Mold, flat earnings, and terrorism spur insurance rate hikes that could force builders out of business. By Daniel Walker Guido

Eric Brown sits alone in his deserted office, glumly answering all the phones. His entire staff is partying at the office holiday bash, but Brown has come back early, needing time to sort out a perplexing dilemma.

The president of Artisan Homes in Phoenix, Brown is currently building three, five-story loft buildings, with 40 units in each building. Talking about the project momentarily lifts his darkened demeanor.

"It's right downtown--a true loft design with concrete floors and exposed ducts: We are selling them as fast as we can build them," Brown gushes. But then, like a shimmering mirage in the desert, his joy evaporates. Brown has a problem. The same one every builder nationwide has, or will, very soon. Insurance.

His liability coverage has escalated so fast and furiously, he's not quite sure how he's going to swing the payments: "The first building cost us $80,000 to insure. The second, which we just insured and is the exact same building, will cost $340,000. We have been told we might not be able to find coverage for the third," he mutters.

Brown's agent has told him that even if he can find coverage for the third building, it will cap at $3 million. "These buildings are worth five times that. It's a prime location," Brown says. "But the cost of insurance has gone up by a factor of four, while the coverage amount has decreased. And then there's the multiple exclusions [for acts of terrorism, moisture, and mold damage] they write in now."

Forest fire

Thanks to flat earnings, escalating mold and home defect lawsuits, increasing worker compensation claims, and the enormous losses suffered Sept. 11 by the reinsurance industry that stands behind the major insurers, insurance rates are skyrocketing. Congressional action is expected to eventually slow the increase, but rates are expected to creep higher and not quickly return to 2000 or early 2001 levels. Multiple exemptions now written into builder liability policies are also expected to remain firmly entrenched for the foreseeable future.

"You have a full-blown forest fire, where we are seeing renewals coming in at 50 percent rate increases, even 100 percent or more," says Bob Rusbuldt, CEO of the Independent Insurance Agents of America (IIAA), a Washington-based trade association.

Due to inaction by Congress before it adjourned in late December, it appeared as though "insurance coverage for acts of terror is likely to become virtually unavailable after Jan. 1," when 70 percent of the reinsurance policies expire, Rusbuldt warns. Reinsurers are insurance behemoths like Lloyd's of London that stand behind insurance companies. Rusbuldt maintains that unless there is some direct federal action, already escalating "insurance rates are likely to continue increasing in the first half of 2002." On June 1, the other 30 percent of the reinsurance policies come up for renewal.

Photo: Jonathan Barkat

"Without an effective government bailout, there will be thousands of small business failures, and big, well-known insurance companies will fail," says Maria Berthoud, senior vice president of government affairs for IIAA. While Congress is expected to take action before that happens, there are indications that insurance company owners are looking to bail. On Dec. 19, 2001, Citigroup, the nation's largest financial services company, announced it would spin off its Travelers Property Casualty insurance business. In a statement to shareholders, Citigroup CEO Sanford Weill says Citigroup is divesting itself of Travelers because the property and casualty business has a lower growth rate than other parts of Citigroup, creating a drag on its stock price.

Risk for all insurers has dramatically escalated because of the terrorist activity that began Sept. 11, Rusbuldt says. "When you have little old ladies dying in Connecticut from anthrax in their homes, you've got real problems with the nearly incalculable risk" for the property, casualty, and life insurance industry, he adds.

"Terrorist attacks can hit anywhere, be it bio-terrorism or bombs," Rusbuldt adds. "It is not confined to skyscrapers or the mega sports arenas or multi-story residential or commercial developments in New York City. Though the home builder finishing homes two miles from the Pentagon in Arlington, Va., has a much higher actual risk than does the builder in Topeka, Kan., the insurance rates will increase for both."

The problem also involves banks. "What lender will give a builder money knowing they have no coverage for an act of terror? Their insurance will not cover car bombs, dirty bombs, and bio-terror and suicide attackers," Rusbuldt says.

Multifamily housing construction could cease until federal action is taken to ensure availability of affordable liability insurance. Multifamily builders have been paying escalating premiums against losses due to mounting construction defect class action lawsuits, especially in the West, where an epidemic of such claims spurred a halt in construction of affordable multifamily units. The December 2000 California Supreme Court Aas v. William Lyon decision slowed the feeding frenzy by requiring homeowners to document actual losses before filing.

Now, multifamily and some single-family builders and their insurers in many areas of the nation are under siege by class action lawsuits alleging mold infestations. In the last three years in the United States and Canada, more than 9,000 documented cases of mold surfaced, including 2,000 against builders for construction defects, 2,000 against homeowner associations for improper maintenance, and 5,000 against insurance companies for bad faith. This is according to a December 2001 presentation to insurers by Harry C. Zimmer III, senior vice president of Gerling Global Reinsurance Corp. of America.

It could get worse. Without federal intervention to ensure coverage is available, the risk will become phenomenal. "Most builders and apartment building owners don't realize that anthrax and small pox are considered to be pollution hazards and are not covered by most policies," warns Jack Haese, a former insurance executive, now CFO of Porten Homes of Rockville, Md.

"Imagine one resident in a 1,000-unit apartment building getting a letter with anthrax in it," Haese says. "All those residents have to be relocated ... the ground-floor retail shut down, with the resulting business loss claims. And then everything has to be cleaned. The project owner goes to his insurance company to recoup his losses, and guess what? He's not covered."

The problem is the insurance companies' insurers are being hit, hard. Three players dominate the global reinsurance market: Lloyd's of London, Munich RE, and Swiss RE. American reinsurers include The St. Paul Cos., American RE, and GE's Employers Reinsurance Co.

St. Paul alone estimates its net pretax losses for 2001 at $700 million from its U.S. primary insurance, reinsurance, and Lloyd's of London operations. The company based its estimate on a total insured loss of between $30 billion and $35 billion for the industry from the life insurance and property claims expected by year's end for the events of Sept. 11. Industry estimates are that the final cost of Osama bin Laden's September surprise will be in excess of $100 billion.

Bouncing bailout

Congress adjourned just before Christmas without finalizing legislation to help ward off the catastrophic impact that failure of the reinsurance industry would inflict on the national economy and security. Though economists argued that work on an insurance rescue was far more important than the more ballyhooed stimulus package, two days before its scheduled adjournment, Congress was still squabbling over the stimulus package while the insurance act languished.

As leaders of both parties in the Senate worked to fashion their own version of the "Terrorism Risk Protection Act," which was passed in early December by the House of Representatives, the president came to Capitol Hill to help work out a logjam that had derailed the act's quick consideration. Citing the need for a healthy insurance industry to maintain economic stability, the act notes that insurance is "critical to economic growth, urban development, and the construction and maintenance of public and private housing."

If passed, the act will establish a ceiling that caps insurance company losses, above which the federal government would step in as the insurer of last resort.

Tough tomorrows

Looking ahead, the picture doesn't improve much, says Brown's insurance agent, Blake Johnson, of the Minard Ames Insurance Group in Phoenix.


Toxic Awards

Insure Survival

"What is ahead? It is not good. Reinsurers are talking about 200 percent to 300 percent increases. This makes me wish I had stayed in commercial and never started taking residential policies. I have builder clients deciding now if they can stay in business," Johnson says. "I know a guy who's been in concrete work for the past 30 years, a subcontractor who never had a claim. His agent brought him in for renewal. He was paying $85,000, and his renewal quote was $379,000," Johnson says. "The guy comes to me and says, 'Blake, that is more than $1,000 a day. Where am I going to get $1,000 a day to pay insurance?' He talked to one of his competitors, and they tell him their policy doesn't come up for another six months. So how is this guy going to compete if he has to jack his fee up by $1,000 or so a day? He's not. By the time his competitor comes up for renewal, there will be one less concrete guy in the business."

"If subs have no insurance, claimants are going to look to their resources, which usually are non-existent," says Houston-based home building consultant Isaac Heimbinder. "Attorneys are going to rip right through the subs to the builder. If you are still building homes without knowing for sure that your subs are adequately covered, you are asking for big, big trouble."

Follow the bard

Steve Hackney, president of Christopher Homes in Las Vegas, worries about his subs' ability to buy coverage, too. He now buys wrap policies that cover everyone working on the house, which costs about $7,000 per single-family house. But times are changing fast. In Nevada, for example, the powerful trial lawyers industry is reeling in huge fees, suing builders in class action cases for product defect claims. Builders find out about the alleged shoddy construction when they are served with a lawsuit.

A series of articles on how builders can identify and mitigate hidden costs that decimate profits.

Gathering Storm

Full Disclosure

Risk Retention

"In Nevada, liability rates have increased 300 percent to 400 percent for home builders and up to 500 percent for subcontractors strictly because of defect litigation," says Leslie Bausher, chair of the construction litigation committee of the Southern Nevada HBA. "Add onto that all the other factors, and the rates will just keep going up. Mold is just beginning to be a problem out here. The rub is that attorneys are prosecuting these cases without even giving us a chance to fix the problems, and the insurance companies are settling. The result? Our rates get jacked up--again and again." Bausher, vice president for corporate systems at Las Vegas-based American West Homes, and Hackney laugh bitterly when reminded of Shakespeare's advice to "kill all the lawyers." Bausher says, "The insurance companies just decide what they would pay to fix the problem, and the attorneys, with their panel of experts, come up with their solution and their price. Many times they say the house has to be completely demolished and rebuilt. ... The insurance companies typically meet them somewhere in the middle and settle.

"We never get a chance to just fix the problem," Bausher continues. "The sad part is that the homeowners don't either, as they most often recover too little money to pay for the repairs after the attorneys take their expenses and their 40 percent fee."

"Already we have seen new-home prices increase 12 percent in the past year," Bausher adds. "Las Vegas used to be known nationwide for its affordable housing prices. Not any more. The average price here is $171,000, thanks to insurance rates, land scarcity, and the extended entitlement process." Some insurers have already withdrawn from the red-hot Las Vegas market, Hackney says.

"You can't find a sub who is insured to work on a multifamily project anymore, and that's typically any market's affordable housing," Bausher notes. "It's criminal, what is happening, and it's not peculiar to Las Vegas. It has spread to Phoenix, Tucson, Ariz., Denver, and Sacramento, Calif., to name a few."

D.I.Y. insurance

Medium and large builders are exploring self-insurance as a remedy. "As it is, the industry is soon not going to have anyone insured for mold anyway," says David Hill, CEO of Kimball Hill Homes in Rolling Meadows, Ill. "We're under siege. The insurance companies are trying to make huge premium leaps to cover their losses from Sept. 11 and instill as much dismay in consumers as possible in order to increase the pressure on Congress for a bailout. We won't know the full dimension of this problem for at least another six months."

Having hired a senior executive away from Kemper Insurance Group, Hill has been learning the ins and outs of self-insurance for the past year and prodding the NAHB to educate the industry on the concept. "Many of the largest and most sophisticated builders are forming captive insurance companies and owner-controlled insurance roll-ups.

"We have run a roll-up for a project in Chicago, where we self-insured with an umbrella policy from an insurance company," Hill says. "What you do is create a roll-up with an umbrella, and then go out and have the contractors pay you premiums for general liability and workman's comp. If you then actively monitor quality and run a comprehensive safety program, you should be able to control your risk. For builders of 1,000 units or more a year, this is something you should examine closely. The umbrella can cover you for say anything over $1.5 million to $10 million or more. But you are responsible for anything under the umbrella."