Expert Commentary

Critical Mass and the Savings Impact

Understanding the financial impact of critical mass is an important step in investigating the feasibility of a construction wrap-up program. This second article in our wrap-up series examines the impact project size has on potential savings and how it affects underwriting decisions.


Wrap-Up Programs
July 2000

Welcome back. I hope you had a good winter and spring. Have you been waiting anxiously for the sequel to our original story? Well, fear not, my fellow readers. Here we go.

Last time we met, we were introduced to our risk manager, who encountered quite a dilemma as respects the construction of her firm's new printing facility. Our discussion focused primarily on wrap-ups and critical mass (project size as defined by hard construction dollars). We also learned how to analyze a construction budget for wrap-up purposes.

So now let's move on. Understanding the financial impact of critical mass is an important step in the feasibility process. In other words, what impact will project size have on potential savings and how the underwriting discipline will integrate with this process?

The Insurance Dollar

Let us not get too far ahead of ourselves. There is a basic concept we need to review prior to our moving on. I like to refer to this part of our script as the "insurance dollar" discussion. In the insurance industry we can be easily sidetracked from some very basic concepts by the sheer magnitude of premium dollars we have grown accustomed to dealing with. In many cases this has prevented us from clearly understanding how each dollar of premium paid to an insurer is used.

What are the two things an insurance company can do with a premium dollar? Any guesses? Well, if you said, "pay claims and expenses," you can go to the head of the class. In fact, we know from our actuaries that approximately 60 percent of the dollar is set aside for claims and the remaining 40 percent should cover expenses and (let us not forget) a profit.

This theory holds true for wrap-ups and is a critical concept in appreciating the impact project size will have on savings to the sponsor (the party that purchases the wrap-up program) and profitability to the insurer. Wrap-up savings result when the ultimate cost of insurance under the wrap-up is less than what the individual contractors would have included in their bids.

When contractors bid projects, they generally will include in their bid prices their maximum cost of insurance, even if their insurance is a loss-sensitive rating plan. This means that, even if their final cost of insurance for the year is reduced by dividends or other loss-sensitive returns, they will (with certain exceptions) pass on the full cost of insurance. This point is also valid when contractors are covered under guaranteed cost programs; only it is the insurer that pockets the difference between the actual costs and what is charged.

Another way to look at this is to apply our "insurance dollar" theory. Rather than the insurance actually costing the contractor $1.00 it might cost $0.40 in a case where it had no losses and was covered under a loss sensitive plan. Simply put, the insurer will keep what it needs to pay expenses and return to the contractor that portion of the insurance dollar set aside for losses ($0.60).

Thus, by instituting stringent safety requirements and a comprehensive claims management program, the final cost of the wrap-up will be lower than what the contractors would have charged in total for the cost of their insurance (contractor deducts).

Wow. I think we are now ready to move on.

Feasibility and Underwriting Issues

If you recall from our previous story, the hard construction budget components of the new printing facility totaled $80 million. Before setting any false expectations our risk manager should have considered that at $80 million, a wrap-up would be considered borderline. But, what does borderline really mean? We often use that term, but you may be asking, "So what?"

To answer that question, it is necessary to illustrate the impact by comparing two potential wrap-ups at their ultimate projected premiums; one has hard construction dollars of $180 million and the other $80 million. The following assumptions also apply.

  • Workers compensation payroll is 20 percent of hard construction cost.
  • Anticipated contractor deducts will approximate 10 percent of payroll.
  • The underwriter will give a slight economy of scale in the expenses for the larger project: 4 percent of payroll for the $180 million and 5 percent for the smaller one.

Construction Value $180 million $80 million
Workers Compensation Payroll @ 20 percent $36 million $16 million
Fixed Expenses $1,440,000 $800,000
Contractor Deducts @ 10 percent $3,600,000 $1,600,000
Containment for Losses* $2,160,000 $800,000
* These are the losses that would be contained at worse case in these two wrap-ups and when added to expenses would break even with contractor deducts.

Now you will see what happens to the smaller project when the underwriter does not have the critical mass or an economy of scale to contain a viable loss level. Underwriters tend to be less flexible in providing dollar savings when they can barely cover their expenses and less willing to cap the program losses at a level ($800,000) that provides the sponsor a breakeven at the worst-case scenario. Therefore the underwriter's loss containment will approach a level that will make the wrap-up infeasible.

Of course the sponsor can always take the approach that maximum exposure is not an issue because of a high level of confidence in the project's ability to control the safety and claims process. What a wonderful world that would be. Unfortunately, most buyers of wrap-ups are rightfully concerned with the financial exposure resulting from the upside risk. The project with a greater critical mass can stand on its own and provide the sponsor less upside risk when evaluating the feasibility of a wrap-up approach and the underwriter with a better opportunity to realize a profit at competitive loss containment.

Consider the Location

Because we do not live in a perfect world, there are particular side issues we need to address that can impact the feasibility of a wrap-up. One very important factor to consider is the workers compensation rating environment from state to state. Our example above would look different if we were in a state with higher workers compensation rates and therefore greater deducts expected back from the contractors. In states with lower workers compensation rates, these issues must be evaluated very carefully. For example, a $100 million project in New Jersey might not produce the same savings as a project in Florida because of differences in rates. Did you know that the average workers compensation construction trade rate in New Jersey is approximately $8-9 per $100 of payroll prior to application of experience modification credits and special rate deviations? In comparison Florida has an average trade rate of approximately $18-22. That's quite a difference.

Conclusion

The next time someone comes to you with information on a potential project, step back and ask a few simple questions rather than hastily recommend or not recommend a wrap-up approach.

· Is there a project budget available? · What are the hard construction dollars? · Are any large equipment purchases included in the budget numbers? · In what state will the project be located?

Only then will you be in a position to begin a process of evaluation. Much additional information will be required. This is only a first step in a lengthy but potentially rewarding endeavor. Just remember there is nothing like getting off on the right foot. Have fun on your journey, but just be aware of some pitfalls along the way.

Hopefully I have been helpful in getting you started and in taking some of the mystery out of wrap-ups. Have a great summer. See you in the fall.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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