Californian residential construction - goldmine or landmine?

West coast residential construction liability is an interesting business class. Premiums are high and the perceived profit potential is significant - which is why there is plenty of capacity studying this sector. However, an analysis of capital providers shows that most of the interest is from new entrants.

The 'old guard', remembering the losses of the 1990s, continue to give residential construction a wide berth or have engaged with great caution. They, better than most, understand that despite the new more sympathetic legislative environment, there is still an active plaintiff's bar and a number of well-remunerated homeowners with a penchant for litigation.

In the late 1980s and 1990s, California residential construction was a minefield for builders, contractors and their insurers. Not only were construction standards low, there was no definition of what constituted a building defect - other than what a good lawyer might reasonably persuade a jury to accept. The so-called 'Montrose' decisions in 1996 made conditions even more difficult. The court mandated a continuous trigger for coverage, making insurers liable for damage that had occurred prior to their own policy period which 'continued' into their own.

Over the years, the construction and insurance industries took a financial beating trying to resolve disputes. Only in 2003, when the California Senate became aware of the lack of commercially available builders' coverage and lack of affordable housing, did the pendulum start to swing back. First there was SB800, the 'right to repair' law which gave builders and subcontractors the right to fix problems before homeowners could file a lawsuit. A second law, passed in January 2006, redressed a historical imbalance in indemnity between builder and subcontractor. The law now reads that subcontractors can no longer be held responsible for the negligence of others in the construction of privately-owned residential housing.

Risks are not straightforward and caution remains essential

It's not surprising therefore that new capital is starting to investigate the class. Construction codes and inspections have been enhanced, peer review and visual recording of construction processes is now commonplace and quality has improved. Many of the poor performers have been identified and homeowners are less inclined to sue because declaration of a construction defect dispute tends to diminish prices. What's more, 15m people (the same number as live in the whole of Greater London) are expected to move to California by 2025, so there will be no shortage of demand.

History has clearly shown however, that risks are not straightforward and successful underwriting hinges on the ability to deconstruct the last ten years of legislation and loss in order to understand all the risk drivers. Just because there is a tendency to write more coverage on a wrap-up basis does not mean the underlying risks are better understood, or controlled, nor that they should be priced lower. This is a long tail class where risks must be engineered and where only a very few have access to long-term, high-quality data.

Kevin Hastings