“You put up these buildings. Even though no one has noticed anything wrong, no one has been injured, nothing has been damaged; by virtue of the fact that you put them up, there must be defects in them. Therefore we will sue.”
Not a pretty scenario, but unfortunately construction defect in the building industry can take on this hopeless appearance for insurers. The trend of litigation, particularly in multi-family construction, is no longer just a Southern California phenomenon.
“It’s like so many other litigation trends we run into, they tend to start out based on the classic horrendous story and branch out from there,” said David Golden, director of commercial lines for the National Association of Independent Insurers (NAII). “That’s how the whole thing has progressed, from starting out with situations that had real merit, to now situations that may not ever have merit to them.”
According to the California Department of Finance, California needs 250,000 new housing starts per year in order to accommodate the population; yet only 139,000 units were built last year. Law firms specializing in construction defect have popped up across California and are now opening branch offices in Nevada and Arizona.
The Miller Law Firm is one such firm, with offices in Phoenix, Las Vegas and Portland, as well as San Francisco, Thousand Oaks and Newport Beach. Miller touts its “Proud Record of Recovery” on its Web site, with the largest recovery in Los Angeles County listed at $15,220,000 for a 416-unit high-rise luxury condominium development.
Robert J. Olson is president of Solvang-based West Star of California Insurance Services LLC, a program manager specializing in California construction risks. In his years in the construction industry, Olson has seen defect litigation move from California to such “hot spots” as Nevada, Arizona, Texas, Illinois and Florida.
“Within the construction segment, there are many subsegments and some of them can be profitable if underwritten correctly,” Olson said. “But there are others that you may never be able to write profitably: large garden apartments, large condo complexes or townhome complexes…it’s the opportunity for one flaw in one [building] to be multiplied 200 times, because everything’s the same.”
Do insurers have a hope against the kind of bank-breaking damages paid out in these all-too-common cases? The answer is yes, if they take precautions to protect themselves and charge a sufficient premium for the coverage.
In 1994, the case of Montrose Chemical Corp. v. Admiral Insurance Company focused national attention on construction defect. The California Supreme Court ruled that in third-party liability cases in which damage occurred over a period of years, any policy in effect during any part of that period could be liable for damages.
“Montrose basically extended the occurrence timeframe that the insurance policies became responsible to respond to,” said Bill Cooper, president of W.K. Cooper & Co. International Insurance Brokers Inc. in Encino, Calif.
“Before Montrose, everyone thought that an occurrence should be within a 12-month policy timeframe; an occurrence was one point in time. With Montrose, you can actually have many occurrences over a long period of time. The decision had to do with pollution, but it quickly overlapped into long-tail exposures.”Homebuilders, contractors and class-action lawyers jumped on the ruling as a means to pass the buck to insurers.
Golden described it as a fairly recent development, particularly outside of the state of California, and not one that insurers were prepared for.
“The premium charged for additional insureds never really contemplated taking on the responsibility of another contractor in any specific case,” he said.
After getting a taste of these types of long-tail exposures, many of the standard companies pulled out of the marketplace. One such example was Maryland Casualty, which was later acquired by Zurich.
Once a very large writer of construction business throughout the U.S., Maryland Casualty pulled out of California about three years ago due to heavy losses combined with the looming specter of the Montrose decision.
“Almost every standard company you can think of is getting out,” Cooper said. “Great American is non-renewing a lot of their construction accounts right now…I used to be an underwriter with Aetna many years ago-we wrote a ton of construction business and they pulled out of writing that business a long time ago.”
The majority of construction defect claims are tied to residential properties. Commercial ventures, such as shopping centers and hospitals, don’t see as much construction defect.
“You do see some, but usually that’s an error and omission/professional liability problem where they’ve designed something incorrectly,” Olson said.
The prospect may look bleak for those sticking it out in the construction market. But hope still glimmers: insurers are finding ways to cope with the threat of litigation.
“The specialty companies who do write this kind of insurance, third-party liability on general contractors and developers, they’ve come up with Montrose endorsement language,” Cooper said. “I don’t know if any of it has been tested in court yet, but they seem to be fairly comfortable that it’s holding… the problem with that is that you never know when a court is going to say ‘well, your endorsement language is very fuzzy so we’re going to throw the whole thing out.'”
Developing Montrose language can at least help companies to establish a more comfortable place in the market. “What we do on our program is we have a lot of restricting endorsements that remove a lot of the undesirable exposures, and therefore we have a better chance of maintaining profitability and also passing that on to our insureds by way of keeping the rates reasonable,” said West Star’s Olson. “Not that we give any rebates or any money back, but by maintaining a profitable program for the subsegment that we underwrite, we can provide them with a stable market and stable rates.”
Insurance Services Office Inc. (ISO) added an endorsement to its commercial general liability insurance policies in September 1999, with the aim of closing the Monstrose loophole. The “Known Loss Endorsement” essentially states that if a known injury or damage occurred before the purchase of a policy, that loss is not covered. Golden said that NAII’s general liability committee wrestled with the construction defect issue when the committee met in April and will tackle it again at the beginning of September.
“We discussed cases and trends, mostly from outside of California-we were trying to get away from the California-only thinking,” Golden said. “One of the main issues of [September’s] meeting will be actions that insurers can take in terms of managing the exposure that they take on. This could be by their underwriting actions or by particular forms language that they use in endorsements, rating approaches-kind of the gamut of what is available right now as we get further into the issue from a technical standpoint, then working on the ultimate solution from an insurance standpoint.”
Innovating to meet a need
W.K. Cooper & Co. developed an effective tool called a Buy-Out that is geared toward residential contractors or developers. The Buy-Out is a project-specific policy, a general liability policy that allows the developer to isolate their exposure to one or two projects at a time. Cooper “guess-timated” that they have around 20 of these policies currently in place, mostly the medium to larger developers.
“The per-project or wrap-up policy allows the developer to go in, especially on a high-hazard project-condo or townhome-where they know that a lot of the subcontractors in the California marketplace don’t have insurance covering this construction,” Cooper explained.
“So the general or developer goes in, buys this one-time wrap-up policy, which includes the liability of the subcontractors. It’s done on a build-out, so the policy is issued for the term of the construction, perhaps two to three years, and then completed operations is extended for ten years to meet the California statute of limitations.”
Because all the costs associated with the insurance are tied directly to the project, Cooper said there are no surprises to the developer years down the road should losses start to develop. Olson is a little less optimistic. “I wouldn’t say that there’s any segment that’s truly safe, that you could just write and never have to worry, because with contractors you also have BI segments and other exposures that they fall prey to,” he said. “So while construction defect is the most glamorous [exposure] attached to the contractor, it is not the only loss potential that you have with that type of class.”
Good things don’t come cheap
As with any high-risk market, it is important to fully understand the extent of exposure and charge the appropriate premium. Thus, rates for multifamily construction are understandably steep. Cooper gives the example of a condominium complex with receipts of approximately $20 million.
“You might be able to get a quote from one specialty company for a project policy with defense inside the limit, for the duration of the build-out plus the ten-year completed operations extension, and they may charge for limits of 2-2-2, a premium of perhaps $75,000.”
On the other hand, Cooper said, “another company could offer limits of 5-5-5, defense outside the limits, and their premium could be as much as $200,000-but it’s a lot more limits. You have to be very cognizant of the limits, because these policies are written with a one-time policy limit for the entire policy duration, so you have to make sure that you’re buying sufficient limits.”
Agents need to incorporate this awareness of sufficient limits into the buying/marketing process, especially to avoid any E&O situations. The cracks in the plaster may be spreading, but it doesn’t need to be a hopeless scenario for insurers. With such a high demand for multi-family housing, there will be a corresponding supply of construction, and armed with endorsements and exclusions, insurers will be there to cover the exposures.
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