Construction Defects

1. Construction Defects CLRS September 19, 2000 Minneapolis

2. Chandu Patel, FCAS Sr. Actuarial Manager KPMG LLP Moderator Ronald Herrig, FCAS Actuary Shand Morahan & Co. Panelist Paul Kanton Sr. Claims Specialist Markel West / Associated International Insurance Co. Panelist Peter Mack Sr. Claims Specialist Markel West / Associated International Insurance Co. Panelist Presenters:

3. Scope of Presentation • Background • Legal Developments • Actuarial Issues • Emerging Issues

4. Background

5. California Population Growth • Between 1980 and 1996: • the US population grew by 16.7%. • California’s population grew by 36% • 2.8 million new housing units were built in California (1 for each 3 new residents) • demand for housing exceeded supply by 600,000 units.

6. When Housing Demand outpaces Supply • Builders rush to meet this demand • Unskilled construction labor enters the market • Laborers are unsupervised • Short cuts are taken to save time

7. In Mathematical Terms: Unskilled Labor + Poor/No Supervision + Unrealistic Deadlines Substandard Housing

8. “So, what exactly is a ‘Construction Defect’”?

9. Categories of Defects • Defects in Design, Workmanship and Materials DefectEffect Framing Structural Failure Roofing Water Intrusion Windows Water Intrusion

10. Categories of Defects • Soil Problems • Improper compaction Subsidence • Inadequate grading Lateral Mvmt • Inadequate drainage • Expansive Soil • Seismic Activity

11. Are These Defects Insurable? Policyholders – Yes, General Liability policies provide coverage for completed operations. Insurance Companies – Yes and No, policy covers damage caused by defect, but not cost to repair the defect. Courts – Sooner or later, we’ll decide!

12. Legal Developments

13. Important California Court Cases, Legislation affecting Construction Defects • Montrose I (1993) • Montrose II (1995) • Stonewall (1996) • Calderon Act (1997)

14. Montrose Chem’l v. Superior Court (of LA County) - 1993 Issue: Insurer’s obligation to defend with respect to proceedings related to the discharge of hazardous substances. Ruling: Complaint need only allege that damages may have occurred to trigger the defense obligation. Impact: Leads to the defense of more claims; increases severity of ALAE.

15. Montrose Chem’l v. Admiral Insurance Co. - 1995 Issue: Use of continuous injury trigger for duty to defend hazardous waste actions. Ruling: All insurers “from shovel to gavel” have potential liability. All past, current and future policies may apply. Impact: Could lead to increased claim frequencies; lower severities.

16. Stonewall Ins Co. v. City of Palos Verdes Estates (1996) Issue: Application of “Montrose” phenomenon to construction defect cases. Ruling: Continuous injury trigger does apply to construction defect cases. Impact: Litigation and claim counts increase significantly.

17. Calderon Act (1997) • Requires communication between HO Association and Builder as a pre-condition to filing a lawsuit. • Encourages Mediation between parties. • Initially increased filing of lawsuits. • Ultimately delayed the filing of lawsuits. • Generally, ineffective in resolving claims and avoiding lawsuits.

18. Actuarial Analysis

19. Scope • Loss Characteristics • Chain Ladder Method and Pitfalls • Frequency and Severity Approaches • Summary

20. Characteristics of Losses • Developers / General Contractors • Sub-contractors / Artisans

21. Developers / General Contractors Shorter Report Lag Longer Closure Pattern Lower Frequency Higher Severity Higher ALAE to Loss

22. Developers / General Contractors Shorter Report Lag Longer Closure Pattern Lower Frequency Higher Severity Higher ALAE to Loss Sub-contractors / Artisans Longer Report Lag Shorter Closure Pattern Higher Frequency Lower Severity Lower ALAE to Loss

23. Other General Characteristics • Lots of Legal Expense • Active Plaintiff’s Bar • Coverage Litigation • Duty to Defend • Long Statute of Limitations • Many Cross Complaints

24. Questions an Actuary must ask: • Are the risks we insure Developers/General Contractors or Sub-contractors? • Is my layer of exposure Primary or Excess? • Is expense Inside or Outside of Limits? • Can my data be broken out separately? • Why’d I become an Actuary?

25. Potential Reserving Techniques • Incurred Chain Ladder • Paid Chain Ladder • Frequency x Severity • Other? Note: Each of the following exhibits is derived from Sub-contractor data. The data used is actual reported data modified by a scaling factor.

30. Problems with Chain-Ladder • GL experience isn’t representative of CD. • Company CD history may not be extensive enough. • Oldest accident years may still be developing, maybe substantially. • Little industry-wide experience available.

31. Will Bornhuetter-Ferguson work better? • B-F is LDF dependant – the same LDF issues will apply • How do you pick an a priori ULR? – short history makes this difficult; highly judgmental.

32. Frequency x Severity Approach • Severities are low and stable/decreasing • Lower for Subs than for General Contractors • Trending downward as: • More Policies are exposed • More insurers are brought into litigation • Frequency is the key to projections

33. Will this continue once fully developed?

35. Techniques to Estimate Ultimate Counts • Accident Year Approach • Calendar Year Approach • Exposure Growth Approach

41. Sample Industry data – Sub-Contractors • ALAE to Loss Ratio Range 75% to 105% • Mature Reported Average Severity Range $22,000 to $23,000 As with any industry data, discretion should be used in applying these factors to individual company analyses.

42. The Future

43. Mitigation Efforts • Settlement Efforts • Coverage Restrictions

44. Settlement Prior to Trial Pros • Reduces expensive Trial Costs • Juries are biased toward Homeowners • Encouraged by Calderon Cons • Mediations can be numerous, lengthy and expensive • Involve many parties, each with own interests

45. Coverage Restrictions • Montrose Exclusions – Could prohibit coverage for losses known to the insured before the policy’s inception. • Cost Inclusive Coverage – Contains ALAE within the Policy Limits • Aggregate Limits – Contains Catastrophic Exposure.

46. What does the Future Hold? • CD Litigation expanding to Other States • Continued Aggressive Litigation • Challenge our Actuarial Techniques

47. Expansion to Other States • Already seeing litigation in Nevada, Colorado, Florida and Washington • Arizona’s population grew 20.4% from 1990-1996, compared to 6.4% nationwide.

48. Continued Aggressive Litigation • Construction Defect litigation is a no-lose situation for Plaintiff’s attorneys. • Army of Plaintiff’s Experts/Army of Defense Experts • New Concepts of Liability being proposed

49. Challenge our Actuarial Techniques • Exposure is Comparable to Environmental/Toxic exposures. • Communicate with Claims and Underwriting Departments. • Continually question/monitor methods. • Incorporate Educated Judgment into analysis.

50. Sometimes they’re all trick questions!