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

2. 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

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

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

5. 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

6. Example: $3 Million Claim

7. 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

8. 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

9. 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

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

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

14. Montrose Adjustment Method

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19. Report Year Analysis

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25. 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

26. 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

27. 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