Litigation Insurance

Premium of $850,000 Equals $1,000,000 in Coverage

In Southern California, there is a high demand for affordable housing, yet a growing segment of the population is being excluded from home ownership because of escalating prices. Some wonder why the cost of housing is so high in California.

Some of the many factors contributing to the runaway prices are exceptionally high demand, high land costs, escalating permit and mitigation fees, environmental issues, and last, but not least, litigation insurance.

For this article, I will limit my remarks to litigation insurance and its impact on developing the most affordable form of entry-level housing – condominiums.

Let me illustrate with an example. Our G5 group was under contract to acquire a parcel of land to construct a 64-unit condominium project in Southern California. The preliminary plans for a very attractive design had already been approved by the City. The approved plans included site plan, floor plans, and elevations. The design package did not include working drawings. When the architect was asked how much he would charge to produce detail construction drawings for the project, he declined to bid. He refused to be associated with a condo project. He was hired to do the conceptual drawings only and would not produce the working drawings under any circumstance, at any price. He declared that the litigation risk was just too high for him to be involved in the final design of a condo project.

On the same project, most of the civil engineers and subcontractors who we interviewed said essentially the same thing. One contractor put it very simply, “Thanks, but no thanks, we don’t work on condo projects, period.” A few agreed to work on the project, but only if we, as the developer, purchased a “wrap insurance policy” that was acceptable to their attorneys.

As I understand it, a wrap policy is an insurance policy that covers liability for construction defects for a ten-year period (more about why “ten years” later). The “wrap” part of the name refers to the fact that all parties associated with the construction process from initial design, to on-site and off-site construction, to final touch-up before delivery is covered under the single policy.

When we solicited bids from the very few insurance companies now willing to issue wrap policies, we were absolutely stunned. For this 64-unit project the estimated premium for $1,000,000 in liability coverage was close to $850,000, yes, $850,000, which calculates to over $13,000 per unit. If the premium was not outrageous enough, the policy also required a deductible of $100,000. The maximum coverage would be for $2,000,000, but that would be paid only if there were two separate claims. We explored the obvious solution of self-insuring and that did not fly with the subcontractors.

How did Southern California get to the point where developers of condo projects are faced with very reluctant subcontractors and outrageously high insurance premiums?

Under California law, buyers of new homes and condos have an implied warranty for ten years against construction defects. During the eighties and nineties, homeowner associations of condominium projects approaching the end of the ten-year warranty period started filing lawsuits in greater and greater numbers. This was due in part to the fact that some law firms had developed a very profitable specialization in condo construction defect litigation. In many cases, otherwise content homeowner associations were approached with the frightening concept that the officers of the association might have personal liability if they did not act in the best interests of the members of the association by conducting exploratory testing to find defects, even where no defects had been observed during the previous eight or nine years. The front-end costs to do the testing were often advanced by the law firm, who brought in their own team of experts to conduct the testing. The laws firms were paid great sums by receiving a hefty portion of the award mandated by a court, or more frequently, by receiving a portion of the huge settlements paid by insurance companies.

As time passed, it became routine for homeowner associations to sue the developer. In these cases, the developer sued the general contractor, and that led to a ripple effect so that nearly everyone who had a hand, directly or indirectly, in the project was eventually caught up in the litigation. The insurance companies who covered the risk for the builders and subcontractors paid out untold millions for these lawsuits. True, some builders who built substandard construction deserved to be sued. However, even the excellent builders were swept up in the litigation, no matter how well they built their product.

Insurance premiums skyrocketed, many insurance companies discontinued offering construction defect coverage, the few remaining insurance companies, with a near monopoly, bumped the premiums even higher, and not unexpectedly, condo construction slowed to a near halt. Developers who built condo projects decided to hold their completed projects as rental projects, complete their ongoing projects as apartments, or sell the projects to investors who had to guarantee not to sell individual units during the warranty period.

The condo conversion phenomena that is currently at a fever pitch in California today is being fueled by a very strong demand for home ownership and is being aided by the existence of so many apartment projects that were originally built as condos more than ten years ago.

Better times ahead? For many years, the building industry has pressed the State legislature for some form of relief. Finally, last year, the State acknowledged the problem and approved a law, commonly referred to as the “Right to Fix” law. Simply put, under certain conditions, homeowners will be required to offer the builder the right to repair construction defects before the homeowner is permitted to file a lawsuit against the builder for those defects. The ability for the developer to return to his project and make necessary repairs and corrections without litigation is more appealing and a lot less expensive. However, so far, the anticipated positive effects of that legislation on insurance premiums are not yet apparent.

Legislation is also being introduced, but is not yet approved, that would make it unlawful for anyone to tell officers of a homeowners association that they may be at personal risk if they don’t pursue litigation against the builder.

As you may have surmised, after determining the additional cost of insurance and the difficulty is attracting the better subcontractors, G5 decided to pass on the condo project.

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