Buckeye Actuarial Continuing Education

April 26, 2011

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Construction Defect Claim Management and Reserving

Presented by:

Nathan Voorhis, FCAS, MAAA

Robin Leibrock, JD

Steven Jokerst, FCAS, MAAA

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What is a Construction Defect Claim?

CGL Policy – completed operations Builder, developer, contractor, subcontractor Construction, repair, remodel Residential and commercial buildings Resultant BI or PD, not the work itself Types of defects

Faulty design, workmanship or material Roofing, flashing, soil preparation, framing,

waterproofing, doors & windows, carpentry

Construction defect Multiple defendants, defects and policies

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Where is this a Problem?

Rapid growth and poor construction Litigious environment and highly organized plaintiff bar Continuous trigger occurrence California and other western states Certain states in northeast and southeast

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Legal Decisions and Statutes (1995) Montrose vs. Admiral – known and progressive loss a

covered occurrence (1996) Stonewall Ins. Co. vs. City of Palos Verdes Estates -

Montrose applied to CD claims (1997) Calderon Process / (2002) Steinberg Bill – establish

procedures for filing CD claim (2001) Presley Homes vs. American States – broad duty to

defend California Statute of Limitation and Repose

Patent defect – 3 years if reasonably apparent Latent defect – 10 years if not apparent

(2004) L-J, Inc. vs. Bituminous F&M – no coverage for “your

work”

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Coverage Endorsements

Revise policy language to clearly reflecting intended

coverage Occurrence

Known or continuous loss (Montrose) exclusion – must

first become aware during policy period Prior work exclusion – no coverage for work completed

prior to stated date Redefine “occurrence”

Exclusions for specified hazards and operations EIFS, mold, subsidence, imported drywall Roofing, residential construction

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Coverage Endorsements

Additional insured endorsement – subcontractor policy

covers GC for work performed on his behalf Other insurance endorsement Failure to complete your work Subrogation against third parties Abandoning the project

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CD Claim Adjustment/Adjudication Claim made by owner, developer, builder, general

contractor Multiple Tenders

Named insured; additional insured Co-carrier for Named Insured Indemnitee

Document intensive HO Matrix Notice of Completion dates, Close of Escrow dates Multiple policies, contracts, job and correspondence

files Trigger of Coverage

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Liability Claim vs. CD Claim Liability Claim

One or few plaintiffs Few defendants Known loss date Few damages / injuries One policy period triggered Shorter Statute of Limitation (BI 1-6 years; PD 1-10

years) Typically the primary focus is on Liability, rather than

Coverage or Damages

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Liability Claim vs. CD Claim CD Claim

Multiple plaintiffs – sometimes 100’s of homeowners Multiple defendants – design professional, developer,

general contractor, multiple subcontractors Undetermined loss date Multiple damages Multiple policy periods Longer Statute of Limitation (breach of contract 3-20

years) Typically the primary focus is on Damages and

Coverage, rather than Liability

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Contracts, Coverage and Allocation

CD claims typically involve multiple contracts (design

professional/owner; owner/developer; developer/builder;

builder/GC; GC/sub; Sub/sub) The coverage available and priority of coverage must be

analyzed for each contract and each policy triggered Allocation of claim costs

Defense expenses – each policy is obligated to answer

so most courts require cost sharing by equal shares;

some courts allow sharing on a prorata basis Loss – time on risk; prorata by limits; combination

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Very long reporting lag – Pure IBNR dominates

Not ideal to combine with other book of general liability claims. Even if premises/operations claims are excluded, development pattern is different from typical products/completed operations pattern

If construction defect triangles broken out separately, exposure base for Bornhuetter-Ferguson approach is subjective as there is no “construction defect” premium since triangles broken out by cause of loss.

Most companies do not have sufficient accident year data to capture tail. Tail estimation is very subjective.

Legislation has calendar year effect, affecting all accident years along a given diagonal.

Difficulties with Traditional Actuarial Methods

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General Liability Claim Count Accident Year Reported Development – CD vs NonCD

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

% R

ep

ort

ed % Reported - CD

% Reported - GeneralLiability NonCD

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General Liability Accident YearIncurred Loss Development – CD vs NonCD

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

% I

ncu

rred % Incurred - CD

% Incurred - NonCD

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General Liability Accident YearPaid Loss Development – CD vs NonCD

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

% P

aid

% Paid - CD

% Paid - NonCD

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Incurred But Not Enough Analysis

Case Development Existing Claims

Incurred loss development approach organized in a report year format.

Significantly reduced tail

Must allocate estimated report year IBNR to accident year

• Can choose among various methods including incurred losses, case reserves, construction contractors premium, or other basis

Multiple methods can be used; for simplicity this demonstration uses only an incurred development approach.

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Incurred But Not Enough AnalysisReport Year Construction Defect Loss Development

General Liability Incurred Loss Report Year Development Construction Defect

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

Years 1 2 3 4 5 6 7 8 9

% I

ncu

rred % Incurred

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Incurred But Not Enough AnalysisReport Year Summary of IBNE ($ Millions)

Report Year

Incurred Loss & ALAE

Inc CLDF

Ultimate Loss & ALAE

Indicated IBNE

1995 $2,842 1.000 $2,842 $01996 $4,713 1.000 $4,713 $01997 $8,709 1.011 $8,802 $931998 $18,646 1.014 $18,916 $2701999 $19,315 1.013 $19,568 $2532000 $18,465 1.013 $18,706 $2422001 $18,695 1.013 $18,939 $2442002 $30,311 1.013 $30,707 $3962003 $14,315 1.030 $14,741 $4272004 $10,143 1.045 $10,599 $4562005 $20,117 1.046 $21,051 $9342006 $17,701 1.065 $18,849 $1,1482007 $10,912 1.108 $12,090 $1,1782008 $9,640 1.174 $11,314 $1,6752009 $7,063 1.332 $9,410 $2,3472010 $7,300 1.318 $9,619 $2,319

$218,886 $230,867 $11,981

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Incurred But Not Enough AnalysisAllocation of IBNE to Accident Year ($ Millions)

$11,981

Accident Year

Case Reserves

Case Reserves % of Total IBNE

1995 $37 0% $291996 $132 1% $1061997 $1,895 13% $1,5131998 $328 2% $2621999 $1,860 12% $1,4852000 $4,254 28% $3,3962001 $611 4% $4882002 $878 6% $7012003 $1,058 7% $8452004 $88 1% $702005 $138 1% $1102006 $297 2% $2372007 $523 3% $4172008 $1,494 10% $1,1922009 $1,250 8% $9982010 $166 1% $132Total $15,009 100% $11,981

Selected IBNE for all Report Years

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Pure Incurred But Not Reported Analysis

Accident year analysis of reported claim counts

Selected Loss Severity

Selected ALAE / Loss Ratio

Selected Claims Closed with Pay

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Pure IBNR AnalysisAccident Year Claim Count Development

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

Years 1 2 3 4 5 6 7 8 9 10 11 12

% R

epo

rted

% Reported - CD

% Reported - GeneralLiability NonCD

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Pure IBNR Analysis - Summary of IBNR Claim Counts (000’s)

Accident Year

Reported Claim Counts

Reported Claim CLDF

Ultimate Claim Counts

Selected IBNR Claim

Counts

1995 2,800 1.030 2,884 84

1996 13,181 1.035 13,644 463

1997 20,566 1.044 21,468 902

1998 4,571 1.059 4,842 271

1999 3,175 1.101 3,494 319

2000 6,122 1.163 7,118 997

2001 2,450 1.266 3,102 652

2002 2,972 1.404 4,172 1,200

2003 963 1.587 1,528 565

2004 291 1.883 547 256

2005 214 2.253 481 267

2006 336 2.802 942 606

2007 651 4.108 2,674 2,023

2008 2,279 4.834 11,014 8,735

2009 1,911 6.501 12,423 10,512

2010 914 9.783 8,937 8,023

63,392 99,268 35,876

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Pure IBNR AnalysisSelected Loss Severity

Review past historical average paid loss and/or incurred loss severity ratios

Exclude unusual claims or years

Incorporate IBNE into incurred severity calculation

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Pure IBNR AnalysisSelected ALAE / Loss Ratio

Review past paid ALAE to paid loss and/or incurred ALAE to incurred loss ratios

Ratios above 100% not uncommon

Alternatively, severity analysis separately for ALAE

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Pure IBNR AnalysisSelected Claims Closed without Pay

Review past claims closed without pay to total closed ratios

Ratios above 75% not uncommon; significant variability by policy year

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Pure IBNR Analysis - Summary of IBNR

Accident Year

IBNR Counts (000's)

Loss Severity

ALAE/Loss Ratio

Closed With Payment %

IBNR ($Millions)

1995 84 $10,000 100.0% 20.0% $3361996 463 $10,000 100.0% 20.0% $1,8531997 902 $10,000 100.0% 20.0% $3,6061998 271 $10,000 100.0% 20.0% $1,0841999 319 $10,000 100.0% 20.0% $1,2782000 997 $10,000 100.0% 20.0% $3,9862001 652 $10,000 100.0% 20.0% $2,6072002 1,200 $10,000 100.0% 20.0% $4,8022003 565 $10,000 100.0% 20.0% $2,2602004 256 $10,000 100.0% 20.0% $1,0262005 267 $10,000 100.0% 20.0% $1,0702006 606 $10,000 100.0% 20.0% $2,4222007 2,023 $10,000 100.0% 20.0% $8,0922008 8,735 $10,000 100.0% 20.0% $34,9402009 10,512 $10,000 100.0% 20.0% $42,0492010 8,023 $10,000 100.0% 20.0% $32,092Total 35,876 $143,505

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Summary of Construction Defect Losses ($ Millions)

Accident Year Case IBNE IBNR

Total Reserves

1995 $37 $29 $336 $4021996 $132 $106 $1,853 $2,0911997 $1,895 $1,513 $3,606 $7,0141998 $328 $262 $1,084 $1,6741999 $1,860 $1,485 $1,278 $4,6232000 $4,254 $3,396 $3,986 $11,6362001 $611 $488 $2,607 $3,7062002 $878 $701 $4,802 $6,3802003 $1,058 $845 $2,260 $4,1632004 $88 $70 $1,026 $1,1832005 $138 $110 $1,070 $1,3182006 $297 $237 $2,422 $2,9562007 $523 $417 $8,092 $9,0322008 $1,494 $1,192 $34,940 $37,6262009 $1,250 $998 $42,049 $44,2962010 $166 $132 $32,092 $32,390Total $15,009 $11,981 $143,505 $170,494

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Recent Years

Most recent three years or so still very green

Possible approaches

• Hold loss ratio (use earned premium exposure summarizing only construction contractors classes)

• B/F accident year approach (use earned premium exposure summarizing only construction contractors classes)

• Same approach as described if large and stable enough book of data

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Q & A

Buckeye Actuarial Continuing Education

April 26, 2011