Captives and the Federal Government: The TOTAL cost of Risk

1. Charlie Woodman, CPA, MTx, MPA Risk Finance Willis North America SCCIA 12th Annual Executive Education Conference September 13, 2011 Captives and the Federal Government: The TOTAL cost of Risk

2. The Setting • Challenging economic times • Federal Government and Public Sector Appropriations • Firms gravitating towards more and more Governmental work • Governmental work includes • Direct Federal: DOT / NASA / DOD / EPA / HUD / HHS & CDC / etc etc etc • Indirect Federal: Grants and Cooperative Agreements (joint ventures) • Direct State and local • Public sector entities: universities, hospitals, etc. • Governments Contract For • Materials and Products • Services • Mission Specific • Operational Outsourcing • Specific Projects Feasibility Prerecorded Lecture/2

3. Very Basic Contract Types • Fixed Price / Bid: for the entire project or activity • Variable Fixed Price: Adjustable for Activity Basis (i.e. Exposures: man-hours, days, quantities, distances, etc.) • Cost-Plus: Actual (and allocated) costs plus % • Cost-Fixed Fee: Actual (and allocated) costs plus $ • Issues arise over: • Reimbursable costs (our discussion for today) • Fair bidding and negotiation (Truth in Negotiation Act: Civil and / or Criminal Violation – be afraid)

4. General Price Components • Direct Costs: Sometime referred to as ‘General Conditions’ • Often subject to direct audit or cost verification • Direct Labor • Direct Materials • Direct Overhead – including project specific insurance, self-insurance and risk management • Indirect Costs and Fees: Overhead Allocations and Profits • Allocations of SG&A (with limitations) • Auditable is cost recovery mechanisms are in place • Indirect insurance, self insurance and risk management • Subject to audit if not fixed in contract and subject to cost reimbursement

5. Insurance, Self-Insurance & RM • Insurance as C/G/S or SG&A: Components you should know • Project or Activity Specific (Cost of Goods / Services): • Direct WC / GL / AL / Pollution / Surety etc. Evidenced by Dec Pages and project name & insureds • Direct losses incurred • Direct claims adjustment, defense, loss control and safety activity • General company costs and allocations: sometimes referred to a “home costs” (SG&A) • Annual expected ultimate losses allocated by specific project exposures • Company insurance allocations • Risk management allocations

6. Federal Government Contracts • The Federal government can enter into contracts. Binding on the government unless in violation or superseded by public interest • Generally governed by the Federal Acquisition Regulation (FAR) located in the Code of Federal Regulations which is a compilation of promulgated regulations augmenting various US Acts regarding private enterprise interaction with the Gov. • Many agencies can contract work; various FAR provisions may have been written by one agency or authority, but will bind government work in other areas. FAR and Supplemental FAR must be referenced; ignorance is not a defense. • Agency must have actual authority to engage work, ‘implied’ does not perfect a contract. • Many individuals but the main party is the Contracting Officer. • Federal anti-fraud and false claims laws contain 9 distinct criminal statutes and 6 civil statutes. - False Claims Act is the hairiest.

7. The ‘Big Tuna’: The Recovery Act • Recovery Act contractors are subject to the FAR plus additional requirements specific to the Act. These Recovery Act-specific obligations fall into four general categories: • Reporting • Buy American requirements • Davis Bacon Act requirements • Certification requirements • Liability for False Claims or Statements in connection With the Recovery Act • Recovery Act specifically provides that the information contained in the quarterly reports are material representations and report submission is a condition for receipt of Recovery Act funds. This is “trigger” language for application of the False Claims Act (“FCA”). • Subsequently, the May 2009 Fraud Enforcement and Recovery Act (“FERA”) expressly made the FCA applicable to Recovery Act recipients and expands FCA Liability. • Recovery Act requires recipients to report suspected instances of fraud. • Qui Tam or whistle-blower

8. FAR Requirements: Compliance and Ethics Programs • For contracts exceeding $5,000,000 and 120 days, within 30 days of contract award, a contractor must have a written Code of Business Ethics that must be distributed to all employees engaged in the performance of the contract. • All contractors other than small businesses must establish within 90 days (i) an ongoing business ethics awareness program, including training, and (ii) an internal control system that meets the requirements set forth in the FAR. • All contractors may be suspended or debarred for knowing failure by a principal to timely disclose to the Government credible evidence of a violation of Federal criminal law involving fraud, conflict of interest, bribery, or gratuity violations or a violation of the Civil False Claims Act. • Public, media and congressional scrutiny pose additional risks.

9. The Federal Government and Insurance Costs • So what… • Insurance costs are generally recoverable under government awards, but can be long tail well beyond project period • Establishing well-defined processes and proper accounting are key practices to achieve recovery of insurance costs • Certain practices contractors employ for commercial contracts (e.g. lump sum or fixed rate) may be questioned by government auditors • Government regulations may require a different practice • Government auditor may believe a different practice is necessary • Typical existing practices: • Measuring cost of self-insurance based on losses incurred or aggregates rather than a projected average loss (PAL) • Self-insurance charges not in accordance with accepted actuarial principles • Insurance costs based on premiums charged from captive insurers or companies under common control of contractor • Insurance programs have not been approved or are not customary

10. Regulations • Key regulation* for accounting for insurance costs: • Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs • Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs • FAR 31.205-19, Insurance and Indemnification • FAR 31.201-5, Credits • FAR 28.3, Insurance • When to evaluate your current accounting practices for insurance costs? • Contracts will be CAS covered (19 current standards) • Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification *Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html

11. Identifying CAS and FAR in contracts • Typically, CAS and FAR requirements are disclosed in: • Contract and subcontract solicitation documents • Draft contract terms and conditions • Solicitation representations and certifications • Draft contract clauses to be incorporated by reference in the awarded contract • FAR cost principles may apply in other circumstances where the original contract did not require application of FAR cost principles: • Change order proposals • Cost reimbursement or progress payment requests • Equitable adjustment claims • Termination clauses

12. FAR Cost Principles • FAR Part 31 Applicability • Cost reimbursable contracts • Fixed price contracts priced based on submission of certified cost or pricing data • Cost principles in effect when contract awarded applicable for life of contract, with certain exceptions • Allowable costs limited by FAR Part 31 and CAS requirements • Includes FAR 31.205-19, Insurance and Indemnification

13. FAR Part 31, Cost Principles Allowability • Factors for determining allowability :“A cost is allowable only when the cost complies with all of the following requirements” • Reasonableness & Allocability • Cost Accounting Standards (CAS), or otherwise generally accepted accounting principles and practices appropriate to the circumstances • Supported directly by terms of the contract • FAR subpart 31.2 limitations (highlights) • Costs of project specific insurance required by contract are allowable • Costs of general insurance are allowable if reasonable and measured, assigned and allocated in accordance with the requirements of CAS 416 • Costs of business interruption insurance must exclude coverage for lost profits • Self-insurance program approval may be required • The cost of insurance to protect the contractor against the costs of correcting its own defects in materials and workmanship is unallowable.

14. Basic CAS Insurance / Self Insurance Accounting Concepts • CAS includes an express requirement that the amount of insurance cost assigned to a period is the projected average loss (PAL), both retained and transferred for that period plus insurance administration expense • Because CAS requires a projected average loss, measuring insurance costs based on actual losses is limited to circumstances where actual losses will not vary significantly from a projected average loss • Under the CAS 416 concept, a risk of loss is covered by either purchased insurance, payments to a trusteed fund or self-insurance (which can include Captives) • Under CAS 416, three ways to measure projected average loss (PAL) 1.Actual Losses: actual amount of losses (where actual losses not expected to differ significantly from PAL) 2.Comparable Purchased Insurance: Estimate of the PAL based on the cost of insurance that could be purchased for the self-insured risk 3.Actuarial Measurement: self-insurance charge based on the contractor’s or industry experience and anticipated conditions in accordance with generally accepted actuarial principles • The total of self-insured charges plus insurance charges must not exceed guaranteed cost insurance for the same exposures

15. Insurance Reserves • IBNR (Incurred But Not Reported) • Reasonable reserves for IBNR • While generally understood by Government reviewers to be a common feature, may be concern that reserves are too large • If Government reviewer considers reserve unreasonably large, may question a portion of the reserve and the related insurance cost • To lessen risk of issues with purchased insurance reserves, contractors and insurance carriers should be prepared to demonstrate that reserves are reasonable based on: • Exposure to loss • Actual loss experience • Loss Trending and / or Inflation • Loss development experience or “lag” studies • Discounting reserves not expressly required by CAS 416, but DCAA guidance suggests reserves may be subject to present value discounting • DCAA: Defense Contracting Audit Agency (the IRS of Gov audit)

16. Allocation of insurance costs under CAS 416: “Home Office”: Non-Project Direct • Commonly allocated home office costs: • Purchased insurance • Self-insurance • Administrative costs • Main allocation concepts: 1.Insurance costs and losses allocated directly to segments (to maximum extent possible) 2.If not allocated directly to segments, allocation base should reflect factors used to determine premium or self-insurance charge 3.Material administrative costs are to be allocated same as related premium or self-insurance charge

17. FAR 31.205-19(b): Captive Insurance = Self-Insurance • Mistake to account for payments to a captive as purchased insurance • Exception when able to demonstrate that captive sells insurance to general public in substantial quantities and insurance charges reflect market forces • Contractor should plan to measure captive insurance as self-insurance, unless: Captive sells the coverage commercially and premiums paid by the contractor can be demonstrated to be based on market prices • Must treat Government as a “Favored Insured”

18. Discussion • Single Parent • Segregated Cell (or Rent-A-Captive) • Group Captives • Group Captives will generally be treated as purchased insurance with limitations for deductible or “A-Layer” accounts. • RRGs • Multi-unrelated Insured • Premiums for insurance purchased from fronting insurance companies (insurance companies not related to the contractor but who reinsure with a captive insurer of the contractor) are unallowable to the extent they exceed the sum of— • (i) The amount that would have been allowed had the contractor insured directly with the captive insurer; and • (ii) Reasonable fronting company charges for services rendered.

19. Summary: Government Contracts & Insurance Costs • Insurance accounting under government regulations is complex and interpreting regulations can be difficult • Insurance, self-insurance and RM costs are generally recoverable under government awards • Establishing well-defined processes and proper accounting are key practices to achieve recovery of these costs • Can be applied directly or conceptually to non-Federal work. • Grants • Cooperative Agreement • State and Local Contracting Regulations • Organization specific requirements • The actual contract itself

20. Successful RM Strategies • Adhere to planned project procedures and document any deviations, including source, reasoning and resulting impacts • Know all contract terms & conditions prior to start, reconcile any provisions that are vague / use, where practical, hard rate terms especially for reimbursable items • Maintain and keep accessible records and files throughout the project • Conduct cash to cost to projection reconciliation regularly and anticipate audit issues preemptively • Update exposure estimates • Claims oversight

21. These discussions were meant to be general in nature. We at Willis, as risk management professionals, do have a layman’s working knowledge of the tax, regulatory and accounting issues associated with many risk financing arrangements. However, we do not provide legal, tax or financial reporting advice. Therefore, none of our comments in this area may be relied upon to be either accurate or indicative of probable outcomes when applied to specific facts and circumstances. + Circ. 230 Warranty (and CYA Statement) Hear no evil, see no evil, do no evil. I Am Not Here.

22. Charlie Woodman, CPA, MTx, MPA Executive Vice President Risk Finance Advisory Willis National Construction Questions and Thank You