Purchasing insurance is a dreadful task. Not only is it money out of pocket, but many brokers and insurance carriers seem to talk in a foreign language.  In this post, we discuss three tips to help combat the confusion and ease those insurance pains. After reading, you will be ready to speak the language and understand insurance terms. This will keep you confident at the negotiating table. In addition,  the pointers will save you money and reduce unexpected financial shocks.

1. Negotiate with the RATE, not PREMIUM

Contractors are very busy and like to get right to the point. “What’s it going to cost me?”  Cost translates directly into premium.  However, the smarter question would be, “What is my rate?”

RATE

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This week’s Case ‘n Point will focus on the risk of misleading financial data. As our real-world example will show, inaccurate accounting can cause poor management decisions that ultimately hurt a contractor’s bottom line.   In a quick informal survey, I asked several members of our community what information they gather to make decisions. Every contractor said that financial statements are either the first or second resource of information.

Business functions across the gamut are tied to financial statement results: everything from hiring, equipment purchases, salaries/bonus, financial credit, to surety credit. For this reason, many of the risk factors in the category “Accounting Procedures” have high importance for contractors. We could easily make the case that financial statements have (or at least should have) the greatest influence on a company’s decision making.  

The Risk Victim
Conway Remodeling, Inc. (CRI) is a relatively young contractor who has been in business for six years. CRI has historically performed 80% residential and 20% commercial remodeling. Commercial projects are relatively small and almost never consist of more than two or three units of an office building.

During the most recent year, CRI took an opportunity to perform a large commercial project. Instead of the common two or three unit remodel, CRI was in charge of remodeling an entire five story office building. Since the commercial work was more sizable, management felt the carpentry work, which was typically subcontracted out, could be self-performed.  Using historical financial statements, management determined that the carpentry could be performed at a profit.

The Risk Impact
CRI’s management relied on their historical financial statements to make a decision, which is usually a good practice; decisions should be made by gathering the most information available.  However, just because a company has prepared financial statements does not guarantee that the information is accurate. The financial data could be of poor quality and relying on incorrect financial data is just as bad as guessing.

As is the case with many small contractors, CRI did not allocate some indirect costs to projects or to their labor burden rate.  Instead, the costs were kept as General and Administrative because they were not believed to be significant.  When management determined carpentry would be profitable, they used financial statements that didn’t properly allocate workers’ compensation premium to each project. Thus, they didn’t realize that the carpentry work would add significant costs and was not as lucrative as expected. If management had the correct labor burden rates and allocated costs correctly, they would have determined the margin was too small and continued to subcontract out carpentry.

The Lesson
As CRI’s workers’ compensation insurance policy came to a close, the insurance carrier came in for a final audit to determine the audit premium. Overall revenue had grown only slightly, so CRI expected the audit premium to be rather small. However, there was a fundamental change in the structure of CRI’s operations. Almost twice as much in wages was paid as a result of self-performing the carpentry work. Thus, workers’ compensation insurance was going to be twice as expensive and this would all be reflected on the final audit. CRI was shocked to learn that their audit premium for workers’ compensation was $30,000 and, as standard, was due in 30 days.

We mentioned that financial statements are the linchpin for decisions throughout the entire company. In addition to performing the carpentry work, CRI had made several other bad decisions based on the financial statements. Additional labor was hired, not enough cash was banked to cover the audit premium, slightly higher Christmas bonuses were paid to reflect what appeared to be a good year, and more commercial jobs were bid using the estimates from the last job.

In the above exhibit, CRI would have made a better decision if they used high quality financial data. By installing two controls, CRI could have had high quality financial statements:

1. Performing a monthly insurance audit: The monthly audit makes adjustments to the premium in order to reflect the year-to-date difference in estimated and actual wages. 
2. Use approprate labor burden rates: If CRI’s accounting system tied the indirect cost of workers compensation to wages paid, the calculations used to estimate profit margin would have signaled management to subcontract out the carpentry work. 

If both controls were in place, either would have sent off a red flag early in the project, or even before the project was bid. Unfortunately,  many contractors don’t install these controls until they are burned the first time.  

We can’t overstress the importance of controlling your “Accounting Procedure” risk factors. Our Free Construction Business Analysis reflects this same level of importance. Many contractors who perform a Business Analysis expect to score very high. However, they often receive lower than expected scores due to weak accounting procedures. Strengthening the business practices that control accounting procedures will have a large impact on decision making and help ensure that more earned revenue is sent directly to net profit.

Technorati Tags: Accrual Accounting, Construction Accounting, Construction Business Analysis, Construction Estimate, Construction Insurance Audit, Construction Labor Burden, Construction Risk, Construction Risk Management, Construction Workers Compensation, Cost Estimates, Enterprise Risk Management, ERM, Inaccurate Accounting, Indirect Cost Allocation

Today I met an individual who asked what I did for a living. I was somewhat distracted and mumbled the word “risk management.” As I regained my focus this gentleman said “Oh, you’re a risk manager. I’ve had trouble with my Workers’ Compensation…” and he began to talk about insurance.

This was a prime example of the perception surrounding the terms “risk management” and “risk manager,” and how they’ve been equated solely to insurance coverage and insurance professionals in the past.   I’ve witnessed this misrepresentation of the terms so many times that I felt not just inspired, but a public obligation, to write this article and help clear the confusion with the terminology that began long ago.

PASSING THE SMELL TEST

In the early 1960’s, two professors, Robert Mehr and Bob Hedges, developed the concept of Enterprise Risk Management. These two could easily be called the Godfathers of Risk Management. They published the first text to fully address the subject of business risk, “Risk Management in the Business Enterprise.”  The book introduced how risk management of an entire business could maximize efficiency, which would result in greater productivity. The basic premise was that all business risks should be managed, not simply those that could be “insured.”

Suffice it to say that over time, the term “risk management” began to take on a more limited meaning, referring just to insurable risks (for a slightly more elaborate outline see history of enterprise risk management). Now, some 45 years later, many large public firms are finally returning to the original roots of risk management. The Risk Managers of these firms manage the risk exposures of the entire business, not just those risks that are insurable. Mehr and Hedges would be very happy about this if they were here with us today. And, I might add, this helps put my mind at ease as well.

You see, having been heavily involved in construction for much of my lifetime and having witnessed many different construction business failures, it became evident to me that the causes for each failure all boiled down to risk. However, it never seemed to make sense that insurance brokers and agents called themselves risk managers, especially since they only provided a form of management that addressed insurable risk. It just never sat right with me. First of all, they really didn’t address anywhere close to all of the business risks that exist. Second, out of all the business failures I had witnessed, none were the result of having too little insurance or poor loss control procedures. When I finally came to understand how risk management evolved over the years it was somewhat of an awakening.

THE ENTERPRISE RISK MANAGEMENT PROCESS

Robert Mehr and Bob Hedges came up with the steps for the risk management process, and the basic form is still in practice to this day:

• Risk Identification (Identify all the risk factors; all the possible causes for loss in a typical company)
• Risk Analysis (Analyze the risk; assess and measure the potential for loss in the company to be examined)
• Risk Response (Determine what to do; either assume, transfer or reduce the risk)
• Risk Control (Implement internal controls to reduce or transfer the risk)
• Risk Monitoring (Select a method for monitoring results and put it in practice)

As originally intended, risk management would encompass management of the entire business enterprise; hence, the field became known as Enterprise Risk Management (ERM for short). ERM requires examination of all risks that an organization faces and applies directly to four distinct types of risk: Operational Risk, Financial Risk, Strategic Risk, and Hazard Risk.

For the most part, only hazard risks are insurable.  Thus, insurance brokers should have called themselves hazard risk managers instead of just “risk managers”.  Now, with the reemergence of ERM, traditional insurance-based “risk managers” are being pushed into a wider arena of risk management, one that incorporates all other areas of business risk, many new forms of risk analysis, and a wider array of risk control mechanisms.

The primary challenge of expanding risk management across the enterprise is that, because it involves so many different aspects of an organization’s operations, traditional insurance-based risk managers (who focus only on hazard risk) are simply not qualified as enterprise risk managers. They simply don’t have the experience or expertise necessary to have a firm grasp of all aspects of a business, and there are already signs they are losing their hold on the “risk manager” title. In fact, the fastest growing position in the business world today is that of Chief Risk Officer (CRO). As ERM continues to filter down from public companies to smaller and smaller private companies, you can expect a CRO type individual to become part of every management team. After all, the adoption rate of the ERM process has already reached 40% in public firms.

In order for risk managers to evolve from insurance minded professionals to ones who understand the risks of an entire business enterprise, they will have to learn the language and the approach of each business area, either alone or as a team. If they are to act as a team, the team leader will need to have a basic understanding of all the steps involved in the entire process of risk management and the methodology used in each business area. Clearly, traditional risk managers will need to obtain additional skills to be involved with enterprise risk management.

TYPES OF RISK MANAGERS

There is no doubt Enterprise Risk Management is making its way from large public firms to firms in the private arena. It is being dictated by credit providers of large public firms as a result of Sarbanes-Oxley and, given the current credit environment, may soon be expected of private firms too. It may not be long until ERM becomes an expected and necessary way for all companies to operate.

Since risk management has expanded to cover risk across the entire enterprise, one of the largest challenges has been finding individuals capable of understanding and managing such risk. Since insurance agents or brokers who only provide insurance advice to their clients do not fit the bill, corporate decision makers only have a couple options:

1. Salaried employees who can learn to manage a wider scope of risk for their company than traditional risk managers (often chief financial officers or treasurers); and
2. Independent consultants who provide comprehensive Enterprise Risk Management services.

Individuals who perform at this level are called CRO’s. They are in very high demand today and typically are drawing salaries even higher than the CFO. As time progresses, I expect that there will be a lot of CRO’s working on a consultancy basis since smaller firms won’t be able to find, much less afford individuals qualified to identify, assess, and control all of the risks in a business enterprise. Obviously, such individuals must be very specialized in a particular industry to serve their clients well.

To choose the best type of risk manager for their companies, corporate decision makers must now consider the potential increase in profits that the adoption of the Enterprise Risk Management process can bring. For those early adopters, employing an experienced professional in Enterprise Risk Management is the key to real benefit. If that person is a consultant, he can be used as the de facto enterprise risk manager who can be relied upon to retrain traditional risk managers already on staff so they can gain the full knowledge of how to control risk across the enterprise. As time will tell, the true risk manager will not be the traditional insurance professional who addresses Hazard risk, but will be the individual who can address Operational, Financial, and Strategic risk as well. That is how risk management is evolving and what is expected of a risk manager in many companies today.

Thus, will the real risk manager, please stand up!

By:  David F. Druml, ERM Specialist a My Risk Control, LLC

Excerpts from “Journal of Risk Management of Korea Volume 12, Number 1” D’Arcy, Stephen P., Professor of Finance, University of Illinois at Urbana-Champaign, May 30, 2001

Technorati Tags: Bob Hedges, Business Failure, Chief Risk Officer, construction consultants, Construction Risk, Construction Risk Management, CRO, Enterprise Risk Management, ERM, financial risk, hazard risk, Insurable Risk, operational risk, Risk management, Risk Manager, risk quadrants, Robert Mehr, strategic risk

The certificate of insurance description box must read: “Jake’s General Contracting is named as general liability additional insured.”

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THIS CERTIFICATE IS ISSUED AS A MATTER OF INFORMATION ONLY AND CONFERS NO RIGHTS UPON THE CERTIFICATE HOLDER. THIS CERTIFICATE DOES NOT AMEND, EXTEND OR ALTER THE COVERAGE AFFORDED BY THE POLICIES BELOW.

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If the certificate holder is an ADDITIONAL INSURED,  the policy(ies) must be endorsed. A statement on this certificate does not confer rights to the certificate holder in lieu of such endorsement(s).

Technorati Tags: Acord 25, additional insured, Certificate of Insurance, Construction Risk, Construction Risk Management, Enterprise Risk Management, Insurance contract, Risk management, Subcontractor Insurance

This weeks Case ‘n Point (and first ever) reveals the painful truth about being too relaxed with risk control. The lesson of our story illustrates how Enterprise Risk Management is shadowed by its own success. As always, the names of those involved have been changed.

The Risk Victim
Xcavator Inc has been in operation for just under a decade. Its strong reputation places it on top of local GCs’ calling lists when excavation and grading work is needed. Unfortunately, management is a bit closed-minded to installing risk control procedures.  Xcavator Inc has been lucky during its last few years of growth and has grown a little cavalier, mostly due to effects of the success paradox. But all games of Russian Roulette must come to an end.

The Risk Impact
While grading for a public works project, Xcavator Inc hired a third-party to off haul dirt from the construction site. The expense for off hauling dirt wasn’t part of the original contract, but Xcavator received a verbal change order from the public agency’s construction manager to incur the extra cost.

The bill for off hauling came to $20,000 and Xcavator Inc added the additional expense to its next invoice. But the public angency rejected the extra cost, stating that it hadn’t approved the change order. Xcavator Inc tried to produce a valid change request, but since the order was verbal, none could be produced. And to compound matters, the construction manager who had given that verbal order was no longer with the agency.

The Lesson
Faced to absorb the $20,000 expense, Xcavator Inc management set out to lay blame. Ultimately, the superintendent had blame for ordering the hauling company to begin work. With proper controls, there should have been at least two responsible parties: the superintendent making a request and the project manager approving the request.  Lack of a written change request should have been a red flag for one or the other responsible parties. This weakness would have been uncovered by the MyRiskControl system during a review of the Contract Non-compliance risk factor.

This story helps illustrate how Enterprise Risk Management shadows its own success. Xcavator Inc learned a hard lesson. Whether it begins to get serious about installing risk controls has yet to be seen. But even if it does, the reward for installing controls after a disaster is greatly reduced. However, if the controls were in place from day 1, we would never know the value Enterprise Risk Management can have.

Technorati Tags: case in point, Change Orders, construction consultants, Construction Project Management, Construction Risk, construction risk analysis, Construction Risk Management, Contract Negotiations, Enterprise Risk Management

“These factors don’t matter.” Those were the words I heard after presenting a contractor with a proven list of over 65 risk factors that can impact a construction company’s ability to make a profit.  He gave the list back to me with 20 risk factors circled and told be the rest were of no consequence. If I hadn’t previously run a number of construction companies and closely observed hundreds more, his words may have cast doubt.  But I knew better.  Some risk factors are certainly less important than others, but they all can play a roll in causing business failure; even seemingly unimportant risk factors can interact with one another to have a large impact.

With respect to business, a risk factor is defined as an activity, practice or condition that can cause financial harm. Risk factors vary by industry.  For example, smoking is a risk factor in the medical world, specifically related to the health of an individual. It does not apply to a construction business. Likewise, failing to have a job cost system in place is a risk factor related to a construction business, but certainly is not a risk to an individual. Risk factors are also different across businesses. A risk factor related to overstocking perishables in a restaurant due to poor inventory control does not apply to construction. Poor humidity control is a risk factor in a flower shop but not in a restaurant.

As you can imagine, there are many different types of risk factors and for the most part they are specific to an industry.  Some risk factors are really important because the harm they can cause is great.  Other risk factors are of lesser importance because the harm they can cause is not so great, thus having a smaller impact. To actually determine the impact a risk factor can have (its importance), takes years of case study. But suffice it to say, importance varies.

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Technorati Tags: Construction risk factors, contract review, Enterprise Risk Management, focus on expertise, Risk analysis, risk assessment, strategic risk

A few days ago I met a fellow after doing laps in the pool, ala Michael Phelps! (I’d like to think we know as much about construction as Michael knows about swimming.) We began talking and sure enough he was the proud owner of a thriving construction company… but it wasn’t always that way. In fact, he shared with me the trials and tribulations he had experienced in the construction business. We laughed about the scrutiny his work received when doing custom mansions for the very wealthy and how the Irish side of him loves whiskey. And then we talked more seriously about a dramatic change in his career. You see, this strong willed Irishman was a victim of a key risk factor: Mismanagement of cash flow.

He shared with me how cash flow had put him out of the construction business. His claim to fame was the installation of high end custom wood work in plush offices and homes. As he became bigger, he just was not prepared for the cash flow crunch that he would experience. He shared with me his frustrations at getting paid from General Contractors who always had an excuse for not paying, and he used a few choice words. It was obvious that he had experienced what has put so many companies out of business, a cash shortage. He indicated he was making good money, and I believe that because custom millwork brings a good margin and there is not a lot of competition for highly specialized woodwork. He had different types of wood shipped in from all over the world and he shared with me how even though he was profitable, when he pursued the bigger work, cash flow became too much of an issue and he was forced to reinvent himself. This certainly is a familiar story.

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Technorati Tags: Accounts receivable, Bank Credit, Business, Cash flow, Construction, Construction Risk Managment, General contractor, risk factor, Risk management, Surety Credit, Trade Contractor

Credit underwriting decisions are a cornerstone of any economy. Made wisely, they can assist entrepreneurship, promote economic growth, and generally ensure that capital is allocated to its highest and best use. On the other hand, poor credit underwriting decisions can negatively impact an industry or the economy as a whole.  Recent troubles in the U.S. economy are directly tied to the poor credit decisions of lenders to support prospective home owners who had little money and provided little information about their financial strength in an over-inflated housing environment. Recent failures of banks such as IndyMac are partly tied to poor credit underwriting decisions and over-leveraging.  The failure of banks to consider the full range of construction risk is leaving many banks high and dry due to the recent spate of construction business failures, with many more to come. The five consecutive years of recent losses in the surety industry was directly related to poor credit underwriting decisions. With all of these losses you have to wonder what is going wrong. The answer is twofold: an unusually high tolerance for risk and credit decisions based upon insufficient data.

Creditors

In the case of mortgages that went bad, because loans could be packaged and resold, an anything goes atmosphere developed and many risk management practices were thrown out the window. Many loans were provided based on simple applications that provided minimal financial information. The fallout of this lending environment is showcased on Mortgage Lender Implode-o-Meter. In the case of IndyMac, a large portfolio of non-performing Alt-A loans, sometimes called liar loans, and risky construction and land development lending, left the bank with very little cushion in a falling housing market. Other banks impacted by losses only relied on financial data, failing to consider all the risks of lending to high risk industries such as construction and auto dealerships.

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Technorati Tags: boom and bust, Credit, credit decisions, credit underwriting, Economy of the United States, IndyMac Bank, qualitative data, quantitative data, Risk analysis, risk control, Risk management, Surety

Companies usually find themselves in one of four quadrants of the ERM/Business Success matrix:

1. A company has proper risk controls in place and is successful/profitable
2. A company does not have proper risk controls in place and is successful/profitable
3. A company has proper risk controls in place and is unsuccessful/unprofitable
4. A company does not have proper risk controls in place and is unsuccessful/unprofitable

The Success Paradox

The term “Success Paradox” has been used to refer, among other things, to individuals that are economically successful not being as happy as those less economically well-off, to the increased vulnerability of developed countries to diseases such as measles, and to the concept that an enterprise, such as a poverty NGO, can put itself out of business if it is successful.

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Technorati Tags: business success, construction risk control, Construction Risk Management, Enterprise Risk Management, luck in business, Risk, Risk management, success paradox

Effective Enterprise Risk Management is not rocket science.  In fact, most risk controls turn out to be very simple policies or procedures that will prevent adverse shocks to a business.  Oftentimes, though, it’s hard to cut right to the core of a problem and separate the effects from the root cause.  In Construction Positions and Responsibilities, one of our advisers discusses drilling down to determine the root cause for the difficulty a client was experiencing trying to grow its business.

Technorati Tags: Risk management