2
Charlie Woodman, CPA
Caroline Keonraad, CPCU
Risk Finance Advisory
Willis National Construction
2012 Willis Construction Risk
Management Conference
September 20, 2012

• With increased competition, the dynamics of the bidding process is becoming more critical as are the recovery of costs where allowed
• Insurance and risk management costs are a significant and, often, highly variable element in project profitability, especially where loss retentions are assumed and insurance rates are in specific or cyclical flux
• Establishing realistic risk cost ranges provides greater flexibility in job costing / traditional costing to aggregate levels erodes competitiveness
• Components to always consider and factor into a costing rate:
• Program costs with ultimate expected and adverse loss performance
• Un(der) insured high severity adverse loss risk margins
• Insurance renewal fluctuations especially where projects are long-term
• Insurance program minimums and exposure-based premium adjustments
• Administrative and internal risk management costs
2

• All value is added to the engineering and construction process by managing risk
• Two broad categories of risk
• Fortuitous: Insurance Costs
• Commercial/Technical
• Managing commercial and technical risk is what engineers and contractors do best
• Design / Cost / Schedule / Quality
• Subcontractor performance
• Some engineers & contractors also manage fortuitous risk well and increase their margins at both the corporate level and the project level

• Risk Transfer: Contractual
Insurance
• Risk Retentions
• Deductibles
• Property
•
Fixed Property
• Builder’s Risk
• Equipment
• Casualty, including Legal Defense
• Self-insured Retentions
• Un(der) insurables: Rework / Rip & Tear, etc.
• Business Risk
• Legal Defense
• Workers’ Compensation
• General Liability / Casualty
Umbrella
• Professional and Pollution
Liability
• Subcontractor Default
• Safety Operations
• Claims and Defense Management
• Compliance
• Time
• Transaction Costs
All These Can Exhibit Variability To Some Extent

• Financial Recognition of Losses and Contingencies (Expenses)
• Costing Dynamics
• Expected Losses & Retentions
• Adverse Loss Sensitivities
• Severity Exposures
• Insurance / Risk Transfer Costs
• Internal Costs
• Issues and Considerations
5

Expected Losses within
Deductible
Taxes
Insurance Premiums
Brokerage Commissions or Fee
Uninsured Losses
6
Loss Adjustment
Expense
Regulatory
Compliance
Adverse Losses within Retention
Legal Expenses
Cost of
Reinsurance,
Imbedded
Administrative
Costs
Risk Control

st
• Components of Traditional
Insurance:
 Expected loss and ALAE

Taxes and regulatory fees
 Overhead and administration

Insurer selling and distribution expense
 Reinsurance and
Intermediary charges

Risk Margins
 Surplus charges

Risk Based Capital offsets
Profits & Losses
55 -75%

Fixed (25%-35%)
Insurance Company
Overhead, Taxes,
Reinsurance Cost,
Commission

Profits & Investment Income
Underwriting Profit and
Investment Income Accrued by
Insurance Company and or
Reinsurer
Odd Variable
 Risk Margins
 Surplus & RBC
7

Incurred Losses: The Variable Stuff
65% – 90+%
“Fixed
Costs”
Fixed
• Risk Transfer
• Taxes
• Safety & Claims
Mgmt
• Loss Control
• Admin & Compliance 8

• Make up the vast majority of insurance cost uncertainties
• In Guaranteed Cost: Standard Premium including Experience Mods
• In ‘Loss-sensitive Programs’ : Deductibles and Retentions
• Losses = Pure Loss (claimant satisfaction costs) + Loss Adjustment
Expense (loss reconciliation activity costs)
• Losses and their uncertainty broken down into two (2) types
• Frequency / Burning Losses: Actuarially Predictable – WC / GL / AL
• Admin vs Self-perform GC
• Severity / Adverse / Catastrophic Losses: Tougher to Predict - PL / Comp Op / SDI
• Generally, loss intensity grows with time
We can measure outcomes / pose “what ifs” / Apply Portfolio
Approaches
9

• Financial Reporting is expense recognition which is a reactive activity
• Costing is a rationalization activity which is a proactive activity
• Financial reporting is the responsibility of Owners, CFOs, Management,
Controllers and Independent CPAs - all share the risk
• Reliance by various users on financial statements:
• Sureties
• Banks and finance companies
•
Regulatory boards - licensing
•
Owner and prime contractor prequalification
• Suppliers
• Stockholders (owners)
•
Joint venture partners
• Costing is the responsibility of various technical areas combining to establish reasonable expectations of project costs
10

• A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-But-Not-
Reported (IBNR)
• What is a Loss Reserve?
• Amount necessary to settle unpaid claims
• Case Reserves
• Claim reported but not yet paid
• Assigned a value by a claims adjuster or by formula
• IBNR reserves include: Most difficult to measure and justify
• Reserves for claims not yet reported (pure IBNR)
• Claims in transit
• Development on known claims
• Reserves for reopened claims

• Emergence (E) vs. Settlement (S)
Builder’s Risk
A E
Automobile Liability
S
A E S
Completed Ops / Defect / Statute of Repose (Included in SDI)
A
Workers Compensation
A E
E S
S

• Sometimes solely Industry-based
• Composite to Insurer Expectations
• Loss Development Method using Historical Patterns
• Triangles
• Compiled to measure the changes in cumulative claim activity over time in order to estimate patterns of future activity.
• Loss Development Factor
• The ratio of losses at successive evaluations for a defined group of claims (e.g. accident year).
• Loss Sensitivity Simulation (discussed later): Not Used in Construction
That much

LDFs
24-36
Evaluation Interval in Months
36-48 48-60 60-72 12-24
1.800
1.235
1.134
1.085
1.052
72 to
Ultimate
1.070
Accident
Year
1995
1996
1997
1998
1999
2000
12
3,780
4,212
4,901
5,708
6,093
6,962
Cumulative Paid Los s es ($000 Omitted)
Development Stage in Months
24
6,671
36
8,156
48
9,205
60
9,990
7,541
8,864
10,268
11,172
12,532
9,351
10,987
12,699
13,797
15,477
10,639
12,458
14,401
15,646
17,550
11,536
13,517
15,625
16,976
19,042
Sample Calculations for Accident Year 2000:
At 24 Months :
At 36 Months :
12,532 = 6,962 x 1.800
15,477 = 12,532 x 1.235
or 15,477 = 6,962 x 1.800 x 1.235
72
10,508
12,136
14,220
16,437
17,859
20,032
12 to Ult
3.079
Cumulative Development Factors
24 to Ult
1.710
36 to Ult 48 to Ult 60 to Ult
1.385
1.221
1.126
72 to Ult
1.070
Final
Total
Cos t
11,244
12,985
15,215
17,588
19,109
21,435

• A loss or group of losses is recorded only when (FAS 5):
• The likelihood of actual loss is probable, AND
• The amount of the loss is reasonably subject to estimation.
• If reasonable estimates of loss or losses produces a range of equally likely outcomes – (FIN 14) book the minimum.
• Treat the tail of claims-made expected losses as unlimited loss(es) regardless if a new policy will likely be purchased.
• Importance
• A company cannot set aside reserves for a loss it believes might occur before it actually happens.
• If a loss occurs, a company must recognize the full value of the loss as an expense on its financials in the accounting period in which it knows of the event
• Actual payment reduces a reserve; should not effect earnings.
15

• Remote – the chance of the future event or events occurring is slight
•
Reporting Action: Do nothing or
ID as a Risk of Business, if large, in MD&A
• Reasonably Possible – the chance of the event or events occurring is more that remote but less than likely
• Reporting Action: Disclose in
Notes
• Probable – the future event or events are likely to occur
• Reporting Action:
• If Measurable: Book to Financials:
Disclose in Notes
• If Immeasurable: Disclose in
Notes under “Claims, Lawsuits and Other Contingencies”
16
•
Potential FASB change
– “Remote”, if significant, must be disclosed.

• It Helps In:
• Bidding
• Determining problem projects
• Supporting change order pricing
• Claims process
• Reconciling job costs to financial reports
• Making better decisions
• Making “expansion” less frightening
• Supporting Audits
• Commercial
• Governmental
•
Tax
17

• Meet The “Somes”
• Some contractors only include the cost of insurance premiums in their accrual models without loss consideration.
• Some include the aggregate of total costs and loss exposure (even beyond).
• A contractor’s Total Cost of Risk can include the following:
• Insurance premium costs
• Safety & loss control costs
•
Cost of having risk management staff
•
Claim costs within deductible layers
• Un-recovered legal expenses
• Uninsurable or self-insured risks
• This trick is developing a methodology for quantifying your cost of risk while validating those costs for owners
• And provide you a competitive advantage or wiggle room when bidding or negotiating projects 18

Costing Tolerance

Expected
Losses

Unexpected Losses

Stress Losses
Loss(es) Severities

Fixed Expenses
Risk Transfer Premiums
Program Administration
Safety
Brokerage Fee
Project #1
Project #2 Ins Cost
Allocation
Project #3
Variable Expenses
Retained Losses
Loss Adjustment Expenses
Maximum/
Aggregate Loss
Current
Loss
Accruals
Actuarial
Expected Loss
Potential Profit
Loss

Expected
Losses

Risk/Coverage
Description
Workers Comp
Deductible Funding
Primary CGL
Deductible Funding
Primary Auto Liability
Deductible Funding
Umbrella
1st Layer
2nd Layer (Excess)
3rd Layer (Excess)
4th Layer (Excess)
5th Layer (Excess)
Professional & Pollution Liab.
Deductible Funding
Professional Excess
Builders' Risk/DIC
Contractors Equip.
Deductible Funding
Fiduciary Liability
Excess Fiduciary
Directors & Officers Liab.
Employee Dishonesty
Excess Employee Dishon.
Employment Practices Liab.
Excess Layer
Deductible Funding
Risk Management
Safety Administration
Claims Administration
Brokers Fee
Auto Physical Damage
Total:
Limits
Statutory
$2MM/$5MM
$1MM
$50MM
$25MM xs $50MM
$25MM xs $75MM
$25MM xs $100MM
$200MM xs $125MM
$10MM
$25MM xs $10MM
$1MM
9xs1
$10MM
$1MM
4xs1
10
65xs10
Insurance
Program Cost
3.2390%
8.1429%
1.3192%
4.1429%
0.5685%
1.4286%
INTERNAL COST OF RISK
$1,133,639
$2,850,000
$461,736
$1,450,000
$198,980
$500,000
Notes
MARKET COST OF RISK
Allocation
Cost
$4,382,003 Premium w/ $250k ded.
12.5200%
Deductible Loss Pic
Premium w/ $250k ded.
Deductible Loss Pic
6.0083%
Premium w/ $250k ded.
Deductible Loss Pic
2.1968%
$2,102,910
$768,878
Notes
1st Dollar Standard Policy Premium
First Dollar Cost
First Dollar Cost
1.7000%
0.3743%
0.2250%
0.1589%
0.0000%
$595,000
$131,000
$78,750
$55,619
$0
Policy Premium
Policy Premium
Policy Premium
Policy Premium
Self Insured
0.9221%
0.5590%
0.0000%
0.0000%
0.2032%
0.0714%
0.0000%
0.0243%
0.0000%
0.0000%
0.0189%
0.2100%
0.3429%
0.2143%
0.8388%
2.4314%
0.4514%
0.7971%
0.0000%
$322,742
$50,000
Premium w/ $100k ded.
Deductible Loss Pic
$0 Included in 2nd Layer (Excess)
$0
$71,103
$25,000
Risk Transfer-Per Job
Premium w/ $25000ded.
Loss Pic
Self Insured $0
$8,500
$0 Self Insured
Self Insured $0
$6,600
$73,500
$120,000
$75,000
$293,580
$850,999
$158,000
$279,000
$0
Per Contract with Willis
Self Insured
28.3840% $9,788,748 Total Internal Cost
1.7000%
0.3743%
0.2250%
0.1589%
1.0000%
1.1342%
0.1429%
0.0374%
0.0000%
0.2032%
0.0714%
0.0214%
0.0243%
0.2143%
0.0155%
0.0189%
0.2100%
0.3429%
0.2143%
0.8388%
2.4314%
0.4514%
0.7971%
31.3527%
$595,000
$131,000
$78,750
$55,619
$350,000
$396,973
$50,000
$13,100
$0
$71,103
$25,000
$7,507
$8,500
$75,000
$5,437
$6,600
$73,500
$120,000
$75,000
$293,580
$850,999
$158,000
$279,000
$89,900
$10,973,459
Policy Premium
Policy Premium
Policy Premium
Policy Premium
Market Indications
First Dollar Cost
Deductible Loss Pic
Market Indication
Risk Transfer-Per Job
Premium w/ $ 250000ded.
Based on historical experience
Actual Cost for $1mm
Market Cost for $9mm xs $1mm
Market Cost Indication for $10mm
Actual Cost for $1mm
Market Cost Indication
Market Cost Indication
Market Cost Indication
Per Contract with Willis
Market Cost Indication
Total Market Cost
Loss Pic
Department Costs
Department Costs
21

• The traditional definition of cost of risk has four basic components:
• Insurance purchased
• Retained losses, including claims management costs
• Risk reduction initiatives
• Administration
• = Costs to be divided by Exposures (Project Values / Total Revenues / Total Payroll)
• = Assumed Insurance Rate
• End of Story?
• This traditional definition ignores a key component of cost of risk: the cost of volatility.
22

P r o p e r t y - P r o b a b ilit y D is t r ib u t io n
14%
12%
10%
8%
6%
4%
$500,000 Retention
$1,000,000 Retention
2%
Unlimited Retention
0%
-
75
0,0
00
1,
50
0,0
00
2,
25
0,0
00
3,
00
0,0
00
3,
75
00
0,0
4,
50
0,0
00
5,
25
0,0
00
6,
00
0,0
00
6,
75
0,0
00
7,
50
0,0
00
8,
25
0,0
00
9,
00
0,0
00
9,
75
0,0
00
10
,50
0,0
00
,25
0,0
11
00
12
,00
0,0
00
12
,75
0,0
00
13
00
,50
0,0
14
,25
0,0
00
,00
0,0
15
00
Losses / (Gains)
Unlimited $500K Retn $1MM Retn

P r o b a b ilit y D is t r ib u t io n s - I n d iv id u a l R is k s
14%
12%
10%
8%
6%
4%
Auto Liability
Builders Risk
Workers Comp
Professional Liab.
2%
0%
0
75
0,
00
0
1,
50
0,
00
0
2,
25
0,
00
0
3,
00
0,
00
0
3,
75
0,
00
4,
0
50
0,
00
0
5,
25
0,
00
0
6,
00
0,
00
6,
0
75
0,
00
7,
0
50
0,
00
0
8,
25
0,
00
0
9,
00
0,
00
9,
0
75
0,
00
10
0
,5
00
,0
11
,2
00
50
,0
12
00
,0
00
,0
00
50
,0
12
,7
13
,5
00
00
,0
14
00
,2
50
,0
00
00
,0
15
,0
15
,7
00
50
,0
16
00
,5
00
,0
00
50
,0
17
,2
00
Losses / (Gains)
Prop. @1MM W.C. @1MM Prod. @1MM Auto @1MM

P r o b a b i l i t y D i s t r i b u t i o n s - Al l Li n e s
10%
9%
8%
7%
6%
5%
4%
3%
Retained Risk @ 85th Percentile
Risks Treated In Combination
Retained Risk @ 85th Percentile -
Risks Treated In Isolation
-
2%
1%
0%
15
,00
0,0
00
16
00
,50
0,0
18
,00
00
0,0
19
,50
0,0
00
21
,00
0,0
22
00
,50
00
0,0
24
,00
00
0,0
25
,50
0,0
00
27
,00
0,0
28
00
,50
00
0,0
30
,00
00
0,0
31
,50
0,0
00
33
,00
00
0,0
34
,50
0,0
00
36
,00
0,0
37
00
,50
00
0,0
39
,00
00
0,0
40
,50
0,0
00
42
,00
00
0,0
43
,50
00
0,0
45
,00
0,0
00
46
,50
0,0
48
00
,00
00
0,0
49
,50
0,0
00
Losses / (Gains)
All Lines- Treated as Combined All Lines- Treated as Separate

Outputs Item
Simulation#
Statistics / Cell
Minimum
Maximum
Mean
Standard Deviation
Variance
Skewness
Kurtosis
Number of Errors
Mode
45%
50%
55%
60%
65%
70%
75%
80%
5%
10%
15%
20%
25%
30%
35%
40%
85%
90%
95%
Losses at $250,000 per Occurrence
1
3,264,992
8,585,279
5,297,963
680,733
463,397,165,442
0.259430
3.028987
-
4,837,020
4,231,137
4,427,777
4,584,207
4,710,057
4,825,061
4,916,320
5,009,401
5,098,429
5,182,846
5,271,783
5,356,573
5,454,766
5,543,744
5,636,479
5,738,704
5,859,217
5,997,048
6,193,518
6,475,948
NA
26
Expected Losses
Aggregates usually > 95%

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

28

• Expected Losses
• Loss Variability
• Severe Loss Probability and
Tolerances
• Fixed Cost Variability over Time
• And Combine Them Into a Range of Reasonable Insurance Cost
Rates
2
29

• Key regulation* for accounting for insurance costs:
• Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs
• Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs
• FAR 31.205-19, Insurance and Indemnification
• FAR 31.201-5, Credits
• FAR 28.3, Insurance
• When to evaluate your current accounting practices for insurance costs?
• Contracts will be CAS covered
• Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification
*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html
Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html
30

• Profitability offsetting between projects
• Contract where “deductibles” are borne contractor; language clarity is essential
• Use of insurance quotes to support insurance costs – Basis Risk
• Use of Loss Exposure Aggregates limits as costing levels
• Multi-state differences in retentions or limits / sub-limits
• Monopolistic states
• Incurred and Paid Loss Retrospectively-rated Insurance
• CCIP minimums and insurance cost timing
• CPPI where contract allows Pollution but limits Professional
• Project-specific coverage cost reimbursement disallowances
• Workers Compensation costs – General Conditions (Auditable Labor Burden) and Admin / Fees (Profit Eroding)
• Defect / Completed Operations /DIC
• Subguard / SDI
31

Charlie Woodman, CPA
Caroline Keonraad, CPCU
Risk Finance Advisory
Willis National Construction
2012 Willis Construction Risk
Management Conference
September 20, 2012