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Demand for construction captives began to increase with the advent of the hard insurance market cycle in early 2000. Escalating premiums, lack of viable capacity and affordable coverage for potential construction defect, and diminished coverage opportunity drove many well-capitalized firms to enter into captive arrangements. Because many large risks were already accustomed to higher risk retentions, the idea of greater control offered by a captive was a natural next step.

In order to cope with a changing insurance market, risk managers sought alternatives. They had been aware of alternative risk-financing structures throughout the soft market. The dramatic nature of the onset of restrictive underwriting led many to review captive structures as an alternative to traditional methods to mitigate escalating costs and to manage risk that had otherwise been transferred to an insurance carrier.

As pricing and coverage terms become more restrictive, firms look to alternative sources to maintain a competitive cost of risk structure. This may include larger retentions or other means of financing, including captives. The rationale for utilization varies among sectors and design.

For contractors of all types, there are many reasons captives provide a more attractive choice. One potential driver, the drop in the housing market, has not affected the overall construction industry as negatively as it could have due to the balance among housing, commercial building and infrastructure as part of the overall gross domestic product.

Construction companies like captives for the vehicles' ability to smooth out the opportunity for latent losses. As less income is derived from new housing starts, knowing that dollars have been set aside for future loss becomes more important.

An interesting effect of captives is that, once any group takes the steps to invest in a captive, they typically remain engaged for the long run. This is because captives are a very desirable adjunct to an industry that relies so heavily on cash flow as a key component to its ability to compete.

Coinciding with the capacity shortage and high prices for tough-to-place construction coverages is a change in how the construction industry manages its individual businesses. Today, many construction firms have a desire and willingness to manage and shoulder more of the risk burden that might otherwise rest with brokerage firms and the insurance carriers. This means that the firms employ professionals with advanced degrees in accounting, law and business as part of a well-rounded risk management team.

As in other industries, traditionally only the large risks have the amount of capital and corporate structure necessary to maximize the advantage of single-parent captive insurance vehicles. Group captives and rent-a-captive facilities, however, give midsize construction companies access to this insurance option.

WHY CAPTIVES FOR CONSTRUCTION?

Wrap-up programs, construction defect liability insurance, and premium and coverage stability all are specific examples of the problems facing contractors and owners/developers and explain why creating a captive might be a good alternative for the industry.

General contractors and owners/developers use captives for wrap-up programs due to the lack of availability of subcontractor coverages or limits in the standard market. Using a captive on a wrap-up program can facilitate control over the program for the owner or general contractor, and can foster the ability to set final premiums up front and have the captive take on the underwriting profit or loss.

Residential construction defect liability coverage, especially in certain West Coast states, has been another difficult coverage to place. If contractors have been able to get the coverage at all, it has rarely been at a reasonable premium as compared with policy limits. This is due to the extremely poor, and to some extent uncontrollable, loss experience in the insurance industry overall. Construction defect is a latent exposure where property damage claims might not be known, reported and paid until many years after work is completed. Contractors have looked to alternatives, including captives, to obtain insurance coverage and limits needed and to fund for the risk over time.

The catastrophic nature of losses and the six- to 10-year tail associated with construction defect has forced contractors to struggle with how to protect themselves against these claims. Some states have implemented legislation to help ensure contractors have a right to repair damage before a liability claim can be made.

Also, many contractors have implemented in-house procedures to ensure appropriate quality control. Companies that believe their experience will be better than the pricing offered in the traditional marketplace might look to assume this risk in a captive and reap the investment income over time until potentially paid out for loss.

A good example of a successful construction group captive formation is CS Insurance Ltd. Five years ago, White Plains, N.Y.-based Peckham Industries Inc., a company with hot-mix asphalt plants, stone quarries, bulk asphalt terminals and liquid plants, formed a group captive with seven other midsize construction companies.

Tired of the cyclical nature of the insurance market and hoping that a stable insurance program would help offset the volatility in the construction market, the group set up a captive: CS Insurance Ltd. The group's two-pronged goal for the captive was to eliminate the yearly uncertainty of renewals and establish a stronger relationship with its insurance carrier. This approach worked, and today the group no longer sweats out an annual renewal process while benefiting from a robust relationship with both its onshore broker and fronting company. This relationship ensures that the group's good track record for claims and loss control is fully understood and appropriately incorporated into its investment and services.

Group captives offer midsize companies the opportunity to combine their insurance policy retentions under a single captive with other companies and share the risk. Once in a group captive, these companies utilize the in-house resources of an established insurance company, or a third-party administrator, to handle claims and provide loss-prevention and loss-control services. For construction companies, group captives can be trade exclusive, such as a national roofers association, or the captive can house multiple trades.

This works well for construction companies because group captives can provide broader policy forms than what companies would get in the standard insurance market. These broader forms can cover events such as job-site pollution and contractor's rework coverage. The construction group captive can also provide companies with service providers in claims and underwriting who have expertise in the loss-control issues inherent in the construction industry. This industry-specific expertise can lead to faster claims processing and more targeted underwriting.

Rent-a-captives are also a good alternative for midsize companies that want the benefits of a captive, but are not interested in sharing risks with others as in a group captive. Rent-a-captives give construction companies the ability to rent space in a captive rather than incurring the cost involved with forming their own facility. The upside is a faster, less expensive captive setup, but the downside is less control over captive operations.

When considering a construction captive, the owner or general contractor must consider the needs of inside and outside investors and lenders. These vary from project to project, so any risk assumption taken in a captive needs to be balanced with protecting the investors' interests.

Determining whether a captive is an attractive and appropriate option is specific to each company or group of companies based on their structure; unique set of risk management and financial objectives; and past, present and future exposures to loss. Whether forming your own captive or creating a member-owned group filled with industry peers, the decision should be based on the commonly held belief that the captive's purpose is to leverage a company's loss-control philosophy to reap the profit of safer, less risky operations.

ALISON CALDER is product director of Liberty Mutual National Market Alternative Markets.

MARY ANN KRAUTHEIM is senior vice president of the Willis National Construction Practice.

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August 1, 2007

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