Construction Defects

Seminar on ReinsuranceJune 2-3, 2003

Philadelphia, PAChandu C. Patel, FCAS, MAAA

Scope of Presentation

• Background• Legal Developments• Actuarial Issues• Emerging Issues

Background

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:

Unskilled Labor+ Poor/No Supervision+ Unrealistic DeadlinesSubstandard Housing

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

Categories of Defects

1. Defects in Design, Workmanship and MaterialsDefect EffectFraming Structural FailureRoofing Water Intrusion (mold)Windows Water Intrusion (mold)

Categories of Defects

2. Soil Problems– Improper compaction

Subsidence– Inadequate grading

Lateral Mvmt– Inadequate drainage– Expansive Soil– Seismic Activity

Legal Developments

Important California Court Cases, Legislation affecting Construction

Defects

1. Montrose I (1993)2. Montrose II (1995)3. Stonewall (1996)4. Calderon Act (1997)

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

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)

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)

• 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.

Actuarial Analysis

Scope

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

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

• 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:

• 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

• 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

• 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

• 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

Construction DefectsSeverity Information

12/31/1998

Reported Open Paid ReportedAccident Counts Counts Losses LossesYear 12/31/98 12/31/98 12/31/98 12/31/98

1992 15 5 800,000 925,0001993 223 78 5,000,000 7,000,0001994 570 175 8,500,000 11,500,0001995 688 215 9,500,000 14,500,0001996 535 208 4,500,000 8,500,0001997 168 73 1,000,000 2,000,0001998 38 10 125,000 400,000

2237 764 29,425,000 44,825,000

Paid per O/S perAccident Closed Open ReportedYear Severity Severity Severity

1992 80,000 25,000 61,6671993 34,483 25,641 31,3901994 21,519 17,143 20,1751995 20,085 23,256 21,0761996 13,761 19,231 15,8881997 10,526 13,699 11,9051998 4,464 27,500 10,526

Total 19,976 20,157 20,038

Will this continue once fully developed?

Construction DefectsCalendar Year Statistics

12/31/1999

Cumulative Incremental Cumulative IncrementalCalendar Reported Reported Reported Reported ReportedYear Count Count Losses Losses Severity

1992 0 0 0 0 01993 33 33 175,000 175,000 5,3031994 183 150 3,350,000 3,175,000 21,1671995 538 355 8,250,000 4,900,000 13,8031996 1053 515 14,775,000 6,525,000 12,6701997 1596 543 25,300,000 10,525,000 19,3831998 2237 641 44,825,000 19,525,000 30,460

1999 2875 638 59,915,000 15,090,000 23,652

Techniques to Estimate Ultimate Counts

• Accident Year Approach

• Calendar Year Approach

Construction DefectsClaim Count EstimationAccident Year Approach

Age in MonthsAx Yr 12 24 36 48 60 72 84 96

1992 0 8 10 10 10 10 15 171993 25 53 95 120 155 223 2651994 120 245 340 443 570 7701995 188 408 523 688 8901996 175 385 535 6751997 80 168 2101998 38 481999 0

Reported Construction "+12 Mo" "+12 Mo"Counts Defects Indicated Indicated Actual

Ax Yr As of 12/98 LDFs Ultimate Counts Counts1

1992 15 1.200 18 2 21993 223 1.500 335 56 421994 570 2.000 1,140 190 2001995 688 2.600 1,789 206 2021996 535 3.250 1,739 134 1401997 168 4.250 714 52 421998 38 6.000 228 16 10

2,237 5,962 655 638

Construction DefectsClaim Count EstimationCalendar Year Approach

Age in MonthsAx Yr 12 24 36 48 60 72 84 96

1992 0 8 10 10 10 10 15 171993 25 53 95 120 155 223 2651994 120 245 340 443 570 7701995 188 408 523 688 8901996 175 385 535 6751997 80 168 2101998 38 481999 0

Incremental Cumulative Growth Calcul-Calendar Reported Reported Pattern ated Selection Increment'lYear Time Count Count Factor Ultimate at 12/98 Expected

1992 t=0 0 01993 t=12 33 33 325.000 10,7251994 t=24 150 183 45.000 8,235 2051995 t=36 355 538 10.500 5,649 6011996 t=48 515 1,053 4.500 4,739 7171997 t=60 543 1,596 2.500 3,990 4,100 8421998 t=72 641 2,237 1.750 3,915 6841999 t=84 638 2,875 1.300 3,738 774

Based upon Data as of 12/31/98

Ultimate Losses = Incurred Losses + (IBNYR Count x Selected Severity)IBNYR Count = (Ultimate Claim Count - Total Claim Count as of 12/98)

Incurred Losses as of 12/98: 44,825,000Total Claim Count as of 12/98: 2,237

Ultimate Claim Count Assumptions: 1) Calendar Year Approach 4,100 2) Accident Year Approach 5,962

Severity Assumptions: 1) Low (Decreasing AY Sev.) 15,000 2) Medium (Current O/S Sev.) 20,000 3) High (Increasing CY Sev.) 25,000

Calculation of Ultimate Losses:

F x S ApproachCY AY

Severity: 4,100 5,962

Low 15,000 72,770,000 100,700,000

Medium 25,000 91,400,000 137,950,000

High 35,000 110,030,000 175,200,000

Selected Frequency:

Sample Industry data – Sub-Contractors

• ALAE to Loss RatioRange 75% to 105%

• Mature Reported Average SeverityRange $22,000 to $23,000

As with any industry data, discretion should be used in applying these factors to individual company analyses.

The Future

Mitigation Efforts

• Settlement Efforts

• 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?

• 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

• 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

• Exposure is Comparable to Environmental/Toxic exposures.

• Communicate with Claims and Underwriting Departments.

• Continually question/monitor methods.