**2. Transference or retention of the financial consequence of risks in the construction industry**

#### **2.1 Mechanisms for risk transfer in construction**

Construction firms are subject to a variety of risks with sometimes almost limitless financial consequences. Left unhandled or uncontrolled, the financial consequences of an adverse risk realization can be bankruptcy. There are several different mechanism available to the contractor (and subcontractor) which can transfer these financial consequences to another party. Contractually transferring the financial risk consequences to an insurance company by buying insurance policies designed for the specific risks affords a common method of risk transfer. A non-insurance risk transfer mechanism inserts risk transfer language into the contract of work between the contractor and other entities on the worksite so they bear the risk instead of the contractor. Each of these is discussed in more detail subsequently, along with self-insurance alternatives.

#### **2.2 Self-insurance as an alternative risk handling technique**

Not all risks can be transferred, either through insurance or through contract. According to [1], the top five uninsurable risks faced by the construction company (and needing self-insurance and risk mitigation strategies to address) are reputational risk, regulatory risk, trade-secret-intellectual property risk, political risk, and pandemic risk. With such risks the contractor must choose to either avoid the risk altogether (e.g., not bid on a contract that is deemed too risky or for which the experienced and skilled subcontractors are not available) or the contractor must retain the risk and any financial consequences internally. Alternatively, a large construction company may find risk transfer an ineffective way of hedging a particular risk, and hence choose to assume that risk; otherwise known as the self-insurance option. It is called self-insurance because it is risk financing, like insurance, but with the financial consequences paid by the company itself instead of the insurer paying. In spite of what the name may imply, self-insurance involves no transfer of risk.

All companies engage in self-insurance. Since insurance products generally have a deductible or co-pay, and a limit of liability, the contractor always faces the assumption of some of the risk (that below the deductible and above the policy limits, for example), so they are "self-insuring" these losses. Additionally, there are some risks, such as the risk of incurring criminal fines and penalties, that are not insurable, nor is there a contractual risk transfer option available. For these risks, the contractor must retain the financial consequences internally.

**35**

*Different Market Methods for Transferring Financial Risks in Construction*

This can have significant consequences if losses are severe enough.

enough to take advantage of these techniques, however.

reserve account to pay claims with high probability.

adjusting and claim payments.

Self-insurance can be planned or unplanned retention. Unplanned retention occurs when the company failed to recognize a particular risk, and therefore has not prepared for addressing its financial consequences, and must pay losses internally.

Two formal techniques for planned self-insurance are prefunding a risk account

to pay for claims internally as they arise, and forming an insurance company as a subsidiary of the construction company and then buying insurance from this insurer. This insurance subsidiary is a "captive insurer". Not all companies are large

Insurance companies can accept risk from others because the statistical law of large numbers and central limit theorem allow them better estimate expected losses for a risk pool, and with greater precision, than could an individual insured. By pooling a large number of similar exposures, the insurer both diversifies the assumed risk, and increases precision in estimating average losses, the basis of a premium. Administrative expenses and profit loading are added to the expected loss to arrive at a final premium to charge the insured (see [2, 3]). By knowing the expected loss for an individual insured and how much variability there is across different insureds, the insurer determines how much money they need to keep in a

If a non-insurance company has a sufficient number of exposure units, they can avail themselves of this same process as the insurer described above and determine the amount needed in a bank account to have sufficient funds to pay claims. The benefit of this formal self-insurance arrangement is that there is no administrative fee or profit loading charge, thus making the pre-funded bank account approach to self-insurance more economical for the company. The process may also allow for wider coverage than available on the open insurance market. Usually a company will hire a third-party administrator to assist with claims

The second self-insurance alternative available is to form a subsidiary that is an insurance company, and then have that insurance company write the insurance for the parent company. This subsidiary is a captive insurance company. A pure captive is an insurance company subsidiary that only insures the risks of the parent company. A pure captive is a very formal type of self-insurance since the financial consequences of the risk have not been shifted outside the original parent company. Other types of captive insurance companies can write the business of the parent as well as outside unrelated businesses. There are tax implications concerning the deductibility of the premiums paid to a captive insurer (depending on how spread the risk is between insureds), and expert tax advice is needed here. The benefit, of course, is that the profit from the insurance business is retained internally while still satisfying insurance requirements (such as the mandate to insure workers' compensation risk).

As with self-insurance generally, only very large companies can feasibly handle risk by forming a captive insurer (due to capitalization requirements). Risks in the construction industry often sent to captive insurers include workers' compensation, commercial automobile, builders risk and general liability. The captive then writes

Industry groups can also jointly form group captive insurers, and there are several in the construction industry. The benefit of joining a group captive is the additional diversification, the deductibility of premiums, and the fact that by joining an existing industry group captive, there is specialized industry expertise concerning the types of risk faced. The captive also has access to the reinsurance market (which an individual construction company does not have) and can often get insurance coverage at a lower rate than from a regular insurance company.

insurance policies covering these risks of the parent company.

*DOI: http://dx.doi.org/10.5772/intechopen.84748*

#### *Different Market Methods for Transferring Financial Risks in Construction DOI: http://dx.doi.org/10.5772/intechopen.84748*

*Risk Management in Construction Projects*

**construction industry**

along with self-insurance alternatives.

**2.2 Self-insurance as an alternative risk handling technique**

nisms pertinent to construction risk management.

**2.1 Mechanisms for risk transfer in construction**

Construction contracts are often written with incentive clauses based on the contracted for completion date. When construction is finished ahead of schedule the contractor is rewarded a pre-specified amount per day. If the project finishes after the deadline, a pre-specified penalty is assessed for each day late. Thus, risk realization in the construction process can have twofold financial consequences: direct and indirect costs of liability and damages. We cover direct losses to property, liability to contractors, business interruption coverage (e.g., delay in start-up or completion insurance and contingent business interruption in supply chain management), worker's compensation liability, and other important insurance mecha-

**2. Transference or retention of the financial consequence of risks in the** 

Construction firms are subject to a variety of risks with sometimes almost limitless financial consequences. Left unhandled or uncontrolled, the financial consequences of an adverse risk realization can be bankruptcy. There are several different mechanism available to the contractor (and subcontractor) which can transfer these financial consequences to another party. Contractually transferring the financial risk consequences to an insurance company by buying insurance policies designed for the specific risks affords a common method of risk transfer. A non-insurance risk transfer mechanism inserts risk transfer language into the contract of work between the contractor and other entities on the worksite so they bear the risk instead of the contractor. Each of these is discussed in more detail subsequently,

Not all risks can be transferred, either through insurance or through contract. According to [1], the top five uninsurable risks faced by the construction company (and needing self-insurance and risk mitigation strategies to address) are reputational risk, regulatory risk, trade-secret-intellectual property risk, political risk, and pandemic risk. With such risks the contractor must choose to either avoid the risk altogether (e.g., not bid on a contract that is deemed too risky or for which the experienced and skilled subcontractors are not available) or the contractor must retain the risk and any financial consequences internally. Alternatively, a large construction company may find risk transfer an ineffective way of hedging a particular risk, and hence choose to assume that risk; otherwise known as the self-insurance option. It is called self-insurance because it is risk financing, like insurance, but with the financial consequences paid by the company itself instead of the insurer paying. In spite of what the name may imply, self-insurance involves

All companies engage in self-insurance. Since insurance products generally have a deductible or co-pay, and a limit of liability, the contractor always faces the assumption of some of the risk (that below the deductible and above the policy limits, for example), so they are "self-insuring" these losses. Additionally, there are some risks, such as the risk of incurring criminal fines and penalties, that are not insurable, nor is there a contractual risk transfer option available. For these risks,

the contractor must retain the financial consequences internally.

**34**

no transfer of risk.

Self-insurance can be planned or unplanned retention. Unplanned retention occurs when the company failed to recognize a particular risk, and therefore has not prepared for addressing its financial consequences, and must pay losses internally. This can have significant consequences if losses are severe enough.

Two formal techniques for planned self-insurance are prefunding a risk account to pay for claims internally as they arise, and forming an insurance company as a subsidiary of the construction company and then buying insurance from this insurer. This insurance subsidiary is a "captive insurer". Not all companies are large enough to take advantage of these techniques, however.

Insurance companies can accept risk from others because the statistical law of large numbers and central limit theorem allow them better estimate expected losses for a risk pool, and with greater precision, than could an individual insured. By pooling a large number of similar exposures, the insurer both diversifies the assumed risk, and increases precision in estimating average losses, the basis of a premium. Administrative expenses and profit loading are added to the expected loss to arrive at a final premium to charge the insured (see [2, 3]). By knowing the expected loss for an individual insured and how much variability there is across different insureds, the insurer determines how much money they need to keep in a reserve account to pay claims with high probability.

If a non-insurance company has a sufficient number of exposure units, they can avail themselves of this same process as the insurer described above and determine the amount needed in a bank account to have sufficient funds to pay claims. The benefit of this formal self-insurance arrangement is that there is no administrative fee or profit loading charge, thus making the pre-funded bank account approach to self-insurance more economical for the company. The process may also allow for wider coverage than available on the open insurance market. Usually a company will hire a third-party administrator to assist with claims adjusting and claim payments.

The second self-insurance alternative available is to form a subsidiary that is an insurance company, and then have that insurance company write the insurance for the parent company. This subsidiary is a captive insurance company. A pure captive is an insurance company subsidiary that only insures the risks of the parent company. A pure captive is a very formal type of self-insurance since the financial consequences of the risk have not been shifted outside the original parent company. Other types of captive insurance companies can write the business of the parent as well as outside unrelated businesses. There are tax implications concerning the deductibility of the premiums paid to a captive insurer (depending on how spread the risk is between insureds), and expert tax advice is needed here. The benefit, of course, is that the profit from the insurance business is retained internally while still satisfying insurance requirements (such as the mandate to insure workers' compensation risk).

As with self-insurance generally, only very large companies can feasibly handle risk by forming a captive insurer (due to capitalization requirements). Risks in the construction industry often sent to captive insurers include workers' compensation, commercial automobile, builders risk and general liability. The captive then writes insurance policies covering these risks of the parent company.

Industry groups can also jointly form group captive insurers, and there are several in the construction industry. The benefit of joining a group captive is the additional diversification, the deductibility of premiums, and the fact that by joining an existing industry group captive, there is specialized industry expertise concerning the types of risk faced. The captive also has access to the reinsurance market (which an individual construction company does not have) and can often get insurance coverage at a lower rate than from a regular insurance company.

## **3. Insurance contracts facilitating risk transfer**

The primary technique for transferring the financial impact of construction risks to others is through the purchase of various types of insurance. This section considers which types of construction risks are amenable to insurance and the types that are not. We then examine various important construction risks and insurance solutions to the transfer of their financial consequences.

#### **3.1 What constitutes insurable construction risk?**

Since only some risks are amenable to an insurance transfer solution, we first consider the unique characteristics of construction risk, and then describe the ideal characteristics for a construction risk to be insurable.

#### *3.1.1 Unique aspects of construction risk*

While construction is a form of manufacturing business (taking raw input materials, capital and labor to create a finished product), the differences between traditional manufacturing risk management and construction risk management are many. Risk management of construction projects is especially challenging and complex due to the unique characteristic that each project brings with it. First, the location of the construction enterprise is not fixed, as there may be several construction projects going on simultaneously resulting in many employees in various worksites and transiting between different workplaces.

The safety and risk management of each worksite must be evaluated separately (and continuously) as environmental hazards or exposures can differ from site to site (e.g., one site may have flood risk, another fire risk, another vandalism and theft risk, etc.). In international construction firms, liability risk can differ according to country and legal system. The same risk management or insurance plan will not be applicable to all projects due to location differences, beginning state and ending state site differences, differing neighboring buildings and their vulnerability, differing owners, deliverables, and contracting agreements between the owner and contractor.

Each project is also unique in terms of people working at the site. Numerous subcontractors are generally involved on a construction project, all working simultaneously at the same worksite, each subcontractor with their own contract workers, and with varying skill levels and risk culture. Coordination problems regarding safety and attitude toward risk-taking can occur. Additionally, many subcontractors are small and potentially undercapitalized, so that even if they sign a hold harmless agreement, they may not be able to live up to the assumed financial responsibility agreement (leaving no effective way to enforce it).

Depending on the terms of the contract between owner and contractor, construction projects can become adversarial due to financial pressures and uncertainties. Adversarial relationships may produce negative consequences for cooperation, safety, and the management of other risks. Fixed price contracts can exacerbate ownercontractor conflicts resulting in potential increased losses due to decreased attention to safety and risk management by the contractor (because of financial constrictions). Cost plus pricing can reduce the potential for safety and risk management related losses but increases costs. Many of these issues are also unique to construction contracts [4].

Additionally, construction projects are very labor intensive and often are performed under harsh conditions, adding to the riskiness of contracting. Management of risk becomes more important for construction since clients, specification, and workers differ from project to project.

**37**

financial failure.

**insurance policies**

*Different Market Methods for Transferring Financial Risks in Construction*

Risks can be dichotomized into pure risks and speculative risks. A pure risk has a chance of loss or no loss, but no chance of a gain (e.g., a motor vehicle or a construction workplace accident). There is no gain in this situation. Speculative risks, such as investment in the stock market or contracting to build a project in the hopes high profitability, either can result in losses or gains. Pure risks are potentially amenable

However, not even all pure risks are insurable. The ideal characteristics of an

1.There should be a number of independent similar exposure units as viewed from the perspective of the insurer. This allows access to the law of large

3.A catastrophic loss should not be possible. Quite simply, a catastrophic loss, if transferred to the insurance company, could bankrupt the insurer, a likelihood not desired by the insurer. Also, catastrophes tend to violate condition 1 since adjacent properties are more likely to simultaneously experience losses making

4.Losses should be definite in time and measurable in loss size. Since insurance contracts are for a specified period, the insurer must be able to tell if the loss occurred during the period, and they must be able to measure the loss for

5.The probability distribution of losses should be determinable. Premium setting is essentially a statistical exercise so one must know the possible loss sizes

6.The cost of coverage should be economically feasible to provide and to buy. If the premium is unaffordable to the insured, or if the cost of underwriting (selecting and pricing) the risk is too high for the insurer, then an insurance

Many risks found in construction are insurable (and discussed below). These include: workers' compensation for workplace injuries; builders risk insurance for damages during construction; general liability insurance; professional liability insurance; delay in completion insurance; insurance covering certain operational risks (such as defective construction or faulty workmanship claims); supply chain risk losses due to interruptions or damages at a supplier upon whom the contractor is depends for their own performance, and other risks like subcontractor default or

**3.2 Construction risks amenable to insurance risk transfer and relevant available** 

Several standardized insurance risk transfer policies are available for use in alleviating the financial consequences of risk realization at construction sites. These policies cover different aspects of construction risk and generally satisfy the ideal

and the likelihood of losses of various sizes to set premiums.

insurable risk, as delineated by most risk management texts (e.g., [2]) are:

*DOI: http://dx.doi.org/10.5772/intechopen.84748*

*3.1.2 Ideal conditions for insurability of a risk*

insurable but speculative risk are not.

losses not independent.

contract will not be created.

numbers from statistics to set premiums.

claims payment and to determine premiums.

characteristic of an insurable risk discussed previously.

2.The losses that occur should be accidental or by chance.
