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 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 Deadlines Substandard Housing

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

Categories of Defects 1.Defects in Design, Workmanship and Materials DefectEffect FramingStructural Failure RoofingWater Intrusion (mold) WindowsWater 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) 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 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

Will this continue once fully developed?

Techniques to Estimate Ultimate Counts Accident Year Approach Calendar Year Approach

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.

The Future

Mitigation Efforts Settlement Efforts 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.