Casualty Loss Reserve Seminar September 11, 2001 Reserving for Construction Defects Presented by Michael D. Green & Carolyn Wettstein

Overview Background Montrose Decision What is a Construction Defect Program Knowledge Data Organization Difficulties with Traditional Development Methods Non Traditional Reserving Methods Current Trends What Lies Ahead

Background Groundwork Being Laid Population growth Building boom Shortage of skilled workers Contractors cutting corners Shift in type of residences

Background Law firms target homeowners associations Insurers begin to react Creates insurance availability and affordability crisis Coverage issues

Montrose Decision Continuous trigger theory applied to pollution case Early construction defect case was Stonewall Insurance Company vs. City of Palos Verdes Estates Carriers respond to claims on prorata basis Frequency rises Severity falls Insureds coverage is generally maximized Reinsurers less exposed Indemnity apportioned based on time on risk Expense apportioned based on number of carriers

Example: $3 Million Claim

What is a Construction Defect? Comes from a Variety of Sources Faulty workmanship Plumbing / drainage / irrigation Improper materials Structural failure or collapse Electrical wiring Insulation Landslides and Earth Settlement Conditions Expansive soils Underground water Vertical settlement Earthquakes Important to Understand Specific Definitions used by the Company

What is a Construction Defect? Two Types of Defects Patent Defect detectable through reasonable inspection Statue of limitations generally 2 – 4 years Latent Defect not detectable through reasonable inspection and is manifested over a period of time Time limit governed by statute of repose which begins on the date construction is completed California is generally 10 years

Program Knowledge What is exposure mix (general contractor, designer/builders, subcontractors) Is exposure residential or commercial construction Which states have construction defect exposure Is exposure information available What is the definition of a construction defect claim How is accident date determined What reinsurance agreements are in place

Data Organization California vs. Non California (or other specific states) General Contractors vs. Subcontractors Report year data

Difficulties with Traditional Development Methods Uncertain determination of accident date Varies by company and frequently within a company Uncertain determination of future development pattern Appears to be lengthening Influx of claim activity along recent accident year diagonals Uncertain determination of tail factor selection One assumption to use is no more development after 13 years for California Not sure if it will hold

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Non Traditional Reserving Methods Montrose Adjustment Method Transactional Count / Incremental Paid Loss Method Report Year Analysis (pure IBNR estimated using a selected exposure distribution)

Montrose Adjustment Method

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Report Year Analysis

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Current Trends Frequencies Severities ALAE to loss ratios 1994 – 1999 rising 2000 flat Severities 1994 – 1999 stable 2000 flat to declining ALAE to loss ratios Rising over time Recommend monitoring separately from loss as still evolving

What Lies Ahead? California Housing availability crisis Shortage of skilled workers High real estate prices Population boom Insurance availability crisis Calderon Act (1/96) Mandatory mediation session between association and builder prior to filing lawsuits Appears to have little impact Alan O. Aas vs. Superior Court (12/00) Upheld lower court ruling that plaintiffs could not seek damages for construction defects that had not yet caused property damage

What Lies Ahead? Other States Areas of rapid increase in population Baby boomers retiring – NV, FL, TX, AZ, CO Seen increase in activity but legal landscape is different Statute of limitations shorter Minimal use of continuous trigger theory Claim frequency is rising