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Construction Defects. CLRS September 19, 2000 Minneapolis. 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

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construction defects

Construction Defects


September 19, 2000


Chandu Patel, FCAS

Sr. Actuarial Manager



Ronald Herrig, FCAS


Shand Morahan & Co.


Paul Kanton

Sr. Claims Specialist

Markel West / Associated International Insurance Co.


Peter Mack

Sr. Claims Specialist

Markel West / Associated International Insurance Co.


scope of presentation
Scope of Presentation
  • Background
  • Legal Developments
  • Actuarial Issues
  • Emerging Issues
california population growth
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.
when housing demand outpaces supply
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
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

Windows Water Intrusion

categories of defects10
Categories of Defects
  • Soil Problems
    • Improper compaction


    • Inadequate grading

Lateral Mvmt

    • Inadequate drainage
    • Expansive Soil
    • Seismic Activity
are these defects insurable
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!

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: Could lead to increased claim frequencies; lower severities.

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?
  • Why’d I become an Actuary?
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.
will bornhuetter ferguson work better
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.
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
  • Exposure Growth 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
settlement prior to trial
Settlement Prior to Trial


  • Reduces expensive Trial Costs
  • Juries are biased toward Homeowners
  • Encouraged by Calderon


  • Mediations can be numerous, lengthy and expensive
  • Involve many parties, each with own interests
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
  • Aggregate Limits – Contains Catastrophic Exposure.
what does the future hold
What does the Future Hold?
  • CD Litigation expanding to Other States
  • Continued Aggressive Litigation
  • Challenge our Actuarial Techniques
expansion to other states
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.
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.
  • Incorporate Educated Judgment into analysis.