Construction Defect Claims Trends Influenced By Complex Set Of Factors

Trying to get a consensus on the issues facing insurers writing contractors general liability insurance is like trying to herd cats. This fact has become apparent as we talk to homebuilders, brokers, insurers and reinsurers on the issues facing this marketplace during the course of our consulting work.

Whether we're trying to ascertain the effectiveness of notice-and-opportunity-to-repair (NOR) laws, which state has the potential to become the next problem state for construction defect litigation, or whether wrap policies are successfully keeping loss adjustment expense claims down, we get mixed answers.

Mixed answers are evident in trying to sort out trends in the frequency of construction defect claims by state.

Our list of states with potential construction defect claims, compiled based on discussions with insurers and homebuilders, includes Alaska, Hawaii, Washington, Oregon, California, Nevada, Arizona, New Mexico, Texas, Florida, South Carolina, North Carolina, New Jersey and Minnesota.

In addition to Florida, we are also concerned about Louisiana, Mississippi and Alabama as a result of the rebuilding after Hurricanes Katrina, Rita and Wilma.

Overall, we believe that frequency is declining in California and have seen varying results for other states. For states like Florida, Texas and Nevada, we hear quite different stories from homebuilders and insurers.

Minnesota appears on a number of people's list of states with increasing construction defect claims.

Actions by homebuilders, external environment changes and insurance coverage changes are among the drivers of frequency trends.

Today, the large homebuilders are much more proactive about staying in touch with homebuyers in hopes of learning about possible defects long before homebuyers get fed up and file a lawsuit. Some large homebuilders even host neighborhood barbecues to build goodwill and keep an open dialogue between the parties.

Many builders have instituted warranty programs in hopes of fixing the smaller problems quickly and satisfying the homeowners so they aren't encouraged to file claims. Warranty policies, however, provide significantly different coverages than contractors liability policies.

Warranty coverage is broadest in the first few years–covering workmanship and materials in the first year, systems in the second year. After that, unlike contractors policies, only truly significant structural issues are covered for up to 10 years.

Most contractors' general liability policies cover losses up to the statute of repose, which can be eight-to-10 years.

Many large homebuilders use third-party inspection firms to identify poor construction so that it can be rectified during construction. While opinions vary on the success of these inspections, the intent is good and the implications are favorable to both the homebuilder and homebuyer.

Having observed discussions of Oregon's Construction Claims Task Force this past year, we're more convinced that the way to solve the construction defect problem is to improve the quality of construction. (Editor's Note: The Construction Claims Task Force was authorized by H.B. 2078, passed in 2005, to study the relationship between construction liability claims and construction industry practices.)

The biggest external factor is probably the potential influence of the notice-and-opportunity-to-repair laws. Today, 30 states have adopted NOR laws, which essentially require property owners to put contractors on notice of construction defect claims before lawsuits can be filed.

Insurance companies and builders should beware, however. All NOR laws are not equal. We've been looking, without success, for a good source that compares the various laws and evaluates the best components of NOR reforms. We believe this is key to understanding potential trends in construction defects.

In California, we are on our third attempt at finding an NOR solution, with the implementation of S.B. 800 which became effective on Jan. 1, 2003. Our first two reforms–the Calderon Act (1997) and Steinberg Mandatory Negotiation Bill (2002)–were ineffective in keeping claims from going to court.

Increasing familiarity by the public is another external factor impacting construction defect claims frequency. We would be surprised if you could find someone who bought a new home in California that has not been approached by a lawyer offering to file a construction defect claim on his or her behalf if the need arises. In fact, years ago, one of the authors of this article was walking to work in downtown San Francisco and passed a men's suit store that had as part of its display a book on “filing a construction defect claim.” How that book became a display item in a suit store confounds us.

Besides increasing the frequency of claims, we also believe that widespread awareness of construction defect claims has sped up the reporting pattern of claims in California. It is difficult to ascertain whether claim reporting patterns in other states are changing as most insurance carriers analyze construction defect claims for California, and then non-California. Our view is that there doesn't appear to be a shifting pattern in other states. Opinions can vary significantly, however.

We also never know when another case like Presley Homes v. American States Insurance Company–a 2001 California Court of Appeals case that involved the tendering of the defense to a subcontractor via an additional insured endorsement–will change the landscape for handling construction defect claims.

During the past few years, it seems that more and more insurance companies have been talking about how their coverage changes are going to help keep their losses down. These changes may come in the form of coverage triggers, prior-work exclusions, pre-existing damages exclusions, sunset provisions, or claims-made coverages.

Another important component involves additional insured endorsements, and the question of whether these endorsements apply to completed operations. We had been hearing that AI endorsements were becoming more restrictive for some time, but recently we have heard that insurance companies are once again loosening this endorsement as competition heats back up for contractors.

With the insurance company actions, there are typically two types of effects: those that eliminate coverage and those that move it to another policy.

An exclusion that eliminates coverage for Exterior Insulation Finishing Systems (EIFS) or fire-retardant treated wood truly eliminates coverage. On the other hand, those coverage changes that deal with coverage triggers may just shift the loss from one policy to another. We generally find that most insurance companies consider the percentage of historical claims that would no longer be covered by a policy but forget that new claims could also surface.

An analysis of construction defect claim frequency without commenting about the percentage of claims closing with payment would be incomplete.

Over the past 10 years, lawyers have implemented a “shotgun approach” to filing claims–they file claims against anyone that could even remotely have been involved. As a result, we have seen a significant increase in construction defect claims, especially for subcontractors and artisans, but many of these claims close without payment.

If additional insured endorsement coverage tightens, however, and as courts restrict the passing of liability from contractors to subcontractors, we would expect that indemnification of contractors by subcontractors to be reduced. That may be good news for subcontractors and artisans but bad news for general contractors and homebuilders.

The biggest influencer to severity has been the introduction of wrap policies. Rather than having each subcontractor purchase his own insurance, a wrap provides a single policy covering all parties. The introduction of a wrap decreases the number of construction defect claims filed against the insurance industry.

When not using a wrap, claims are filed against the contractor and a number of his subcontractors. Coverage may be triggered under more than one policy, for each of the contractors or subcontractors. Sometimes more than 10 law firms can be involved in a case. A wrap policy is meant to reduce the infighting between contractors and subcontractors and reduce legal expenses.

For a homebuilder, implementing a wrap policy will not affect claim counts but increase severity. For the insurance industry as a whole, implementing wraps will decrease claim counts but increase severity.

Many companies hoped that implementing wraps would bring total insurance costs down by approximately 25 percent. They assumed that overall allocated loss adjustment expense costs would be reduced by 50 percent. Historical ALAE costs have nearly equaled the cost for losses.

The success of wraps is still not clear. Legal costs are running higher than expected. The trend is fueled by concerns that policy limits are not high enough, and if there is potential to blow through the limit, then each contractor/subcontractor wants his own defense. Also, there are issues when the insurance company issues a “reservation of rights” letter and may eventually decline coverage. Then the contractors and subcontractors will still incur legal costs.

For homebuilders, we believe that severity is decreasing for many of the same reasons that were discussed above for frequency–barbecues, warranties, quality of construction.

Going forward, severities will be affected by policy coverage changes, especially restrictions on completed operations coverage and additional insured language.

While we believe that analyzing contractors general liability trends is much more complicated than most analyzing trends in other lines and segments of business, we are bullish on this book.

With a knowledgeable team of underwriters, claims handlers and actuaries, one can sort out these complicated issues. In addition, the premium increases from 2000 through 2003 were quite dramatic.

Companies today are assuming that this segment has loss ratios as good as other lines, with the potential for significantly more investment income than most other lines. But insurers are well advised to tread lightly so they don't wake up the bear.

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