Reform of Wrap Insurance Limits California Subs' Liabilities On Construction Defects

When Assembly Bill 2738 went into effect in California on Jan. 1, contractors were understandably gleeful.

The bill, which reforms defense obligations in what’s known as “wrap up” insurance policies for construction projects, limits a trade’s liability to the scope of its work, restricts the extent that a home builder can enforce a contractual indemnity claim against a trade partner, and requires builders to provide greater transparency about their wrap up policies to their contractors.

The California Professional Association of Specialty Contractors, which helped move this legislation through the Assembly, heralded the bill that Gov. Arnold Schwarzenegger signed last September as “an enormous victory” for its membership and specialty trades throughout the state. Builders, not surprisingly, were not so enthused.

But ask George Dale, and he’ll tell you that it could have been much worse for builders, were it not for lobbying efforts by the California Building Industry Association and Aon Residential, a Los Angeles-based broker and consultant that worked with the trade group, and where Dale is executive vice president. Indeed, Dale refers to the original version of this bill as “heinous” and, if passed, something that “would have destroyed the housing industry.”

Hyperbole aside, this issue does have some history in California. A “wrap up” is where a builder buys insurance for a construction project under one policy, and has respective parties, such as trade partners, chip in for the cost. Wrap ups became more common for residential projects in California at the beginning of this decade, as builders sought solutions to resolve construction defect lawsuits that had become unwieldy to administer when there were multiple insurance policies for various trades involved.

Dale notes that the popularity of wrap ups grew as the state’s insurance market soured around 2003, when insurers were pulling out of the state. He adds that contractors’ insurance policies typically have exception clauses for multifamily projects, so builders felt they needed more protection.

Any construction-related insurance policy needs to placed within the context of SB 800, which became law on Jan. 1, 2003. That bill (which applies to all new construction but not condo conversions) provides a mandatory grievance process that homeowners must follow before they can file a lawsuit over construction defects. The bill established the standards of that process, and the homeowner could proceed with litigation only after he or she had exhausted all other avenues of redress with builders and contractors.

Prior to 2006, though, certain provisions in wrap up insurance policies obligated a subcontractor to indemnify a builder for all losses except damages caused by the builder’s sole negligence or willful misconduct. AB 758, which was sponsored by the subcontractor industry and went into effect on Jan. 1, 2006, contained limitations that significantly diminished indemnity for a builder. However, that bill’s impact was watered down by exceptions, say legal sources.

Dale says that AB 758 didn’t assuage contractors' discontent about the way builders were administering wrap ups. And the initial language of AB 2738, which the subcontractor industry pushed lawmakers to pass, had “very little” input from builders. “It was very one-sided,” says Dale. CBIA’s general counsel Nick Cammarota and Gene Urban, chief lobbyist for Aon Corporation, of which Aon Residential is a division, opposed the bill in testimony.

Dale, who sits on CBIA’s board and who chaired its risk management and insurance committee last year, says that Aon Residential hired its own lobbyist who managed to set up at least 10 meetings between builders and the bill’s author, Assemblyman Dave Jones. (What surprised Dale was that Aon was the only insurer/broker at the table during these meetings.)

The builders got Jones to tweak the language of his bill so that it alters the defense duty guidelines for construction defect claims. Builders didn’t get everything they wanted, but at least the bill “gives them the opportunity to revisit and redraft agreements with trade contractors in light of the current economic environment,” says Dale. He notes that the first step in this process should be a “thorough review” of the risk transfer structure between builders and contractors, followed by an evaluation of claims experience and assessment of how the wrap up programs had been structured.

Dale isn’t completely satisfied with the results. For example, AB 2738 requires builders to include self-insured retention programs, or SIRs, in all wrap ups for residential construction.

SIRs are like deductibles, where the builder itself would handle claims and disputes up to a certain payout threshold. Most builders had these in their wrap ups and it isn’t uncommon for big builders to have $1 million SIR programs in place for large projects.

But the bill spells out more specifically the circumstances under which builders can charge subs for these programs; for example, it can only be charged if actual costs are incurred, and the builder has to give written notice of the basis of the SIR contribution.

Dale tells builders that they need to change their contracts and wrap ups to take advantage of the new law’s language, even though any construction defects on homes built today won’t show up for years. But he says it’s a “safe bet” that many builders won’t act immediately, based on past experience: when SB 800 became law, Aon was still helping builders comply three years later.

John Caulfield is senior editor at BUILDER magazine.

Learn more about markets featured in this article: Los Angeles, CA.