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Jeff Masters and Stan Luhr
Cox, Castle & Nicholson and Quality Built
December 22, 2004
HousingZone
Bill Lurz, senior editor for Professional Builder magazine, talks with Jeff Masters and Stan Luhr about the general liability insurance crisis, California's S.B. 800 law and risk-management strategies. Masters is a partner in the litigation department of Los Angeles-based law firm Cox, Castle & Nicholson. Luhr, president of Quality Built, is a forensic building consultant.
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Lurz: Is that specifically excluded from the law?
Masters: Yeah. There's a provision.
Lurz: Why?
So I think it was part of that, and I think it was also on the builders' side. They don't want to have evidence collected that may actually show that the builder didn't completely follow through with a QA program. They don't want to have a QA program and have evidence that would be easily subpoenaed by a plaintiff firm. I think it's a builder's opportunity to say, "Well, I can have some bad data in a file, and the plaintiff won't ever get their hands on it."
Masters: Stan and I have both had situations where we'll go in and talk to a builder who has what they call a QC program, but it turns out that it's simply a checklist for identifying deficiencies or anomalies, and they have no way of proving that it was corrected. They just have a checkmark, and it's kind of risky. You may be worse off with that than no program at all because you've got to be able to prove that the condition was corrected. ( 
Listen. )
Luhr: The statute specifically says the inspection by the qualified person cannot be introduced as evidence, nor can any reports or other items generated by the qualified person. So [it might be introduced as evidence] if [quality assurance consultants] don't generate the information but provided it as a form, or even partially as a bit of data, and that information is then continued to be processed by the superintendent or by the trade contractors, particularly sign-offs.
We have a system that very carefully monitors the process of the builders' QA operation, so when we see something wrong we have to alert the builder and the superintendent. Well, it's up to the superintendent to make sure there's closure, but it doesn't usurp the responsibility of the person who installed it wrong to put it back in. So we ask for that corrective signature, that approval, that it was corrected by the trade contractor responsible for creating the defect in the first place.
And that's what builders really like about the overall QA program. The evidence collected is really important for you to track. [It's] how you get closure, and ultimately if it can't be used at time of trial, if the defect doesn't exist, then it doesn't matter that you can't use it. If it does exist, you want that signature, and if that signature is generated by a third party other than the QA consultant, we think we'll be able to convince a judge to bring that in and give it the weight that it deserves at time of trial. But it will be complicated. It will be years before we really test it, right, Jeff?
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| Jeff Masters |
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Luhr: One of the important things about the bill is this is not in any way allowing a builder to build a poorly designed and poorly constructed and high-maintenance home. To the contrary, it really has excellent consumer protection provisions, which essentially mandate builders to improve the quality, improve the durability and the safety of their homes or suffer the consequences, not only through the S.B. 800 process, but also through subsequent litigation that has broadened the exposure of the builder.
Lurz: The insurability of builders in the future may depend on [quality assurance programs], right?
Masters: That's right, and that would be true anywhere in the country. To Stan and me, that's sort of a driver for the whole thing, is the insurance company finally doing some real underwriting of the builder. Part of the underwriting process is going to be, "Tell me about your quality assurance program and actually show me what you've done." Because talking about it doesn't get the job done, as a lot of our clients have found out. How do you document the correct condition after you've closed up the walls, for example? What's your average customer service aging? Is it 30 days? Is it 45 days? So it's not enough to just say we've got an aggressive customer service program. I think you're probably going to have to quantify, "We resolve 95% of customer service requests within X days," and create a bunch of bullets for the underwriter to look at.
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| Stan Luhr |
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There's a program that we run called a builder risk assessment, and essentially that builder risk assessment is a process of auditing the quality in the potential risk of a builder's operation. We've been doing that since 1994, and it's been a tool that's been really effective for many of the bigger builders who acquire a lot of small builders. They want to know what level of quality the acquisition might be against their internal or captive insurance.
Lurz: What would a smaller builder do to try to achieve the same ends [as the big builders]?
Masters: It's very difficult because there really is this stratification of the market, if you will. The big builders have got more options in terms of captives and special arrangements with insurers and so forth, but even they're having a lot of difficulty. Zurich, for its special home builder program, still has a minimum revenue threshold of $100 million, so they're looking at a fairly large builder for their client base. [Read an interview with Mike Hopson of Zurich.] So the truly small builder that you're talking about has probably been buying insurance from the same company for years though an agent, and now with the hard market, what they're finding is that company may not want to write the insurance anymore, or they'll have a lot of exclusions attached. Even the very small builder who does 50 units or less is being affected by this problem. He's seeing much higher premiums and fewer quotes. ( Listen. )
Lurz: What basically is the current state of the insurance market, especially reinsurance? I guess there was some fear that the 9/11 fallout would have a bigger impact than it's turning out to have. Is that true?
Masters: The market is basically the same as it was six months ago, or potentially even a little bit worse, according to the brokers that we talked to. It's all due to the reinsurance, and so far the reinsurers just have no appetite at all for covering home builders, or they certainly don't want to do any more than they're currently doing, let's put it that way. In a number of the western states — California, Arizona, Nevada — there are only two or three insurance companies that are even looking at home builders. So it's as bad or worse as it was six months ago.
Around the rest of the country it's beginning to erode. We think this will probably continue into 2003, and the brokers we talked to are telling us there's no real sense that this is going to turn anytime soon. It's surprising because last year at this time we thought that by the end of 2002 there would be some new facilities or new players because there's so much premium volume to be had from home builders, and that hasn't happened.
Lurz: How much of an impact does 9/11 and the fear of terrorism have on all this? Is it all related to mold, or is some of this other stuff a factor?
Masters: It is partially a factor because the reinsurers have been hit pretty hard from 9/11. But the big driver that I keep hearing from the people that I talk to, both brokers and insurers, is concern about the construction defect exposure, and that's true nationally.
Luhr: I would concur with that. I think the insurers we work with and have to deal with on a day-to-day basis, not only on the litigation side but on the quality assurance side, they are very fearful that there is a proliferation of the type of construction defect litigation that's been happening in California is really rapidly expanding across the country, and mold becomes the driver of that.
Lurz: And what happened in Texas would be a real fear producer, I imagine. Texas has never been in the same boat with California and even Florida in terms of defect litigation, I don't think. [In June 2001, a Texas jury awarded $32 million to a Dripping Springs, Texas, family after deciding that Farmers Insurance Group committed fraud and bad faith in handling the family's mold claim. An appeals court reduced the award to $4 million in December 2002.]
Masters: That decision in Texas — the decision itself really wasn't that much of a driver. It was a bad-faith award against a homeowner's insurer for not stepping up and paying for mold damage. But what it did in my view is it put mold much more on the radar nationally for plaintiff lawyers, and they can see the dollar signs.
Lurz: Mold is gold. That's what I've heard.
Masters: And it is so pervasive. Anyplace you've got water intrusion and the conditions where mold can grow, you've got the potential for a claim, and that's true basically nationwide. That's what makes the mold issue and indoor air quality both pretty scary for the reinsurers who understand this. Now, there's an easy solution for the insurers. Just exclude mold from coverage, and they all have. Once that's done, haven't you solved the problem? And the answer is no. The reinsurers are still concerned about insuring home builders because of the other types of claims that can be asserted. They're not distinguishing based on geography very much, not as much as you think. You'd think they'd have one standard for looking at California and other high-risk states and another standard for the rest of the country. But it's actually more of builders as a class as opposed to geographic locations.
Luhr: It makes it a little bit easier for a plaintiff. They don't have to necessarily prove why something failed. They simply point to the code violation or the missed hardware strap or corroding underground piping and simply project that as a defect that extends throughout an entire project. Up until recently it was difficult to defend those issues because you basically had to try to prove where the quality existed. The extrapolations allowed to be in the court system were so out of hand that it became difficult to defend those kinds of issues without spending millions of dollars in destructive testing and forensic inspections.
Now with S.B. 800, although that will help us look toward more of a unit-by-unit approach toward the inspection, we're still fearful that we'll have product-type liability cases that will be handled outside the S.B. 800 protocol. So the insurance industry is still very much fearful and worried that the sophistication of construction defects will proliferate across the country. Because mold has gotten so much incredible exposure, and because mold is unlike asbestos, where that's a single product, mold is created essentially with any type of water, or condensation, or ice damming, or water-vapor transmission events. So it transcends across all the geographic weather regions, against all codes and types of construction. It becomes a common ingredient to be able to litigate more projects around the country depending on the favorability of the legislation and the types of repair measures that each state might encompass.
So we end up with an additional fear, and there's no one simple way to exclude mold without saying, "We'll exclude the incidents of fungus growth." But what about all the consequential water damage? What about the defects that caused the consequential water damage and the damage to other components within the building? That's what builders buy insurance for. If you're going to try to exclude all that, you as an insurer I think are still going to be sucked into these litigation cases and have to draw a very fine line as to what really a mold exclusion includes and what it doesn't include. Builders will start to realize that there's not much protection and so will want to focus more on prevention, eliminating all of those circumstances rather than worrying about the actual coverage. And that's really the issue — a whole shift from risk management to just simply include insurance devices to risk management, which really includes very detailed programs to permanently eliminate those conditions from ever occurring on a home that they build. ( Listen. )
Lurz: How much of this is related to problems within the insurance industry rather than in the housing industry?
Masters: In part, the crisis is driven by — I'm not sure how deep we want to get into this. Let's put it this way — the stock market crash. It is a big factor. That, plus 9/11, has led to some real reluctance on the part of the insurers and an inability on their part to do more than they're doing because their capacity is driven by how much reinsurance they can get. If there's poor financial performance, they're not able to write insurance. So there are definitely some causes outside of construction defects.
Lurz: Is there really any reason to hope that we're at the end of that long, soft market for insurance?
Luhr: I don't think so. Not from where we see it. The reinsurers who provide the backbone of coverage to their retailers are simply very, very skeptical of getting into a market whereby the risks are so great. The industry doesn't have the resources or the computerization to quantify a good builder from a bad builder. So it's easier for them to withdraw from that type of market. We see the reinsurers demanding higher levels of quality assurance, good risk strategies, incorporating a lot of the legal risk-management philosophies that you see with Jeff's firm and other firms that really focus on true litigation strategies. They're starting to ask all those questions, and that's a good sign, because as Jeff said, they're very interested in this huge premium base, but they're not going to contribute to capacity until they're assured that they're going to have some return on their investment.
Masters: A question we're asking a lot is how long are we going to be in this hard market, and there's no clear answer, and nobody really has a firm prediction. We keep hearing anywhere from one to three years from brokers.
Lurz: How do you define first-generation risk management, and what's the second generation, and is there a third generation?
Masters: Stan and I go back a long way, and I think we would characterize first-generation risk management as a situation where the builder is aware that they have these exposures and they start taking some preliminary or initial steps. For example, they start some kind of a quality assurance program using an outside consultant working with their superintendents. They also start paying a little more attention to the contents of their documents, like the risk-transfer provisions in their subcontracts.
Lurz: And second generation?
Masters: Second generation takes that to a whole new level, which would be, for example, on the quality assurance side, the third-party quality assurance consultant like Stan's company would come in and would develop a very comprehensive program for inspections and documentation and also an advanced way of keeping the records. So instead of having a hard copy with a sign-off by the superintendent and subcontractor, you've all got this on a CD-ROM. So if someone raises a question about a particular house in a particular community, you can go to the CD and find the entries for that home, as well as any photos that might be attached to it. It's a much more advanced, sophisticated approach to quality assurance.
Lurz: And taking photos of each stage of construction would be one of the things you'd recommend doing?
Masters: That's a very builder-specific program, and Stan has a protocol for taking photographic evidence at different stages of construction. Stan, what percentage of builders do you think do that versus ones who just do it on paper?
Luhr: It depends by state, because in states where that extrapolation theory could move a builder into a high-liability, huge lawsuit, it's much, much higher. I would say, on average, probably 75% of our clients opt to have some photographic evidence taken during construction. Only a minority, and I would think the minority is the really small builder, Deep South, Eastern Seaboard type of builder, where they just haven't seen the risks and just don't understand the whole litigation strategy of suing for a defect in one house and trying to extrapolate it out over a hundred houses, as is commonly done on the West Coast.
Lurz: What's the time line on this problem? Did it start with 9/11, or did it start before that? Is it related to the judgment in Texas?
Luhr: It started years and years ago. If you go back to the C&A boom days of the early 1990s where we had probably 15 or 16 major carriers in the California and West Coast market, and then you started to see a proliferation of construction defect litigation and huge claims, roofing and below-grade subsidence, all these other claims, window leaks and so on, and you started to see carriers move out of the market in California and the Western states, it all started to happen in the early '90s. We just continue to see an ever-tightening situation because it wasn't just a California phenomenon. It started to proliferate into other states as well. ( Listen. )
Lurz: But that case in Texas must have been a major catalyst.
Luhr: What do you think, Jeff? I don't think so. Maybe on first-party claims, but I don't think that was as much of a driving influence as all of the other expansion of construction defects in other states.
Masters: I agree with Stan. It was something that got lots of media attention, and it certainly whipped up the plaintiff's bar and homeowners into making more mold claims. But the problem was pretty well-developed even before that happened. Part of it is just bad luck, frankly. The insurance industry, like every other business, has a business cycle. They go through a long period of a soft market where insurance is relatively plentiful and relatively inexpensive, and the insurance companies are eager to write it because they're making a lot of money investing the premium incomes. Then the market hardens when the losses from those policies start to mature.
Lurz: At the same time the investments go downhill.
Masters: Yes. And you have 9/11, and you've got this horrific loss history where they're paying out more in adjusting and defending claims than they are in actually paying indemnity money. So the natural market cycle coincided with a couple of other factors in a way that's just really created probably the hardest market anybody's seen in 20 years or more.
So it just tends to spread geographically, and it's going to catch up with everybody because everybody has to buy insurance. I guess, where I sit, all of this makes the noninsurance risk-management strategies, the second-generation strategies, if you will, more important for every builder. Actually, we have a lot of builders out there who probably need to start with first-generation strategies. They haven't had to worry about this very much, so the notion of revising your contracts or starting a QA program would be something new for them.
Lurz: Are there often conflicts between the builders' and the subcontractors' policies?
Luhr: In litigation, you have builders that obligate a trade contractor to issue them additionally endorsed certificates of insurance — in essence, requiring a trade contractor to purchase insurance and then grant that over to the builder, such that if he gets sued, he allows that insurance to be part of the insurance pool and he wants the trade to indemnify and defend him as a builder.
What doesn't make sense is that the trade contractor, at least from the big builder's prospective, he doesn't have as much buying capabilities as the larger builder. So you end up with folks like the larger companies across the country paying markup on totally retail insurance coming from a substantially smaller company, all just to build the ability of having a good amount of insurance should there be litigation. Jeff has worked with a lot of builders to create different types of insurance that are pretty unique, these wrap policies and other types of policies which combine all of the insurance under one big pool. There are a lot of advantages of those kinds of insurance programs because for one, you don't end up with the adversarial relationship should a lawsuit develop whereby the builder is forced to sue each and every one of the trade contractors who worked on the project. That obviously doesn't make for good business sense.
But it's what has happened in the industry to gain the capacity needed for everybody's interest. I just don't believe that's really in the best interest of the building industry, to constantly have this hugely adversarial program whereby as soon as you get a lawsuit you turn around and sue all the people who built the house.
Final Thoughts:
Luhr: I predict that in the next three years you're going to see a very defined tier from the retail insurance market whereby a builder basically is able to show through some sort of audit, or through some sort of analysis, is able to show what tier they're at, what level of quality that they perform under. I think that's when you're going to see some divisiveness between the best builders in the program and the worst because the worst builders are going to end up paying hugely inflated insurance rates, and they're going to be ripe for either takeover or acquisition, or they may not be able to afford to compete. I think that's what you're going to see in the next three years.
Masters: I think that's right. I think the consolidation in the building industry that we've seen is going to continue and maybe accelerate as some of these smaller players are unable to get insurance that's decent. We're already seeing situations where the builder tries to partner up with some other company that has good insurance, like a large general contractor. Or they take an investor in because the investor has got good insurance. It's really become a driver, a front-end issue. ( Listen. )
© 2009, Reed Business Information, a division of Reed Elsevier Inc. All Rights Reserved.
