A Thought Leadership White Paper by Beecher Carlson
Construction Risk Today:
Exploring Alternatives to Traditional Insurance
A look at the legal issues associated with construction defect insurance and
how to use captive insurance companies to manage construction risk.
Solving insurance and risk finance issues related to construction defect, warranty
and subcontractor coverage isn’t as simple as it used to be. Increased litigation has
caused enormous changes in how insurance is written, how claims are resolved and
how contractors and builders are choosing to manage their risk. More than ever,
construction-related businesses are turning to alternative risk finance methods –
including captive insurance companies – to gain more control and keep costs in check.
The Legal Landscape: What do the experts advise? To avoid problems,
Trends in Construction Defect Coverage clients should meet with the underwriting unit
Over the past several decades, construction and claims department simultaneously before
defect litigation has increased substantially policies are written, ensuring that all parties
across the country. Like many trends, this are on the same page regarding coverage intent.
one started in California, which was the first Also, clients should keep their own records of
state to recognize strict liability in residential these meetings and document all discussions.
property construction defect disputes, When it comes to claims management, good
essentially treating homebuilding as a mass documentation can be very helpful.
production environment, with houses as the Legislative and Regulatory
product. This litigation momentum continues Issues
to move east, and construction defect suits There are several issues of interest to
against developers by homeowners and contractors and developers in the current
condominium associations are becoming more legislative and regulatory arena. It is crucial for
common. builders to know how these laws work in each
state in which they operate.
As expected, insurance companies are
attempting to avoid paying claims on Statutes of Limitation — Statutes of limitation
construction defect coverage under are laws that set the maximum period of time
commercial general liability (CGL) policies. in which a lawsuit or claim can be filed. The
Using the business risk doctrine as the basis period of time varies from state to state for
for their argument, they assert that there is different types of lawsuits. Contractors should
no coverage for defective construction under be aware of the statutes of limitation relative
CGL — that defective construction is not to their work in case of potential negligence or
an “occurrence” under the policy, that it is breach of contract issues.
not an accident, nor is it neither something
unexpected nor an unintended consequence. Statutes of Repose — Statutes of repose are
Several court cases have addressed this issue, laws that set the maximum period of time for
and more are now underway. which a manufacturer, contractor or developer
can be held liable for the performance of a
product. Statutes of repose recognize that Consider A Captive
How to Minimize
Litigation products will eventually stop performing as An Alternative Solution
well as they did when they were new, and that Given the legal, regulatory and risk
Developers and contractors can owners bear responsibility for maintenance. management challenges facing them today,
take several steps to avoid
Statues of repose also vary from state to state. many builders and contractors are now turning
Again, builders should be aware of the statutes to alternative risk management options
Develop a good contract. Include
of repose in their states. — including captives — as they seek better
appropriate dispute resolution
clauses, including arbitration and coverage at better prices.
mediation. Right to Repair Laws — Western states
are leading the way in pushing legislation A captive insurance company is a separate legal
Document everything. Be
that gives builders the opportunity to make entity that insures the risk of its owners and
prepared for litigation by
documenting turnover conditions. repairs before a homeowner or homeowner sometimes that of related or affiliated firms.
Clearly and realistically spell out association files a lawsuit. Developers should Captives began in the 1970s, and are proven
maintenance responsibilities for
be aware of these types of laws in their states entities: there are now more than 5,400 in
— some are “friendlier” than others. operation.
Be proactive. Be diligent about
customer satisfaction and
encourage homeowners to work
Risk Management Challenges Captives are not appropriate for all
directly with the builder to resolve In recent years, residential builders have construction-related businesses, but they
issues. Monitor weblogs to gain changed the way they manage risk — instead work well for those with sufficient insurance
insight about the types of issues premiums and/or retentions to achieve savings.
of transferring risk, many now assume a
that may arise.
substantially larger portion than in the past. To qualify, companies must assess both their
Retain records. Do not rely on loss experience in conjunction with premium
the insurance broker or carrier The reason for this migration? Insurance cost, and premium cost relative to the
to keep copies of policies or other
carriers generally don’t know how to price amount of insurance purchased. Those with
documents. Be sure there’s a
record retention policy in place construction insurance; underwriting and superior loss experience and disproportionate
that reflects appropriate statutes of actuarial models don’t accommodate the premium-to-limit ratios may be good
limitation and repose.
length of time between the completion of a candidates for a captive.
Use wraps. Wrap-up insurance house and the lawsuits that might arise from its
policies can be quite beneficial If considering a captive, companies should
building. Also, residential loss experience isn’t
in minimizing cross-litigation,
segregated from commercial loss experience, also review their own claims experience and
addressing the statute of repose,
and ensuring that all parties, which doesn’t often work to a homebuilder’s loss ratios relative to their peer group. Low
including subcontractors, have loss ratios are obviously attractive in terms of
advantage. Therefore, premiums are extremely
uniform language coverage.
high and coverage provisions are often underwriting. Companies also should consider
inflexible. initial capitalization requirements to fund
the captive — usually one third of the annual
Another challenge is that builders often captive premium (a 3:1 premium-to-capital
don’t have control over the claims and legal ratio).
process. Even if builders believe they purchased
financial certainty, at claims time, it may Captives are flexible entities, and can include a
turn out that the actual coverage isn’t what number of different coverages:
they thought they purchased. In addition,
• General Liability — including premises
subcontractors sometimes have exclusions put
operations and completed operations; this is
on their policies, so the certificate of insurance
the most prevalent use for captives.
doesn’t accurately represent the coverage they
actually have. • Warranty insurance
• Builder’s risk coverage — especially helpful
Types of Captives and Who Uses Them
Pure Captive Group Captives
Aka Single Parent Captive Associations – Small or large premium
Large Public Corporations Trade or Industry Groups
Regional Private Companies with critical mass of premium Homogeneous group by Industry
Heterogeneous group by Coverage
Rent-A-Captive Mid market company looking for more control and cost savings
Protected Cell Captives
Large corporations Risk Retention Groups
Regional Private Firms Associations
Agents with book of profitable business Homogeneous Groups
MGA taking quota share risk on a program Industry Groups
Agents & Brokers sponsored groups
Corporations with affiliated groups
in wind- or flood- prone areas; builders may heterogeneous (comprising unrelated
assume some portion of their own catastrophic industry members drawn together by similar
risk or deductible and fund it through the coverage needs). Group captive participants
captive. are generally mid-market companies without
critical premium size for their own captive but
• Difference in conditions — gap coverage for
looking for more control and cost-savings.
policies that contain poor coverage conditions,
exclusions and limitations. Rent-A-Captives — Sometimes also
referred to as “Segregated” or “Protected” Cell
• Subcontractor general liability and
captives. These structures can be used by large
or regional companies who may not want or
• Specialty coverage — including mold, have the financial ability to capitalize their own
moisture remediation and other risks generally pure captive. These arrangements effectively
not underwritten by typical insurance create a leasing structure that offers some,
coverage. but not all of the benefits of a pure captive.
Insurance agents, brokers and wholesalers
• Excess or buffer layer. often use this type of captive to take risk on a
Captives also come in many different book of business. Rent-a-captives are typically
structures, designed to suit various types of run by insurance companies, reinsurance
businesses and their insurance needs: companies, and brokers to broaden their
Pure Captive — Also known as a single-
parent captive, this structure is typically Risk Retention Groups — This structure
formed by a single owner insuring its own follows the Risk Retention Act of 1986 and
risk — usually large corporations or regional is formed by homogenous groups such as
private companies with a critical mass of associations or industry groups, agents and
premium. broker-sponsored groups, or corporations with
affiliated groups. Often referred to as RRG’s,
Group Captives — Group captives these groups may only be formed for liability
are typically formed by a trade or industry exposures. The Risk Retention Act is the only
association looking to spread risk. These case where federal regulation supersedes state
captives can be homogeneous (made up regulation of insurance companies.
of members in the same industry), or
Captive Benefits Customized Policy Forms
Captives provide substantial benefits to those Customized policy forms offer increased
who utilize them, including: negotiating power which results in more
flexibility with premiums and endorsements.
Significant Savings: Premiums paid into a
captive are based on the loss experience only Getting Started
of the captive itself, so premium savings can Is a captive right for your business? You’ll
be significant. (Of course, premiums are need specific expertise to determine if a
calculated by an actuary — every captive has to captive is appropriate for your company’s risk
have a certified loss forecast and projection and management needs. Obviously, it is important
reserve study.) to work with an organization you trust to
guide you through the decision-making
Lower Overhead Costs: Typically an insurance
process. Give yourself plenty of lead-time
carrier puts a 30% to 40% load on the
— usually three to four months — to work
premium for profit and overhead, much
through these steps:
of which can be saved by a captive. And, if
properly structured, premiums may even be • Conduct a feasibility study.
tax deductible. • Gather data.
Earning Opportunities: Captives can also
• Develop pro forma financials.
earn money — premiums can be invested
• Meet with regulators
and generate income that can be used to
• Make domicile decisions — “on-shore” or
offset premium charges in the future or pay
dividends to the owners.
• Complete an actuarial study and secure a tax
Tax Savings • Engage in reinsurance or excess insurance
Depending on its size, a captive may qualify marketing.
for tax savings under IRS Code 831B, which • Apply for licensure.
applies to small insurance companies. As long • Complete incorporation and organizational
as premiums remain below $1.2 million, the documents.
captive’s income is tax-free, and the entity only • Complete subscription agreements,
pays 15% tax on the investment income membership agreements and offering
it generates. memoranda.
• Complete licensure and capitalization.
Captives create more incentive for loss With various financial, legal, legislative and risk
control, greater control over their own claims management challenges facing construction
handling, and more leverage in the traditional companies today, it may prove wise to
marketplace. investigate alternatives to traditional insurance
programs. Forming or joining a captive may
Access to Reinsurers offer the flexibility and control necessary to
The reinsurance market tends to be more remain competitive and secure.
financially driven and more protected from the
subjectivities of underwriting. The reinsurance
audience is typically quite sophisticated, and
can offer far more attractive pricing than the
traditional insurance marketplace.
About Beecher Carlson In addition, Beecher Carlson construction
Beecher Carlson’s Construction Risk specialists are experts in the design of risk
Management Practice is recognized as management programs to meet the specific
a leading provider of construction risk needs of today’s increasingly popular design-
management solutions for residential builders build project delivery systems. We offer
and developers, project owners, contractors wrap-up programs, both Owner Controlled
and suppliers. Insurance Program (OCIP) and Contractor
Controlled Insurance Program (CCIP),
Using an integrated approach to the financial
which are designed to substantially reduce the
tools available in risk finance, Beecher
costs associated with a construction project
Carlson can deliver both traditional and
when compared with traditional insurance
non-traditional risk management solutions.
programs. We also provide a comprehensive
We are distinguished for our captive
array of core property and casualty
management services, having experience in
coverages to protect against most types of
each of the major domiciles that spans more
than two decades. Our expertise in captive
programs is comprehensive, ranging from For additional information about construction
feasibility consulting and design through risk management and captive insurance
implementation and maintenance and programs, contact Beecher Carlson today.
spans a range of solutions including Rent-a-
Captives and Parent-Owned Captives to insure
2002 Summit Boulevard • Suite 925 • Atlanta, GA 30319 • (404) 460-1400