1. Construction Defects CLRS September 19, 2000 Minneapolis

2. Presenters: 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 Peter Mack Sr. Claims Specialist Markel West / Associated International Insurance Co. Panelist

3. Scope of Presentation Background Legal Developments Actuarial Issues Emerging Issues

4. Background

5. 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.

6. 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

7. In Mathematical Terms: Unskilled Labor + Poor/No Supervision + Unrealistic Deadlines Substandard Housing

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

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

10. Categories of Defects 2.Soil Problems –Improper compaction Subsidence –Inadequate grading Lateral Mvmt –Inadequate drainage –Expansive Soil –Seismic Activity

11. 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!

12. Legal Developments

13. Important California Court Cases, Legislation affecting Construction Defects 1.Montrose I (1993) 2.Montrose II (1995) 3.Stonewall (1996) 4.Calderon Act (1997)

14. 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.

15. 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.

16. 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.

17. 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.

18. Actuarial Analysis

19. Scope Loss Characteristics Chain Ladder Method and Pitfalls Frequency and Severity Approaches Summary

20. Characteristics of Losses Developers / General Contractors Sub-contractors / Artisans

21. Developers / General Contractors Shorter Report Lag Longer Closure Pattern Lower Frequency Higher Severity Higher ALAE to Loss

22. 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

23. Other General Characteristics Lots of Legal Expense –Active Plaintiff’s Bar –Coverage Litigation –Duty to Defend Long Statute of Limitations Many Cross Complaints

24. 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?

25. 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.

30. 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.

31. 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.

32. 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

33. Will this continue once fully developed?

35. Techniques to Estimate Ultimate Counts Accident Year Approach Calendar Year Approach Exposure Growth Approach

41. 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.

42. The Future

43. Mitigation Efforts Settlement Efforts Coverage Restrictions

44. Settlement Prior to Trial Pros –Reduces expensive Trial Costs –Juries are biased toward Homeowners –Encouraged by Calderon Cons –Mediations can be numerous, lengthy and expensive –Involve many parties, each with own interests

45. 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.

46. What does the Future Hold? CD Litigation expanding to Other States Continued Aggressive Litigation Challenge our Actuarial Techniques

47. 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.

48. 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

49. 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.

50. Sometimes they’re all trick questions!