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Starts: A Mine Field in Fine Print

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Amid as grim a future business outlook as home builders must endure, few take the time to look back at the industry's pre-2006 heyday. Instead, most are devoting the bulk of their bandwidth to examining costs line item by

line item. However, by neglecting to take a retrospective look, especially in the critical area of insurance, builders are failing to discover potentially costly missteps in insurance coverage. In fact, looking back may be the only way to gird for legal challenges ahead.

Homes built during the hurry-up period of old–when getting trades lined up to complete projects fast was difficult, if not nearly impossible–are a particular source of risk. In the bygone rush to find and hire subcontractors to build record-breaking numbers of homes up through 2006, and even into the present, many builders may unawares have opened themselves up to huge risks, thanks to inadequate insurance coverage among subs who work on their projects.

Subcontractors customarily provide certificates of insurance to verify that they meet the builders' minimum coverage requirements. However, the problem often lurks in the fine print of documentation that backs up insurance certificates, which seldom, if ever, draws anyone's attention, especially when home building velocity was peaking.

Insurance industry changes have made it ever more difficult and expensive for subcontractors to get insurance and have transformed the way policies are written. Increasingly, that means there are endorsements and exclusions in subs' policies most builders don't know about because they won't show up on certificates of insurance.

Case in point is the experience of a mid-size private builder in the Chicago area; this executive spoke only on condition of anonymity.

In an effort to reduce costs, the chief finance executive re-evaluated his company's insurance program. After studying various options, he selected a captive insurance program with a wrap element, meaning the company's subs pay into the policy to participate in the coverage. After he announced the change, he encountered resistance from some of the subs, who argued the coverage was too expensive.

According to wrap insurance experts, the cost of subs' participation in a wrap typically is plus or minus 10 percent to 15 percent of what they typically would pay for insurance. Nevertheless, several of this builder's subs asserted that they could get insured for one-tenth to one-fifteenth the cost of the wrap.

"I kept thinking, 'How are these guys getting it cheaper?'" the finance executive says.

To get to the bottom of the discrepancy, he asked the company's subs for copies of their policies. After poring over every policy line by line, this builder and his insurance partners at J. Mading Cos. found that many of the insurance policies held by his subs had gaping holes in their coverage. Stipulations that he considered usually covered by general liability insurance–and specified in the company's subcontractor agreements–often were missing.

For example, the home building company was not named as an additional insured on several subs' policies. Other subs' policies excluded coverage for product defects or completed operations, two of the critical provisos all builders and subs need to protect against construction defect litigation. And there were other mind-boggling policy exclusions–an excavator whose policy excluded the moving of dirt and a framer whose policy excluded residential construction are two examples.

"[The exercise] exposed the unbelievable, unspoken truth of what's going on," says James Jackson, president of J. Mading Cos. "And we found it to be rampant."

Although no national statistics are available due to the private nature of the contracts, other insurance specialists confirm Jackson's assertion of the issue's widespread nature. The pervasiveness of the problem leaves many builders–and not just disreputable ones–in a perilous situation in the event of litigation.

"I don't think builders know they aren't covered," asserts the private builder finance executive. "And I don't think a lot of our subs knew they weren't covered."

Although there is an insurance industry "professional standard," according to Karen Schwartzkopf, senior vice president for Zurich North America Commercial's construction business unit, there are no formal safeguards to ensure that subs understand the consequences of any endorsements or exclusions. It's the responsibility of the subs to read their policies' fine print, she says.

However, the full brunt of the consequences falls on home builders. Legal precedent shows that homeowners and their legal counsels will go for what they perceive as the deep pockets of home builders and developers. And if the subs' insurance policies have additional insured or completed operations exclusions, the builders' will get no help from their subs' insurance companies.

Builders' best–and only–line of defense is to verify their subs' policies themselves.

"[But] that's the rub," explains the finance executive. "You need to read every policy and every endorsement and have the insurance knowledge to be able to catch the 'gotchas.' There is zero chance of that."

For builders who lack the manpower or the time to drill into the nitty gritty of their subs' insurance policies, there are few alternatives. They can hire a third party to collect policies and exclusions on the builders' behalf, or they can consider mandating participation in a wrap insurance policy, where the builder ultimately has control over the policy's provisions. However, for many builders, wraps may be unavailable; insurance companies may refuse to offer builders that type of insurance product based on factors such as the amount of revenues they generate or their safety records.

"The developer can be caught between a rock and a hard place," explains Mark Himmelstein, a lawyer with Newport Beach, Calif.-based Newmeyer Dillion. "If the developer can't get a wrap and the subs can't get insurance, where do you go? Developers are really going to take a hit in the case of defect litigation."

–Sarah Yaussi