1 construction defect liability and captives international center for captive insurance education...

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Construction Defect Liability and Captives

International Center for Captive Insurance Education Teleconference

Presenters:

Jim Boone, Alberici Group, Inc.Mike O’Neill, American Contractors Insurance Group

Pat Wielinski, Cokinos, Bosien & Young, P.C.

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Construction Defects

Introduction:

• Google search for “Construction Defects” yielded 1,821,000 hits in .61 seconds.

• Top three paid advertisers on the Google “Construction Defects” page were:

#1 Southern California Plaintiff Law Firm

#2 Construction Defects Expert Witness

#3 Northern California Plaintiff Law Firm

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Four Categories of Construction Defects

The trial courts have recognized that construction defects are tangible and can typically be grouped into the following four major categories:

Design Deficiencies

• Sometimes design professionals, such as architects or engineers, design builders and systems that, from a performance standpoint, do not always work as

intended or specified.

• The motivation for the design may be form, function, aesthetics, or cost considerations, but the completed design could result and/or manifest into a defect.

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Four Categories of Construction Defects

Material Deficiencies

• The use of inferior building materials can cause significant problems, such as windows that leak or fail to perform and function adequately, even when properly installed.

• Example: siding, windows, roofs, plumbing, HVAC

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Four Categories of Construction Defects

Construction Deficiencies(Poor Quality or Substandard Workmanship)

• Poor quality workmanship often manifests as water infiltration through some portion of the building

structure.

• Cracks in foundations, floor slabs, walls, dry rotting of wood or other building materials, termite or other pest infestations, electrical and mechanical problems, plumbing leaks and back-ups, lack of appropriate

sound insulation and/or fire-resistive construction between adjacent housing units.

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Four Categories of Construction Defects

Subsurface/Geotechnical Problems

• California, Colorado, and other parts of the country have a significant amount of expansive soil

conditions.

• As a result of this type of terrain, there have been many problems when housing subdivisions and/or developments are built into hills or other sloping areas where it’s difficult to provide a solid and/or stable foundation.

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Four Categories of Construction Defects

Subsurface/Geotechnical Problems (cont.)

• If the subsurface conditions in these subdivisions and/or developments are not properly compacted and prepare for adequate drainage, problems will

inevitably result, which can include vertical and horizontal settlement (subsidence), movement (expansion), slope failures, flooding, and in extremely

wet/rainy climates, landslides, etc.

• These types of conditions typically lead to cracked foundations, floor slabs, and other damage to a

building.

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Four Categories of Construction Defects

Subsurface/Geotechnical Problems (cont.)

• A worst-case scenario in some instances could render a building uninhabitable, as well as uninsurable.

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Risk Management for Construction ProjectsLong-Tail Liabilities

• Patent Defects

– Apparent with reasonable inspection

– Statute of limitations requires claim to be submitted within x years of project completion (usually short, e.g., 2 or 3 years)

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Risk Management for Construction ProjectsLong-Tail Liabilities

• 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, WA is 6 years (confirmed by WA Supreme Court in September 2001), and FL is 10 years.

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Statutes of Repose

State

Alaska

Alabama

Arizona

Arkansas

California

Colorado

Number of Years

Ten Years

Thirteen Years

Eight Years

Five Years

Ten Years

Six Years

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Statutes of Repose

State

Connecticut

Delaware

Dist. Of Columbia

Florida

Georgia

Hawaii

Number of Years

Seven Years

Six Years

Ten Years

Ten Years

Eight Years

Ten Years

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Statutes of Repose

State

Idaho

Illinois

Indiana

Iowa

Kansas

Kentucky

Number of Years

Six Years

Ten Years

Ten Years

Fifteen Years

Five Years

Seven Years

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Statutes of Repose

State

Louisiana

Maine

Maryland

Massachusetts

Michigan

Minnesota

Number of Years

Five Years

Ten Years

Ten Years

Six Years

Six Years

Ten Years

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Statutes of Repose

State

Mississippi

Missouri

Montana

Nebraska

Nevada

New Hampshire

Number of Years

Six Years

Ten Years

Ten Years

Ten Years

Eight Years

Eight Years

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Statutes of Repose

State

New Jersey

New Mexico

New York

North Carolina

North Dakota

Ohio

Number of Years

Ten Years

Ten Years

No Statute of Repose

Six Years

Ten Years

Fifteen Years

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Statutes of Repose

State

Oklahoma

Oregon

Pennsylvania

Rhode Island

South Carolina

South Dakota

Number of Years

Ten Years

Ten Years

Twelve Years

Ten Years

Thirteen Years

Ten Years

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Statutes of Repose

State

Tennessee

Texas

Utah

Vermont

Virginia

Washington

Number of Years

Four Years

Ten Years

Nine Years

Six Years

Five Years

Six Years

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Statutes of Repose

State

West Virginia

Wisconsin

Wyoming

Number of Years

Ten Years

Ten Years

Ten Years

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Risk Management for Construction Projects• Legislative Efforts at the State Level

– Intended to improve the standards and procedures for early disposition of construction defect claims

– Outlines prelitigation procedures

– Notice and opportunity to repair laws

• See Handout for a State-By-State Analysis

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Definition of Occurrence

• Traditional: property damage neither expected nor intended from the standpoint of the insured is an accident.

• Recent: Property damage arising out of an insured contractor’s breach of contract or warranty is natural and foreseeable and not an accident.

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l. ‘Property Damage’ to ‘your work’ arising out of it or any part of it and included in the ‘products-completed operations hazard.’

This exclusion does not apply if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor.

Your Work Exclusion

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Subcontractor Exception

• Major inroad to the “Business Risk Doctrine”

• “Subcontractor” is broadly construed to include many entities

• Key to completed operations coverage

• Source of classic judicial statements of coverage for defective work

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Restrictive EndorsementCG 22 94

Exclusion 1. of Section I – Coverage A – Bodily Injury and Property Damage Liability is replaced by the following:

This insurance does not apply to:

“Property damage” to “your work” arising out of it or any part of it and included in the “products-completed operations hazard.”

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Additional Insured Endorsement CG 20 10 11 85

WHO IS AN INSURED (Section II) is amended to include as an insured the person or organization shown in the Schedule, but only with respect to liablity arising out of “your work” for that insured by or for you.

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Additional Insured Endorsement CG 20 10 10 93

WHO IS AN INSURED (Section II) is amended to include as an insured the person or organization shown in the Schedule, but only with respect to liability arising out of your ongoing operations performed for that insured.

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No More Sole Negligence Coverage

Relevant 2004 Endorsement Language

Section II – Who Is An Insured is amended to include as an additional insured the person(s) or organization(s) shown in the Schedule, but only with respect to liability for “bodily injury”, “property damage” or “personal and advertising injury” caused, in whole or in part, by:

1. Your acts or omissions; or

2. The acts or omissions of those acting on yourbehalf; in the performance of your ongoingoperations for the additional insured(s) at the

location(s) designated above.

© ISO Properties, Inc., 2004

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Additional Insured Endorsement CG 20 37 07 04

WHO IS AN INSURED is amended to include as an insured the person or organization shown in the Schedule, but only with respect to liability arising out of ‘your work’ at the location designated and described in the schedule of this endorsement performed for that insured and included in the ‘products-completed operations hazard.’

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Restrictive EndorsementsHabitational Exclusions

• Excludes “residential” construction as defined in the endorsement

• Varies from insurer to insurer

• Apartments, assisted living, condos, co-ops, hospitals, hotels, military housing, nursing homes, single family, dorms, townhouses, tract housing

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CGL-Common Restrictive Endorsements

• Mold

• Silica

• Lead

• EIFS

• Subsidence

• Employment Practices

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Controlled Insurance Programs - Pros

1. Reduce insurance costs through

a. Projectwide buying power

b. Improved loss experience

c. Elimination of redundant coverages and premiums

d. Reduced litigation between insurers

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Controlled Insurance Programs - Pros

2. Lower expense factors

3. Improved insurance coverages and uniform policy limits

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Controlled Insurance Programs - Pros4. Superior claims management

a. Uniform and coordinated claims handling

b. Aggressive claim settlement

c. Thorough investigation and supervision of claims

d. Resist questionable claims

e. Common defense – avoids “legal blackmail”

f. Can contribute to superior customer relationships

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Controlled Insurance Programs - Pros

5. Utilizes the general contractor’s relationship and experience with quality subcontractors

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Controlled Insurance Programs - Cons

1. Complicated

2. Extended period of involvement after completion of project, the “tail”

3. Administrative intense

4. Substantial risk

5. Volatile costs

6. Unexpected cancellation from markets

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Self-Insured Retention

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Self-Insured RetentionPlan Characteristics• SIR applies on a per-occurrence basis to both

indemnity and expense.

• Insurer is under no obligation to defend, until the SIR amount has been funded.

• In-house vs. TPA to handle losses within the SIR.

• Tax Treatment - Premiums are deductible when paid. SIR losses deductible when paid.

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Risk Retention Group

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Risk Retention GroupPlan Characteristics• May need a front for certificates.

• In-house TPA claim handling.

• Thinly capitalized.

• Limited risk retention capability.

• Dependent on reinsurance.

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Single-Parent Captive

InsuredOwner

CaptiveReinsurer

Front/ExcessInsurer Claimants

ShareholderDividendsCapitalization Insurance Premiums

ClaimSettlements

Fronting SecurityReinsurance

Premium

Reimbursementof Loss Excess

of Retention

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Single-Parent Captive

• An insurance subsidiary created by the insured that allows the firm to participate in the underwriting risk and investment profits associated with the firm's risk financing program.

• The captive is capitalized and premiums are paid to the captive.

• The captive will retain a level of risk and purchase reinsurance for limits in excess of its retention.

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Single Parent Captive

• Tax issues:

– Premiums generally deductible for federal income taxes

– Dividends taxed similar to any stockholder's dividend

– Return premiums taxed as ordinary income at the parent's rate

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Single-Parent Captive

• Fronting issues:

– Workers compensation requires a front

– Certificate holders may require a front for liability lines

– Fronting costs are similar to the basic charges in a retro plan

– Wind-down/runoff issues

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Entity Structuring and Alter Ego Risks

Entity selection

• Sole proprietorship or dba

• Partnership

• Corporation

• Limited liability company

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Entity Structuring and Alter Ego Risks

• Liability protection offered by corporations and LLCs

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Entity Structuring and Alter Ego Risks

• Use of single purpose entities (SPEs)

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Entity Structuring and Alter Ego Risks

Attacks on the protection of the entity

• Alter ego (aka piercing the corporate veil)

• Enterprise liability

• Parent-subsidiary relationships

• Substantive consolidation

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Entity Structuring and Alter Ego Risks

Practical tips for minimizing alter ego risks

• Adequate capitalization

• Observe formalities

– Separate bank accounts, letterhead, contracting procedures

– Meetings, minutes, resolutions

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Entity Structuring and Alter Ego Risks

• Intercompany relationships

– Use of employees

– Loans

– Intercompany services

– Transfers of assets

• Adequate insurance

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Entity Structuring and Alter Ego Risks

Dissolution strategies

• Post-dissolution liability of the entity

• Post-dissolution liability of the partners, shareholders, members

• Does the developer really want to dissolve the entity?

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Alternative Dispute Resolution (ADR) Provisions Contracts• Alternative dispute resolution (ADR) provisions

– Provision governing disputes between the owner or developer and the design professionals/subcontractors

– Residential: Provision governing disputes involving homeowners or HOA

– Alternatives:

• Mediation• Bench trial, with waiver of jury trial• Binding arbitration• Rent-a-judge, special master

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Quality Control Programs

Why Are QC Programs Important?

1. A risk management best practice– avoid “designed in” defects and errors during construction

2. May be required by the developer’sCGL insurance program

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Quality Control Programs

QC during the design phase

Objectives:

Maximize constructability of the plans, consistency, code compliance, and appropriate product, material, and systems selections

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Quality Control Programs

• Develop procedures for peer review of plans and specifications

• Establish criteria for selecting and managing peer review consultants, including methods for managingthe paper trail

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Quality Control Programs

QC during construction operations

Objectives:

Inspect a statistically relevant sample of units and common area construction and document correct as-built conditions

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Quality Control Programs

• Establish criteria for selecting and managing QC consultants

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Quality Control Programs

• Obtain consultant guidance on the following:

– Which components should be inspected?

– When to inspect (stages of construction)?

– Appropriate sample size

– Procedures for identifying defects andfor obtaining and documenting corrections

– Some or all of these components may be dictated by the developer’s CGL insurance program

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Quality Control Programs

• Role of superintendents; obtaining contractor and subcontractor buy-in

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Quality Control Programs

• Training of subcontractors

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Quality Control Programs

• Consider risk-specific QC initiatives

– Windows

– Roofs

– Other building envelope issues, particularly moisture intrusion

– Acoustical issues

– Other issues, rated by litigation claims potential

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Quality Control Programs

• Handling field changes or repairs during construction

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Quality Control Programs

• Red flags:

– Value engineering

– Design-build trades (may be outsidecoverage of developer’s CGL due to professional services exclusion)

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Warranties

Another powerful but underutilized riskmanagement tool

• Legal and practical consequences

– Opportunity for disclosure and education

– Reinforce ADR structure

– Set and manage owners expectations

– Owner maintenance

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Warranties

Warranty as the roadmap for performing customer service

• Performance standards

– Qualitative

– Quantitative

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Warranties

Exclusions

– Normal wear and tear

– Acts of third parties or the homeowner

– Lack of required maintenance

– Acts of God

– Claims covered by homeowners insurance

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Warranties

Stand-alone dispute resolution provisions

– Notice, access, inspection, testing, repair

– Mediation followed by binding arbitration

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Warranties

Duration of the warranty

• One-year warranties increasingly are outdated, may depend on particular system

• Relationship of the express warrantyto statutes of limitations and statutesof repose

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Warranties

Transferability to subsequent purchasers

Binding on subsequent purchasers?

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Design and Implement Customer Service ProgramWhy customer service is critical:

• Radar function and litigation avoidance

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Design and Implement Customer Service ProgramWhen does the customer service process begin and end?

• Walk-through – the handoff

• Relationship between customer service and statutes of limitations/statutes of repose

• Repairs toll (stop the running of) statutes of limitations

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Design and Implement Customer Service ProgramDocumentation – practical tips

• Get it in writing

• Make your record

• Be objective (don’t editorialize or speculate)

• Be precise about dates (tolling ofstatutes of limitations)

• Develop a customer service databaseand tracking system

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Design and Implement Customer Service ProgramDevelop issue-specific protocols for high-risk claims

• Water intrusion

• Mold

• Acoustical

• Soils

• Other

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Design and Implement Customer Service Program• Train customer service representatives on

maintenance manuals and warranties

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Record Retention Policies

Why is record retention important for developers?

• Long tail liabilities

• Delayed manifestation of defects

• Statutes of repose

• Critical to defense of claims, prosecution of cross-claims, and insurance recovery

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Record Retention Policies

Effective record retention allows developers to:

• Identify potentially responsible parties

• Identify potential witnesses

• Compile contracts and insurance information from other parties

• Marshal the developer’s direct insurance resources

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Record Retention Policies

Effective record retention allows developers to:

• Retrieve QC inspection records to demonstrate correct as-built conditions

• Help establish defenses, such as statutes of limitations and comparative fault