General contractors (GCs) that self-perform less than 70% of their work often prefer Controlled Insurance Programs (CIPs) to manage and finance risk.

In years past, GCs could return a profit on the CIP program because the deductions to subcontractors bids would be in excess of the costs of the CIP insurance program.

In today's competitive environment, the CIP still allows the contractor to be in control, but with fewer program savings than historically available.

There are several advantages to procuring site-specific coverage rather than each contractor on the job purchasing separate coverage for workers' compensation, employer's liability and general liability. Those advantages include:

  • Obtaining the broadest possible coverage

  • Controlling insurance through the statute of repose

  • Controlling claims resolution

  • Reducing cost by obtaining a volume discount

  • Reducing litigation

CIPs create more competition

A CIP also allows smaller contractors the ability to bid for work and compete with larger firms because of the high limits of liability and insurance coverage the CIP provides. This allows a contractor to pursue a broader range of subcontractors. Furthermore, all of the participants in the construction process benefit from the elimination of fraudulent certificates or canceled insurance. In addition, the general contractor does not have to worry if the subcontractor maintained insurance during the statute of repose, because if designed correctly, the CIP provides this coverage.

Contractor uses CIP

With the exception of guaranteed cost, the GC retains a significant retention or deductible on the exposures insured under the CIP. (Photo: Shutterstock)

How a CIP Works

In a CIP, the general contractor (or sponsor) is a fiduciary for securing coverage for all participants. That is why a well-designed program provides the broadest possible coverage to the benefit of all participants. While there are numerous benefits, there are aspects of CIP programs which are of concern. Paramount in those considerations is the long-term financial impact arising from the CIP. Proper structuring of a CIP is important; deductible levels, statute of repose, and potentially using a captive to finance retentions need to be evaluated to determine the most efficient structure. Thus, having a broker with the tools to assist with the impact of risk financing is essential.

With the exception of guaranteed cost, the GC retains a significant retention or deductible on the exposures insured under the CIP. This includes construction defect claims which may take years to develop. Absent a CIP, these risks would be insured under the subcontractor's insurance program for all subcontracted work (if that insurance exists and coverage is not specifically excluded!) In a CIP, contractors are willing to accept subcontractors' risk because an appropriate credit (or deduction) is applied to the subcontractors bid to perform work. By reducing the subcontractor's insurance expense, the general contractor is able to develop funding for this exposure. In total, those deductions should be sufficient to pay for losses as well as fixed costs of the CIP.

This framework demands the CIP sponsor manage the risk under the program effectively and understand the long-term cost of the self-insurance component. The ability to forecast the cost of self-insurance and properly document the costs is vital to the overall success of a CIP. If the self-insurance costs are properly documented they can be included in bids and in some cases approved under the Federal Acquisition Regulations when government work is involved.

CIP Risks

As is true in most risk financing arrangements, collateral requirements impact a CIP. (Photo: Shutterstock)

What risks are covered?

Contractors may not fully understand what risks are insured in the CIP. For instance, the period for warranty work is limited. Additionally, subcontractors need to be given proper notice when coverage on the CIP lapses so they can cover additional warranty work on their own policy.  A well designed and properly administered CIP will address these issues so that neither the contractor nor the subcontractor has a gap in coverage.

As is true in most risk financing arrangements, collateral requirements impact a CIP. As CIP exposures contain the risk of subcontractors where historical loss performance is unavailable, all too often we find insurers and brokers relying exclusively on predetermined loss development factors or unmodified state loss costs promulgated by NCCI or ISO. This is where a good broker can help! In reality, there are numerous other data points available to accurately forecast loss experience that takes into account CIP experience and subcontractors' past loss history.

A thorough review of exposure by state and a revenue waterfall chart can also be constructed to better understand the exposure. Using these methods, we are able to convince insurers to understand when the CIP is performing above expectations and thus reduce collateral requirements. Most insurers' actuarial teams are not devoting the energy to understand each risk under their preview. However, they are reasonable and if the analysis dictates a redundancy, prospective and legacy collateral requirements can be decreased.

The tax impact

If the subcontractor retains their own insurance, the revenues paid to the subcontractor are deductible for tax purposes upfront when the work is performed. In a CIP, the deductions reduce the revenues paid to the subcontractor increasing the sponsor's taxable income. While the sponsor will obtain a tax deduction for fixed insurance costs, the deductions allocable to loss costs within the CIP retention will not be tax deductible until the claims are paid.

A captive can change this dynamic by allowing the sponsor to deduct case and IBNR reserves. Captive program structures should be designed to the individual contractors' situation. The program structure will change depending on whether the contractor is an S-Corp, LLC or C-Corporation. State tax considerations, the payout and volatility of the risk insured are also important to evaluate when constructing the policy and determining funding requirements. A captive can enhance the ability to monitor the program and account for costs of self-insurance.

Lockton has worked extensively with CIP programs for more than 40 years. Like many facets of insurance, the execution of details on program design' are critical to its success. When properly administered and managed, a CIP will often provide a more comprehensive and economical option than a traditional insurance program.

Mark Morris is Senior Vice President of the Risk Finance Group at Lockton Companies LLC.

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