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

Negotiating with the RATE places the contractor in a better position. For example, ABC Contractor Inc. performs 10% more work than last year. The insurance carrier explains that the 10% PREMIUM increase is entirely due to the increased business. That makes sense. However, contractors strive for continued savings. A larger EXPOSURE usually means your can negotiate a lower RATE. Ignore the PREMIUM when negotiating insurance and focus on lowering the RATE.

2. Compare the RATE Year-to-Year

Be careful. Although the RATE is a better number for comparison from year-to-year, it can also be affected by LIMITS, COVERAGE, CLASS, and LOSS HISTORY.

LIMITS

Lowering LIMITS and COVERAGE may leave a company exposed. In our Business Analysis, one of the risk factors examined is “Ignoring Insurance Needs”. When money is tight, contractors often fall into the trap of reducing or canceling coverage altogether. Every reduction can cause a gap. The small savings today may result in a large expense down the road. LIMITS and COVERAGE should be analyzed on a needs basis and not a price basis.

3. Be Prepared for the Final Audit

At the end of the policy period, most liability policies will have a final audit to adjust the estimated EXPOSURE with the actual EXPOSURE.

AUDIT PREMIUM

Final audits can cause a great deal of heartache. If a contractor hasn’t been properly accruing insurance expense, what was a good year could turn sour when the AUDIT PREMIUM hits. Inaccurate insurance accrual is identified by the risk factor “Inaccurate Accounting.” AUDIT PREMIUM shouldn’t be a slap in the face. During the entire year, the accounting manager can determine the expected price of the AUDIT PREMIUM by comparing overall revenue to the estimated EXPOSURE. This was the subject of a recent Case ‘n Point article.

In reverse, the MINIMUM EARNED PREMIUM is designed to catch overestimating. Contractors may try to reduce the RATE by increasing their EXPOSURE (i.e. estimate $25 million, lock in a low RATE, then end the year with only $15 million in sales). However, insurance carriers have placed MINIMUM EARNED PREMIUM conditions in the insuring agreement to avoid this type of gaming. Avoid making optimistic estimates as the consequence will hit harder than the savings.

Final Thoughts
Insurance renews once a year. Since you can’t be an expert, brush up on the details when your renewal comes around so you can speak to your broker with confidence, and ensure they are getting you the best deal possible.  In summary, we’ve provided three quick tips you should incorporate into your insurance purchasing process:

1. Negotiate with the RATE, not PREMIUM
2. Compare the RATE Year-to-Year
3. Prepare for the Final Audit

and 1 more for good measure…

4. Don’t leave renewals to the last minute.  Talk to your broker at least 30 days before renewal to ensure he is working in your best interest and has scoured the market for the best deal.

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Construction Insurance: Tips for Purchasing Contractor’s Insurance

Technorati Tags: construction ERM, construction insurance, construction insurance exposure, construction loss history, contractors general liability, contractors insurance, contractors worker compensation, insurance exposure, insurance final audit, insurance general liability, insurance premium, insurance premium vs rate, insurance rate, insurance risk management, negotiate insurance, policy limits, tips on construction insurance

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.

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CnP: Using Cost Estimates in Construction Accounting

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

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

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Will the Real Risk Manager Please Stand Up!

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

This weeks Case ‘n Point looks at the question on all our minds, “Is risk management doing its job?” Our real-world example isn’t based on just one story. We’ve encountered this scenario so many times that we’ve provided the quintessential example. As always, the names have been changed to protect the innocent parties.

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).

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CnP: Risk Management is Useless

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

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.

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CnP: Construction Change Orders

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

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.

What also varies is a contractor’s perception of the importance of various risk factors. Interestingly, the risk factors that a contractor usually thinks are important are the ones which it has experienced. While those the contractor thinks are unimportant are the ones it has yet to experience, and some of those can actually be very important. This is pointed out in the article discussing .

Focus on Expertise

Now a case in point:

The particular contractor I mentioned at the beginning of this article was a General Contractor (the word “was” is telling). One of the risk factors he determined was of no consequence is taking on new types of work without prior experience. Another was estimating without historical data. In the months to come, this contractor decided that it could make more money by doing the rough carpentry work (framing) of buildings by itself rather than using subcontractors.

In California, there are separate companies that do framing and that is all they do. It is very competitive and the cost is simply driven on how fast carpenters can put lumber in place. This GC proceeded to bid three large school projects. Now it had done schools before, but never the framing. I personally advised against the approach indicating that the estimating staff did not have experience bidding framing work, that the estimating staff did not have any historical information on hand to rely upon, that the personnel were not in place to do the framing, and that the company had no prior experience doing the work. Well, this particular contractor looked at themselves as a risk taker. Indeed they were. The net result was as follows:

1. The contractor couldn’t man the jobs with experienced tradesmen.
2. The tradesmen they did hire ended up quitting because the quality of the work was so awful.
3. The agency made them do the work over because it was so shabby.
4. The union ended up picketing the sites because the GC was taking on framing work as a non-union contractor
5. The estimating department did not anticipate the rising cost of lumber because they were not connected into the framing world and did not know that dramatic increases were coming; thus they paid much more for lumber than budgeted
6. The estimated amount of labor hours was insufficient.
7. On one of the three jobs they had to ask another framer to step in to do the work because they could not put together the resources; the framer charged much more than what the GC had in its original bid.
8. All of the jobs were severely delayed resulting in liquidated damages and preventing one of the schools from opening on time for the fall classes enraging parents against the Agency.
9. The contractors money was held by each Agency for damages.
10. The contractor could not meet financial obligations.
11. The General Contractor finished the jobs, then dissolved and did not pay the subs and suppliers and did not have financial resources to go back to do punch list items or repairs.
12. The bonding company stepped in to pay subs and suppliers left hanging and to complete punch list and repair work.
13. The contractor went out of business. Game over.

This particular GC was in business for over seven years and had been quite successful. However,  GCs work on very tight margins. The contractor could ill afford to lose large money on the framing, but they did, and it cost them their business. That was all based upon risk factors that the contractor did not consider of importance.

Contract Review

Let’s look at another case in point:

A contractor performed steady work in a niche market and historically made good money, however it didn’t have a contract review procedure in place. In fact, this contractor had signed a contract without having reviewed it completely and was unaware of the insurance requirements. One of the requirements was for $5MM of pollution coverage, but the contractor only had $1MM in place. The contract was for repair of 450 balconies on a 40-story apartment complex. It had done this type of work on large structures before, but never for a building that did not have air conditioning.

During the summer months it became unusually hot while work was underway and many of the 450 residents had to keep their windows open because of the stifling heat, even while the contractor was chipping and grinding out the old concrete that needed repair. Concrete dust invariably drifted into some of the apartments. Simultaneously, the owner had given notice of eviction to a lawyer. To get back at the owner, he banded a bunch of the residents of the apartments together convincing them of great rewards, and proceeded to file a lawsuit against the owner for allowing cancer causing silica dust to harm the health of all of the residents. Since a lot of the residents were old, having little funds, and had little to do with their time, they had nothing to do but listen to an evicted attorney. Once the thought of cancer causing dust was put in their minds, even the invisible bothered them.

During that time, one of the residents who had chronic respiratory problems was hospitalized even though work was not being performed at the time near her apartment. This just fueled the claim that all the residents were being exposed to a major health hazard, even though open windows were being covered with a filter cloth. Unfortunately, the court approved the suit as a class action with all 450 residents represented. The owner in turn tendered the suit to the contractor only to find out that the contractor did not have $5MM of pollution coverage in place as called for in the contract. The contractor had no choice but to reject the tender and the owner began to pick up the attorney’s fees to defend itself.

Well, since the owner’s counsel was sure that they would ultimately recover the attorney’s fees from the insurance carrier, they showed up at every meeting and at every appearance with a fleet of staff attorneys, no less than four each time. The attorney’s fees for the owner went through the roof. Since the owner did not know if its own insurance carrier would even cover the fees or whether the contractor’s insurance carrier would eventually be forced to do so, the owner began to withhold large sums of money from the contractor’s payments. As a result, the contractor’s cash flow was severely impacted. The attorney’s fees grew to over five hundred thousand dollars and it surely looked as if the $1MM coverage limit would be exceeded. With little other options, the Contractor began making plans for a new company.

During this time, another risk factor came into play, one that contractors often pay little attention to, namely, computer backup. The contractor had a backup system in place for its server, but it wasn’t being checked. Well, the server went down. No problem, call the computer guy it fixed., right? Well, it wasn’t that simple, the hard drive had crashed. No problem, get another drive up and running and use the backup to restore it. Big problem, there wasn’t a procedure in place to check that backups were running properly and a backup had not run properly for almost a year.

The computer consultant tried to retrieve the data to no avail. Now the contractor has several problems going: (1) not getting paid on its largest job making the contractor go deep into its line like it never had before thus causing the bank to become so concerned as to request current financials, (2) unwillingness to bid additional bonded work because the owner did not want to be personally liable for bonded jobs if the company was to fail, (3) inability to provide work-in-progress reports or financial information to the bank or surety therein casting doubt (4) making the staff turn over to a completely manual process having lost all of its historical data and unable to resurrect current financial information, (5) and countless sleepless nights. Could it get worse? No, it got better.

After a month of down time Intel was able to recover the data, the contractor was able to produce financials, the accounting staff was able to get caught up, the class action lawsuit was dismissed after the owner’s attorneys had built up close to $750K of fees, the contractor’s carrier picked up the tab only causing the contractor to lose the $25K deductible, and the contractor did not have to start a new company, nor go broke. But what did it cost him?

Well, historically, this contractor made $250K in profit year after year. At the close of the fiscal year containing all of the problems, the company recorded only $24K in profit and opted to make up for the business lost during all of the distractions by taking on a big job in a different type of work. The jury is still out.

Moral of the Story

So, the contractor experienced the simultaneous consequence of uncontrolled risk related to two risk factors, one important one: review of contracts, and one not so important: computer backup. You can see how the consequence of two risks working together can cause havoc. Not being able to produce financials when both the bank and bonding company want to see them during tenuous times could have turned disastrous. But that is how risk works. The overall consequence of risk in a business is rarely the result of one uncontrolled risk, but instead, normally multiple uncontrolled risks working together. Sometimes the overall consequence may be caused by risk related to just a couple important risk factors, or maybe a lot of not so important risk factors, or maybe a mix of important and not so important risk factors. Any combination is possible and any combination can be a knock out punch. The graph below explains how.

We’ve established how risk factors vary in importance, and we’ve established that the overall consequence of risk in a business is almost always the result of the risk associated with multiple risk factors. We’ve established how contractors rarely recognize the ones that can and will hurt them, and we’ve established that even though a risk factor may seem of little importance it will usually work in conjunction with others to cause an overall consequence. In other words, we’ve established that even though a risk factor might only cause a small amount of financial harm when uncontrolled, all such risk factors do matter.

So the real question becomes: How do we lower the potential consequence of risk related to a multitude of risk factors in order to prevent loss or potential failure? The Answer: Adopt an Enterprise Risk Management (ERM) method of running your business. The ERM process identifies risks factors that might otherwise be unknown, establishes a way to assess the level of risk with respect to each risk factor, and determines what kind of controls need to be put in place to minimize risk and the potential consequences.

For a thorough understanding of ERM visit the about risk section of MyRiskControl’s home page. Take the available tours to learn how MyRiskControl helps a contractor implement practices, systems or procedures to control risk and then monitor risk on an ongoing basis. There is no question that implementing ERM in your company requires a change in philosophy, a change in thinking, and a call to action. But with ERM, you don’t have to do all the work yourself, it gets spread to the staff, and MyRiskControl makes that easy. It is the only total enterprise-wide solution to identify, assess, analyze, control and monitor construction risk. And remember, just because you choose to ignore risk, risk won’t ignore you.

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Construction Risk Factors - Ignore at Your Own Peril

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

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.

There is a basic collection tenet that states “the longer the bill is outstanding, the less the chance of collection.” Although this particular construction company was able to collect its money, the bill was outstanding just too long, often up to 90 days according to his description. This brings us to the importance of conducting cash flow projections. You see, if he had been able to project the cash demands for his company, he may have found the cash resources in advance to continue it. That is why it is imperative to continually assess the timeliness and the probability of collecting open accounts receivable. This is particularly important in the construction industry because of the sizable dollar amounts that can be withheld. It is also important to recognize that the longer the bill remains outstanding the more likely you could be talking about a bad debt, and that possibility needs to be taken into account in cash flow projections as well.

Particularly in tough economic times as we are now experiencing, each owner, developer, and general contractor has to be scrutinized before doing business with them and finding out that they themselves have run out of cash. Since it is difficult to accurately predict when down cycles will come and go, a continuous aggressive collection effort will assist in increasing cash flow and lowering doubtful accounts. Therefore, accounts receivable personnel and/or project management must regularly meet with senior managers to discuss potential collection issues that might arise. If a contractor does not regularly perform this task, it will usually fail to react fast enough to manage potential cash shortages. Failing to do this exercise over a long period of time can result in overstated receivables and a misrepresentation of the financial strength of a company, potentially misleading management, banks and bonding companies. Since bad debt expense directly impacts the bottom line of the financial statement, a bank or surety may believe it was misled in its credit decisions by the contractor’s failure to reveal the bad debt in advance. When a bad debt expense suddenly arises after being uncollectible for a long period of time, key bank and bonding relationships may be damaged.

The summary of all this is that cash is king, and failing to perform cash flow projections is a major risk factor in industries that experience fast moving cash like construction. To lessen the risk of potential harm, a contractor must project speed of receipts, have meetings to identify potential collection problems, try to recognize bad debt in advance and aggressively collect open accounts receivable. Only by doing cash flow projections can you take all these factors into account and avoid a surprise cash flow shortage. In the case of my new contractor acquaintance, every story has a silver lining. He decided to go into high end millwork as a manufacturer only. Now he gets paid up front for the expensive woods he uses and gets paid within 30 days as a vendor having a much needed product that is not easily found elsewhere. Hurray for him, he avoided being another one of the many construction companies that have simply failed by running out of cash, even while making a profit.

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In Construction, Cash is King

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

At the end of the day, business is about achieving profitability, which is defined as the ability of an enterprise to generate revenues in excess of the costs incurred to produce those revenues and is often measured by a rate of profit or rate of return on investment. Credit underwriters also seek to achieve profitability, and that means avoiding large, unforeseen losses. To maximize profitability, underwriters need to find the optimal balance between premiums charged and risk present.

Unfortunately, as discussed in , underwriters are often working with insufficient, inadequate, or obsolete data so measuring the “risk present” becomes quite a tall order, and many times involves outright guessing. They have no way of knowing where the applicant lies in the . Fortunately, with the advent of a standardized mean to collect and analyze qualitative data, most of these underwriting deficiencies can be overcome. In this post, we’ll discuss how qualitative and quantitative data fit together to form a complete picture of an applicant during the credit underwriting process.

One of the most important components of the Enterprise Risk Management is risk assessment. Without that step, there is no process. However, the assessment of risk focuses principally on qualitative data, an observation that involves subjectivity by the very nature of the measurement. Is it possible that ERM, the process for managing risk, could be used to determine the likelihood of a company’s success or failure based solely upon qualitative data? The answer is no.

In the world of ERM, there is often talk about business failure and determining its likelihood by measuring risk based upon qualitative data. In fact, the term failure risk is often referred to in discussions about the ERM process. The truth is that the study of risk data alone cannot determine the likelihood of failure without due consideration of financial data. In other words, without regard for the results provided by financial statements.

You see, failure may seem all but guaranteed by terrible business systems and controls, which both indicate a high presence of enterprise risk. However, if the company being analyzed has billions of free cash in the bank and routinely makes huge profits, is there a high likelihood of failure? Unless that company is also extremely leveraged, such as was the case with Bear Stearns, the answer is certainly no. Therefore, qualitative data alone cannot determine the likelihood of business failure, which should clear up the incorrect application of the term failure risk. Just as Yin and Yang must coexist by definition, qualitative data must be joined with financial data to make the whole, to complete the risk picture; risk data and financial data are both required to determine the likelihood of business failure.

That being the case, how do we classify the qualitative risk data derived in the ERM process? What is it standing alone? As stated, it is not a determinant of success or failure in itself. However, since every system and process that is not in place, or poorly in place, will harm profitability, qualitative risk data is clearly a determinant of the likelihood of achieving the best results possible. And in the business world that is the likelihood of achieving Maximum Profitability, or the highest level of profitability achievable by an enterprise under ideal conditions. In essence, the qualitative risk data derived in the ERM process determines overall Profitability Risk, that is, the likelihood that an enterprise will not achieve its Maximum Profitability.

Risk by definition is the possibility of suffering loss or harm. In the business world, harm is not a black and white issue, which is suggested by the terms business failure or failure risk. Rather, harm is a spectral issue with a lot of gray area, which is why speaking of a decrease in profitability or profitability risk is more appropriate. Therefore when we talk about the ERM process and focus purely on examining qualitative data, we should be talking about profitability risk of a company, not failure risk. And knowledge about where a company stands in relation to its ability to make a profit is a very valuable piece of underwriting information. Combined with quantitative data, it gives an underwriter a firm grasp on a prospects total potential for business failure or failure risk. The following chart shows the basic relationship between the two:

This relationship between quantitative financial results and qualitative risk data holds true for every industry, however the exact line between profitability risk and financial results will vary.  The bottom line is that both types of data work harmoniously to define the risk of business failure and provide much needed insight into the inner-workings of enterprises.  Those who seek to consider both types of data when making decisions to grant credit or guarantees will be considering the whole of risk.  Like the concept of Yin and Yang, qualitative and quantitative data complement each other and will protect creditors and guarantors if used regularly!  For more information on how qualitative risk information is being standardized, we encourage you to read about the Certified Risk Assessor Program.

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Yin and Yang of Credit Underwriting

Technorati Tags: credit underwriting, Enterprise Risk Management, ERM, failure risk, guarantee underwriting, maximum profitability, profitability risk, qualitative data, quantitative data, Risk analysis, risk data, risk premium

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.

For instance, how many lenders gave adequate consideration to potential increases in fuel costs and its effect on buying habits? Just ask a Hummer dealership with vehicles anchored on the lot in concrete how well-prepared they were. For that matter, Mike Shedlock makes a convincing argument that the entire U.S. auto industry appeared to be caught off guard by changing consumer sentiment. It’s well worth reading. The fallout is that we could very easily see the implosion of a U.S. Big 3 auto maker, and more bank failures are almost certain to follow. Bank Implode-o-Meter provides a sobering play-by-play.

As a predictable reaction to experiencing losses, and watching other banks fail, the New York Times is reporting that Worried Banks Sharply Reduce Business Loans. Equally predictable, however, is that the reduction in business loans comes too late to significantly reduce losses, and will actually do more economic harm than good at an aggregate level.

Guarantors (Sureties)

In the case of sureties, dependency on old financial data, insufficient attention to all risk factors, and generally loose credit set up the industry for a fall. The industry was ill-prepared for any shock to the system, and 9/11 proved that, exacerbating losses that would not reverse until 2005.

Surety Industry Losses - Data from Surety Association of America

Riding a wave of construction spending and bubbling real estate valuations, the surety industry posted good results for the years ending 2005-2007. However, we doubt that trend will continue past year end 2008 into 2009; the industry still remains exposed to economic shocks:

In the past quarter, many contractors have been cutting volume significantly, some in half! Imagine trying to carry the same overhead on 50% of your previous sales. Most companies don’t know how to manage that kind of fall off, and many won’t, ending in failures that sureties will have to support. Chubb recently reported a large surety loss of $75 million and a surety combined ratio of “128.4% due to one large loss.” While many sureties “appear” to have learned their lessons from the loose practices of the early part of the decade by implementing tighter underwriting guidelines, we still expect to see more of these “surprise” losses. Why? Because, for the most part, sureties still aren’t using all the underwriting data they should be, and many contractors are just now starting to feel the brunt of a severely tightening construction environment.

So what does all this mean? In simple terms, neither banks, sureties, nor those receiving credit are accounting for all potential risks and, consequently, their decisions were made without due consideration for all the risk factors present. Although it is typical to see a high number of business failures in risky industries during downturns, if we want improved underwriting practices (a better functioning economy), losses shouldn’t be accepted with an “oh, well” mentality.

The Underwriting Deficiency Problem

So how could some of these losses be prevented? It is inevitable that there will be truly unexpected, “Black Swan” events that lead to unpredictable losses. It is impossible to completely foresee these events. That said, financial companies suffer more predictable, common losses everyday because of flaws in the underwriting process. These flaws generally fall into two categories: unusually high tolerance for risk and poor underwriting data. Addressing these issues can lead to better, more predictable results:

1) Unusually High Tolerance for Risk

This problem can never be fixed completed, but a good first step is an integrated risk management program that includes rigid policies and procedures that must be strictly adhered to when making decisions to grant credit. Unfortunately, most financial institutions already have strict underwriting guidelines in place; they simply are not followed on a consistent basis. When markets soften and competition increases, it’s all too common for underwriters to “bend” guidelines to win business. Not bending guidelines, in fact, becomes very difficult because pressure mounts from management, and sometimes Wall Street, to maintain consistent revenue growth. This causes companies to tolerate a higher level of risk than they should. Ultimately, this is a management or psychological issue. The more pressing issue is lack of useful, truly predictive data:

2) Incomplete or Misleading Underwriting Information

A common complaint we hear from underwriters and credit providers is that they just don’t have a good sense of what goes on behind the four walls of their potential clients. No matter how much financial information they receive, there’s always the lingering uncertainty of how valid the data really is. At the end of the day, financial data is only good as the inputs used. How is an underwriter supposed to know if the inputs are correct? More importantly, how are they supposed to know whether strong financials are due to a company playing Russian Roulette with risk as discussed in the “Success Paradox”, or due to a company being truly well-run? Basically, credit decisions, are only as good as the information they are based upon. If accurate or actionable information is unavailable, underwriting decisions will suffer, especially when underwriters have to guess how predictive the data really is. There are three primary causes of poor underwriting data: insufficiency, inaccuracy, and obsolescence:

a) Insufficiency is a lack of data and usually a poor excuse for underwriting failures. There are plenty of management training programs that teach “if you are missing something, then go get it.” Some underwriters do, but a lot don’t. For optimum results, all data that can help predict the likelihood of a loss should be considered. Unfortunately, sometimes data is simply either not available entirely or not available in an easily usable form.

b) Inaccuracy is caused by (1) fraudulent data or (2) poorly compiled data, and is a constant concern in every company. The old adage “garbage in – garbage out” really applies here. If the data is not accurate, then underwriting decisions will be impacted. Most inaccurate data in business stems from poor accounting procedures.

c) Obsolescence refers to data that is old and can be misleading. In most industries, data less than one year old is typically good enough to make credit decisions. However, in risky, volatile industries, cash moves through the companies very quickly. In these industries, data more than even a few months old often leads to poor credit decisions. That is why creditors should always want the most recent information available.

So how can these problems be solved?

Finding a Fix

Up until now, almost all underwriting decisions have been based primarily upon quantitative data, that is, financial information. However, pure logic tells us that financial information alone has not served to adequately stem the losses that have occurred.  To fix the problem of data insufficiency, obviously more data would be better and would help in underwriting decisions.  That is why qualitative data about an individual or company can greatly assist in underwriting decisions.  In the case of mortgage lending, would losses have been reduced if consideration was given to the risk of deflated home values, the risk of concentrated loan types, or the risk associated with lending to those with a single source of income? The answer is yes, and all of that is qualitative data.  In the case of construction lending, would losses have been reduced if banks had considered the risk of a contractor’s revenue concentration in one type of work of large proportions, or the risk that developers would not be able to pay them if houses did not sell?  The answer is again yes, and all that too is qualitative data.

So why isn’t qualitative data considered to a greater degree? There simply has been no standardized means to collect qualitative risk data. And if it was collected, there has been no way to compile and understand it. To further compound the problem, qualitative data is typically subjective and difficult to quantify. Consequently, although qualitative risk data can fill a number of credit underwriting deficiencies, it simply isn’t available in a useful form. As a result, it hasn’t been relied upon for credit decisions. It just didn’t fit into the tried and true world of numerical reporting… until now.

Recent Catalysts for Change to Underwriting Practices

Although computers and the Internet have played a role in the development of qualitative information for use in credit decisions, the real catalyst has been the emergence of Enterprise Risk Management (ERM), which has come onto the shores of corporate America in a strong wave. Ever since the Enron fiasco, the Arthur Andersen debacle, and the response with Sarbanes Oxley, attention has turned more than ever toward examination of business practices and metrics to assure that handling of company records follows strict procedures and guidelines.  The immediate response to Sarbanes Oxley was the development of corporate governance systems designed to not only incorporated procedures for handling company records, but also install business controls. However, these systems initially failed to consider all business practices that could impact profitability. In addition, they typically looked at practices in somewhat of an on or off manner; either practices were in place or they weren’t. ERM on the other hand, considers all business practices that can impact profitability and examines them in a variable form, i.e. not in place, poorly in place, functional but needing improvement, acceptably in place, etc. As such, it provides a more holistic view of the entire corporate framework and the inherent risk to enterprise objectives. Recently, S&P and other rating agencies have begun to review how well companies utilize Enterprise Risk Management, as part of their credit rating procedures. However, the rating agencies reviews seem to be more focused on whether an ERM system exists in a company and less on actually assessing the value of the controls in place.

A true enterprise risk assessment determines whether a company has the necessary systems and controls in place to maintain profitability, whether its accounting procedures are strong enough to produce reliable financial information, and whether it’s exposed to undue risk as a result of overlooked exposures. Data from the risk assessment is analyzed to reveal profitability risk, potential increases in failure risk, and has the added benefit of validating the quality of financial information generated by a company. In addition, it is usually available within a week of assessment, a much shorter time frame than financial reports. By providing additional underwriting information and analyzing the quality of accounting practices in an almost real-time manner, enterprise risk data addresses the three causes of poor underwriting data: insufficiency, inaccuracy, and obsolescence. With this data, a credit granting decision can be made without that unknown hanging over the underwriter. Just what goes on behind those four walls no longer needs to be a mystery. Now it can be known.

A Long Awaited Solution

To be truly effective as an underwriting tool, there must be a standardized system for gathering and analyzing enterprise risk data. In addition, because the risk factors in each type of business vary considerably, any system that attempts to collect qualitative risk data and quantify it must be designed specific to an industry. For example, a risk factor in the restaurant industry would be the presence of rodents, which is not really a concern in the construction industry.

MyRiskControl.com utilizes the patent-pending DGR Risk Analysis System, which is licensed from Druml Group, Inc. The DGR Risk Analysis System provides a standardized means for assessing and analyzing qualitative risk in a business enterprise. The source data required to produce a MyRiskControl Report comes from a standardized risk assessment, which can be performed either by a MyRiskControl Certified Risk Assessor or by a company’s own personnel. Although both approaches can produce accurate reports, company personnel could have inherent biases or lack a full understanding of all the risk factors. MyRiskControl Certified Risk Assessors are trained to be fully knowledgeable about each risk factor to ensure the greatest accuracy and neutrality of the resulting risk analysis report.  In turn, the risk analysis report scores and rates the overall severity of risk present in the assessed company.  MyRiskContol Reports are often provided to banks, sureties, and other creditors or guarantors trying to obtain a more complete picture of their prospects. As a result, credit underwriters no longer have to work solely on financial data, but can get a much clearer view of the current and projected health of their applicants to avoid undue risks. Now when choosing whether to grant credit, underwriters no longer have to play their own high stakes game of Russian Roulette.