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Over the last few years, residential home builders have seen their insurance deductibles soar as a result of a wave of big losses on construction defect claims.

With insurers demanding they accept more of the risk in the form of higher deductibles, an increasing number of home builders are turning to the alternative market to form captives.

"We have a very high deductible on our general liability program," says Deborah Broom, vice president of risk management at KB Homes, which is based in Los Angeles. "So what we decided to do was to formalize our risk exposure, formally assess it," she says. After assessing it, the company decided to form a captive, which would help it to comply with Sarbanes-Oxley because the reserves for the exposure would be more carefully audited, she says. The captive would provide tax advantages as well.

KB Homes established Escoba Insurance Co., a single-parent captive, in October 2006 and domiciled it in Arizona.

"It is essentially for our long-tail construction defect exposure," Broom says.

KB Homes is not the only residential home builder taking this route. The entire industry is feeling the squeeze.

"There's definitely been a significant increase in captives in the construction industry, and particularly I have noticed it in the last year or two in the Western states. And so you will see domiciles like Hawaii, Arizona and Nevada," says Ron Kozlowski, consulting actuary at the Tillinghast arm of Towers Perrin.

"I have a couple of large national home-builder clients that have been looking at doing it," he says. "There are some that have not started up yet, but they may in the next year or so."

Big losses on construction defect claims have driven a number of insurers out of the construction market, and those that are left are offering much more limited coverage, with significantly higher deductibles--all at a higher price.

As a result, a lot of the large home builders have to take retentions of up to $10 million.

"Since the largest home builders have self-insured retentions of up to $10 million, it is much more important for them to put more of a structured process in terms of how they are funding these liabilities," Kozlowski says.

CAPTIVES ALL AROUND

Although home builders have been actively forming captives, other industries are also showing an interest.

Hospitals and physician groups continue to form captives, for instance, because of the problems they've been experiencing with medical malpractice. Insurance companies and real-estate owners have also been active in forming captives. In Vermont, the biggest domicile in the United States, captives were formed by nine insurance companies and by seven real-estate companies.

"Real-estate owners have been active lately due to the high property rates in the commercial market," says Mike Meehan, regional marketing coordinator at Milliman Inc. "This is especially true in coastal areas where catastrophe rates are particularly high," he says.

A growing number of captives are also being formed in order to provide employees with health insurance benefits.

Although the rate of captive formation in Vermont is down from its peak in 2002-2003, captive formation still remains strong, says Derick White, director of captive insurance at the Vermont Department of Banking, Insurance, Securities and Health Care Administration.

In Vermont, statistics show that 37 captives were formed in 2006, equal to the number of captives formed in 2005, but down from the high of 77 in 2002.

"Despite the relatively soft market we are in, the captive market continues to grow," Meehan says.

Even though captive formation has returned to more normal levels after peaking in 2002, there is still plenty of room for additional captive formation, according to Aon.

While some sectors have a long history of using captives as an alternative to traditional insurance, other industries have not yet really embraced the concept--and that could mean opportunity for additional captive formation in the future.

Research shows that more than one-third of the Global 500 companies do not currently own a captive, according to the Aon G500 Captive Report released in late 2006. The Global 500 list is sourced from the CNNMoney.com Web site and is based on size of revenue.

Even in the United States and Europe, where captives are a familiar concept, 22 percent of the companies do not have a captive.

"Captive formations have been steady," says Nancy Gray, executive director at Aon Insurance Managers. "Captives continue to be formed in a soft market."

In fact, deductibles often remain high even though market conditions soften, giving companies yet another reason to consider captives.

"In the hard market conditions, it's both pricing and capacity (that drive captive formation)," Gray says.

"In a soft market, pricing may be down and capacity might be acceptable, but the deductibles are still high," she says.

Alberici Corp., a construction company based in St. Louis, formed its first captive, Contractors Casualty Co., in 1992. It handles most of the company's risks, including general liability, workers' compensation and auto.

"In 1992, when we actually formed the captive, it was the beginning of the softer market," says John Alberici, chairman of Alberici Corp.

"I think the lesson there is you really need to take a long-term view of insurance when you form your own captive. The conditions in the market at any given time are going to vary, and as soon as you make plans on it being a tough market, it's going to turn," he says.

Companies that formed captives in Vermont in 2006 did so to cover a variety of risks. The greatest number, 13, were formed to provide property insurance. Another 11 were formed to cover general liability, and nine were formed to cover workers' compensation insurance. Four were formed to provide health insurance.

Even though there were no captives formed by residential home builders in Vermont in 2006, the state is home to several large ones, which were formed over the last several years, White says.

Big builders like Pulte, Beazer, Centex and Toll Brothers all have formed captives in Vermont.

WILD WILD WEST

But most of the action is taking place in the Western part of the United States, where the construction defect exposure is the greatest.

As a result, it is the home builders with big operations in states like California, Nevada and Arizona that are at the greatest risk and are under the most pressure from their insurers. They are, therefore, the most likely to be considering a captive.

However, an area of emerging risk is the Gulf states of Louisiana and Mississippi as a result of reconstruction following hurricanes Katrina and Rita, Kozlowski says.

Construction defect claims are such a problem for a couple of reasons. Under the statute of repose in California, construction defect claims can be filed up to 10 years after the problem emerges. That makes it a particularly long-tail line of business for insurers.

In the mid-1990s, things got even more complicated as a result of a court ruling in California that said claims of this type should be treated as a continuous trigger on policies, according to Kozlowski. So rather than having a claim be under just one insurance policy with $1 million in limits, for instance, the courts said this was a continuous loss and affects 10 years of policies, each with $1 million in limits, for a total of $10 million.

The problems were compounded by the fact that California experienced an unprecedented growth in population between the 1970s and the 1990s and housing was in short supply. A lot of construction went up very quickly.

In addition, the plaintiffs' bar in California was extremely aggressive.

No one tracks exactly how much the insurance industry has lost due to construction defect claims, but Kozlowski, who is a leading expert in this area, says he has reviewed at least $11 billion in construction defect claims.

"The 90s were tough times for the construction industry from a litigation standpoint," Broom says. "The (insurance) companies that got hurt in the 90s began to say, 'We think construction is a bad risk, and we don't want to write it.' The ones that used to be what we called the primary carriers are simply saying we don't want to write it, or if we do, we're going to charge you gazillions to do so," she says.

"For the very large builders, there's simply no market for it. You can self-insure for less than you can buy that insurance," Broom says.

Ironically, the worst problems may be behind the residential home builders. In many cases, third-party inspections are now the norm, and some home builders are using improved materials.

"In my mind, I'm probably more bullish on these risks today than I was historically," Kozlowski says.

Broom of KB Homes agrees.

"There's a lag--a four-, five-, six-year lag--in what the insurance underwriters perceive as risk and what I think the actual risk is," Broom says. In spite of changes for the better within the industry, "underwriters are sitting it out and want several years of proof to believe it," she says.

Those home builders who are doing a better job and are now better risks still get lumped in with all the other home builders.

"So if we say we do know what our company has done, and our company is doing it different and better, we don't get the benefit of that unless the underwriters believe the entire industry is doing it better," Broom says.

And residential home builders that feel they are not being given credit for being better than the rest of the industry are the very ones most likely to look at a captive.

"They feel their loss history is better than the norm and that they should get better treatment. But they are all lumped together as bad risks," Aon's Gray says.

Although KB now has a captive, that doesn't mean the company can't return to the traditional insurance market some time in the future if market conditions improve.

"There's this perception that once you set one up, you have to live with it for however many years," she says, adding that the opposite can be true: You can change your mind if the market softens.

"If the cost of insurance comes down, or the market opens up, then you take your predetermined exposure and you sell it," Gray says.

There are other reasons companies in the construction sector form captives.

In the case of Alberici Corp., it was the opportunity to better manage insurance costs and improve the company's overall profit margin.

Profit margins tend to be very small for construction companies, and insurance is one of the biggest costs for companies in that sector.

"All of the insurance costs amount to 10 percent to 12 percent of that project," Alberici says. "All of those coverages amount to a very large dollar amount of the project." If you could reduce those costs by just 1 percent or 2 percent, you could double your profit margins, he says.

Many in the construction sector, however, just want to build things and don't want to be bothered with thinking about managing risk.

"If you say, 'I'm just in construction, and that's just the cost of being in construction,' you may be missing what is a very controllable addition to your profit line," he says.

As you grow and really start to understand what construction entails, you find that construction is not just construction, it also includes risk management, Alberici says.

"That's why more contractors, especially of a certain size, understand they are in the insurance business whether they want to be or not," he says.

PATRICIA VOWINKEL lives in New Jersey.

March 1, 2007

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