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Whether real or imagined, the threat of construction defects litigation has burned through the residential contractors liability insurance market like a California wildfire. Over the past couple of years, contractors and their agents across the nation have been left to sift through the ashes for coverage for an industry that is otherwise enjoying a booming housing market fueled by shifting populations and low interest rates.
Availability of general liability coverage for residential contractors seems to be particularly tough in high growth states like California, Colorado, Florida, Nevada, Texas and Washington, which have suffered high numbers of construction defects liability cases. But even states that have kept a relatively low profile in terms of construction defects litigation are not immune to the effects of runaway lawsuits on insurers’ appetites to take on construction risks in the housing sector.
“In some states, it’s construction defects and in other states it’s the fear of construction defects,” said Paul Norman of Norman- Spencer McKernan Agency (NSM) in Dayton, Ohio. He added that some insurance companies have modified “their construction underwriting strategies because of either the actual or perceived exposures. … Construction defects is not in every state, there are just fears of it. Because of that some companies have some very stringent underwriting practices for this class of business.”
Darwin Lucas, a senior vice president of programs for RISC Inc. in Dallas, agreed that construction defect claims are “the primary contributor” to the market difficulties.
“Everybody who touched a project is getting named,” Lucas said, “and that’s unfortunate, because 90 percent of them wind up getting out of it because they had nothing to do with the construction defect claim.”
Builders and contractors working with new start tract home construction, condominiums and townhomes have been among the hardest hit, partly due to the relative ease of initiating class-action lawsuits in those types of communities.
According to the National Association of Home Builders (NAHB), a trade group with some 215,000 builder, remodeler and trade contractor members, the difficulty in securing liability insurance is universal.
“In terms of availability and the cost of insurance, it has been the single number one highest rated problem of our membership in every survey we’ve taken,” said Jerry Howard, executive vice president and CEO of the NAHB. “Therefore it’s safe for us to conclude this is across the board and across the
country.”
“I would say the market continues to be tough for new start residential tract contractors,” said Bob Olson, executive vice president of California-based Trinity E&S Insurance Services. “It’s still tough for anybody who’s building condos or townhomes. It’s easier, there’s more availability, there’s more carriers writing broader coverage for your commercial contractors or your contractors that only do residential or commercial remodeling.”
Olson conceded that pricing, at least, “seems to be kind of leveling off. Over the last, probably, 18 months [there have been] some pretty dramatic increases, but right now the pricing seems to be leveling off.”
Filling the gaps
In an April 21, 2004, announcement the NAHB reported that, “single-family housing starts are expected to remain at high levels, declining slightly from 1.5 million units last year to 1.488 million in 2004 and 1.422 million in 2005. Bolstered by growing strength in the condominium market, this year’s multifamily construction is forecast to remain at last year’s 348,000-unit level, with a small drop to 320,000 units next year.” NAHB analysts believe that rising interest rates won’t necessarily impact the housing market adversely. Even if the interest rate rises to 6.25 percent by the end of this year, that rate is still low by historical standards.
So what can a builder or contractor with plenty of work ahead of him or her do about liability insurance?
According to Peter Foley, president of NationsBuilders Insurance Services (NBIS), a national risk retention group for contractors, “agents should not discount the alternative marketplace to deal with this problem.”
California-based Foley, whose company is active in 21 states, added that the need to respond quickly to market conditions makes it a difficult line for admitted markets.
“I’m not going to criticize any of the admitted markets, but surplus lines give you the flexibility to respond to changes both on your coverage issues as well as your rate issues,” Foley said. “On the admitted side you’ve got to go through the throes of getting approval either for rate or form change. Our insurance departments are understaffed, so they can’t respond in a timely fashion. … This is a class that almost should be in an alternative market or using … surplus lines or some kind of alternative risk sharing mechanism that can respond to those changes.”
In New York, one builders group has opted to create its own insurer. As Britton Wells reported in the May 3, 2004 issue of Insurance Journal-East, members of the New York State Builders Association (NYSBA) are creating the Reciprocal Liability Insurance Company (RLIC) to fill the gaps in liability coverage. In addition to construction defects, the building trades in the state of New York claim that Sections 240 and 241 of the New York State Labor Law have further caused the liability market to dry up. Under Sections 240 and 241 contractors are liable for virtually any gravity related injuries suffered by a worker on a job site, even if the fall was caused by the worker’s own mistakes.
Subscriber-members of the RLIC will provide the capital, and coverage will be handled through 25 insurance agencies across the state that already have a book of business with the association’s members. Marsh USA, which consulted with NYSBA on developing the alternative, will provide management services as a third party administrator.
Marsh is also working with the NAHB on a national level to try and find solutions to the general liability crisis in the home building industry. While the NAHB’s Howard was reluctant to talk about the Marsh initiative due to the proprietary nature of the arrangement, he said an announcement about the project could come by the end of the year.
Programs targeting the building trades are also coming into play. A national program covering a host of specialty contractors was recently launched by program brand administrator Construction Insurance Solutions (CIS). It is managed by three separate entities in different states: NSM-Ohio, Texas-based RISC and Arthur J. Gallagher of Louisiana.
RISC’s Lucas, who is the national underwriting and compliance officer for CIS, said while the program is available nationally, “there are some states that we even have a difficult time working in because of the legislatures and some of the laws that have been passed and some of the suits that have been paid.”
He described the CIS program as a “revolutionary approach … because it’s a collaborative effort between two carriers and one program administrator, or three program administrators in our case, [and] one marketing company. It’s probably the first of its kind where two carriers actually collaborated and pulled the program together as a solution to their distribution chains.”
He acknowledged that while the program is not designed totally for residential contractors, “it is a solution for those guys. It is a distressed market. Most of the carriers are putting some very stringent exclusions on the policy for habitational work, which makes a lot of the contractors ineligible, or uninsurable. So most of the major carriers have either put some exclusionary wording on or [have] gotten out of it entirely.”
Lucas noted that CIS is able to put the program together in this environment “primarily because we’ve got the expertise to know how to underwrite construction business.” He added that CIS’ key program administrators have more than 20 years experience in the construction area and that the “underwriters have been underwriting it for 10 to 15 years.”
He said their claims documentation process is a very important element of the program. It “will allow us to track who’s doing what project, what subcontractors are on each project,” Lucas said. “And when there is a claim, if it’s not a direct result of our contractor’s work, we know who was on the project. Even if it happens ten years from now we will know who did what and we will be able to go back and catch those contractors.”
Turning down the heat with NOR laws
With insurance companies passing the expense of defense costs and settlements down to builders via increased premiums and added exclusions, or exiting the market, the NAHB considers it a priority to help its members gain access to liability insurance.
The NAHB created a General Liability Insurance (GLI) Task Force in 2002 to assess the problem and make recommendations. As a result, the association’s research affiliate, the NAHB Research Center, developed a quality assurance program for homebuilders and contractors.
According to Donna Reichle, a public affairs spokesperson with the NAHB, the pilot program, designed to increase efficiency and consistency in building practices, is all about quality control. She added that it has “really had a dramatic effect on builders who are in the pilot program—reducing the amount of call backs and reducing the amount of buyers that have found something wrong with their house when it’s first delivered to them.”
Another initiative the NAHB is actively pursuing is the passage of notice and opportunity to repair (NOR) laws in all 50 states. NOR-type legislation has been implemented in 24 states so far, 21 in the last two years.
“NOR legislation is an incentive-based system,” said Steve Henry, an attorney with Gardere Wynn Sewell LLP in Dallas and an outside counsel for the NAHB. It is designed to get homeowners and homebuilders talking “whenever a homeowner has a concern with a construction issue with their home.”
“Historically … we had situations where a homeowner had a construction issue … and rather than calling up the builder up and saying ‘why don’t you get out here and get this repaired’ they would simply … file a lawsuit,” Henry said. “Conversely there were bad builders out there who would get a call from a homeowner and for whatever reason wouldn’t go out and take care of their problem in a prompt manner.”
NAHB’s Howard explained that, “In states where notice and opportunity laws are enacted the homebuyer would have to first notify the builder of the construction defect or alleged construction defect. The builder then would have 90 days to acknowledge it, to negotiate, to talk to the homebuyer and ultimately to fix it before any lawsuit can be instituted.”
Howard said the association believes if that happens, “you have a homebuilder who is making the necessary repairs and achieving his ultimate goal, which is a satisfied customer. You have the homebuyer getting what their ultimate goal is, which is a livable, properly constructed house, and you have the insurance companies not having to eventually bear the brunt of the cost of litigation.
“We think that it’s a win-win-win for the three major parties,” Howard continued. “Moreover we think it’s a win for public policy because these suits have been increasing so incrementally that in many places they’re starting to clog the judicial system.”
Henry said Texas has had a NOR law since the late 1980s but last year the legislature increased its effectiveness by establishing what he calls “NOR version two—the Texas Residential Construction Commission Act.”
The act, which requires homebuilders to register with and be licensed by the commission, is “really a sea change as far as home building in Texas,” Henry said. “Because for the first time homebuilders voluntarily agreed to be regulated.”
Henry noted that “99.9 percent of these things get resolved with a notice to the homebuilder and they go out and do their work.” But in situations where the homeowner and the homebuilder can’t agree, the case can be taken to the TRCC for resolution. State inspectors hired by the commission will analyze the problem and makes a binding decision on how to proceed.
According to Trinity E&S’ Olson, California’s NOR law, S.B. 800, has yet to have a big impact on the market, partly because it’s new and because it only applies to homes sold after a certain date. But he’s
hopeful.
“California is a perfect example—the statute of limitations is 10 years,” Olson said. “So if you’re looking at a development that was built maybe seven or eight years ago, S.B. 800 doesn’t apply to it. S.B. 800 in California only applies to homes sold after Jan. 1, 2003.
“When anything is new it’s always an uncertainty. Insurance carriers don’t like uncertainty or a high degree of uncertainty, and they say the jury is still out on whether the effect of S.B. 800 is going to be noticeably positive for the insurance industry. I personally think it will be.”
Transferring the risk
Bruce Lockhart, an executive with the Dawson Companies, a large retail agency based in Cleveland, Ohio, and a member of the RiskProNet International Inc. construction practice group, described the contractors liability area as a “contract game,” in which “everyone is trying to pass off as much liability onto everyone else as they possibly can.”
Insurers are looking for proper risk transfer in the contracts between the property owner, the general contractor and the subcontractors. “If proper risk transfer is not in place, insurance is very, very difficult to come by,” Lockhart said.
He explained that the “indemnification agreements between the contractor, the owner, and the lower tier contractors to the general contractor are probably the most important element, and the contractors should be passing down as much liability as they are assuming from the contract ahead of them.” He added, “Some of the most important words in an indemnity agreement are: to the fullest extent permitted by law.”
According to Lockhart there are three types of indemnification agreements—broad, intermediate and limited.
“Broad indemnification agreements essentially transfer the risk of virtually anything happening,” Lockhart said. “They transfer all of the risk described in the contract. That’s regardless of who is at fault. An intermediate type of agreement transfers all of the risk, except when the risk is entirely your fault. In a limited indemnity agreement, the lower tier contractor indemnifies you for its share of the liability of the loss.”
Like Lucas, Lockhart acknowledged that variations in laws from state to state make contractors’ issues complicated ones. “Indemnification agreements are affected by state law,” Lockhart said, explaining that contractors should educate themselves as to how their state interprets those agreements.
With each player passing on to others as much liability as he can, the contractor has to be aware of what he is assuming and be careful “that he’s not assuming too much liability in the indemnity agreement, especially liability that would not be covered in his insurance policy,” Lockhart said.
Another vital element of the contract “is the hold harmless agreement,” he said. “The hold harmless simply states that the lower tier contractor or the lower tier agrees not to recover damage to the higher tier. …
“Third and what backs all of this up are the additional insured endorsements. And the additional insured has undergone numerous changes since 1985. I can’t even count how many additional insured type of endorsements there have been.” The important thing, Lockhart stressed, is “each contractor should be named an additional insured under the lower tier’s policy.”
While Ohio has not been adversely affected by construction defects liability cases so far, Lockhart acknowledged, “it may eventually catch up.” It is his belief, however, that “failure to properly transfer the risk, failure to properly document the construction proceedings, failure to have a good idea of all the underlings—of what their scope of work is—has probably led to a dramatic amount of these problems.”
What to do
In Olson’s view, to be effective in the contractors liability arena, “a retail producer either has to have an in-house expertise in writing construction accounts, especially in the area of general liability and completed ops coverage, or they need to seek somebody out that has the expertise that can guide them through the marketplace.” He recommended that retailers who don’t handle a lot of contractors accounts look for “a surplus lines broker that has the expertise, that can take care of their clients for them.”
Foley of NBIS said his company expects agents to get a jump on renewal business and to start working on it early. He also looks for lots of information on the risk.
“The days of limited information to get a quote—those are long gone,” Foley said. “You’ve got to be ready to provide detailed information,” such as whether the insured’s operations have changed or whether they have had losses in the past. In the case of losses, the more information provided the better, “because maybe it’s one of those situations where the contractor was just swept up in a broad action lawsuit. … We look at it as whether it was a bad contractor, bad workmanship or just—’hey, this was a contractor that was part of a group that was involved in a project or a home and got swept up in a class action suit through no negligence of their own.'”
Lucas and Lockhart both stressed the importance of data collection. Lucas noted that in the past, most contractors failed to keep records on projects. He said that keeping claims documentation and contracting trails are a must so that in the event of a problem losses can be mitigated.
“The importance of written contracts anymore is imperative,” Lockhart said. “[Contractors] just can’t do anything on an oral agreement, a handshake agreement. It has to be in writing. And that contract has to document everything.”