(Editor’s Note. In our consulting practice, we frequently encounter disputes on whether certain insurance costs are allowable, whether they are allocable to a specific contract and whether they should be charged direct. Also, recent government initiatives have increasingly transferred risk (e.g. environmental, etc.) from the government to industry making proper pricing of risk without unduly increasing bid prices a critical concern in winning awards. We have relied on a "White Paper" prepared for a client by a consultant colleague of ours named Keith Davis, one of our favorite texts "Accounting for Government Contracts" by Lane Anderson and our own experience.)
Regulation Coverage
Insurance costs can arise either through purchased policies or self-insurance programs. Coverage by insurance includes that required by a contract or what is necessary for the general conduct of the business. FAR 31.205-19 covers general allowability of both purchased and self-insurance, CAS 416, Accounting for Insurance Costs focuses on self- insurance and FAR Part 28 covers the type of insurance coverage contractors need to obtain. In addition, certain types of insurance (e.g. fringe benefits such as health, death, post-retirement) are more relevant to FAR 31.205-6, Personal compensation and CAS 415, deferred compensation.
Allowability Criteria
The Lane Anderson text addresses six areas:
1. Contractually required. Costs of coverage required by the terms of the contract are allowable.
General Business Insurance. Costs of insurance related to the general conduct of business are generally allowable with certain exceptions. The type and extent of coverage must follow sound business practice and be "reasonable." Exceptions include: (a) the cost of insurance covering an asset in excess of an its acquisition value is unallowable unless the contractor has a written policy providing that in the event of an involuntary conversion, the new asset will be valued at the book value of the replaced asset plus or minus adjustments for the difference between insurance proceeds and the actual replacement cost (b) costs of insurance for the risk associated with government property is allowable only to the extent a contractor is liable for damages other than that caused by willfull misconduct or lack of good faith (c) business interruption insurance premiums are allowable except for any portion that provides coverage for loss of profits and (d) life insurance on company officials are unallowable when the beneficiary is the company or partners while when the beneficiary is named by the company official (e.g. family member, estate) it is considered additional compensation covered by FAR 31.205-6, personal compensation.
Also insurance coverage exists for a particular occurrence so a contractor must seek recovery on the insurance rather than from the government in the form of indemnification. The rationale for this is since the government helped pay the insurance premiums the loss must be borne by the insurance carrier not the government. We also frequently encounter assertions by government representatives that certain types of insurance (e.g. product liability, professional liability) are either unallowable or if allowable, not allocable to government contracts because the government does not receive benefit (e.g. damages paid on military products are less than commercial, no third party law suits result from government funded projects). Such questioned costs generally should be challenged on the grounds they are a necessary cost of doing business (see the GCA DIGEST Vol. 3, No.4 for a case study of a successful challenge to such questioned costs).
3. Actual losses. Actual losses are unallowable unless they are (a) expressly provided for in the contract (b) for nominal deductibles required by purchase insurance policies and (c) minor losses that occur in the ordinary course of business and are not usually covered by insurance (e.g. spoilage and breakage). Also, in accordance with CAS 416, actual losses may be used to determine the self-insurance charge provided the actual losses do not differ significantly from the projected average losses for the accounting period.
4. Contractor defects. Insurance expenses to protect against the costs of having to correct the contractor’s own defects are unallowable except for casualty losses like fires and floods. The government’s rationale is it does not want to have to pay to insure against the contractor’s own poor performance because it is paying for a quality product (however, warranty costs are generally allowable).
5. Professional Liability Insurance. General practice coverage is usually considered an allowable indirect cost allocable to all work. If the policy contains special coverage on designated products, services or projects a direct allocation is generally required. You can expect auditors to compare commercial and government work to ensure the relative risks in the two areas are comparable.
6. Self-Insurance. FAR 31.205-19 limits the recoverable amount for self-insurance programs to purchased insurance, if available, plus administrative expenses. Insurance provided by captive insurers is considered self insurance unless the captive can demonstrate it sells insurance in substantial quantities to the general public and that the premiums it charges are based on market forces. Premiums for "fronting" arrangements with companies who reinsure with a captive are allowable but cannot exceed the amount (plus reasonable fronting company service charges) that would have been charged directly by the captive.
"Allowability" Requirements of CAS 416
Though most cost accounting standards apply to allocation as opposed to allowability questions, CAS 416 provides prescriptions for how self insurance costs should be computed which comes mighty close to allowability. Any contractor that establishes a program of self-insurance must comply with the requirements of CAS 416. If it is anticipated that 50% or more of the self insurance costs to be incurred at a business segment is allocable to negotiated government contracts and those self-insurance costs will exceed $200,000 the contractor must submit written information regarding the proposed self insurance program to the ACO and obtain approval of the plan.
CAS 416 provides detailed criteria for measuring insurance costs and assigning them to periods and cost objectives (contracts or indirect cost pools). For purchased insurance, premiums must be assigned to cost accounting periods on a pro rata basis. Any refund, dividend or additional assessment must be an adjustment to the pro rata premium cost for the earliest period in which the refund or dividend is actually received or in which the added assessment is payable. Where insurance is purchased for a specific cost objective and the costs are directly allocable to it, the premium need not be pro rated between accounting periods.
For self insurance, CAS 416 provides the contractor will make a self insurance charge for each period for each type of self insured risk. The charge is to represent the projected average loss for the period. If insurance could be purchased against self-insured risk the cost of such insurance may be used as an estimate of the projected loss; if this method is used, the self-insurance charge plus insurance administration expenses cannot exceed the cost of comparable purchased insurance. If insurance cannot be purchased, the amount of the self-insurance charge for each period is to be based on the contractor’s actual experience, relevant industry experience and anticipated conditions in accordance with accepted actuarial principles.
Other Considerations
In addition to the FAR and CAS, individual agencies may have their own regulations and clauses affecting insurance companies. The Department of Energy and Environmental Protection Agency, for example, have unique specifications (e.g. Management and Operating contracts). In addition, there may be negotiated "advance agreements" where, for example, certain indirect rates may be capped making such costs as increased insurance costs unallowable if they are included in the capped indirect cost pools. Also, under indefinite delivery indefinite quantity contracts, price is determined at the task or delivery level so insurance costs need to be budgeted there – for fixed price task orders insurance costs needs to be included in the price and for cost type orders insurance needs to be considered up front rather than later after issuance of the task order putting a constraint on recovery by the Limitation of Cost and Funds clauses.
Direct vs. Indirect
Certain costs are clearly direct or indirect. For example, a special policy required by a contract would be direct while general liability and director and officers liability insurance is clearly indirect. Most other insurance costs – workers compensation, property insurance, professional liability, environmental, etc. – can plausibly be considered direct or indirect. Both the FAR and CAS provide wide latitude in how to treat these costs, generally requiring that established policies be set and like costs under like circumstances be treated consistently.
If the insurance costs are material and a change in treatment would yield considerable cost savings for the government, you may expect your practices of allocating otherwise allowable insurance costs to be challenged at some time. No matter what general FAR or CAS provisions are cited, the general allocation issues are in the gray area and should be challenged. If challenged, you will need to demonstrate your methods are consistent with both prior practice and/or written policies; if you change your method, you should be prepared to demonstrate it is a different cost or incurred under different circumstances and benefits the company as a whole (if charged to G&A), multiple contracts (if charged to overhead) or a particular final cost objective (if charged direct).
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