Abstract:
Faced with the current hard insurance market and no real confidence that it will soften soon, many builders are following the Franklin Roosevelt policy - try something, anything.
Byline:
Bill Lurz, Senior Editor, and Jeffrey D. Masters, ESQ.
Third Eye Keeps Las Vegas Litigators at Bay
A small company in Las Vegas, Third Eye, has come up with a great innovation for builders, especially those in attached housing. It seems to ward off plaintiffs' attorneys searching for easy targets for construction defect litigation.
The firm digitally photographs 10 key stages of the construction process and scans documents such as contracts, blueprints, structural details, lumber-grade receipts and inspection cards. All this is converted into a CD-ROM, using a proprietary software package, making it easily accessible to the builder's attorneys if a defect claim arises.
Las Vegas builder Gary Frey came up with the idea and founded Third Eye. "When a builder is involved in a lawsuit, the litigation trickles down to everyone," he says. "The builder has to defend the product, and the trades their work."
Director of operations Mike Kostelecky says, "We're now documenting about 900 houses a year in five different developments. It costs the builder about $350 to document construction of a 2,000-square-foot house.
"We keep very careful records. Every photo is time-sequenced and the exact date and place logged into our computer software the second the photo is taken. There's a 10-digit code visible on every picture. The fact that we are independent, third-party inspectors is important. We give the builders a ready-made line of defense.
"Thomas E. Miller, the California construction defect lawyer, has set up an office here in Las Vegas. He throws lavish lunches for the homeowner associations," Kostelecky says. "I've been to his seminars and talked to him. He told me that 50% to 70% of the time he would not take a case where the defense has the kind of thorough documentation we provide. When a builder has this kind of documentation, a dispute is more likely to end up in alternative dispute resolution. Even if it goes to court, it will be resolved quickly because there’s no debate about what was done or when. That's not the kind of case Miller wants."
Third Eye is looking to expand operations into Arizona and perhaps even the East Coast. "We're just starting to go after the insurance underwriters," Kostelecky says. "We want to get a premium break for our builders. It hasn't happened yet, but we're hopeful."
Dated photographs of key construction stages, taken by independent, third-party inspectors, document what was done and when for Third Eye's Las Vegas builder clients.
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Faced with the current hard insurance market and no real confidence that it will soften soon, many builders are following the Franklin Roosevelt policy - try something, anything. The biggest builders are the most active innovators but certainly not the only ones changing the status quo.
Builders of all sizes are moving aggressively into risk-management programs designed to minimize their liability and shift more of it to the trades. Many insurance professionals believe that if and when the liability insurance market softens and more insurers enter the market, they'll do so with robust underwriting programs designed to separate builders into "tiers" of risk. The best risk-management programs will garner the best rates and fewer exclusions.
Horsham, Pa., builder Stuart Price (Granor Price Homes) had plenty of reason to get involved in the NAHB task force he chaired to investigate the general liability insurance crisis. Price builds primarily townhouses and at one time faced a tenfold increase in his liability insurance premium.
"NAHB is instituting a course in risk management that will teach builders the basics of how to avoid losses by implementing quality control and safety programs, good design, good customer service," Price says. "And we'll show them how to transfer risk wherever possible. You have to make trade contractors responsible for the work they do and the materials they provide.
"We provide our buyers with an insured warranty, and we require our trades to comply with that set of standards. In states where binding arbitration clauses are allowed in contracts, you need to do that in all contracts, those with trades as well as those with buyers. The crux of our course is the same approach I take in my business: You have to do everything you can to make your company look good to insurers and their underwriters."
"We had no losses," Price says, "and yet the carriers didn’t want us because we build attached product. When we went shopping for a policy, we found carriers were afraid of townhouses whether they were condo or fee-simple."
Price ended up with an umbrella coverage written by a regional carrier at three times his previous rate, a big improvement over 10 times.
"You need more than a clean claims record," Price says. "You have to be able to document every element of your risk-management program " warranty history, quality control, your safety history, even the biographies of company owners and key employees."
Captives and Wraps
Among large builders, the innovations generating the biggest buzz are "captive" insurance companies and "wrap" policies, on a project-by-project basis or involving the full company.
Erick Johnson, a Phoenix insurance broker and former risk manager for Del Webb Corp., once ran that public Giant's captive company. He's an expert at setting up captives but not a big fan of putting local and regional builders into such insurance vehicles. "I'm trying to keep builders from chasing captives for the wrong reasons and wasting a lot of money in the process," he says.
| I'm trying to keep builders from chasing captives for the wrong reasons and wasting a lot of money in the process. - Erick Johnson |
A captive insurance company is just an expensive way to self-insure, Johnson says, not so different from a standard policy with a self-insured retention of $250,000 or $500,000 per occurrence. "Deductible is another way to say the same thing," he says. "Operationally, it's all the same."
"In a captive, you just set up your own company to insure only your corporation. In the old days, most of them were domiciled offshore. Ours was in Bermuda."
The captive takes the first $250,000 of risk, Johnson says. "Then you find a domestic carrier to 'front' a $1 million general liability policy - first-dollar coverage. That carrier then reinsures the first $250,000 with the captive and cuts a separate $750,000 policy with another reinsurer. The captive's dollars are the parent's dollars. If there's a claim, the front pays the whole thing but turns around and bills the captive for $250,000. It's the same as a deductible."
Originally, captives were tax dodges. When the parent paid premiums to the front, some of the money went back to the parent through the captive. But the parent took a tax deduction for the full amount of the premium.
The Internal Revenue Service figured that one out some years ago, Johnson says. So why are captives so popular today? "In a hard market, they work for someone who's getting a raw deal from the underwriters " not getting credit for low losses and good risk management," Johnson says. "The trouble is, setting up a captive is not cheap. There are a lot of costs, and most builders cannot realize enough benefit to justify the costs. Any builder thinking about doing a captive should do a feasibility study first and carefully count the nickels. I killed the one we had at Del Webb."
| Builders must establish systems to track compliance with contractual insurance requirements.-Jeff Masters |
Nonetheless, most of the top names in PB's Giants rankings operate captives. Maybe it's a status symbol.
In California, wraps are almost standard operating procedure because it's so hard for trades to get liability insurance. A wrap policy bundles the builder and trades together as if one company did the whole production process. Former PB Builder of the Year Mark Buckland of The Olson Co. is a big fan.
"After 9/11 we looked for liability insurance for months, and nobody was in the market," Buckland says. "Then we found that Zurich was still around, but they had this new full-company wrap program that required a lot of diligence by the builder."
"They send out teams of people to go over your quality control and inspection processes. You have to do third-party inspections at various stages. They want a lot of customer service, and you have to stay with your homeowner associations for 10 years. They also look at your history, and in the last 12 years we've had just one claim for $50,000."
Sivage Finds New Ways to Manage Risk
When Albuquerque, N.M.-based builder Michael Sivage lost his insurance carrier of 15 years, he didn't just look for another one. He remade his company to make it more attractive to underwriters.
Sivage Thomas Homes builds in Albuquerque and Phoenix and is just opening operations in Tucson, Ariz. The firm closed 1,200 homes for $165 million in 2002 and plans to sell 1,500 homes for $200 million this year. "That makes us kind of an in-between size," Sivage says. "We're not small, but we're not big enough to go to the self-insurance options the really big builders use. St. Paul was our carrier for 15 years. They'd been getting out of the home building sector for a while, but they kept us because of our low claims history. They finally dropped us because of our operations in Phoenix. That market is so litigious, they just didn't want to deal with it."
When Sivage started looking for alternatives, he landed a seat on the NAHB liability insurance task force and learned just how important risk management can be to finding affordable coverage.
"Eventually we went with HBW [Home Buyers Warranty], where we've had our 2-10 home warranty coverage for many years. It helped that their underwriters knew us. But we had to agree to mold and subsidence [active soils] exclusions. And we had to comply with how they want us to write sales contracts and contracts with the trades. We now have binding arbitration clauses in both."
"We're changing the way we run the company, and we're staying away from attached housing," Sivage says.
Sivage plans to do a lot more quality control, especially on soils engineering and foundations, and also employ third-party engineers to do extra inspections. "We'll also have third-party engineers look at all our plans to make sure we're building them the best way. And we're now doing mechanical ventilation in all of our houses.
"A number of years ago we started excavating to 10 feet below our foundations, then treating the soil and re-compacting it before we start foundation work," Sivage says. "We think there's more benefit in treating the soils than in designing a foundation to deal with the movement that active soils produce."
Sivage also has developed a mold protocol, a step-by-step procedure for how to respond to any mold claim or water-penetration issue that could lead to a mold claim.
"Beyond that, we may offer an extended workmanship warranty that would allow us to stay in touch with buyers longer. A lot of these problems are due to poor home maintenance. People never learn how to maintain a home, or they're just so busy they let things go. When that happens, it hurts them - and we feel the pain. We might want to provide them with an added service that would protect us at the same time."
Dated photographs of key construction stages, taken by independent, third-party inspectors, document what was done and when for Third Eye's Las Vegas builder clients.
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Olson was able to get a Zurich full-company wrap, which includes all the trades. "That's a good thing," Buckland says, "because the trades can't get insurance anywhere, especially for attached, and we do a lot of attached.
"With the full-company wrap, we get better pricing from our trades because we're able to offer them work they can't get elsewhere. We ask each trade for a small deductible to keep them focused on quality. For all practical purposes, we are building the whole project ourselves."
But even Olson's costs are going way up on its next renewal - from $2 million to $4 million, which adds about $3,500 to the price of the company's average home. The deductible is $250,000, but there's no mold exclusion. The firm did 680 units for $150 million in 2002.
If there's one message that comes through loud and clear from how the smartest builders are responding to this insurance crisis, it's that the days of fly-by-the-pants business management are probably gone for good.
"Builders must establish systems to track compliance with contractual insurance requirements," says Los Angeles attorney Jeff Masters, a litigation partner in the law firm of Cox, Castle & Nicholson, which specializes in protecting builders against construction defect litigation. "You've got to ensure that your key contractual risk-transfer provisions are never modified or diluted. Effective record retention is important to ensure that insurance information and project documents can be retrieved whenever they are needed."
Project documentation must include sales contracts, warranties and any alternative dispute resolution provisions in place, such as mediation or binding arbitration. Other important records include all claims of defects and guarantees of builder right of access, inspection, testing and repair.
Effective customer service can make or break a builder's risk-management program, Masters says. "Until now, insurers generally required only confirmation that an ongoing post-sale customer service program was in place. But today insurers are placing a much greater emphasis on it. They want to know exactly what you're doing."
Back to LLCs?
In many states builders can operate through limited liability companies (LLCs), which combine a partnership's tax efficiency with a corporation's liability-limiting features. It used to be more common that builders created single-purpose LLCs for each project, with other entities providing the LLC with contracting, accounting and other services via development management agreements. In an increasingly litigious world, it might be time to dust off this approach.
But while LLCs offer advantages, they also have disadvantages. They require the builder to respect the separateness of each entity by observing corporate formalities such as maintaining separate bank accounts and carefully documenting intercompany loans and other transactions. These steps are essential to avoid alter-ego and enterprise liability attacks, in which a claimant attempts to "pierce the corporate veil" and reach assets of owners or affiliated entities.
LLCs also raise questions about when to dissolve the entity, including who will perform customer service and warranty work after dissolution, and whether adequate completed operations liability insurance coverage can be purchased for the dissolved entity.
Specialized Policies
To address the problem of exclusions in standard liability insurance, many builders are buying specialized policies such as "contractor's pollution liability insurance," which covers builders against claims of bodily injury and property damage resulting from releases of "pollutants" associated with builder operations. Such coverage is especially prudent for builders operating on urban infill sites, brownfields and former military bases. But equally important, these policies provide coverage for mold claims that often are excluded from general liability policies.
Kentucky-based Giant The Drees Co., which operates in a number of states (including highly litigious Texas) and closed 2,831 sales for revenue of $850 million in 2002, has taken this step. "We used to have a $1,000 deductible on our general liability policy," chairman Ralph Drees says. "Now it's $5 million. We're really insured only for catastrophic events. But we got the contractor's pollution coverage to protect against mold claims, especially in Texas."
"Texas has a lot of expansive soils," Drees operations administrator Dianne Walter says. "That movement sometimes causes plumbing or water-intrusion problems that can lead to mold. That's one reason there are so many mold cases in Texas. We've addressed the issue with a very aggressive mold protocol in our standard operations. Our excess insurance carriers say it's the best they've seen in the industry."
