How to Control Construction Claims in a Collapsing Homebuilders’ Market

By Paul Jansen and Kevin Hastings | November 16, 2008

Working with Experienced Homebuilders, Rigorous Inspections and Defect Remedies Reduces the Risk from Possible Shortcuts

A significant increase in unsold assets represents a substantial hole in the balance sheet for builders of every size. Combine this with rising costs for construction commodities … and it’s not surprising that some builders are taking shortcuts in order to keep costs down.

The credit crunch and housing crisis have put unprecedented pressure on the residential construction industry. Media reports suggest falling house prices have encouraged builders to take shortcuts and that buyers are alleging defects in an attempt to recoup their spending. As a managing general agency specializing in the construction industry, we have a different perspective on how builders are reacting, the challenges they face and possible solutions moving forward.

There is no doubt that builders are having a difficult time everywhere, particularly on the West Coast. With land falling in value, housing stock sitting idle and costs mounting up, there are reports that the industry is resorting to desperate measures to keep afloat.

In a bid to keep cash coming through the door, builders have been selling off house lots for a fraction of what they paid, not just to realize cash from such a fire sale, but in order to reap tax benefits.

Tax law allows companies to offset losses from land and other asset sales to profits earned in the previous two years. This means that builders could claw back more of the profit they generated in 2006 — the last strong housing market year — and roll that forward onto today’s balance sheet. Although the cash they generate from these sales will go in some way to pay running costs, it will not be sufficient to pay down outstanding debt or to fund new projects.

Land Sells, But Not Houses

While land may be selling, albeit at knock-down prices, houses are not. Standing inventory in California alone was up to approximately 12,000 units in May. This represents an increase of around 56 percent in total, although that figure masks some interesting differences in categories. The volume of vacant condos in the state is actually up over 70 percent on last year and in townhouses and complexes the situation is worse — up more than 150 percent on May last year.

Such a significant increase in unsold assets represents a substantial hole in the balance sheet for builders of every size. Combine this with rising costs for construction commodities like timber, steel and concrete and it’s not surprising there are reports that some builders are taking shortcuts in order to keep costs down.

Skimping on the quantity of insulation in a cavity wall, or substituting cheaper materials in areas which will later be covered by cladding are not the kind of cuts that will result in a defect. These practices will not be obvious to the homeowner — nor are they easy to spot unless the inspector is present at the right time. However, they do mean a builder can save some of the expense in the normal construction process.

Insurers’ Concerns

Although the pressures placed on builders to reduce costs remain substantial — and insurers remain concerned that the desire to keep costs to a minimum could result in poor practice — we do not expect to see a dramatic worsening in the claims history of the insureds we have underwritten. In fact, in analyzing the last six months of reported claims covering the years since 2002, we have actually seen a distinct reduction in claims numbers — which runs counter to many of the scare stories over frivolous lawsuits and more recently builders taking shortcuts.

Why we are seeing fewer claims than some other reports?

One of the key reasons we believe that this downturn is different than the last, resulting in far fewer claims, is that we have been working with builders at our firm for many years now ensuring that rigorous inspections are carried out by independent inspectors to ensure proper practice is observed and high quality maintained. This is an approach we have mandated since 2002.

A second key contributing factor is the significant shift which has taken place in the legal landscape since the end of the last building booms of the ’80s and ’90s and their subsequent waves of litigation. For example, California Senate bill 800 was passed five years ago, which requires the homeowner to allow builders to opportunity to fix the problem before there is any threat of legal action. This has significantly reduced the volume of frivolous lawsuits against homebuilders.

We believe the third reason for a lower claims incidence comes from improved risk selection. For a number of years we have been focusing on builders with experience. These local or regional builders demonstrate their business depends on their reputation and the strength of their ability to produce high quality homes consistently and reliably.

This combination of factors — the focus on local or regional firms with a good name; insistence on quality irrespective of market conditions; rigorous inspection regimes and a legal environment for builders to be given the option to remedy defects — is what is now driving a far lower claims incidence than market conditions would suggest.

Solutions Moving Forward

Better claims history means that although builders now face extremely tough market conditions, some may have a reserve to draw on in the form of captive insurance companies which they established earlier in the decade.

In the hard market of 2002-2006, builders’ insurance was extremely expensive — in some circumstances virtually a dollar premium to a dollar insured. The costs were so high that many builders decided to establish their own captive insurance company. For those who were not tempted to take short-cuts on construction, this made excellent business sense. The cash was set aside for a number of years (10 years in California) — the period in which a householder is able to bring a defect claim — and at the end of the term, the builder would be able to release its underwriting profits in cash from the captive, plus interest.

This pot of gold, accumulated in the hard insurance market, is now looking extremely tempting to hard pressed building companies that would rather forgo future profits in the interests of hard cash up front.

JHI has been working with numerous homebuilders, insurers and other financial organizations to organize the transfer of risks out of these captives. This enables the homebuilding owners of these captive firms to access significant amounts of capital, and other risk-taking entities to acquire high quality risks at an acceptable price.

How does risk transfer work in practice?

As an example, we worked with one insured that for three successive years fully funded a captive/fronted insurance program with $2 million of annual premium (for $2 million of liability limits annually). We were able to transfer the risk (hundreds of millions of dollars in construction costs) out of that captive/fronted program and release 40 percent of the original $6 million premium back to the builder owner of the captive. The transfer of risk was to A-rated specialist construction insurers.

Vacant Properties

The cost of insuring vacant housing stock is also substantial. Generally builders have to insure standing inventory as an extension to their builders’ risk policy. This can work out to be very expensive. Furthermore, after a certain period of time post construction, builders can no longer keep these homes on their builders’ risk policies. At this point the homebuilders have to purchase some form of vacant property coverage, which can be very expensive and only offers quite restricted cover.

While it now seems inevitable that the credit crunch will become a full-blown global recession, by continuing to work closely together, we hope that builders and specialist insurers will minimize its impact.

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