By Mark A.W. Smith
The insurance marketplace can be a difficult one for contractors. Fewer and fewer insurance companies write coverage for trade contractors and those that do are increasing prices and decreasing coverage.
Profit and loss
Your first question may be…why? Why is the contracting business so unattractive to insurance companies? The reasons are complex, but it all boils down to claims. Insurance companies are in the business of paying claims and expect to do so. However, once the amount of money paid in claims exceeds the amount collected in premiums (your bill), the insurer is losing money. Insurance companies refer to the relationship between dollars collected and dollars paid as the loss ratio. Loss ratios are computed based on all of the policies sold in a particular industry. The goal of most insurance companies is to have an underwriting profit, meaning a loss ratio less than 100 percent.
Because there is usually a delay between the time the premium is collected and when the claims must be paid, the insurance company can invest that money in short term markets. When those markets are doing well, the insurer can afford worse loss ratios and still make a profit. In our current market, with low interest rates and volatile stock prices, insurers need loss ratios from 95 to 110 percent to see a profit. Therein lies the problem: typical loss ratios for contracting risks can run 100 to 250 percent. In other words, for each dollar you pay the insurance company, it can expect to have to pay out as much as $2.50. Not a very good deal for the insurance company.
Contracting losses are simply very expensive, from workers comp to claims for defective work or materials, the payouts and claims costs (lawyers, adjusters and experts) can be huge. For example, if you install a water softener in a homeowner’s garage your fee will probably be under $3,000. If the unit leaks and floods the garage, allowing water to seep into interior walls, the cost to dry out the walls, kill any mold that grows and restore water damaged property could well exceed $10,000. Adding insult to injury, if the homeowner sues you to get the repairs done, the insurer will pay another $5,000 to 6,000 defending you.
Claims and the industry
In addition to the typical severity of contracting losses, there are simply an awful lot of claims. Several insurance carriers report losses arising at as much as five to seven claims per policy written. In other words, for every individual policy the insurer sells, five people will make claims against its insured.
Even if your business has been relatively free of claims and has not had to pay out much on the few claims it has had, that may not help you a whole lot in the insurance marketplace. Insurance underwriters look at a number of factors when deciding what risks to take on. While an important component is the loss experience of the individual applicant, the loss experience of the entire industry is equally important. Insurance companies are in the business of pooling risk. Being the best of a bad lot doesn’t put you in a much better position than the worst player in a less risky line of business.
Your insurance costs are probably skyrocketing and its becoming harder each year to find an insurance company willing to write your policy at all. Each year your broker is probably introducing you to insurance companies you’ve never heard of. You may be concerned that your policy is being written by some fly-by-night operator and you could be correct.
The majority of insurance carriers, including all of the majors, are admitted to do business in each state they sell policies in. By being admitted they come under the authority of the state’s insurance authority, usually an insurance commission. The regulations typically effect price, terms and conditions of the policy and impose a requirement that the carrier accept a certain percentage of poorly-rated risks. Because the amount they can charge and the terms and conditions of the policy are more generous, the admitted carriers are very picky about the risks they will write. If you have any significant loss history, or are in a market with high potential losses, chances are the majors won’t be interested in your business.
Differences in surplus lines
The surplus lines markets are made up of insurance companies that are non-admitted. Polices from these companies will have three disadvantages over polices from the majors. First, they’ll cost more. The insurer is entitled to a higher premium to make up for the fact that all of its customers are a worse risk than those written by the majors.
Another factor you’ll face is more restrictive coverage; an non-admitted carrier is not required to use the state-approved insurance forms. These forms, written usually by the Insurance Service Organization (ISO), provide the broadest coverage available in the market. One of the strategies non-admitted carriers employ to reduce their loss ratio is to limit coverage for some kind of losses. For example many surplus lines carriers will not extend additional insured coverage to the general contractor (GC) or builder once they have left the job site in new construction cases. Since most losses are incurred years later, the AI coverage is worthless and increases the chance that you’ll be sued.
Finally, depending on your state’s laws, the carrier is probably not a member of your state’s guarantee fund. If the insurer goes out of business (and a number have in the past five years) you’ll have to try to collect from a fund in another state, or face paying the claims yourself.
What you can do
There are a number of strategies you can employ to make your company more attractive to insurance carriers in both the short and long term:
Find out about the financial strength of the insurance company you are considering. Start with the ratings, companies such as AM Best and Moody’s rate insurance carriers. You should avoid carriers with lower ratings. Check the balance sheet. Your broker can run a Dunn & Bradstreet check on the carrier and its parent. You want to know if the company’s capital exceeds its projected 10-year losses. Find out the company’s loss ratio, if it exceeds 120 percent for more than three years, the company may have a rocky future.
Ask if the carrier is using an ISO-approved policy form. If not, have your broker compare the policy being offered to an ISO policy. Your broker can then advise you whether the terms and conditions being offered are acceptable coverage for your business.
Define your business
Decide what business you’re in and stick to it. Picking up occasional work outside your typical business can have a huge impact on your insurability and costs. The worst loss histories are in the residential new construction market. If this is your business, stick with it but price accordingly. If your main business is retrofits to existing homes or businesses, you may get asked to bid new construction jobs from time to time by a local developer. Think long and hard before you agree and if you do – contact your broker for pricing guidelines. Once you do any residential new construction work you’ll be classed in that line, even if it is only one or two percent of your business.
Develop risk management strategies; document them and implement them and document that implementation process. If you can prove to the insurance carrier that you have an active safety program; that you seriously screen all your drivers and continually train your installers, your broker will have a much easier time getting you coverage at the best price.
If you find that one or more of your material suppliers is sending you defective or poorly made components, find a new supplier. Product liability claims are expensive and a single such claim can mar your loss run for years. Such claims are a red flag to most underwriters and may keep you out of the admitted market altogether.
Make sure that the manufacturers whose products you sell and install have a ‘Vendors Endorsement’ on their policy and that you’re included within its terms. A Vendors Endorsement makes dealers and sellers of a manufacturer’s product an additional insured on the manufacturer’s insurance policy for any claims arising out of a defect in the product. These are fairly common claims and your insurer will more readily take on your risk if it knows it isn’t also going to have to insure all your business partners.
Consult with you broker about how your risk is managed. Excess insurance is generally much less expensive than primary insurance. If you need more than $1 million in coverage, consider buying two policies instead of one. Your primary insurance can cover the first million, with a cheaper excess policy covering up to $5 million more.
Also decide how you are willing to allocate your share of the risk. A deductible and self insured retention (SIR) are each sums of money that the insured is required to pay for each loss. The difference between the two is this: a deductible is paid after the claim is resolved and an SIR is due before the loss is paid. A significant number of insured never pay their deductibles, either because they have gone out of business, don’t have the money or simply refuse to pay on the gamble that the insurance company won’t bother to sue them if the amount they owe is small. Because an SIR is paid up front and the insurance company has no obligation to you or the person making the claim until it is paid, the insurance company doesn’t have to worry about your future solvency or integrity. SIR policies are usually less expensive and easier to obtain. The downside, of course, is that if you can’t or won’t pay your SIR when the claim comes in, you lose the benefit of the policy.
If your loss run is cluttered with claims and you face the prospect of paying ever- increasing premiums for ever-less coverage, the best long term solution is to improve performance. Claims against water industry contractors are almost always a combination of faulty materials and poor workmanship. Upgrading the skills training and dedication of your field staff together with your vendor relationships will decrease the frequency of claims, and improve your standing in the insurance markets.
About the author
Mark A.W. Smith is the principal of Mark A.W. Smith & Company, providers of alternative dispute resolution services, including mediation and arbitration of claims in the construction, environmental and insurance coverage arenas. Smith worked for over 25 years as a claims adjuster, manager and executive for several of the major carriers as well as an E & S company.