Owner controlled insurance programs (OCIPs) or contractor controlled insurance programs (CCIPs), commonly referred to as “wraps,” that have been traditionally used for large, commercial projects with construction costs of $50 million or more now are being used for all sizes of residential construction projects.
OCIPs are a relatively new insurance vehicle for residential construction projects. Due to the proliferation of construction defect litigation, those insurance policies are fast becoming the only option for developers, general contractors and subcontractors who build single-family or multi-family homes in California, Nevada and other western states.
Under those policies, the developer, general contractor and all of the subcontractors become named insureds under a single policy that covers a single construction project, or in some cases, multiple projects. This new insurance model is a drastic departure from the previous insurance model, where each contractor individually purchased and negotiated his or her own policy to protect the company’s liability in the event of a claim.
In the traditional insurance model, lower tier subcontractors named the general contractor as an additional insured on their policy and provided a broad indemnity agreement that shifted the responsibility for losses arising out of the project to the subcontractor. The general contractor would provide a similar broad indemnity agreement to the developer and name the developer as an additional insured on the general contractor’s policy.
Through the use of indemnity agreements and additional insured endorsements, those policies were configured in a pyramid fashion with the liability pushed downstream onto the lower tier contractors’ insurance policies. The general contractor and the developer sat at the top of the pyramid, insulated from loss until all of the downstream contractors’ policy were exhausted. If there were 20 to 30 contractors on the project, then there were 20 to 30 policies that could potentially respond to liability claims arising out of the project.
Traditional versus OCIP loss funding
Under the traditional multi-policy model for residential construction, the limits of each individual policy could be used to satisfy a large claim. Theoretically, 30 policies with a $1 million limit of liability each could produce $30 million of coverage to fund a loss.
In the new insurance model for residential construction under an OCIP, there is only one commercial liability insurance policy to protect the developer, general contractor, subcontractors and sub-subcontractors, and the coverage is restricted to the designated project or projects. A mediator no longer has the ability to tap the multiple individual policies of the contractors who worked on the project to build a fund to resolve the dispute in a construction defect case before the parties have to resort to protracted and expensive litigation.
Under the new insurance model, there would not be the level of protection available unless an excess liability policy was purchased to bring the limit of insurance up to $30 million for the project. Another thing that the traditional model provided, although it has disappeared recently, was defense costs in addition to the policy limit. Defense costs contribute to the erosion of the aggregate policy limit under an OCIP.
A few years ago The Building Industry Association estimated that defense costs, such as attorney fees, expert fees and related costs, may exceed indemnity costs by as much as 5-to-1. For every $1 that goes to a “damaged party,” as much as $5 is spent on legal fees, experts and court costs.
If defense costs contribute to the erosion of the policy limit, then it would only take an indemnity settlement of $175,000 to result in $825,000 in defense costs, which would exhaust a $1 million per occurrence policy.
If you assume that the new insurance model for residential projects under an OCIP will help to reduce the legal costs by removing the expenses associated with the cross complaints that are typically a part of every construction
defect case under the traditional multi-policy model, then under an OCIP, defense costs should be reduced.
For example, generously estimate that the new insurance model brings the defense costs to indemnity ratio down 50 percent to a ratio of 2.5-to-1. That would allow for a $350,000 indemnity settlement before exhausting the same $1 million per occurrence policy.
Construction defect claims
Construction defect settlements are not required to be systematically reported to any governmental agencies for tracking purposes, and most construction defect settlements are confidential. However, sources that disclose those judgments and settlements (typically from self-promoting attorney’s Web sites) indicate ranges usually are in excess of $2 million, which excludes the costs incurred by the insurance company to get to the point of settlement.
Using the new insurance model estimate of a 2.5-to-1 ratio of defense costs to indemnity payments, the estimated defense costs for a $2 million indemnity settlement would be approximately $5 million. The OCIP policy covering the project where the claim occurred would need to have an insurance limit of at least $7 million per occurrence to adequately pay for the claim.
As proof that those numbers reflect the real world, type in “construction defect” in Google and you will receive 9.58 million hits in 0.31 seconds, and the sponsors of those Web pages will mainly be construction defect attorneys and expert witnesses. Go to any of the construction defect attorney’s Web sites and click on their verdicts and settlements section. One listed 57 settlements under its “1995-2006 Proud Record of Recovery,” 41 of which were listed at $2 million or more. That list of victories also states, “This record is one that has been consistent in the past and will continue to be in the future”.
Claims from construction operations
While construction defect claims are grabbing headlines due to their lengthy statute of repose and high dollar settlements, they are not the only losses that can erode the limits of the OCIP policy.
Most OCIP policies contain two aggregates, a premises-operations aggregate and products-completed operations aggregate. They respond in the same fashion as the standard ISO commercial general liability policy, where exhaustion of the premises-operations aggregate does not exhaust the products-completed operations aggregate.
Some OCIP policies provide a “basket” aggregate that combines both operations losses and completed operations losses under one aggregate limit. When the policy contains this form of coverage grant, it is possible to have the entire OCIP’s policy limit exhausted by a single bodily injury claim during the construction operations phase of the project.
If that were to occur, there would be no policy limits left available to pay for any completed operations claims that might arise between the time the project is completed and the time the statute of repose expires (10 years in California).
When an injured employee brings suit against the project owner or general contractor for injuries sustained while working on the project, traditionally those third-party-over actions were transferred back to the subcontractor via the “insured contract” under the a commercial general liability policy. That does not work under an OCIP, as there is only one policy for all of the contractors, and it is the only policy that can respond to that type of claim. Construction accident settlements can run into the millions when scaffolding, trenching, cranes or multi-story projects are involved. Brain injuries and wrongful death claims can easily exhaust a primary OCIP’s premises-operations aggregate — even before the project is completed.
Calculating the minimum limits
When it comes to residential OCIPs, “adequate limits” do not exist. Minimum limits of liability coverage should always be recommended and offered to the client when presenting the OCIP quote. The question becomes what limits of liability do you recommend to a client that is interested in purchasing an OCIP for his or her next residential construction project?
There are three different “rules of thumb” that can be used to calculate what minimum limits of liability insurance should be carried under an OCIP for a given project. The drawback with “rules of thumb” is that they are usually very basic and do not apply to every situation. They must be used cautiously, weighing the various factors that are a part of a specific construction project. Let’s look at the three “rules” used to begin the analysis:
- $30,000 per unit
- 125 percent of the project Cost
- $5 million per occurrence.
Look at a few different types of residential projects that would be written under an OCIP and apply those “rules” to see which ones make sense based on the facts of the project.
Two 11-Story towers, type 1 construction with 354 residential units and 50,000 square feet of retail space at a construction cost of $80 million. Using the three methods, the recommended limit to carry on this project would be:
- $10.2 million
- $100 million
- $5 million
In this scenario, option 2 seems to make the most sense given the exposures associated with high rise and condominium construction. Offering quotes up to $100 million would seem prudent.
Three hundred garden style frame condominiums built at a cost of $40 million.
- $9 million
- $50 million
- $5 million
In this scenario, option 1 rounded up to $10 million would appear to be the reasonable choice. Remember, you are only testing the “rules” here and have not come to any conclusions regarding the limits of liability you think the client should carry on the project.
Fifty frame single family dwellings built at a cost of $10 million.
- $1.5 million
- $12.25 million
- $5 million
Option 1 appears too low, so a good starting point for calculating the minimum limit appears to be at least $5 million, or option 3.
Twelve unit frame condominium built at a cost of $3.95 million.
- $4.94 million
- $5 million
Again, option 1 is too low and option 2 and 3 are almost the same, so the starting point would be $5 million.
The conversion of an existing eight story building built in the 1920s into 100 condominium units at a cost of $9 million.
- $3 million
- $11.25 million
- $5 million
This project presents some unique exposures and rounding option 2 to $10 million would be a reasonable starting point.
Looking at scenarios 1 through 5, notice that some of the rules don’t work in every situation, but they do present a good starting point from which to begin a more detailed analysis.
Factors that affect limits of liability
Each project is different, and the characteristics of the project must be evaluated to determine what potential impact they may have on a recommendation for a limit of liability on the OCIP.
- Type of Construction — Single family homes, multi-family homes, high rise, mixed use or conversion.
- Size of the Project — Cost of construction, number of stories and type of construction.
- Length of Construction Phase — 1, 2, 3 years or more.
- Extent of construction — Is their any demolition that will be done? In the case of a conversion, will any of the building remain occupied during the conversion? Will any seismic retrofitting be done? Will there be extensive exterior work required?
- Will there be more than one project covered under one OCIP policy. What if there are claims on multiple projects at the same time?
- How many contractors (named insureds) will be covered under the policy? 10? 20? 50? The more named insureds, the greater the claims cost that will erode the aggregate. Remember, each named insured is treated as if they had their own policy under an OCIP.
- Has the earth movement exclusion been removed from the policy? A broadening of coverage allows for additional claims that can erode the aggregate.
- Are the architects and engineers included as named insureds? Again, a broadening of coverage and additional named insureds contribute to an accelerated erosion of the aggregate in the event of a claim.
- Are there any additional factors that could create a need for additional limits of insurance? Metropolitan vs. rural, contractual requirements, type of OCIP policy form?
It would be nice if every project carried just enough limits of liability to cover its losses, but economic and perception issues enter into the insured’s decision of how much limit to buy. Premiums on OCIPs are not inexpensive, and purchasing additional limits of insurance may be difficult for the insured to fund. Or, they may just feel that they have never suffered a large claim before and have an “it won’t happen to me” attitude.
Presenting an OCIP quote?
A professional should do the following when presenting an OCIP quote:
- Always present an excess quote with every primary OCIP quote.
- Recommend the client purchase as much limit as he or she can afford. That is not really the place to cut corners.
- Discuss the individual characteristics of the project and why you are recommending additional limits of liability insurance be purchased on the project.
- Inform the developer or contractor purchasing the OCIP policy that there are multiple parties depending on the coverage provided by the policy to protect their company’s assets and, while not required by law, there may be a duty on the part of the developer or contractor to provide reasonable protection to all participants on the project.
- If the insured declines to purchase the recommended additional limits of insurance, document the file and have the insured sign an acknowledgement that they have declined the offer of additional limits. Be sure to include in your acknowledgement that once the project starts, additional limits of liability insurance may not be available or, if they are available, there may be significantly higher premiums than are currently being quoted.
Robert Olson is a construction risk and insurance specialist and surplus lines broker with Bliss & Glennon Inc. in Palm Desert, Calif. E-mail: email@example.com.