## Calculating the cost of risk

I’ve spent a lot of time on the road lately, talking to engineers. We discuss trends in design and construction, the legal climate, and always, the economy. And the question often comes up: “How can I lower my insurance costs?”

I understand their concern, but I think they should be asking a different question. Most people think the cost of insurance equals the cost of their risk, but that’s not the case. While insurance provides essential protection in the event of a lawsuit, even the best insurance policy can’t cover everything. Your insurance premium is the price you pay to transfer risk, but it only represents about 30 percent of the total cost of loss.

It helps to think of the cost of risk as an iceberg, with the largest portion below the surface. When you encounter a claim or dispute, the costs you readily see are the direct costs: your insurance policy deductible or the direct payments you make to resolve the issue. But the larger costs are the indirect costs: damage to your reputation, lost business opportunities, and the cost of your time to manage the problem.

That’s just the beginning. Many people forget to factor in the additional revenue needed to offset the costs. This can amount to 10 times the direct loss.

According to data from the 2010 American Council of Engineering Companies (ACEC) Professional Liability Insurance Survey (www.acec.org/advocacy/committees/pdf/plcompanies_survey_2009.pdf), member firms reporting claims said that they spent an average of nearly 80 personnel hours defending those claims. At \$80 per hour, for instance, that’s \$6,400, which means they need to earn \$128,000 of problem-free revenue to make up for those indirect costs alone — more than any direct costs. That’s a pretty big tab, especially when you consider that the typical fee is \$5,000.

How to think like an underwriter
An engineer can do several things to reduce the cost of his or her risk. First, they can start by learning to think like an underwriter.

It’s the underwriter’s job to evaluate the probability that your firm will experience a claim. Insurance companies look at claims in two ways: frequency and severity. Underwriters know that for civil engineers, the frequency of claims on utilities projects, for example, is relatively low, but claims on these projects tend to be expensive, or more severe. They also know that, in general, some disciplines see a higher percentage of claims — such as structural engineers, civil engineers, and architects.

The underwriter looks at several other aspects of your practice. For example, they’ll take into account your geographic location. Some areas, such as Florida, are simply higher risk than others, such as North Dakota. They’ll want to know about your firm’s claim history and the circumstances surrounding past disputes. Were you at fault? Have you taken steps internally to address problem areas?

Underwriters ask about the kinds of projects you accept. For instance, certain project types experience more frequent and more severe claims: condominium projects, educational/institutional projects, and single-family residential projects. On the other hand, claims involving low-rise commercial/industrial structures account for both a low frequency and a low severity.

Finally, underwriters look at certain aspects of your practice. For example, is there a written contract on all your projects? Do those contracts contain unreasonable provisions such as indemnities and certifications? Are you able to get limitation of liability provisions on most of your projects?

Studying claim trends
It’s also helpful to keep an eye on claim trends. According to XL Insurance’s ongoing study of closed claims, the owner is the most likely entity to make a claim against a design professional. While the frequency of owner-driven claims is showing a slight upward trend, the severity is decreasing. For civil engineers, there has been a corresponding shift in claims made by non-contracting third parties. In a 2002 study, 19 percent of both the claims count and claims dollars paid could be tied to non-contracting third parties. Now, 27 percent of claims filed are by third parties, and the settlements represent 40 percent of the total claims dollars paid.

The frequency of economic loss claims against civil engineers has remained fairly steady around 50 percent, although the severity has dropped. Property damage claims percentages have remained about the same, but we’ve seen an increase in the severity of post-construction bodily injury claims.

Residential subdivisions historically see a low claims frequency, although these claims are very costly to settle. Claims involving wastewater treatment plant projects show a higher frequency but a lower severity, while school projects show a higher claims frequency and an even higher severity for civil engineers compared with the percentage of fees they represent.

In a 2002 study of the elements most involved in claims against civil engineers, pavement claims represented just 6 percent of the claims dollars, compared with 10 percent of the claims count. Pavement claims have since increased in both frequency and severity, representing about 18 percent of both the claims count and claims dollars. The frequency of grading claims has increased from 10 percent to 16 percent but has shown a slight decrease in severity.

But claim trends are not the whole story. If you want to manage your risk, it’s crucial to understand what actually leads to those claims. The good news is that many factors are under your control.

Understanding the issues behind the claims
At XL Insurance, we’ve analyzed the non-technical factors that contribute to or exacerbate a claim — they’re what we call “risk drivers.” Studies in 2001 and 2009 show that eight out of 10 claims had a non-technical aspect that led to or contributed to the claim. Figure 1 shows the top four non-technical risk drivers for both studies.

The following key findings can help when you evaluate your own firm:

• Negotiation and contracts — While the number of claims went down in this category, nearly 40 percent stem from unclear or inappropriate scope of services. Also important is a lack of formal project evaluation. Both kinds of claims tend to be severe.
• Client selection — Inexperienced clients or clients with a history of claims or litigation account for more than 60 percent of claims in this category.
• Project team capabilities — Inexperienced design staff has risen to account for 50 percent of claims in this category.
• Communication — The lack of procedures to identify conflicts, errors, and omissions makes up a huge percentage of claims in this category. The failure to handle project disputes correctly is another key factor. (These are instances in which the firm has a mechanism in place to confront problems, but fails to handle them effectively.) And not surprisingly, the failure to have a mutual understanding with the client about the scope has become an issue in a significant number of claims.

Evaluating risks
It’s important to get a sense of your own risk exposure. There are resources available to help you. To begin, sit down with your professional liability insurance agent or broker or your insurer’s claim representative and have an honest talk about your practice. Using current claim trends to understand the risks you face is a key step in this process.

Your agent, broker, or insurance company should be able to provide current claim trend data. If you don’t have access to this type of information, remember that just as the total cost of risk is more than your insurance premium, your insurance program should include more than just a policy. Make sure you have the right risk-management partner to help you identify and avoid or manage your risks.

 Figure 1: XL Insurance studies in 2001 and 2009 identified the top four non-technical factors that contribute to or exacerbate a claim.

Many firms conduct detailed client and project evaluations. In fact, one firm has established a process to evaluate how frequently a risk presents itself and how much of an impact it can have on its business. The severity of each risk multiplied by its frequency determines a priority for managing each risk, beginning with those risks with the highest total values.

Dealing with risk
Once identified, you can manage risk in a number of ways. Some risks you just accept as part of your everyday practice. This doesn’t mean that you’re powerless to control them; you can reduce some exposure by offering more comprehensive services and by developing a clear and reasonable contract. In addition, learn to spot those risk drivers in your day-to-day work that can result in claims.

For example, a quick glance at the risk driver key findings above suggests that by choosing to work with clients that have a solid understanding of the realities and limitations of design and construction, you reduce the risk of being engaged in a dispute. Your contract should set forth the terms of your relationship and clearly outline your respective responsibilities.

By assembling a team whose capabilities align with the client’s objectives, you’ll position yourself to deliver on your commitments and respond to problems that arise. Perhaps most important of all, good communication skills help you understand your client’s objectives, direct team resources, and solve problems when they arise.

Some of my engineer friends worry that “all this process improvement” will be too time-consuming. “I can’t afford it,” they tell me. And I agree that identifying and managing risk isn’t easy. Then I suggest they think about those 80 hours mentioned in the ACEC survey. Compared with that price tag, a little time spent reducing their risk exposure seems like a bargain.

Randy Lewis, CPCU, manages the XL/Design Professional Client Education & Loss Prevention department at XL Insurance, which develops and delivers practice management programs for XL clients. Lewis has authored and delivered presentations on risk management to the AIA National, ACEC National, and numerous individual design firms. He holds a Bachelor of Science from the University of Central Florida. He can be contacted at randy.lewis@xlgroup.com.