The tough insurance and surety markets have changed the face of construction for building contractors in 2003. Rapidly rising premium costs for general liability insurance have hit contractors at their bottom line. Even worse, exclusions and substantially increased deductibles have shifted risks from insurance carriers to contractors.
What is a contractor to do? Residential and multifamily projects are moving ahead during this period of economic slowdown, but how can a building contractor take on these projects without risking the company to uninsured risks, such as mold claims? How can a contractor get insurance to do these projects, and what about those growing deductibles or self-insured retentions (SIR)?
Those contractors that find the answers to these questions and to related ones will not only survive these hard times but will prosper by gaining a competitive advantage in the commercial and multifamily markets. They will position themselves as the leading contractors when the economy turns and the pace of construction increases.
The solutions to these problems or challenges are multiple and fall into these categories:
- Entity formation and asset protection strategies;
- Alternatives to traditional insurance and alternative risk financing options, for contractors that have sufficient financial strength;
- Risk shifting and allocation through construction contracting, including prospective releases for building envelope claims;
- Project-based initiatives, including enhanced scrutiny of design by the contractor and improved quality control and inspection procedures;
- Project closeout processes to assure quality building envelope construction and to alert owners to proper building commissioning and maintenance procedures.
In this article, we will briefly address the first two strategies.
Entity Formation and Asset Protection
A risk management strategy starts with the use of business entities to protect a contractor's assets. These assets may include real property, equipment, and accounts receivables. If the contractor is currently operating as a single entity, such as a corporation, these assets, if owned by the single entity, may be at risk from uninsured or underinsured claims, such as mold claims.
For contractors building commercial and multi-family projects, separate operating entities are often recommended. The contractor retains its existing entity, which becomes a holding company and the repository of its assets. The work is then performed by wholly owned operating companies, typically limited liability companies (LLC's). The contractor may form one LLC for its commercial work and another for the higher risk multifamily projects.
The LLC's must be adequately capitalized, but the contractor's primary assets will not be owned by these operating LLC's. The contractor must respect the legal separation between the several entities. This will require additional accounting support. The contractor can expect additional changes in its operations, ranging from potential changes to its succession planning to the need to set up an employee leasing entity.
While these changes may appear burdensome, they can protect the contractor's assets from the risk of large, business ending claims that are not covered by today's general liability insurance policies.
Alternatives to Traditional Insurance
In the days of low premiums and full coverage, contractors treated insurance like a commodity. Contractors either had no deductible or a modest one. Insurance was the primary risk management tool and contractors had few reasons to consider alternatives to it.
These alternatives include high deductible or large self-insured retention (SIR) policies, or the formation of a captive carrier or some variant, such as a group captive or rent-a-captive. It will not be the purpose of this article to address captives other than in the most general sense.
Today, contractors are actively investigating these alternatives. In the case of high deductible policies, contractors are finding that the choice is no longer theirs and that upon renewal, the insurance carrier has imposed a high deductible-sometimes as great as $250,000, in the case of the larger general contractors.
Each of these alternatives carries great risks and costs, compared with the days of inexpensive, traditional insurance. All involve a form of self-insurance, to a greater or lesser degree. However, some contractors are finding a competitive advantage through these alternative risk-financing options.
The contractor that is prepared for the large SIR can potentially reduce its insurance costs and pass these savings on to owners. By self-insuring the first layer of risk, the contractor must only buy insurance for those levels of risk greater than the SIR. Thus, the contractor with a $250,000 SIR buys insurance for risks in excess of that amount. The result can be reduced premiums.
For the largest contractors, a captive may be appropriate. A captive insurer is one that is formed and owned by the insured-the contractor, for example. Typically formed in a select number of domiciles, these wholly owned insurance companies permit the large and risk savvy contractor to manage its own insurance program and control its risk management program. However, it requires a high tolerance for risk.
In the context of general liability policies, all of the alternative risk financing options require the contractor to institute a comprehensive risk management program for a variety of claims and risks. Construction defect claims must become the subject of an intensive risk management program that includes claims management and resolution. Since the contractor will be using its own dollars, at some level, to resolve claims, the contractor will want to aggressively prevent and when necessary, resolve claims.