For about two years now, the insurance industry has looked like a commercial disaster for buyers and sellers alike.

By David Engle

Underwriters paid out historically huge claims following the events of September 11, 2001. Estimates range from $40 billion to $70 billion, according to insurance broker Bob McPherson of the Huckleberry, Sibley & Harvey insurance agency in Maitland, FL. As he points out, "The year 2001 marked the first time in modern memory that the insurance industry actually lost money, even after its investment income."

Another brokerage firm, Willis Group - a global company with more than 3,000 contractors as clients in North America - researched the current business insurance crisis and its impact. Luke Laborde, president of the Willis office in Cary, NC, notes, "Basically about 25% of the net worth … of the insurance industry got wiped out in the catastrophes of September 2001."

Ripple effects from that day also have been enormous. From an earthmover's standpoint, the main consequences stem from a severely diminished underwriting capacity. Shortly after taking huge losses, several major reinsurers either collapsed or withdrew from the casualty market and other insurance segments. Under industry regulations, underwriters cannot return to their pre-2001 volume until they replenish their sorely depleted reserve accounts. This task now is occurring slowly - amidst a bear market for investment income and a weak economy overall.

Those insurers who have remained in the market were forced to become extraordinarily selective. They're scrutinizing every risk and jacking up rates to all-time highs.

For many contractors, the net effect has been devastating. According to Willis Group figures, virtually all segments of insurance have shown average premium hikes well into double-digit over the past 12-18 months, including auto, inland marine, workers' comp, general liability, and other casualty coverage. "We find people reeling from 30% to 40% increases on their average insurance costs," observes Laborde, noting that comprehensive insurance was probably averaging 20% higher in 2002 than a year earlier.

"Umbrella liability polices went up 80% and even 200%," he adds. Contractors' equipment rates (i.e., inland marine insurance) also rose, with higher deductibles being imposed, along with premium hikes of about 30%. Auto fleet coverage for grading and excavation contractors increased "an average of 28% between the first quarter of 2001 and first quarter of 2002," Laborde reports. "We saw similar figures for workers' comp - a 27% increase. General liability was up 40% and umbrella, 29%. The year 2002 also marked the first time in at least 24 years in which construction insurance, surety bonding, and employee benefits costs all rose in double-digits simultaneously. It's really crushing a lot of the subcontractors and specialty contractors."

Moreover, not all can buy coverage anymore. An undetermined number of dirt-movers' policies have been cancelled. Early in 2001, a major Illinois contractor (who requested anonymity for this interview) received a cancellation notice from CNA Insurance Companies. "My policy wasn't being renewed," he recalls, "because the carrier was experiencing losses on some construction policies" and was reportedly leaving the market. Through his brokerage he eventually found an Australian firm named QBE to pick up the cancelled coverage. But the terms were horrendous. Rates immediately doubled for liability and umbrella and rose again in 2002. "They're now triple those of a few years earlier," he declares. "It's been terrible. But only one company would accept the risk."

Contrary to reported rumors, CNA actually hasn't abandoned any markets. Rather, explains CNA's National Program Director John Tatum, "[The company] has increased its focus on underwriting excellence, [and some accounts] do not meet the company's underwriting criteria and therefore are not acceptable from an underwriting standpoint." During better times, riskier accounts were often carried despite their higher losses because income from premiums could be stretched with investment gains. Now, though, remarks Tatum, "You really can't make the money on those investments - and so there's a huge focus on underwriting profitability."

Another recipient of bad news from a broker was Ralleen Ratzlaff, a partner of grading contractor M.J. Ratzlaff Engineering of El Cajon, CA, near San Diego. In business profitably for 16 years, and with a reasonably good claims history, she was notified by her broker soon after September 11 that only one carrier would take her workers' comp policy. Premiums then doubled. Her deductible on general liability also was raised from $1,000 to $5,000. Still she believes she's relatively lucky, noting, "We've seen a lot of cancellations and nonrenewals in this area." At least three underwriters apparently bailed out of the hard market after many years and are no longer writing policies for dirt-movers.

Ratzlaff's broker eventually dug out a few more workers' comp bidders. She settled on State Fund. "The premiums are really outrageous every month," she states.

In Ratzlaff's San Diego region, exorbitant rates for liability protection seem to be driven skyward by pervasive lawsuits. Twice, she reports, the company has been forced to file claims to settle suits in which plaintiffs unfairly dragged her and another subcontractor in as codefendants for others' mistakes. In condo construction especially, she comments, "It's now almost guaranteed that within 10 years of completing a project, they're going to sue everyone who worked on it."

This rash of litigiousness in turn has caused developers to demand ever-higher aggregate liability coverage of their subcontractors. The latter must accept this "offer they can't refuse" or they'll get no work. Only two years ago, a total of $1 million worth of coverage was sufficient, Ratzlaff recalls. More recently, contractors have been demanding $2 million. "Every year it seems to be going up," she observes. "And they are even dictating how much workers' comp you have to carry." In addition, hold-harmless agreements are being demanded, contracts dating since 2001 have been requiring waivers of subrogation, and in 2002 they began demanding purchase of subsidence insurance. (Essentially, all three are devices for relieving the owner-developers of liability and shifting it to others.)

Ratzlaff notes that it's not uncommon (or very surprising) that brokers sometimes can't find insurers for such transfers, and these onerous clauses become negotiable. This suggests that subcontractors might be able to prevail more often by banding together. "If enough are willing to resist, then the developers will have to come down," she says.

George Sullivan, vice president of finance at S.T. Wooten Corporation - a very substantial earthmoving business in Wilson, NC - has seen major increases in his premiums dating back several years. To counteract these, Wooten raised its policy deductibles across the board. Sullivan advises other dirt-movers to push these to the highest level they can afford while lowering coverage limits as well. "We don't want to be underinsured," he maintains, "but we have looked very closely at our excess liability coverage recently [and made some economizing adjustments]." Sullivan points out that because "umbrella" coverage is written "over" an underlying liability policy, "there's a very good possibility that this umbrella will never have to pay off unless you had some really bad claim." He suggests that if you loaded up on liability protection when rates were cheap in the 1990s, be sure you have pared it back to only what you need.

How Much Is Enough?

Another way to ask the same question: How much can you really afford to risk in order to cut down on premiums? McPherson concedes that no easy formula exists because each enterprise differs in terms of its loss history, hazards, assets, and current revenues. For instance, he says, "A five-person operation doing a million-and-a-half a year probably can't afford to bite off a claim of $15,000 and $20,000" - and thus it should probably insure against this loss. Conversely, a corporation doing $15 million annually probably could self-insure its losses at this level or higher. "Its all relative, based on the size and wherewithal of the firm," he points out. McPherson sees the earthmoving business gravitating toward significantly higher deductibles, set to cover only catastrophic losses - "and not the nickel-and-dime things that a contractor should pay for as a cost of doing business."

Underground utility contractor Joe Wilkerson, president of J.F. Wilkerson Contracting Company in Morrisville, NC, agrees with the concept of self-insuring affordable losses by raising the bar on deductibles. Wilkerson began revising his insurance bid specs in that direction when he saw his policy rates soar in the neighborhood of 18-25% in 2002. ("Although some premiums actually declined a bit," he points out.) Contractors should bite the bullet and accept losses they can afford, he believes, in order to win lower rates for the industry. "Filing claims on every minor fender-bender will cost more in the long term, with higher premiums." Also, to complement the strategy, he advises, "Run a tight safety program that trains people to avoid those accidents and problems." Wilkerson blames some of the huge run-up in workers' comp premiums on a decade of abuses - that is, fraudulent claims by workers, supported by doctors who are pressured to certify them.

Looking at the New Year

As of this writing, few signs of significant industrywide improvement are on the horizon, but the news is not entirely negative. Willis Group's research has found, for instance, that sharply rising prices in auto insurance premiums now have begun luring more underwriters back into the fold. With average rates having nearly tripled in three years, to about $1,100-$1,250 per vehicle, the profit margins are very attractive once more.

A similar return to underwriting seems to be happening in construction liability, again due to the draw of stratospheric premiums. As a typical example, in North Carolina in mid-2001, only three underwriters - St. Paul, Travelers, and Zurich - were willing to take liability policies in the $100 million range. A year later, in mid-2002, there were seven or eight players again, at least for bigger policies, Laborde notes. Similar positive signs are occurring nationwide. In addition, as a result of the departures of some major underwriters, smaller regional firms have picked up some of the slack.

Another more-or-less positive impact (depending on your point of view) has been the elimination of weaker subcontractors. Some excavation and grading firms that sprouted during the 1990s boom have begun folding - and are taking with them their higher loss ratios. Survivors now tend to be tougher, better managed, and more experienced companies, buttressed with strong safety programs and lower losses. In time, this quality group probably will reap more reasonable rates.

Fundamental problems remain, however. As Laborde points out, high premium income still is being applied to offset huge reserve adjustments on prior losses. Your insurance rates therefore are unlikely to flatten out for some time, let alone come down again. "In simple terms," he states, "this means that, unfortunately, a one-year premium adjustment isn't going to do it in terms of replenishing market capacity. We're likely to see another round of premium increases in 2003. And we don't foresee any turnaround in the market until 2003 has played out. It's going to be a painful time."

Surety Bonding: Also Heavily Impacted

Insurance protects you against assorted material and personal losses; surety bonding promises performance on contracts. The two - insurance and surety - differ fundamentally, but in reality, their fates often are intertwined. This would seem to describe the current surety bond market. Insurers were not the only ones who suffered ruinous losses in 2001: "The surety industry lost money in 2001 and likely will in 2002 - the first such losses in about 10 years," notes Tim Mikolajewski, director of contract surety at Safeco in Redmond, WA.

Bond specialist Rick Scheer of Scheer's Inc. in Countryside, IL, sees 2002 as almost certain to set the all-time record in surety claims payouts - although, as of last autumn, the Enron claims still were being untangled. Enron alone produced more than $1 billion in claims, he reports; an amount roughly equal to the entire sum of premiums paid to sureties in a year. "The loss ratio was skewed - big time," Scheer observes.

Even before Enron's debacle, surety bonds had suffered higher losses among small and medium contractors for about two years and among jumbo contractors for about five years, observes Mikolajewski. Surety claims overall were up significantly in these sectors in 2002. Moreover, he reports, "The number of contractors experiencing problems has increased substantially over the last two years." About 40% of Safeco's construction bonds cover graders and excavators.

The impact of these hits on surety bonding has been (not surprisingly) rather the same as they are on insurance - namely, higher costs for those seeking surety bonds, reduced underwriting capacity, and greater selectivity. "Surety firms," says Scheer, "are taking a harder, closer look at what they have on the books right now." Lines of surety credit have shrunk for many big homebuilders, developers, and contractors, he adds, "because sureties simply don't want any more exposure now." Overall, Scheer estimates the percentage of bonds resulting in some type of claims at about 20% - or slightly worse odds than in Russian Roulette.

For Illinois excavation contractor R.L. Hummel, the hardening of the surety market has coincided with a period of explosive business growth. This was the very time when Hummel needed to boost its surety bond capacity. Prior to 2000, Hummel's chief estimator, Lars Lindquist, had been accustomed to doing jobs requiring bonds in the modest $100,000 range, but the company then sought and won some juicier public-sector jobs. In three years' time, Hummel's annual volume tripled. Despite the hard surety market, Hummel managed to up its bondability from the low six-figures to $5 million in 2002 - but even this has proven constraining, Lindquist relates. "I have two jobs going, each of which hit the $3 million mark for performance bonds," leaving him still $1 million short.

One solution: Lindquist succeeded in leveraging his surety limit by effectively releasing and renewing it month-to-month throughout the year. To do this, he asked his CPA to prepare financial statements for ongoing work on a "percentage of completion" basis. Lindquist explains, "If a job is 50% complete, you can bill and collect for 50%." This allows you to release half of the original bond amount (say, $1.5 million of a $3 million bond). The released portion can then be used on a new job bid. To extend your bondability this way, notes Lindquist, "You've always got to know how much you have in the job and how much you've got left to get out of it. And you need to let the bond company know that their exposure is being reduced because you've successfully completed portions of the job." By skillfully implementing percentage-of-completion financial statements, you can raise your basic bondability to as high as perhaps twice your annual limit. The technique isn't unusual, and any good surety broker can help you do it.

Next, after you've extended your surety limit, you'll naturally want good bond terms. "Anybody can get you bonded," Lindquist observes, "but it can easily cost you a fortune." If too steep, high rates might price you out of many bids. To earn a lower rate, he advises, show your bond brokers a solid, CPA-audited financial statement indicating that you're making money on your work.

R.L. Hummel's rapid expansion also has necessitated adopting more detailed and in-depth accounting disciplines in order to keep track of work change orders, job extras, and subcontracting issues and to give a ready "snapshot" of job status. Tighter financial controls are truly critical to building up your bondability, as several surety agents pointed out. They'll help reveal, early on, any underbidding mistakes you've made - preferably before the cash-flow crunch and the red ink. Lindquist, who eventually enrolled in a course to improve his estimating skills, admits, "We have altered our bidding practices considerably, based on the information we have obtained by closely documenting what we are doing on the job."

Having a track record of accurate estimating, with bottom-line profits, will prove to be one of your strongest selling points each time you go back to ask for new surety bonds. Conversely, errors in bidding probably cause more business difficulties for contractors - and lead to more surety claims - than any other mistake.

Bad news of this sort must be confronted early on, stresses Mikolajewski. If you've blown a bid and are over your head, don't duck out or try to fix problems alone but, instead, go to your surety agent. "Get help," Mikolajewski advises, "especially if problems are impacting the financial statements significantly." The future of your surety credit - and hence your business - is at stake. He adds, "Surety companies don't respond well to surprises. But we do respond well to problems that may develop, [providing that] we're brought in early enough so that we understand the issues and see what the impact is going to be." If you call them soon enough, surety firms might be able to kick in some money to ease cash shortages as well as to share good ideas and offer lots of expertise. Remarks Mikolajewski, "Being honest and open about problems will protect your line of credit down the line; the key word being credibility."

Lindquist adds, "If you learn from your mistakes, hopefully your mistakes won't put you out of business."

La Mesa, CA - based writer David Engle specializes in construction-related topics.

GEC - January/February 2003

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