1. Casualty Actuarial Society - Annual Meeting C7: Changes to Construction Defects Coverage, Claims, and Reserving New Orleans Marriott New Orleans, LA November 10, 2003 Presented by: Jennifer M. Levine Thomas L. Ghezzi Michael D. Green Paul B. Swank

2. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 2 Jennifer M. Levine, Regional Actuary, Zurich North America In the numbers: n 18,691 = number of condo units built in CA in 1994* n 2,945 = number of condo units built in CA in 1999* n 30 = number of carriers insuring CA condo construction in 1991* n 2 = number of carriers insuring CA condo construction in 2003* n $314,855,200 = recovery dollars for construction defect and mold cases claimed by only two law firms listing such recoveries on web n 227 = number of construction defect lawsuits in Clark County, NV District Courts at end of 2002** n 7.5% = percentage of all cases in Clark County NV District Courts at end of 2002 that were construction defect in nature** n $2.50-$5.00 = dollars paid out for every $1.00 collected in premiums for construction dispute insurance† *Seattle Times 11/02/03 **Las Vegas Business Press 06/27/03 †Insurance Journal 06/23/2003 In the numbers: n 18,691 = number of condo units built in CA in 1994* n 2,945 = number of condo units built in CA in 1999* n 30 = number of carriers insuring CA condo construction in 1991* n 2 = number of carriers insuring CA condo construction in 2003* n $314,855,200 = recovery dollars for construction defect and mold cases claimed by only two law firms listing such recoveries on web n 227 = number of construction defect lawsuits in Clark County, NV District Courts at end of 2002** n 7.5% = percentage of all cases in Clark County NV District Courts at end of 2002 that were construction defect in nature** n $2.50-$5.00 = dollars paid out for every $1.00 collected in premiums for construction dispute insurance†

3. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 3 Thomas L. Ghezzi, FCAS, MAAA, Consulting Actuary, Tillinghast n Background, Basic Principles and Coverage Changes

4. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 4 California Population Growth and Housing Supply Shortage n In the late 70s through early 90s, California experienced unprecedented population and housing growth n CA population growth was twice the US population growth rate in many periods n Demand for housing exceeded supply n Construction of multi-family units (condos, townhomes) increased significantly n Builders stepped up production Unskilled construction labor “cut corners” - cheaper materials and built quicker Less supervision

5. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 5 Litigation Ensues n Aggressive plaintiff’s bar n Success in early suits funded additional suits n Unfavorable legal decisions (discussed later) n Construction of multi-family units (condos, townhomes) encourages large cases multi-family units four times more likely to sue n Homeowners associations sold on idea by aggressive lawyers potential suits against condo Board if Board fails to take action

6. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 6 Major Exposed Classes of Business n Real estate managers n General contractors n Sub-contractors n Artisans (e.g., plumbers, landscapers, electricians) n Owners and developers n Architects and engineers n Manufacturers of construction and building products-roofing materials, plumbing systems, windows and doors, drywall, stucco and siding

7. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 7 CD Most Commonly Alleged Defects n Roofing n Sheet Metal Flashing n Lath & Plaster n Soils n Rough Framing n Waterproofing n Doors & Windows n Concrete n Painting n Masonry n Design & Plan Deficiencies n Site Work n Metals n Carpentry n Thermal & Moisture Protection n Finishes n Specialties n Mechanical n Electrical n Water Damage/Fungus/Dry Rot/Structural Pest Control

8. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 8 Important Legal Cases n I - Montrose Chemical Corp v. Superior Court (Canadian Universal Insurance Co) - 1993 An insurer must defend an insured in case involving the discharge of hazardous substances Even if the complaint only alleges property damage that would trigger coverage n II - Montrose Chemical Corp v. Admiral Insurance - 1995 Continuous trigger: all insurers with potential for “property damage” during policy period - Applies to duty defend only Does not address allocation among insurers

9. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 9 Important Legal Cases (Cont.) n Stonewall Insurance Co. v. City of Palos Verdes Estates - 1996 First post-Montrose v. Admiral case to examine duty to indemnity in context of construction defect claims Continuous trigger of coverage determines the obligation of successive liability insurers to indemnity n Combined effects: Increased ALAE due to defense requirement More limits at risk; increased severity Multiple carriers on many claims Significant claim count increases

10. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 10 Important Legal Cases (Cont.) n Aas v. William Lyon Company - 2000 Supreme court decision disallowing negligence claims for construction defects unless damage has actually occurred (a defect without resultant damage is not sufficient for a liability claim) Does not define property damage Claims for defects must be brought under home warranties instead Unfortunately, only removes one theory of liability and plaintiffs have been successful using other avenues against insurance policies

11. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 11 Important Legal Cases (Cont.) n Presley Homes v. American States Insurance Co. - 2001 Presley tendered its defense to subcontractor’s insurer via additional insured endorsement Insurer offered to pay share of Presley’s costs, assuming it had duty to defend only on those suits where subcontractor was named insured Court ruled  duty to defend applies where there is mere potential for coverage  duty to defend applies to entire action Effects  Shifts ALAE costs from contractor to subcontractor  More defendants (claims), lower severity (ALAE only)

12. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 12 “Notice and Opportunity to Repair” Legislation n Generally provide builder with written notice and description of alleged defects - 90 days before filing lawsuit n California - Calderon Act - 1997 Homeowners association must provide notice of a claim to the developer and to the members of its association before filing a lawsuit Specifically, must give written notice to the builder against whom the claim will be made, including a list of defects Does not apply to single family homes Encourages parties to talk Final result is that filing of lawsuits gets delayed, increasing lag time Ineffective

13. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 13 “Notice and Opportunity to Repair” Legislation (Cont.) n California - Steinberg Mandatory Negotiation Bill Effective July 1, 2002 Builders, subcontractors, insurers and suing homeowners will be required to negotiate a solution to specific alleged defects in a timely manner before a lawsuit can be filed A construction defect expert will act as a referee Bill is supported by both builders and attorneys If cases go to trial, courts required to give these cases priority Intended to be an improvement over Calderon

14. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 14 Other Recent Legislative Changes n Nevada Chapter 40 Allows plaintiff to recover legal costs from defendant if plaintiff wins case n California Senate Bill 800 Established building standards to govern claims against builders Established a 10 year statute of limitations Mandatory pre-lawsuit process Statutory affirmative defenses Effective January 2003

15. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 15 Reducing Exposures n Many carriers exited the market starting as early as 1992 n Some carriers reduced exposure to “target classes” like residential contractors but continued to write commercial contractors and subcontractors n Many carriers placed “known and continuing” endorsements or Montrose endorsements on policies beginning as early as 1996 Standard ISO Form denies coverage for claims that were known prior to the policy period Some carriers are even more restrictive, excluding claims first occurring prior to the policy period n New multi-family units in California drop from 18,681 in 1994 to 2,945 in 1999 n Today many contractors looking at self-insurance and captive options

16. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 16 Common Exclusionary Endorsements n Known loss provisions excludes coverage where insured was aware (ISO/2001) some exclusions apply to “known and continuing” “deemer” provision - property losses “deemed” to have occurred at a specific time; only one policy can be triggered n EIFS exclusion - appears on EIFS installation contractors and contractors tied to moisture (e.g., roofers, HVAC, plumbers, window installers) n Mold exclusions - applies to broad spectrum of contractors (e.g., roofers, HVAC, plumbers, window/sheetrock /siding installers, foundation workers, landscapers) n Earth movement exclusions - applies to contractors working on foundations or grading; applies to earthquake prone areas

17. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 17 Common Exclusionary Endorsements (Cont.) n Residential construction exclusions - carve out protection on mainly commercial contractors/subcontractors n “Damage to Your Work” exclusion - prevents policy from acting as warranty on insured’s work n Subcontractor exclusion endorsements - can add back in damage caused by subcontractor’s work n Additional insured endorsements - adds contractor as an additional insured; questions as to whether applies to completed operations or losses caused by insured’s own negligence (pre 1993 - all; post 1993 - “ongoing”) n “Other insurance” - if other insurance exists this policy is excess; recent court decision that should be treated as primary n Endorsements generally do not eliminate coverage but rather shift responsibility

18. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 18 Paul B. Swank, Claims Consultant, Tillinghast n Claim Considerations

19. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 19 Why Are CD Claims So Complicated? n Reporting lag n Multiple claimants n Multiple defendants n Multiple insurance companies n Litigious environment n Additional insured endorsements

20. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 20 Construction Defect – Coverage Trigger n EXPOSURE: Each insurance policy on the risk during the period a plaintiff is actually exposed to an insured’s product is triggered. n MANIFESTATION: Each insurance policy on the risk on the date that property damage or bodily injury is discovered is triggered. n INJURY-IN-FACT: Each insurance policy on the risk on the date compensable injury or damage is established through actual proof that the BI/PD was sustained is triggered on a case-by- case basis. n CONTINUOUS TRIGGER: All insurance policies on the risk beginning at the time of first exposure through the date of manifestation are triggered.

21. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 21 Claim Coding - What is the accident date? n Due to Montrose, the claim can trigger any policy between the date of project completion or the date of third-party damage and the date of remediation n Insurers may not code claims consistently Record entire claim in policy period where project was completed or first effective policy thereafter. As policy limits are extinguished open up new claim on next policy Record a claim in every policy effective between completion and remediation Record expense on only one policy or multiple

22. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 22 Indemnity Provisions In Construction Contracts n Indemnity clauses n Classification of construction contract indemnity provisions Type I. Type II. Type III. n Design considerations as defense to indemnification obligations

23. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 23 Indicators of Construction Defect n Water stains n Cracks in walls, concrete/asphalt (e.g. foundation, garage floors) Hardscape - exterior property walls, swimming pool walls/decks n Standing water on porches n Buckled siding n Cracked stucco n Rotting and/or moldy wood, wall board, carpeting

24. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 24 Commonly Alleged Defects - Mold n Water damage, mold and construction defects are intricately related n If the mold is caused by excess moisture which was in turn caused by construction defects, the cost to clean up the mold and the cost of repairs to prevent future mold may be covered n Insurance Information Institute estimates 10,000 mold related lawsuits pending in U.S. - 20% involve construction defect allegations n 52 mold related bills introduced in 20 states during 2003 legislative session n Mold allegations being thrown in as “negotiating tool” n Issues in CA, FL, LA, MI, NV, NY, NC, ND, TX, WA

25. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 25 Commonly Alleged Defects - EIFS n Exterior insulating finishing systems (EIFS) n Synthetic stucco n Water gets trapped behind the stucco and rots the frame, plywood, and particle board n If installed correctly, could be a manageable risk n In the past, primarily a residential problem; may become a commercial problem in the future: in 1997, EIFS used only on 1.5% of residential, but on 22% of commercial construction; residential failures have not curtailed commercial applications n Some homebuilders’ insurance companies have taken action to exclude EIFS construction from commercial general liability policies; insurers of commercial builders have not taken the same action n Warm climates such as southern CA, FL, TX and NV

26. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 26 Plaintiffs Advance Multiple Legal Theories n Strict liability n Negligence n Breach of contract n Breach of express warranty n Breach of implied warranty n Fraud n Negligent misrepresentation n Breach of fiduciary obligation n Negligent and intentional infliction of emotional distress

27. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 27 Defenses To Construction Defect Claims n Statute of limitations Patent Defects  Apparent with reasonable inspection  Statute of limitations requires claim to be submitted within 2 to 3 years of project completion Latent Defects  Defect is not apparent by reasonable inspection  More time is allowed to submit a claim, in some cases 10 years after completion (CA). For comparison purposes, AZ is 8 years, and WA is 6 years (confirmed by WA supreme court in September 2001)

28. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 28 Defenses To Construction Defect Claims (Cont.) n Tolling the statute of limitations n Standing issues — who is the proper plaintiff? n Comparative negligence/cross-complaints for indemnification n Cost of repair vs. diminution in value n Special contract defenses n Prior homeowners’ failure to disclose known defects at the time of transfer

29. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 29 Commercial General Liability Policy – Are Construction Defect Claims Covered? n Insuring agreement n "Property damage" as defined in the policy" n “Property damage" resulting "during the policy period;" and n An "accident" resulting in property damage "neither expected nor intended" by the insured. n Injuries/damages caused by continuing processes extending over multiple years (policy periods)

30. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 30 Commercial General Liability Policy – Additonal Insureds n Named additional insured n Endorsed as an additional insured; 2009 2010 n Other insurance

31. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 31 Construction Defect – Effect of Exclusions n Completed operations n Insured's products n Faulty workmanship n Contractual liability n Sistership exclusion n Owned or leased property n The work product exclusion n Premises alienated

32. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 32 Controlling Expenses n Case Management Orders (CMO) n Special Masters n Mediation n Experts n Construction Analyst

33. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 33 Allocation of Defense and Indemnity n Defense Allocation n Indemnity Allocation n Primary/Excess Issues

34. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 34 Michael D. Green, ACAS, MAAA, Deloitte n Reserving Considerations and Methodologies

35. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 35 Issues to Address Exposures/Underwriting n Policy year n California and Other States n Residential v. Commercial n Developer/Contractor v. Subs/Artisans n Changes in mix by SIC codes, class, etc. n Primary and/or excess n Endorsements/coverage restrictions n Premium and exposures n Other mitigation efforts When setting reserves, it is critical to obtain background information on the following topics:

36. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 36 Issues to Address (Cont.) Coding/Availability of Data n By report year and accident year n Definition of CD claim n Coding of accident year n Limits n Reinsurance n Sub-classes additional insured endorsements EIFS mold

37. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 37 Issues to Address (Cont.) Claim Adjusting/LAE n Changes in claims handling philosophy n Reserve setting practices e.g., independent or formula reserves n Treatment of ALAE as regards reinsurance (in or out of limit) n Changes in reserving methodology

38. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 38 CD Reserving Methodologies n Several methods are typically used to provide an overall picture of the company’s reserve exposure and to test sensitivity n Reserving methods include Accident year analysis Report year analysis, including varying runoff claim estimates using multiple claim reporting scenarios Exposure analysis Calendar year analysis Varied loss development approaches using both CD specific and non-CD loss development factors

39. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 39 “Recommended” Approach n Analyze accident year and report year data cumulative, incremental, loss development factor basis loss development - paid and reported, loss & ALAE separately claim count development - reported, CWP, CWNP paid/reported ratios severities - paid, paid-on-closed, reported count ratios - closed/reported, CWP/closed, CWNP/closed large loss data net/gross ratios

40. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 40 “Recommended” Approach (Cont.) n Combination of Report Year Loss Development and Frequency/Severity Method for “Pure” IBNR Once claim is reported, it is settled relatively quickly Less uncertainty for the reported loss emergence Ability to isolate changes in claims handling Allows scenario testing of pure IBNR n For reasonability check, compare results against other methods used

41. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 41 “Recommended” Approach (Cont.) n Report Year Loss Estimation Generally, loss development approaches work well for estimating supplemental reserves on known claims Take care to adjust for changes in claims handling practices Monitor results using diagnostic testing  Develop claim counts  Examine closure rates  Review reported, paid, outstanding, and ultimate severities

42. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 42 “Recommended” Approach (Cont.) n Frequency/Severity Method for “Pure” IBNR Estimate future claim counts using three methods  Exposure base emergence  Curve fitting reported to date  Accident year development and Bornhuetter-Ferguson methods

43. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 43 “Recommended” Approach (Cont.) n Frequency/Severity Method for “Pure” IBNR Exposure base emergence  Assume exposures for a specific year are evenly spread out over the statute of limitations  Reorganize the exposures on an report year basis  Calculate the report year frequency  Apply the selected frequency against the future report year exposures to estimate future claim emergence  See example on next page

44. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 44 “Recommended” Approach (Cont.)

45. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 45 “Recommended” Approach (Cont.) n Frequency/Severity Method for “Pure” IBNR Curve fitting reported to date  Lognormal curve fitting the report year claim emergence  Curve is adjusted using two parameters  Average year of claim emergence for the peak  Coefficient of variation for the shape of the curve  Target ultimate counts to minimize the sum of squares  Check R-square for reasonableness  Cut off claim activity at the statute of limitations  See example on next page

46. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 46 “Recommended” Approach (Cont.)

47. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 47 “Recommended” Approach (Cont.) n Frequency/Severity Method for “Pure” IBNR Claim Count Accident year development and Bornhuetter- Ferguson methods  Accident year loss development method  Accident year loss development method w/ tempered LDFs  Bornhuetter-Ferguson method using premium, risk factor, and claim frequency as initial expected claim count  Reasonability check on calendar runoff  Estimate CWP ratios  Disposal rate method  Select after reviewing accident year and report year data

48. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 48 “Recommended” Approach (Cont.) n Frequency/Severity Method for “Pure” IBNR (Cont.) Estimate loss severities  using paid on closed claims  using reported losses and estimated CWP  make adjustments for large losses  select trend factor

49. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 49 “Recommended” Approach (Cont.) n Frequency/Severity Method for “Pure” IBNR (Cont.) Estimate ALAE component  Similar approach to loss  Use ALAE to loss ratio  Segment additional insured expenses and analyze separately

50. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 50 All n Recent Trends and Survey Results

51. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 51 Trends n Claim counts Depends upon when reduced exposure Reported peaked in 2000 to 2001, started decreasing in 2002  mostly from mid 1990s accident years Some companies saw spike in 2003 - (could be mold or additional insured claims) n Severity Appears to be decreasing Larger claims settled or in litigation Impacted by more defendants Depends on contractor or subcontractor - additional insured endorsement

52. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 52 Trends (Cont.) n New States AZ, CO, FL, NV, NM, NC, OR, SC, TX, WA and WY n Developer v. subcontractor developer used to pay 50% - 60%; now pays 20% - 30% 1 developers may be running out of limits n ALAE/Loss ALAE currently ranges from 80% to 110% of loss Ratio rising - impacted by lower loss payments and possibly increasing additional insured (AI) exposure 1 Thomas E. Miller, California Attorney

53. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 53 Trends (Cont.) n CWP/Reported ratios Decreasing Quick coverage denials/”shot gun” approach n Reinsurance Lower severities leading to less recoveries n Consideration of insolvent insurers Remaining companies to share loss California Insurance Guarantee Association - denies coverage if other insurance is available n General contractors running out of limits

54. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 54 Recent Large Cases 1 n NV homeowner awarded $14 million – mold-related illnesses due to faulty construction n $7.8 million awarded to class of 200 NV homeowners – cracking concrete foundations n $55 million settlement to WA consumers – defective sealant resulting in mold damage n $4.7 million settlement for WA Condo owners – defective siding, decks, roofs, plumbing, paving and drainage n $75 million CA class action settlement – defective roofing shakes 1 Mealey’s Litigation Report: Construction Defects

55. S:\21643\03TILL\Presentations\ConstructionDefects (final).ppt 55 Recent Survey of CD Claim Practices n Preferred approach is to use centralized claim handling with specialized adjusters n All carriers use some form of exclusionary language, and most use a variety of exclusions n Most carriers use a manual process to track multiple claims per policy n Nearly all CD claims are related to latent damages n Shift towards additional insured claims n Trade categories are not generally isolated in claim process n CD claim counts are flat or rising n Mold related CD claims are an emerging issue n Heavy use of outside CD specialist law firms n Top claim volume: CA, NV, WA, AZ, OR, CO