A strategy for contractors dealing with high umbrella insurance premiums

Ideas for construction industry companies and their insurance brokers

By Roy E. Wagner, Partner, Michael Best

Rising Insurance Premiums Creating Difficult Choices

Some businesses are low risk and insurance costs do not make a big dent in cash flow. Yet businesses in other industries – especially the construction industry – face greater day-to-day risks and mandatory insurance requirements imposed by upstream owners and customers. For construction companies, robust insurance coverage is a necessary risk mitigation tool to protect hard-earned assets and cash from lawsuits and casualty losses; especially if your company has lots of cash or equipment and you want to protect your hard-earned gains from claims. Insurance coverage is a logical way to protect assets, but it comes with a cost: premiums.

Amidst the ongoing challenges associated with the COVID-19 pandemic, hurricanes and wildfires, insurance premiums, particularly rates for critical umbrella coverage policies, are surging across the Midwest. General liability and auto insurance rates have risen an average of 10%. The most dramatic rate hike has occurred in the umbrella and excess insurance market, where the average increase for lead umbrella in Q2 2020 was 20-30%. Unfortunately, this rising trend for umbrella policy premium rate increases shows no sign of slowing and likely will continue over the next 12 months. Umbrella coverage is one of the most important risk management tools available, providing asset protection coverage for businesses with a balance sheet north of $1 million. With umbrella premiums rising, how should construction businesses respond, especially during a period of such economic uncertainty?

Some construction companies may opt to purchase lower umbrella coverage limits to save $3,000–$50,000 on umbrella premiums. Though this decision to avoid higher premium expenses by settling for lower coverage may seem appealing, it may turn out to be a “penny wise and pound foolish” decision that exposes a contractor’s cash, equipment, building and accounts receivable to uninsured excess losses. Take, for example, a construction contractor that has only purchased $5 million in umbrella insurance coverage in order to pay a lower umbrella premium. If that contractor’s employee causes an accident, flood, fire, or defective construction resulting in a $12 million-dollar loss, that contractor may face $7 million in uninsured excess losses. Believe it or not, huge claims like this one are becoming more common.

Construction Business Owners: How to Protect Your Assets When Challenged with Rising Insurance Premiums

If opting for lower umbrella coverage is not the wisest option to respond to rising umbrella premiums, what should your construction business do to mitigate your exposed asset risk? The answer is a carefully planned corporate legal strategy that decreases your exposed asset risk while bolstering your business’s succession preparation. An effective strategy will segregate certain assets into separate legal entities that can generally be excluded from most claims, even those that exceed insurance coverage.

Under this strategy, the original (operating) company sets up a separate company (“Leasing Company”) to which the original company can transfer certain assets, thereby making the Leasing Company the new owner of those assets. The ownership of the Leasing Company can mirror that of the operating company. By creating a separate Leasing Company, the original company can “silo off” assets from claimants – even those with a $12 million claim against the operating company and a plan to go after other business assets with an “excess claim.” Traditionally, business owners have employed this strategy by creating separate entities to hold operating company building and real estate, which then is leased back to the operating company. Such a system mimics a tenant-landlord relationship. This real estate lease structure enables the business owner to take advantage of tax benefits, provides rental income, and removes the real estate from their operating business balance sheet.

When this strategy is applied to equipment-heavy construction companies, it can efficiently and effectively mitigate the threat of uninsured claims. The construction contractor can separate valuable equipment (and its associated exposed asset risks) from the operating construction business by setting up an Equipment Leasing Company to own the construction equipment. In addition to reducing threats to the business’s balance sheet, the creation of the separate Equipment Leasing Company may produce separate income for the owner, facilitating the future sale of the business or succession planning. Many contractors have taken advantage of this highly-beneficial strategy in a cost-effective manner; often for less than the cost of the premium increase for higher umbrella coverage.

Insurance Brokers: Understanding Risk Mitigation Options Beyond Insurance Products

While construction business owners should employ commonsense corporate legal strategies to protect themselves against uninsured claims, lawsuits and losses, insurance brokers must stay up to date on their contractor clients’ insurance coverage and exposed risk. For example, if you have a client with $10 million in net assets, do not facilitate their purchase of $5 million in liability or umbrella coverage without thorough scrutiny, discussion and documentation.

By remaining vigilant in your scrutiny of your clients’ business needs, you can shield yourself from post-claim criticism. Always ask your clients about their asset value to ensure that they’re fully insured or are considering strategies to manage risk. Furthermore, consider advising them to seek legal advice and corporate planning assistance to reduce their exposed asset risk by using the strategy described above: transferring equipment or real estate to a separate Leasing Company to silo these assets from claims, especially if coverage is limited. These separate Leasing Companies will still need insurance coverage.

Roy E. Wagner is a partner with Michael Best and can be reached at rewagner@michaelbest.com or 414-270-2707.