Following recent legislation in Colorado, which dictates that construction defects are considered an occurrence and which may mandate coverage retroactively, re/insurers are wondering - what are our liabilities under existing agreements, and will other state legislatures and courts unexpectedly expand construction defect coverage? And where does this leave Colorado construction companies, who, in some cases, may be left without insurance?

A ripple of concern has run through the U.S. re/insurance industry in recent months, following the passage of legislation in Colorado that could have serious coverage ramifications with respect to construction defect claims. Colorado HB/10-1394, which was signed into law on 21 May, 2010, shifts the balance in Colorado towards the insured in a number of ways, and may also be retroactive in some cases. This leaves re/insurers with potentially high unexpected liabilities.

Liability for construction defects varies according to state law and judicial interpretation. These liabilities often involve continuous damage caused over a period of time and latent emergence of that damage. The basic issues in construction defect insurance claims and coverage under a commercial general liability (CGL) policy are to determine whether a defect in workmanship or materials is an occurrence as defined by the policy and secondly whether it is excluded under traditional business risk or property damage exclusions.

The new legislation in Colorado follows the trend in recent years by many U.S. courts to hold that damage caused by the work of a construction professional is an ‘accident’ under the occurrence definition of the policy and therefore covered. It also has a number of other troubling provisions dealing with exclusions. Paul Feldsher, SVP Underwriting Practices, PartnerRe U.S. explained: “The wording of the law is ambiguous in a number of places, but it appears to say that if the injury or damage was unknown when the policy was issued, the law compels the insurer to defend contractors against claims for faulty construction performed by them or by one of their subcontractors. It also shifts the burden of proof to insurers away from the insured and allows ‘parole evidence’ to be heard. This means that the judge can examine memos and other evidence that relate to the intent when the exclusions were drafted. This makes it more likely that those exclusions may not be effective. Finally, the legislation may be retroactive, affecting multiple years of policies where insurers thought that they were adequately protected against claims for these kinds of construction defects.”

What is interesting is that the Colorado bill was supported by the construction industry, but it seems they achieved the reverse of what they wanted to achieve, which was to obtain broader coverage. According to Paul Feldsher there is anecdotal evidence that insurance companies are refusing to provide coverage, leaving contractors with a limited number of carriers and higher costs. This may mean that contractors in other states will be less likely to pursue the same kind of legislation.

Construction defect claims became a major issue in the U.S. for the re/insurance industry in the 1990s and the early 2000s due to the rapid expansion of large, new tract, identical residential complexes across the Sunbelt states. The biggest problem was in California, because it has a 10-year statute of limitations on construction defect cases, whereas in other states it tends to be 5-7 years. A landmark case in California in 1993, Montrose Chemical vs. Admiral Insurance Company, compounded the problem. In this case (which actually concerned pollution, not construction defects) the California Supreme Court ruled that the standard CGL policy would respond to damage on a continuous trigger basis, meaning that not just one but a whole series of insurance policies would be involved, as long as the damage continued through those multiple policy periods. This greatly multiplied losses for insurance carriers.

In response, the Insurance Services Office and insurers came up with so-called Montrose exclusions, which exclude damage if the insured knew prior to the policy period that damage had occurred. Some insurers included additional anti-stacking language which said that if multiple policies issued by the same carrier applied to the same occurrence, then the maximum limits that would apply would be the largest limits of any applicable policy issued by that insurer.

The Montrose exclusions and anti-stacking provisions appeared to be effective defenses against stacking of limits on continuous construction defects until recently. However, the Colorado legislation makes these exclusions unenforceable unless the insurer proves that the insured had actual knowledge of the damage before the policy incepted. This legislation is in fact the second troubling recent development in this area. The first arose in Louisiana where Chinese drywall was a particular problem. Following Hurricane Katrina there was a shortage of drywall in the U.S. and builders imported drywall from China. The Chinese drywall was made with a flawed production process that resulted in sulfur fumes emanating into homes, along with corrosion of appliances and wiring. Although there seemed to be unanimity in most states that the defect was not covered in Homeowners’ policies, a widely publicized Louisiana trial court decision in March 2010 did not enforce certain exclusions and allowed coverage under these policies.

It is still unclear how the situation regarding construction defect claims will develop. The Colorado bill, or portions of it, may not be upheld in the face of inevitable judicial challenges and, in fact, recent court decisions in other jurisdictions have swung the other way. In April, an appeals court in Washington State upheld an anti-stacking provision; in May a Hawaiian court held that construction defect claims for poor workmanship do not in fact constitute an occurrence under a CGL policy; and in June the U.S. Court of Appeals for the Third District, which encompasses Pennsylvania, New Jersey, Delaware and the Virgin Islands, ruled that the insurer has no duty to defend the contractor under a CGL policy for claims based on faulty workmanship and resulting in foreseeable damages.

Whatever the jurisdiction, construction defect coverage is clearly impacted by political considerations and trends. “There are always going to be challenges, because construction defect claims can be very widespread and this is such a sensitive issue with voters and with local industry. Nobody wants to live in a house that has problems that are expensive to fix and people look for somebody to pay for them,” said Paul Feldsher.

PartnerRe has traditionally supported a small number of cedants writing business in Colorado for artisans in the construction trade.
“We recognize that our cedants have been challenged by recent construction defect claims and resulting coverage litigation,” says Paul. “As carefully as we watched the development of the legislation, we will also watch the courts' consideration of the new law which will ultimately determine the true impact of the legislation, and share our views with our clients.”