Profitable Business Models in Homebuilding

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					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
lawsuits:
                                        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
the homeowner.
                                        — 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
                                   wrap-ups
                                                                                     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
                                                                                     product offerings.
                                 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
                                                      “off-shore”?
offset premium charges in the future or pay
dividends to the owners.
                                                    • Complete an actuarial study and secure a tax
                                                     opinion letter.
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.
Operational Advantages
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
                                                construction risks.
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
construction risks.




                          www.beechercarlson.com




  2002 Summit Boulevard • Suite 925 • Atlanta, GA 30319 • (404) 460-1400

				
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