Construction Defects

1. Construction Defects Seminar on Reinsurance June 2-3, 2003 Philadelphia, PA Chandu C. Patel, FCAS, MAAA

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

3. Background

4. When Housing Demand outpaces Supply • During mid to late 1990s demand for housing far exceeded supply, particularly in states such as California, Arizona • Builders rush to meet this demand • Unskilled construction labor enters the market • Laborers are unsupervised • Short cuts are taken to save time

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

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

7. Categories of Defects • Defects in Design, Workmanship and Materials DefectEffect Framing Structural Failure Roofing Water Intrusion (mold) Windows Water Intrusion (mold)

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

9. Legal Developments

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

11. 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.

12. 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: Leads to increased claim frequencies; lower severities; less reinsurance protection

13. 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.

14. 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.

15. Actuarial Analysis

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

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

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

19. 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

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

21. 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?

22. 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.

23. 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.

24. 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

25. Will this continue once fully developed?

27. Techniques to Estimate Ultimate Counts • Accident Year Approach • Calendar Year Approach

31. 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.

32. The Future

33. Mitigation Efforts • Settlement Efforts • Coverage Restrictions

34. 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

35. What does the Future Hold? • CD Litigation expanding to Other States (Nevada, Colorado, Florida, Washington) • Continued Aggressive Litigation • General Contractors invoke Sub-Contractor policies; claim reporting activity continues • Insurers seeking ways to aggregate claims to collect from reinsurers • Reinsurance actuaries need to be cognizant of the potential lag

36. 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

37. Challenge our Actuarial Techniques • Exposure is Comparable to Environmental/Toxic exposures. • Communicate with Claims and Underwriting Departments. • Continually question/monitor methods.