Looking for answers to the problem of construction defects

When I started working in claims years ago, adjusters sometimes got calls from attorneys who were considering lawsuits. The attorneys would say, "If you can show me a reason why we don't have a case against you, we're not going to file a lawsuit." Today, attorneys are more willing to use what I call "indiscriminate surprise litigation." They sue first and then use the discovery process to determine whether their case has merit.

Insurers might determine that specific allegations in a lawsuit have no merit and wouldn't be covered even if proved. But the possibility of a later bad-faith claim leads many carriers to issue a reservation-of-rights letter and begin at least a "skeleton" defense while they investigate the possibility of any coverage. They then seek clarification from a court about whether they have a duty to defend. Not wanting appellate-court reversals on their records, an increasing number of judges are reluctant to dismiss insurers from lawsuits if there is even the smallest possibility that a duty could be found. So a frivolous claim, alleging 48 things that are clearly not covered and one that has only the slightest chance of being covered, can still result in thousands of dollars of defense costs for an insurer.

Several states have begun to address part of this problem through "right-to-cure or repair" legislation. In West Virginia, Virginia and South Carolina, for instance, homeowners are required to notify homebuilders of construction defects, and homeowners are not allowed to pursue a remedy in the courts until they have given a homebuilder the opportunity to correct the problem.

Legal theories behind lawsuits

The most common allegations in construction-defect suits have been negligence, breach of contract, breach of express warranty and breach of implied warranty. Although courts in some jurisdictions have said that a breach of contract can result in negligence, attorneys have figured out that a simple breach of contract is not covered by insurance, and so they don't make this their primary claim.

Breach of express warranty is a simple concept: A contractor put guarantees in writing and allegedly failed to live up to them. A more serious problem for homebuilders and insurers is the allegation of breach of implied warranty. Homebuilders customarily have given homebuyers an unofficial one-year warranty on new homes. It might not be written in law, but builders have long promised to take care of every little blemish for the first year. After that, the homeowners are on their own.

This notion of a one-year warranty would be laughed out of court today. When someone purchases a home from a builder, the courts recognize an implied warranty of habitability. By selling the home, the builder implies that the home is fit to live in-whether or not the builder admits such a guarantee. Already in practice in many states, this doctrine was articulated by the Massachusetts Supreme Court in a 2002 case, Albrecht vs. Clifford. The court in this case said that the doctrine of "caveat emptor" is invalid in the sale of new homes, and homebuilders have a responsibility not just to disclose latent defects (those hidden to the buyer), but to fix them as well.

The statute of limitations and the statute of repose combine to stretch this implied warranty for much longer than one year. In particular, it's the statute of repose that creates a future long-tail claim possibility and determines how long an implied warranty lasts. Repose is a period of time during which no defect is discovered and after which no claim can be filed. In other words, a statute of repose says that a homebuyer must notice (discover) the problem within a set time to bring a claim against a builder. The most common statute of repose is 10 years, though in some states it's as high as 13. In contrast, the statute of limitations "clock" starts ticking once an alleged defect is discovered. So a homebuyer might notice a defect nine years after purchasing a home, then file a claim four years later-13 years after the builder turned the home over to the owner.

Homebuyers also are increasingly making allegations of fraudulent concealment regarding patent (apparent) and latent (hidden) defects. Courts have recently decided that what is apparent to a homebuilder might not be apparent to a buyer. This further reduces the responsibility of a homebuyer to notice potential problems before buying a home, and it weakens a homebuilder's defense against certain claims.

Trigger happy

When an alleged defect is discovered years after a house is sold, determining when the defect occurred can be problematic. If a contractor has switched insurance companies after selling a home, this determination is important to figuring out who has to pay any claims or defend the contractor. One of several theories may be used, depending on the state, to determine when damage occurred:

• The "manifestation theory" holds that the insurance policy in effect when a defect is discovered (is known or should be known) responds.
• The "damage-in-fact" or "injury-in-fact" theory dictates that the responding policy should be the one in place when the damage actually first occurred-something that can be quite difficult to discover. A North Carolina court recently decided that it would use the damage-in-fact basis for deciding coverage in any case in which both the plaintiff and defendant agreed on the exact date the alleged damage occurred. If the facts of a future case indicate the application of another theory is proper, the court said it will adopt that other theory.
• The "continuous (multiple) coverage" theory is scary. In the case of successive policies, this theory says property damage that is continuous or progressively deteriorating throughout several policy periods is potentially covered by all policies in effect during those periods. This theory, used in the Montrose case in California, finds that all policies in effect from the time damage first occurred are responsible for responding to a claim, if damage had continued to occur during successive policy periods.

In response to the Montrose decision, the Insurance Services Office introduced the CG 00 57 09 99 endorsement, "Amendment of Insuring Agreement-Known Injury or Damage." This endorsement says that coverage for bodily injury and property damage does not apply if the insured "knew that the bodily injury or property damage had occurred" prior to the policy period. This endorsement prevents an insured from taking advantage of Montrose by purchasing a new policy to gain additional coverage for a defect it already knows about. Beginning with the 2001 edition, the ISO CGL form incorporates the "known injury or damage" language within the insuring agreement for bodily injury and property damage.

Damage to your work

The Wisconsin case of Kalchthaler vs. Keller demonstrates how insurers have unintentionally provided coverage for a business risk broader than that intended in the CGL. In this case, a general contractor hired a brick mason subcontractor to work on a home it was building. The subcontractor's work was of poor quality and defective, which led to water damage to the home. The homeowner sued both the general contractor and the subcontractor.

The court agreed with the subcontractor's insurer that the subcontractor had no coverage for damage to his work arising out of his own labor, because of the "Damage To Your Work" exclusion. This exclusion did not apply to the resulting damage caused by the subcontractor's defective work, because that resulting damage was done to the GC's work, not the subcontractor's.

The general contractor's carrier in this case faced a different issue. There was no disagreement that the ensuing damage to the home-which was the GC's work-was caused by the subcontractor, so the GC's policy responded because of the "give back" language in the policy's "Damage To Your Work" exclusion. Though the policy definition of "your work" includes "work or operations performed by you or on your behalf," the exclusion provides an exception by saying, "this exclusion does not apply if the damaged work out of which the damage arises was performed on your behalf by a subcontractor."

By the reasoning of this ruling, all damage could be covered, except the work that is both the insured's own work and damaged by the insured's own work. Addressing the possibility that this would equate the CGL with a performance bond, the court stated, "for some reason, the industry chose to add the new exception to the business risk exclusion in 1986….We realize that under our holding a general contractor who contracts out all the work to subcontractors, remaining on the job in a merely supervisory capacity, can ensure complete coverage for faulty workmanship. However, it is not our holding that creates this result; it is the addition of the new language in the policy. We have not made the policy close to a performance bond for general contractors, the insurance industry has."

The Kalchthaler case also addressed the issues of an "occurrence" and the "expected or intended injury" exclusion. Regarding the general contractor's coverage, the court first turned to section 1.a.(1) of the insuring agreement, which states that insurance applies if the damage is caused by an "occurrence," which is defined within the policy as an "accident." Since "accident" is not specifically defined within the policy, the court turned to Webster's dictionary, which defines "accident" as "an unfortunate event that happens without volition or intent, resulting from carelessness, unawareness, ignorance or a combination of causes and producing an unfortunate result."

In Kalchthaler, the general contractor did not intend for the damage to occur, and it argued that it was unaware that the subcontractor was doing bad work. The court agreed, and thus the subcontractor's poor work was an accident from the standpoint of the GC. The court's decision to apply this definition of "accident" effectively negates the first CGL exclusion of "expected or intended" damage as far as the GC is concerned-of which the courts seem to say, "Don't blame us for the way you wrote your policy." I have long argued that a GC has a duty to supervise the work of subcontractors, and thus that a subcontractor's poor work is also the poor supervisory work of the GC. In the court system this argument sometimes seems to fall on deaf ears.
In many states, as this case demonstrates, the CGL has thus become a performance bond for "paper" contractors who hire subcontractors for all the work on a project. Consider the implications of this for two types of general contractors:

• A GC whose employees do the work on a project is insured under a CGL. When a construction-defect claim arises on one of the GC's projects, coverage for the claim is denied, since the GC was doing the work itself and thus should have at least expected the damage resulting from its own poor work.
• A paper GC with the same coverage faces a similar claim after completing a project entirely through the work of hired subcontractors. The subcontractors have no coverage for their work, since they should have expected the results of their work. But the GC can claim it did not expect the poor work. Since the work was done on the GC's behalf, it has coverage where the "hands-on" GC does not.

Between these two contractors, it's the "hands-on" general contractor who is more likely to have control over the quality of work, and thus have fewer construction defect claims. Yet as the CGL is written and interpreted, the "paper contractor," who is more likely to have claims, is the one who gets coverage, and the better risk is not covered. This is insane.

Since December 2001, ISO has made available two similar endorsements to solve this problem. Endorsements CG 22 94 and CG 22 95 replace the wording of exclusion l, to state, "This insurance does not apply to 'property damage' to 'your work' arising out of it or any part of it and included in the product-completed operations hazard." This is the same wording of exclusion l, but the exception for work performed by a subcontractor has been eliminated. Endorsement 94 applies on a blanket basis to all projects covered for an insured; CG 22 95 can be used to cover individual projects on a scheduled basis.

Many contractors and insurance agents have been upset about this, believing the endorsement removes all coverage for the products-completed operations hazard. But that's not true, though the endorsements certainly restrict coverage for poor work. For example, consider what happens if a general contractor hires a subcontractor to do the electrical work for a house, and the electrician does poor work, leading to a fire that destroys the house. According to the endorsements, the general contractor would not be covered for any damage to its work on the home-even the ensuing damage caused by the subcontractor's work. However, the general contractor would be covered for the loss of the homeowner's personal property and automobiles if those were destroyed, as well as for any work done on the home by another contractor (such as a new floor or an addition to the home performed after the general contractor finished its work).

Future possibilities

The current endorsements have benefits beyond limiting the insurer's responsibility for a business risk, but they are not a perfect solution to the construction-defect problem. They provide an incentive for a general contractor to be more careful when selecting subcontractors. Of course, they don't protect GCs from the risks of working with even reputable subcontractors. If the GC has to pay for uninsured ensuing damage caused by a subcontractor, the GC can always seek reimbursement from the responsible subcontractor. But given the possibility that a claim may occur years down the road, there's a chance the subcontractor may be out of business, may no longer have coverage (even if it was covered during the project,) or may otherwise be unable to pay damages.

Some companies are using their own endorsements to limit coverage to just the ensuing damage. Such endorsements partially limit what insurers would be required to pay. Unfortunately, the ensuing damage often is 10 to 50 times as expensive as the original faulty work.

Other companies are excluding coverage for damage resulting from any work completed prior to the policy inception date of their first policy for a contractor. However, excluding prior completed operations does not address the long-tail issue created by the statute of repose for future construction operations.

I know of one company currently using limited completed operations coverage as a marketing tool for homebuilders. The insurer says it will provide completed operations coverage for one year, since that is when the majority of the claims occur. As we have seen, the problem with that statement is that it is not accurate. Many, and perhaps the most costly, construction defect claims arise several years after a home is sold.

One of my homebuilder clients purchases a third-party inspection and a 2/10 warranty on every home he builds, which adds about $1,000 to the sale price of the home. He uses the inspection and warranty as a marketing tool, and his houses almost always sell faster than those of his competitors. Furthermore, by obtaining a warranty on the home from an outside party, he transfers some of the responsibility for later defects to the warranty and the inspector's professional liability insurance. If we could convince all homebuilders to take this approach, we might be able to save substantially on claim costs and pass on some of the savings to our clients.
However, homebuilders frequently will strive to save a few dollars on material costs, so convincing them to add $1,000 in upfront costs to a house is difficult.

We're exploring various different approaches to limiting exposure while providing coverage for the ensuing damage. One option is to apply a large completed-operations deductible, somewhere between $10,000 and $25,000. This will give homebuilders some "skin in the game" and encourage them to be more attentive in the supervision of construction activity. It should also encourage them to seek out long-established and insured subcontractors. We're still studying the idea, trying to determine what size deductible would be both fair and effective.

The long-term answer could be to alter the language of the policy itself, rather than just address the issue through endorsements, but that hasn't happened yet. My concern is that while the industry seeks a more permanent solution, some insurers-driven by the prospect of quick profits-will come to the market and decide they can do what others have been unable to do in the past, which would be a big mistake. When the initial premium dollars flow in, the idea looks good-but it is the long term that tells the final loss story.

This article was derived from Mr. Hargrove's presentation at the AAMGA University Weekend, which was held in August in Scottsdale, Ariz.