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Construction Defects. Seminar on Reinsurance June 2-3, 2003 Philadelphia, PA Chandu C. Patel, FCAS, MAAA. Scope of Presentation. Background Legal Developments Actuarial Issues Emerging Issues. Background. When Housing Demand outpaces Supply.

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construction defects

Construction Defects

Seminar on Reinsurance

June 2-3, 2003

Philadelphia, PA

Chandu C. Patel, FCAS, MAAA

scope of presentation
Scope of Presentation
  • Background
  • Legal Developments
  • Actuarial Issues
  • Emerging Issues
when housing demand outpaces supply
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
in mathematical terms

In Mathematical Terms:

Unskilled Labor

+ Poor/No Supervision

+ Unrealistic Deadlines

Substandard Housing

categories of defects
Categories of Defects
  • Defects in Design, Workmanship and Materials


Framing Structural Failure

Roofing Water Intrusion (mold)

Windows Water Intrusion (mold)

categories of defects8
Categories of Defects
  • Soil Problems
    • Improper compaction


    • Inadequate grading

Lateral Mvmt

    • Inadequate drainage
    • Expansive Soil
    • Seismic Activity
important california court cases legislation affecting construction defects
Important California Court Cases, Legislation affecting Construction Defects
  • Montrose I (1993)
  • Montrose II (1995)
  • Stonewall (1996)
  • Calderon Act (1997)
montrose chem l v superior court of la county 1993
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.

montrose chem l v admiral insurance co 1995
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

stonewall ins co v city of palos verdes estates 1996
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.

calderon act 1997
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.
  • Loss Characteristics
  • Chain Ladder Method and Pitfalls
  • Frequency and Severity Approaches
  • Summary
characteristics of losses
Characteristics of Losses
  • Developers / General Contractors
  • Sub-contractors / Artisans
Developers / General Contractors

Shorter Report Lag

Longer Closure Pattern

Lower Frequency

Higher Severity

Higher ALAE to Loss

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

other general characteristics
Other General Characteristics
  • Lots of Legal Expense
    • Active Plaintiff’s Bar
    • Coverage Litigation
    • Duty to Defend
  • Long Statute of Limitations
  • Many Cross Complaints
questions an actuary must ask
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?
potential reserving techniques
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.

problems with chain ladder
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.
frequency x severity approach
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
techniques to estimate ultimate counts
Techniques to Estimate Ultimate Counts
  • Accident Year Approach
  • Calendar Year Approach
sample industry data sub contractors
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.

mitigation efforts
Mitigation Efforts
  • Settlement Efforts
  • Coverage Restrictions
coverage restrictions
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
what does the future hold
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
continued aggressive litigation
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
challenge our actuarial techniques
Challenge our Actuarial Techniques
  • Exposure is Comparable to Environmental/Toxic exposures.
  • Communicate with Claims and Underwriting Departments.
  • Continually question/monitor methods.