December 15, 2005

Is it safe to jump back into the condo market?

  • With insurance expensive or difficult to get, developers need to take control of their projects by using risk management techniques.
    Schwabe, Williamson & Wyatt


    The Seattle condo market is growing hotter. Rising single-family home prices, more empty nesters, and growth management regulations favoring denser urban development are all factors fueling the popularity of condominiums.

    Yet despite the need and the opportunity, developers and contractors are facing a major challenge. The high cost of insurance for construction defect claims is impeding new condo development and increasing prices for consumers.

    With the high stakes for our region, there needs to be a continued focus on how to resolve this important issue. Legislative reform efforts have met with limited success. Condo developers must take charge of their own destinies by adopting sophisticated risk management approaches.

    The crisis

    Condominiums, by their nature, generate more construction defect claims than detached single-family homes. In a condo project, if a defect occurs in one unit, it is likely to be repeated throughout the building. The risk is compounded by current law, which provides expansive liability for defects. Plaintiff lawyers anxious to earn contingency fees have used statutory condo warranties to obtain millions of dollars in settlements from insurance companies.

    Contractors and building professionals, including architects, claim that the situation has gotten out of hand, and that plaintiffs' lawyers are preying on condo association officers worried about personal liability. The result appears to be lawsuits that the public might easily deem as frivolous.

    The impact

    According to the Building Industry Association of Washington, the extremely litigious environment in Washington state has caused many insurance companies to pull out of the contractor liability market. As a result, a majority of subcontractors cannot obtain liability insurance for condo projects. Those that can obtain insurance often pay high premiums.

    According to Stan L. Bowman, executive director of the American Institute of Architects Washington Council, "The liability insurance market in Washington is one of the worst in the nation when it comes to the cost and availability of insurance for architects, engineers and contractors."

    Although construction industry groups label prevailing premium rates as "exorbitant," John Emery, senior vice president of Marsh USA, an insurance brokerage firm, says that the reasonableness of insurance premiums is in the eye of the beholder. He says that insurance companies who insure in this market expect to be compensated for their bravery, and charge premiums commensurate with their risk.

    Whether insurance costs are viewed as reasonable or exorbitant, the fact remains that some quality builders have abandoned the condo market for other types of construction in order to avoid the higher risk of lawsuits and the high cost of insurance. Other condo developers buy so-called "wrap-up" insurance, insuring not only the developer/owner but also the general contractor and subcontractors at every tier. To reduce the high cost of these policies, many developers self-insure some risks, purchasing only so much liability insurance as they believe they need and can afford.

    And, a few irresponsible developers plan to sell condos quickly, distribute the cash, and rely upon their limited liability company to shield them from liability for any major defects. Ultimately, it is the consumer who pays.

    Addressing the crisis

    Washington legislators have not been idle. In 2002, the Legislature enacted a "right to cure" statute, which prohibits the filing of a lawsuit for construction defects until the builder is notified and given an opportunity to fix the defect, even though there is no requirement that the builder's offer be accepted.

    Then, in 2004, the Legislature amended the Washington Condominium Act, with language modeled after the B.C. Homeowners Protection Act, to provide a non-mandatory version of home warranty insurance. Other legislative changes have addressed construction industry concerns by, among other things, requiring proof that the defect will adversely affect the performance of the condo.

    And, earlier this year, the Legislature enacted new measures to prevent water intrusion and to promote the early and cost-effective resolution of construction defect claims through mediation or arbitration.

    Washington legislators hoped that insurance companies would respond to these legislative changes by offering home warranty insurance and by reducing liability insurance premiums. Unfortunately, this is not yet happening. Despite the legislative changes, home warranty insurance is not available and condo developers continue to find it difficult and expensive to obtain liability insurance.


    So, what else needs to happen? Further legislative changes might be attempted. Some states, such as Maryland, have adopted "certificate of merit" requirements, which require the owner to obtain expert confirmation of the existence of defects before a suit can be filed. Kansas requires the agreement of a majority of unit owners to authorize a condo association to file a lawsuit for construction defects. Still others, including the British Columbia government, impose regulatory requirements on builders and mandate a minimum level of insurance per building.

    Ultimately, insurance costs will come down only if the insurance industry changes its assessment of the risk. If the perception of runaway liability in Washington can be reversed, it is likely that insurance companies that abandoned the market will return, and competition among insurers will result in more rational pricing of coverage for condo defects.

    Fortunately, condo developers can be proactive risk managers, even in this complex environment. Insurance products are customized, not off-the-shelf, and creativity is possible. For example, a developer can obtain minimal-premium, first-dollar coverage by collateralizing a so-called "fronting policy."

    Developers can become expert risk managers by employing best practices in contracting and management. This means adopting provisions in their contracts which directly address the claims process and construction-related risk, and which work seamlessly with the developer's insurance program. Developers can also manage risk effectively by using trusted contractors, methods, systems and materials; competent construction supervision; and periodic and well-documented inspections.

    The potential rewards are great. Lower insurance costs encourage the development of denser, affordable housing, and enable builders to manage their construction-related risks. Ultimately, it is the consumer who would benefit most — by peace of mind and lower condo prices.

    Dennis A. Ostgard is a shareholder with the firm of Schwabe, Williamson & Wyatt. He is chair of the Seattle office's Real Estate and Business Practices.

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