005). Walsh Construction Co. v. Mutual of Enumclaw, 189 Or App 400, 76 P3d 164 (2003)Oregon Supreme Court.  Affirmation.

Associated General Contractors  Construction Inflation Alert, by Ken Simonson, Chief Economist.  Retrieved from www.agc.com.

General Accounting Office.  (1987).  Insurance Failures (GAO/GGD-87-100).

Lew, J. and Overholt, M.  (1998).  Managed contractors insurance programs.  Associated Schools of Construction Proceedings. 1998, 205 -215.

U.S. House of Representatives, Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce.  (February 1990).  Failed promises: Insurance company insolvencies.