As stated in Part 6: Advantages & Disadvantages for Contractors, there were various advantages and disadvantages, for contractors to be considered when participating in an OCIP. In this section, we will review the potential savings that could be derived from an OCIP by a project owner. “If an OCIP is structured properly.” (Emphasis added.)
Potential Savings from an OCIP for a Project Owner
It’s extremely difficult to determine the total savings a project owner can realize from an OCIP because these potential savings can vary significantly based on several factors.
Savings are derived when contractors and subcontractors remove insurance costs from their bids because these bid reductions lower the total contract price. A project owner’s cost for providing workers’ compensation, CGL, and excess liability coverage on behalf of the contractors and subcontractors will likely be substantially less than the deduction received from the contractors and subcontractors. The potential savings is the difference between the contractor’s bid reductions from removing insurance cost from their bid, and the project owner’s cost of the contractor and subcontractor-provided insurance.
Contractor and subcontractor bid deductions can vary between 2-5% of construction costs. However, the amount contractors and subcontractors spend on OCIP-provided coverages will vary by geographic area, contractor size, and type of project. The range is variable depending on several other factors, including; the insurance and reinsurance market conditions, and the premium rates of the coverage(s), at time of procurement.
Let’s Crunch some Numbers
A study conducted several years ago by an independent risk management association provided some statistical data on the average cost of insurance. This data was collected from approximately 30 contractors on their cost of risk (COR) based on annual revenue. I realize this is a relatively small sample size versus obtaining a larger population of contractor COR data, but for our example it will suffice for making a rough calculation.
The largest contractors that participated in this study indicated a COR of approximately $25 per $1,000 of revenue. Okay, let’s use this rate to formulate a theoretical calculation for a project’s cost of insurance. If you subtract the cost of the insurance coverages that an OCIP would not normally include, e.g. auto liability insurance coverage. Then, if you subtract a contractor’s average risk management administration costs. The difference of the OCIP-provided insurance cost would be less than $20 per $1,000, or 2% of revenue.
Assuming a total bid reduction of 2%, total project owner savings would be 2% of the construction costs, less what the project owner expends to purchase the OCIP-provided insurance coverages. An estimated savings in the range of 0.5-1% of construction costs.
Most construction estimators use one of several techniques when preparing their bids. When bidding fixed-price work, they may use either a unit rate (cost per square foot for an office building or cost per floor, room, etc., for a hotel). Or, they may use labor and material estimates provided by the project owner or project owner’s design professional.
When bidding cost-plus work, estimators may use prevailing wage rates for the project geographical area, then, gross-up this rate to include G&A expenses. Regardless of what method is used to estimate the work, the contractor’s bid will contain insurance costs.
The costs on fixed-price bids are usually embedded in the wage rate. This can be directly factored into the estimate or indirectly included in the unit rate. The contractor’s bid includes wage rates that are comprised of its employees’ base wages and overheads, and are usually expressed as a percentage of the base wage. Some of the overheads that are factored into the gross billing rate include profit, G&A, benefits, taxes, and insurance.
Contractors typically include state workers’ compensation rates (adjusted by their own experience modification rates), and use their company-specific general liability rates in their insurance overhead calculations. The insurance overhead assumes first-dollar coverage (i.e. no retrospective rating plan or deductible fixed-cost insurance plan). This insurance overhead is usually in a range of 8-14% of payroll, depending on the project’s geographic location and other factors.
Many large contractors will include a standard premium figure in their billing rates because their actual insurance cost is undetermined at the time they are bidding on a proposed project. They could use the previous year’s annual insurance cost to include in their bid, but contractors would be gambling on the unknown because their insurance premiums are based on their total projected project exposures. CGL is typically rated based on revenue. Workers’ compensation is typically rated based on the number of employees or payroll. Since contractor’s insurance premiums also fluctuate from year to year based on their annual construction values, using a range for bidding is reasonable.
On an OCIP, the bid packages issued to contractors and subcontractors will contain an “Instructions to Bidders” section specifically stating that bids are to be submitted with and without insurance. However, the cost of insurance is to be included with their bids, as either an “alternate add”, “net-of-insurance” or “alternate deduct (straight deduct)”. Each of these insurance cost extraction methodologies has its positives and negatives.
The alternate add method is when a contractor bids the construction contract work with a price that excludes insurance cost with an alternate add amount included in their bid. This method can be easier to manage from an OCIP administration perspective, but it has its drawbacks, e.g. the possibility of awarding a construction contract to a contractor with a poor safety record.
With the alternate add method, it is also difficult, if not impossible, to verify the accuracy of the contractor’s insurance cost. This could result in a project owner making double payments to the contractor. In addition, there is a higher probability of errors in the contractor’s submitted insurance cost estimates, since these costs are not only for the general contractor, but for all the GC’s contractors and subcontractors on an OCIP.
For these two reasons, it is recommended that a project owner incorporate a more tangible insurance cost extraction method into their OCIP such as the Alternate Deduct or Straight Deduct method, which we will discuss after the Net-of-Insurance method.
The net-of-insurance method is when a contractor bids the construction contract work with a price submitted without insurance costs in their bid. In principal, this method may be simplistic, but it has some deficiencies. The key deficiency is that the cost of insurance cannot be verified and may be suspect. A project owner will never be certain that all the insurance cost has been removed from the contract bid, or if this cost was just reallocated and buried in other line items in the contractor’s estimate. On fixed price lump sum bids, a project owner would probably never know.
The biggest deficiency from my own lessons learned on public transportation projects is that a project owner will never be able to make a comprehensive and accurate audit or a final accounting of what the cost of the insurance would have been using a traditional insurance program (without an OCIP) in order to make a direct comparison of the actual cost for the project owner-provided OCIP insurance. Putting contractors on the honor system is a novel idea for a project owner with good intentions. However, keep in mind that the road to hell is paved with good intentions!
Another lesson learned is for a project owner to not be misled by a project management team who’s thinking is flawed or is paranoid that if a more aggressive insurance cost extraction method is used in the bid process, such as an Alternate Deduct or Straight Deduct approach, there will be a higher potential for contractor bid protests. News flash! There will always be the potential for contractor bid protests on construction projects! That’s just life in the construction industry. Unfortunately, it has become more the norm than the exception on larger capital construction projects, especially on public projects where the political risk of bad media publicity makes some public entities acquiesce to contractors who use these bid protest tactics. Remember, numbers never lie!
Alternate Deduct (Straight Deduct)
The alternate deduct or the straight deduct method is when a contractor bids the construction contract work with the cost for insurance included in their bid. Basically, a contractor will bid the work for the OCIP project in the same way they bid the work on a non-OCIP project with traditional contractor-provided insurance. This method evens the playing field for contractors. Also, the contractors with the best safety records and lower EMR with workers’ compensation insurance will be evaluated accordingly, and this will be reflected in a project owner getting more competitive and lower bids.
Once the lowest responsible bidder is selected by the project owner, the cost of insurance is deducted from the contractor’s construction contract price. This is done either before the issuance of a formal executed contract or through the issuance of a deductive change order to the contractor’s contract prior to the issuance of the notice to proceed to start the construction project. This method is probably the best of all the other insurance cost extraction methodologies.
The alternate deduct or the straight deduct method is good for contractors with favorable safety records so that their safety performance is included in the bid evaluation process. It’s definitely good for a project owner who is concerned about recovering their OCIP insurance costs. And, it’s good for the OCIP administration team to make the initial base bid insurance cost extraction, as well as the insurance cost extractions on all subsequent change orders during the course of the construction project. It is also the best method for conducting a final audit and performing project close-out. There is one caveat. The alternate deduct or the straight deduct method requires a higher level of administration effort. But, it’s worth the effort for a project owner to know the OCIP insurance costs.
Insurance Market Leverage
By combining the cost for all the contractors’ and subcontractors’ owner-furnished insurance coverages into an OCIP, a project owner creates substantial leverage in the insurance market. That’s why project owners can purchase insurance at a much lower rate than individual contractors. A project owner can realize potential cost savings of as much as 10-15% due to the economies of scale of volume purchasing of OCIP insurance.
Project owners can significantly reduce project insurance costs using a higher retention on OCIP insurance policies. Assuming a higher deductible (e.g., $100K, $250K, $500K) per loss can considerably reduce the OCIP insurance costs. Additional cost savings can also be realized if the project loss experience is better than the actuarial loss experience factors contained in the insurance underwriter’s estimated projections for the OCIP. It should be noted that loss experience on a significant number of OCIPs has historically averaged less than 40% of standard insurance rates. Loss control improves these rates.
A Hypothetical Example
Let’s look at a hypothetical example of how the OCIP insurance costs can be calculated. A project owner is considering building a $500 million luxury hotel, conference center, and entertainment complex. The construction project schedule total duration is 2 years from start to completion. The estimated payroll for this project is equal to 25% of the hard construction cost. The average contractor and subcontractor insurance rate is $10.75 per $100 of payroll (this is a composite rate, i.e. includes workers’ compensation and general liability). Using a traditional insurance approach, the insurance cost on this project would be approximately $13.5 million.
[($500M x .25)/100] x $10.75 = $13,437,500
Based on construction data collected over the past several years on various projects, we can expect to reduce this insurance cost by approximately 5% using an OCIP, spending $12.8 million over a 24-month period, instead of the $13.5 million in the above example.
$13,437,500 – (5% or $671,875) = $12,765,625
The cost of owner-provided insurance contains two components: 1.) fixed expenses, and 2.) retained losses. Fixed expenses typically include overhead expenses, claim reporting, commissions (if fixed), and premium taxes and assessments. Retained losses are the contractor’s and subcontractors’ losses that are paid on a first-dollar basis by the project owner under the project owner’s established deductible threshold. If the loss experience on this hypothetical luxury hotel project is average, the total OCIP insurance cost would be approximately $8.75 million, and the project owner’s savings would be $4.02 million.
$12,765,625 – $8,750,000 = $4,015,625
We realize that there are a number of variables in this hypothetical example. However, what our rough calculations exhibit is if a project owner can procure its OCIP insurance coverages in the market at a reasonable rate to keep fixed expenses low, can collect the estimated bid credits from all contractors and subcontractors enrolled in the OCIP, can mitigate insurance claims to keep project losses within established thresholds, and can manage the OCIP administration process efficiently and effectively, the probability is high for the OCIP to be equitable for a project owner. On this $500 million project, the project owner’s net savings of $4.02 million is a compelling factor to consider an OCIP.
Hope you enjoyed this post. I will look forward to your comments. I will share more Insights in future posts.
In OCIP 2.0 – Part 8, we will review OCIP Insurance Coverage Considerations.
Thank you for visiting and reading C-Risk Insights.
Until next time…
David Grenier is the Managing Director and Principal Consultant at C-RISK, LLC.
C-Risk is a risk management consulting company that provides strategies and insights on wrap-up insurance programs to help project owners in the public and private sector who are involved with large capital construction projects.
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