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A modest proposal Residential contractors: Ideal candidates for RRG? By Michael J. Moody, MBA, ARM Overall pricing within the U.S. property and casualty insurance market has softened significantly over the past few years. With rare exceptions, rates for most lines of coverage have tumbled in a continued downward trend. Even the medical malpractice market, which was the poster child for rising rates just a few short years ago, has improved in most states. There are several notable exceptions to this general trend though. Chief among these market segments is coastal property coverage. Another area that has become a major challenge for insurance buyers is construction defect liability coverage. Coverage for this market segment has become much more restrictive and costly for most building contractors. While there has been some softening in the commercial construction area, residential construction contractors continue to have major problems finding coverage. And while there are a number of reasons for this situation, the major problem revolves around the simple question of “what is a construction defect?” It appears that everyone has his or her own idea about what constitutes a construction defect, and each of the 50 states also has its own view on this matter. In general however, construction defects run the gamut of problems from the aesthetic issues such as improperly painted surfaces around windows and doors to the more serious foundation and framing issues that can threaten the structural integrity of the building … and everything in between. The past decade has seen a serious rise in the number and sizes of awards in these types of liability claims. And like so many other trends in the legal world, this one started in California and has been working its way east ever since. California was the first state to recognize strict liability in residential property construction defect disputes. Historically, contractors have looked to their commercial general liability (CGL) for coverage from construction defect claims; but once the claims began emerging, insurance carriers began denying claims and restricting coverage. Most of this activity revolved around the concept that construction defects were not an “occurrence” since it was not an accident, nor was it something unexpected or an unintended consequence. As a result, many contractors have been left in limbo with regard to coverage in this important liability area. Market response The effect of the hardening market was rapid for many large contractors. Most of the larger contractors were quick to form captive insurance companies as a way to insulate themselves from the rate increases and coverage restrictions that were occurring within the residential construction segment. But the mid-sized contractors have been at the mercy of the insurance market for the past few years. And while this market has softened slightly for the larger contractor over the past few months, mid-sized firms are still looking for a viable way of financing this vital coverage. One solution that is available to mid-sized contractors is a risk retention group (RRG). RRGs are made possible by a federal law that was passed in 1981 and originally was designed to provide products liability and completed operations coverage to the group’s owners. The act was later expanded in 1986 to cover all liability coverages. Subsequent to the passage of the 1986 amendments, approximately 250 RRGs have been formed. The federal law preempts the state laws and, while it applies to liability coverage only, it would offer mid-sized contractors a possible alternative risk transfer method. The federal act states that the RRG must be a homogeneous (similar risks) group that is owned by its insureds, and typically there are a number of advantages to the RRG form to potential members. As noted above, the federal law preempts state laws, which means that once the RRG is licensed in one state, it can insure members in all states. This offers a major advantage over a more traditional group captive approach. By utilizing the federal legislation, the RRG will not be required to use a fronting carrier to operate outside its own state. Usually, the charge associated with fronting can be as much as 12% to 15% for a startup group captive. Over the long run, avoiding this charge can result in significant savings to the RRG members. A number of other advantages can be obtained from the formation of an RRG for mid-sized contractors. In addition to the substantial savings derived from not needing a fronting carrier, other expense savings are typically available to alternative risk transfer operations, as opposed to the traditional insurance industry expense factors of 30% to 40%. These would include such things as insurance company overhead and some state and local government administrative fees. Monies are also available from investment income from claims reserves. By holding the claim reserves, the RRG can obtain some investment income, and since most of the construction defect claims are considered long tail (six to 10 years to settlement), this can be a meaningful number. Additionally, if structured properly, the RRG may offer potential tax advantages for the members. First and foremost, any insurance company, including captives and RRGs, has a favored tax status from being able to take a deduction for future expected losses. And, again assuming the RRG is properly structured, the members will be able to have a tax deductible expense for premiums paid to the RRG. Finally, the RRG may be able to take advantage of Internal Revenue Service section 831(b), which allows insurance companies that collect less than $1.2 million in annual premium to be taxed solely on investment income. Thus the RRG could potentially pay no tax on its premium income, and only 15% on the investment income it generates, thereby providing a very tax-efficient vehicle for both itself and its members. Other considerations There are several other advantages to an RRG. This approach provides many of the benefits of captive ownership to organizations that would not be able to form a captive on their own. And as long as a prudent approach is taken to the overall design and operation of the RRG, it should be able to offer a viable option to residential contractors. As with any group insurance program, the RRG must maintain strict underwriting requirements and allow only “best-in-class” applicants who are unable to obtain sufficient rate reductions in the traditional insurance market for their superior loss experience. In addition, the RRG must formulate a proactive approach to both claims management and loss prevention. This may well be an excellent time to consider the RRG approach, because several things are occurring with regard to the construction defect arena, and they may have a bearing on the long-term loss profile for this business segment. Many of the current issues arise as a result of the differing view of 50 state courts’ understanding of the concept of construction defect; and until the courts settle on a standard for deciding these types of claims, market disruption will continue. One of the real problem areas for this coverage has been that the statutes of limitation (which vary by state) have been so long. But now, some states are recognizing that products will eventually stop performing as well as they did when they were new and, further, that the owners bear some responsibility for maintenance. Another major change has occurred with the “right to repair laws.” Some states are now allowing builders the opportunity to make repairs before a home owner or a home owners association files a lawsuit. Having the repair option without endangering the contractor’s coverage could lead to greatly reduced claims experience. One further development may also help in reducing the overall claims activity. This development has to do with the introduction of a new policy form by the traditional insurance market (Zurich). The policy form, which is known as the “Home Builders Protective,” dramatically improves the policy wording for defect coverage. The traditional general liability policy requires that a formal lawsuit be presented to trigger the insurer’s duty to defend and indemnify, and most policies prohibited the contractor from making “voluntary payment” without the insurer’s consent. This new policy form offers coverage for certain contractors’ warranty and customer service expenses without the need of a suit. Any RRG that is considering drafting a policy form would do well to use the HBP form as a starting point. Conclusion The insurance market for residential contractors has proved to be difficult at best over the past decade or so. While there has been some recent relief, it is primarily directed at the large contractors, many of whom already have captives. Unfortunately, it’s the mid-sized contractors that have struggled the most to find adequate liability coverage. However, it would appear that a properly structured risk retention group may offer some assistance in this important area. While RRGs are most often associated with medical professional coverage, they may be ideally suited for the mid-sized residential contractors as well. Most contractors operate on very thin profit margins and because insurance makes up one of their major expense items, cost savings in this area can be critical. * |
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