A hole in the wall: soaring construction-defect litigation is shaking the foundation of the commercial general liability market--and residential contractors are getting hammered. (Property/Casualty: Litigation).

As the third generation to run a painting and drywall contracting company, Bruce King hopes to see the fourth generation of the family take over one day. But if general commercial liability rates keep rising, that dream may never be realized.

King, president of Pete King Drywall, the company founded by his grandfather in 1947, said that as little as four years ago, he was able to get five or six quotes for coverage, and could get as many as 20 quotes if he wanted to. Now it's difficult to get any quotes at all. The annual premium of general liability insurance for his company, which has 550 employees in Nevada and 550 employees in Arizona, has grown from $175,000 in 1998 to $700,000 last year. The deductible has risen from $2,500 to $25,000.

John A. Maksimik, an account executive with Las Vegas broker Orgill Singer, said new builders, builders with only one claim or builders of tract homes may find themselves in the surplus market, risk retention market, or unable to afford the first layer of liability premium.

"The residential builder with any claim activity is hard to place," Maksimik said. "I have marketed some contractors six months prior to renewal. I fax a profile and loss run to the different wholesalers just to see who wants the follow-up application later. At least 90 days before renewal, I meet with the builder and lay Out all options. If it looks unfavorable, I advise the builder of one or two other reputable agencies that he might look to, in case they have other markets."

Nevada is just one of many states across the country where contractors are seeing a crunch in the market for general liability. Industry experts said construction-defect litigation is a major factor driving that crunch, and several states are passing laws that would give contractors time to fix a defect before they could be sued.

Trend-Setting California

General liability coverage for construction contractors--developers, general contractors and subcontractors--is hard to find and expensive when it can be found, said George Dale, president of DBH Resources, a risk management company.

"It's a nationwide phenomenon, but California, Nevada, Colorado, Texas, the Carolinas and Florida are at the top of the difficult list," Dale said. "The capacity is what's driving the pricing problem. The number of carriers willing to write general liability insurance are reduced because they've had bad experiences, or others said they'd like to write the business but can't find reinsurance."

CNA, which wrote $460 million in general liability for construction and $1.3 billion for all construction property/casualty lines in 2002, pulled Out of the residential construction market in 1997, said Greg Mallon, vice president, construction, for CNA's Global Specialty lines.

CNA left the market due to construction-defect litigation, Mallon said. "I consider construction defect the gift that keeps on giving. We're still paying losses on it. When all is said and done, losses will approach $1 billion. The losses have outstripped any premium we earned while we were in the business."

The problem is more pronounced among residential builders and has particularly plagued the builders of multifamily homes such as condominium units and apartment complexes. Many point to California as being the root of the problem.

Since 1994, construction-defect litigation--lawsuits filed against developers, contractors and subcontractors when a home has a problem that can be traced back to its original construction--has discouraged developers from building multifamily homes in California, according to the National Association of Home Builders, a trade group that represents 800 state and local builders associations. New multifamily units dropped from 18,681 in 1994 to just 2,945 in 1999-an 85% decline in a state that has already experienced a shortage of affordable housing, the association said.

"It's more of a problem in some states than in others, but it is a national problem. Not surprisingly, it's most prevalent in large states that have large markets of trial attorneys, many who specialize in suing for construction-defect issues," said Clayton Traylor of the National Association of Home Builders.

More Is More Risky

Building multifamily homes is about as profitable for developers as building single family homes, but builders are four times as likely to be sued for building a multifamily unit as for a single family home, said Mark Sektnan, assistant vice president for the western region of the American Insurance Association. Builders can be sued up to 10 years after a project has been completed for a construction-defect issue, and often, no matter what the defect, the lawsuit involves every subcontractor involved from the landscaper to the company that provided temporary fencing, Sektnan said.

"With the exception of medical liability, California is litigation heaven," said Dave Golden, director of commercial lines for the National Association of Independent Insurers. "Multifamily units, whether it's condos or apartments, make it that much easier for a plaintiffs attorney to go in and find a bunch of clients for a class-action lawsuit. They tell the condo association that they are responsible to do something, and that if they don't, the people in the condos can sue you on the board for not fulfilling your responsibility. Then they go in and do destructive testing until they find a defect. It is totally out of whack from what most people would consider the way the civil justice system should work."

Sektnan said one AIA member company took in $17 million in premiums for construction-related general liability, and has had to put up $120 million in reserves for the business. "That's why they are no longer doing it," he said. Another company told the MA it had a combined ratio of 400 for that class of business, so for every $1 of premium it received, it's paid out $4 in claims and expenses for construction liability coverage, Sektnan said.

The problem with the residential construction liability market is mass tort actions, Mallon said. If 15% of condo units in a development have a problem, and a class-action lawsuit is filed on behalf of all condo owners, all units must be repaired or tested even if there's no construction defect in most of the units. "If there's a likelihood of a problem, you have to fix them all, whether there's a problem or not," he said.

Robert Diamond, an attorney with Reed Smith, said lawyers are hiring forensic engineers to examine properties to find defects. The defects can range from a serious, legitimate problem--such as a leaky roof or window--to a minor inconsistency with the building code, such as studs being two inches farther apart than they should be.

"When we are in boom times, and sales are good, getting qualified labor is hard," Diamond said. "So sometimes builders will hire less than qualified labor, and the quality of construction isn't so great."

According to California attorney Thomas E. Miller, four of the most common construction defects are leaky roofs and windows; mold and mold-related claims resulting from water damage; residences not properly attached to foundations; and balconies and decks that prematurely fall. In a handbook for consumers, "Home and Construction Defects," Miller estimated that a third of new residential and commercial construction has some significant structural defects.

"I'm seeing builders--instead of cleaning up their own houses and looking inside and doing quality control measures to avoid these types of mistakes--are lashing out at the consumer attorneys who have taken them to task and have shown again and again that their products are lousy, the workmanship is shoddy, the materials aren't of the quality needed, and the product doesn't perform as it is supposed to," Miller said. "Homeowners should be able to figure out who the good guys are, and who the bad guys are. But there is no Consumer Reports that rates home builders. The average guy on the street doesn't have any place to turn to find out that kind of inside information."

One trend that troubles Miller is that the largest builders in the country have begun to put clauses in their sales contracts that stop the future homeowner from suing for construction defects, and forces the homeowner into arbitration should a problem arise. "There's not enough protection for the homeowners," Miller said.

But, Miller said he didn't represent builders today, and couldn't say if the construction liability market was truly difficult. "But in the past, I've seen the builder cry wolf so many times about not being able to find coverage, and then there's always a carrier willing to step in. The crisis comes and goes," Miller said.

Some say that the construction liability market, like all casualty lines, has hardened as insurers face a downturn in the economy and investment income, in addition to increased reinsurance costs.

"This is the insurance industry trying to foist their poor investment strategies and their losses in the downturning market on builders by arbitrarily raising rates to recoup losses," said Jeffrey A. Manheimer, a New York-based plaintiff's attorney.

But it's not that simple, said King, the drywall contractor.

"There's no question the cost of insurance is related to the economy and Sept. 11," King said. "But if that was the only problem, you'd still have companies writing coverage; they just raise the rates. Why you can't find insurance is related to the fact that we have so many unnecessary lawsuits here in the state of Nevada."

Right to Repair

California may have been the first state where contractors have experienced a hard liability market, and also is one of the first to adopt legislation in an attempt to lower the number of construction-defect lawsuits. Last year, California, Nevada and Arizona adopted "Right to Cure" or "Right to Repair" laws, under which homeowners or condo associations must notify builders of a construction defect and give the builder an opportunity to fix the defect before it can be sued.

"Often, the first time I ever hear of a [construction defect] problem is a lawsuit. That's simply not a way to get needed repairs taken care of," King said. "Hopefully the right-to-repair bill will allow us to make the repairs. People get tied up in these lawsuits, spend four or five years in court, end up collecting the money, and then they call me. What we are saying is call us first, don't spend five years in the court system."

Golden, of the NAII, said one of the problems with suing without advance notice is the contractor can be prevented from fixing the problem. "Say you have a water leak. If the builder can get in right away, you can fix it and keep it from becoming major damage. But when a lawsuit is filed, an attorney can get a court order to stop the repair, on the basis that the contractor is destroying evidence," Golden said.

Washington, Colorado, Idaho, Kansas, Kentucky Montana, and West Virginia also have recently adopted similar legislation. Other states are considering, or have considered, adopting similar policies, including Alaska, Arkansas, Florida, Illinois, Indiana, Mississippi, Missouri, New Mexico, Oklahoma, South Carolina and Texas.

The laws tend to have three provisions, Diamond said. First, homeowners aren't allowed to sue developers for construction defects without advance notice. Secondly, once a developer is given notice, they have a period of time to fix the problem and if they fix it, no lawsuit can be filed. The third provision, which is not included in every law, requires a homeowners' or condo association to hold a vote of its members before a lawsuit can be filed.

CNA's Mallon said giving builders the time and opportunity to correct a problem is key, but said he'd like to see a couple of other additions: a chance for the builder to buy back the home if the homeowner isn't happy and a provision that would force arbitration instead of a lawsuit.

"We need to give the builders some options," Mallon said. "If they could buy back the property, they could fix it and resell it. And forcing a dispute into binding arbitration would eliminate the lawyers from running around to every house saying, '15 homes have this problem; do you want to join the lawsuit; there's no charge."'

It's not clear yet what the effect of the right-to-repair bills will be. With a 10-year statute of limitations in some states, including California, those who own homes built during the last decade can still sue without notice, said Sarah Heidenreich, policy manager for the Alliance of American Insurers.

"It always takes time to tell what the effect of a bill is going to be, but generally a provision that may help reduce litigation is positive, and that's what the intent of these is' eidenreich said.

The bills are a step in the right direction, but the market will be difficult unless laws are changed to reduce class-action lawsuits, Mallon said. "The coverage would be available and reasonably priced if you did away with the mass tort phenomena;' he said.

Insurers Share the Blame?

Diamond said insurers are responsible for part of the construction-defect problem because they often get bogged down in technical details- such as what percentage of the defect should be covered under the policy- and end up spending more to litigate the problem than they would have to spend to simply pay for the repairs. Also, the insurance industry isn't savvy when it comes to dealing with homeowners associations, he said.

"Rather than engage lawyers who are very familiar with community associations or construction-defect litigation, they engage a panel attorney, someone who is approved by the insurer to handle any kind of liability claim," Diamond said. "They are highly competent with typical negligence claims, like slip and falls, but do not have any experience or skill in dealing with the complex issues of construction defect."

Negotiating with homeowners associations isn't like dealing with a commercial entity, Diamond said. "We're dealing with peoples' homes, and there's a big emotional attachment. You can throw out money, and put in its place game theory. Moving these associations forward is like pushing rope. It just drags on, and you have to be patient to deal with it. How insurance companies' claims departments deal with these claims is one of the reasons why there is significant claims and significant losses."

For example, Diamond said he had worked out a $220,000 settlement for one developer that had problems with leaky stucco, but the insurance company wouldn't pay, and opted to go to trial. Three years later, there are a dozen third-party defendants involved, and the original insurer has spent more than $200,000 in legal costs alone--and the case still hasn't gone to trial and the defect hasn't been fixed.

"All of this could have been solved at the beginning," Diamond said. "If there was zero coverage under the policy, I could understand insurers taking that position. But often they're responsible for a portion of the developer's work."

He recommended that insurers get all subcontractors and contractors to agree ahead of time to a joint defense if they are sued, which saves time and money. He cited one case that involved a myriad of contractors and subcontractors, several insurance companies-and 200 attorneys ending up in a court room. "You'll never get them to reach a settlement," Diamond said.

A pilot program in San Diego does just that, and so far, it's been successful cutting down litigation costs for subcontractors, contractors and their respective carriers, Sektnan said. "They decide ahead of time what their portion of the settlement will be, and are represented by a single entity. It Cuts down the litigation by 40%;' he said. California is considering expanding the program statewide.

Risk Management Key

Mallon of CNA said construction liability can be profitable for insurers if they follow three steps: select the risks they write carefully; monitor contractors' risk assumption; and work with the contractor to mitigate any losses should a problem arise. "Contractors are some of the most optimistic people I know. I call it the six A's. They think, 'I can build anything, anywhere, at any time for any price for anyone and I'll sign anything to prove it,"' Mallon said. "That's where we assume our liability."

Having an effective risk-management program can help prevent lawsuits, while encouraging better construction. "What a builder has to do to have a really effective risk-management program does result in a better product," Golden said. However, it also can raise costs to the homebuyer, and not always costs that are practical. For instance, Golden said some developers have begun using cameras and video equipment to document every aspect of construction-from the surveyors laying out the stakes to the last nail being hammered-to defend themselves if a construction-defect suit is ever filed. "That's overkill," Golden said.

No matter what laws are passed or steps contractors take, the hard market facing construction contractors is likely to continue for some time, experts said.

"There is no quick fix to the problem," Maksimik said. "Some compromise has to be worked out for the overall good of our community. The consumer has a right to fair protection as the builder has a right to know the true standards he will be held to, now and in the near future."

RELATED ARTICLE: Gravity Pulls at N.Y. Construction Liability Market

The market for construction liability insurance is difficult in many states, but might be the worst in New York, experts said.

Like the rest of the country, New York is seeing an increase in construction-defect litigation. In addition, New York is the only state in the country where contractors are automatically held 100% liable for "gravity related" accidents, critics said. Under section 240 of the labor law, also called the New York Scaffold Act, any worker who falls and is injured is not only eligible to receive workers' compensation benefits but also can sue the developer or owner, who is considered liable even if the worker was at fault, some insurance experts said.

"We have a double whammy. We have the property defect issues with general liability, but we have this other problem with third-party liability. Forget about the admitted carriers, now excess line brokers and organizations are saying they've reached their capacity and beyond," said Phil LaRocque, executive vice president of the New York State Builders Association, which represents 3,500 builders and remodelers in New York state. "New York is an absolute crisis and disaster. There is no market."

There are two primary problems, said Lou Coletti, president of the Building Trades Employers Association, an organization representing 1,500 construction managers, general contractors and subcontractors in New York City. "No. 1 is the dramatic increase in liability insurance costs. No. 2 is the issue of availability at all."

The New York State Builders Association said the following companies have restricted their construction liability writings in New York or pulled out altogether: CGU, CNA, Great American, Kemper, Royal, St. Paul, Travelers and Zurich. The association said builders who can still find coverage are paying 300% to 600% more for less coverage. Much of that higher expense is due to the Scaffold Act, the builders and insurance industry said.

The average loss costs in New York City are 500% higher than the loss costs in seven other states--Pennsylvania, Virginia, Georgia, South Carolina, Ohio, Massachusetts and North Carolina--combined, according to a study by the American Insurance Association. For example, for one class of steel worker, loss costs are 745% higher in New York than the other states. Compared to Philadelphia, loss costs in New York City are still 171% higher, indicating the difference is not strictly an "urban phenomenon," the AIA said.

For New York state, outside of New York City, the loss costs averaged 232% more than the other states. The study indicated that the only difference between New York and the other states was the Scaffold Act, which accounted for one third of the cost differentials.

"If one of my guys in Queens is an executive supervisor being paid $ 100,000, I know of one company that charges $65,000 a year for [construction liability] insurance for him. If that same guy was making the same money in Hartford, the company would charge slightly under $10,000," LaRocque said.

Smaller contractors are the ones suffering the most, said Coletti, noting that 88% of the construction companies in New York are classified as small.

The building and insurance industries are pushing for legislation to change the Scaffold Act. "If we simply had the ability to introduce as evidence that the injured worker of a subcontractor had been drinking or doing drugs, or had disobeyed safety or didn't follow safety training, we'd have a fighting chance to defend ourselves," LaRocque said. "You're never going to be 100% clean or 100% dirty. We should be able to introduce evidence that his action or inaction caused the accident."

However, those who are in favor of keeping the Scaffold Act said it saves lives.

"It's easy to point to these workers and say it's their fault, but the purpose of the law, which goes back 100 years, is to protect workers who can't protect themselves," Jeffrey A. Manheimer, a plaintiff's attorney, said.

The U.S. Department of Labor found fall-related construction fatalities in New York state accounted for 15% of all fatal occupational injuries compared with 25% in Massachusetts, 23% in Maryland, 25% in New Hampshire and 22% in Florida, Manheimer said.

"The law makes sense," Manheimer said. "It makes the owners and general contractors ensure safety on the job site."

He disagreed with the building industry's contention that the Scaffold Act makes owners and contractors automatically liable in gravity-related accidents. "They think that every time there's an accident, there's an automatic recovery. That's not true. The case law is if a worker refuses to use proper safety equipment, they can't recover. If the sole cause of the accident is the worker's negligence, they can't recover. If they think this is a walk in the park, they are way wrong," Manheimer said.

The Scaffold Act has also impacted liability insurance for the janitorial and maintenance industry, said Jeff Ruben, senior vice president of Kaye Insurance Associates, a subsidiary of broker Hub International. "Almost all office cleaners have traditionally performed window cleaning. In the last year, the carriers have gotten very strict and are refusing to provide cover or quotes if there's any window cleaning. They're recommending the cleaners open a separate corporation and purchase separate liability for window cleaning. Now, some carriers are saying they don't want to write the office cleaners at all, even if they subcontract window cleaners."

Not only is the New York State Builders Association lobbying to change the Scaffold Act, it's also forming a reciprocal insurance company to offer construction liability coverage to its members.

"I didn't plan on being the CEO of an insurance company in addition to being the CEO of an association," LaRocque said. "We're doing it because of the lack of ability."

It may be easier for the builders to find reinsurance, instead of primary insurance, said George Dale, president of DHB Resources, a risk management company.

"Reinsurers like captives and risk retention groups because the insured has skin in the game," Dale said. "When they see the insured has a higher retention level, they think there's a better chance that the insured will take better care of their risk rather than pass it over on a traditional, first-dollar program."

But starting an insurance company isn't the solution, Coletti said.

"The solution is the law has to be changed. Why is New York the only state in the nation that has this requirement? Isn't it logical that individuals should have some level of accountability for their own performance? That's all we're asking," Coletti said.

Higher Costs

(Accident Year 1999)

The average loss costs for general liability coverage in New York City for classes of construction with "scaffold hazards," run considerably higher than the loss costs in seven other states. Loss costs are made up of claims payments and loss adjustment expenses. The average loss costs below represent losses per 1,000 earned exposures.

                                            AverageLoss Costs
Classes With                                           NY
Apparent Scaffold Hazard                NYC    (exc. NYC)     VA

Electrical Work Within Buildings     $27.53        $12.60  $2.27
Excavation                           122.66         93.99  12.88
painting Steel Structures or Bridgs  315.86        165.37  18.27
Roofing Commercial                   144.94         78.87  15.90

                                           AverageLoss Costs
Classes With
Apparent Scaffold Hazard                GA        SC        OH

Electrical Work Within Buildings     $3.32     $3.90     $2.69
Excavation                           18.66     21.99     16.78
painting Steel Structures or Bridgs  29.80       N/A     24.49
Roofing Commercial                   23.12     27.26     24.83

                                             AverageLoss Costs
Classes With
Apparent Scaffold Hazard                MA        NC     Philadelphia

Electrical Work Within Buildings     $4.86     $2.83            $9.13
Excavation                           30.16     16.06            57.10
painting Steel Structures or Bridgs  33.00     22.22              N/A
Roofing Commercial                   44.12     19.79            85.80

                                       AverageLoss Costs
Classes With                                          PA
Apparent Scaffold Hazard             (exc. Philadelphia)

Electrical Work Within Buildings                   $5.49
Excavation                                         28.23
painting Steel Structures or Bridgs                36.57
Roofing Commercial                                 42.11

Source: ISO Properties Inc.

Small Contractors Carry Big Burden

Large and regional builders are able to find some coverage for construction liability, or are able to go to self-insurance or captives, but smaller players, especially subcontractors, don't have that ability, said George Dale, president of DBH Resources, a risk management company.

"Most builders, even smaller guys building 100 homes a year, by hook or by crook, are getting insurance. Trade contractors--plumbers, roofers, electricians--are going out of business or going without insurance. You see that more in California and Texas, because those markets that are willing to write insurance are concentrating on the builders. They believe the larger builders are a bigger risk and better premium," Dale said.

Small contractors in other states also are getting squeezed.

"In Nevada, there's no real insurance for subcontractors anymore," said Mark Sektnan of the American Insurance Association. "Many are choosing to go bare."

Bruce King, president of Pete King Drywall, the company founded by his grandfather in 1947, has been taking time away from work to visit Carson City and lobby for change. "All of us here in Nevada have seen some pretty incredible increases in both the cost of the general liability and a reduction in coverage, as well as tremendous increases in deductibles," King said. "But on top of that, it is incredibly difficult to get a legitimate offer to renew cover at this time."

When small contractors can't find insurance, it can hurt the big contractors, too.

Tim Mason, vice president of risk managers for Red Bank, N.J.-based Hovnanian Enterprises Inc., the ninth-largest home building company in the United States, said the company has been able to obtain liability coverage for itself, but said a lot of subcontractors can't find coverage.

In the past, Hovnanian, like many home builders, has required subcontractors to include coverage for Hovnanian as an additional insured under their subcontractor's policy. So if the subcontractor finished a job, and a construction defect was later found, Hovnanian would be covered for the subcontractor's defect by the subcontractor's policy.

If Hovnanian's carrier paid for the repair, there also was a provision that allowed Hovnanian to go back to the subcontractor and subrogate any defects for which the subcontractor was responsible. But, in recent years, the subcontractors' carriers have tightened the wording on the certificates of insurance to limit coverage, so even when Hovnanian received a certificate, it didn't have the coverage Hovnanian required. The homebuilder had to pay closer attention to the small print.

"We had to hire a third party to assist in reading [the subcontractors' insurance certificates]," Mason said. "We spend a lot of time and additional dollars evaluating the coverage we are getting."

The company, which built 9,514 homes in eight states--California, Texas, Pennsylvania, New York, New Jersey, Maryland, Virginia and North Carolina--in 2002, has begun to buy what's called a wrap-up policy, where the developer buys insurance to cover itself and the subcontractors, and then passes the subcontractors' premium down to them.

When the subcontractor can't obtain the proper insurance, "we either get another subcontractor or we'll place them in a wrap-up policy It depends on the liability we see," Mason said. A subcontractor responsible for putting up closet shelves may be more likely to be included in the wrap-up policy than a subcontractor performing riskier work.

Thomas E. Miller, a California attorney who specializes in construction-defect litigation, said the developer and its insurer used to pay 50% to 60% of settlements in construction-defect cases. Now the developer only pays 20% to 30% of the settlement, and looks to the subcontractors, and all of the subcontractors' carriers, to cover the rest.

"The subs always end up with a raw deal with this anyway," said Miller. "The subs are up against huge, consolidated builders who have a lot of clout. The subcontractors tend not to be able to negotiate a better deal. If they want the work bad enough, they will sign away all of their rights and end up being the insurance company for the developer."

Greg Mallon, vice president, construction, for CNA's Global Specialty Lines, said 80% of the company's business is subcontractors. He said contractors need to watch the wording in the contracts they sign or they'll end up with more responsibility than they contemplated. "Maybe they've got a good bid price, but not in the context of the contract that they have to perform...some subcontractors will work for general contractors that will lay everything off on them. They're not balanced contracts and that's what will get you in trouble," Mallon said.

Mason said that if subcontractors make a mistake, they should be responsible for fixing it. "Everyone wants to protect themselves in our litigious society," he said.

Hovnanian currently has a three-year liability policy "I don't know that if we'll get a three-year policy the next time around, but our company has been very successful," Mason said. "The management of the company is doing all the right things to make sure we build a home as best as possible to make sure the customer is happy We have an extensive

policy and procedure in how we build a house and how we deal with issues related to water damage to avoid potential lawsuits."