Limiting Construction Failure Losses – A Challenge for the Insurance Industry

Thomas K. Butt, AIA, is President and John E. Clinton, SE, AIA, is Chairman of the Board of Interactive Resources, Inc., an architecture-engineering firm in Richmond, California. Mr. Butt is a registered architect, licensed general contractor, and real estate broker. Mr. Clinton is a registered structural engineer and architect. Interactive Resources, Inc., has investigated construction failure in over 5,000 multi-family dwelling units as well as hundreds of institutional and commercial projects. The firm has also provided pre-loan reviews for over two billion dollars of commercial, industrial, and multi-family residential projects ranging in construction cost from $5 million to $100 million.


In the elder days of Art,
Builders wrought with greatest care
Each minute and unseen part;
For the Gods see everywhere

    –Longfellow, The Builders

All of us routinely use and occupy buildings. We expect them to keep the wind and rain out and to keep us comfortably cool or warm within. Above all, we expect them not to fall down.

When something goes seriously and unexpectedly wrong with a building, it is known as building failure. When buildings fail, we don’t just suffer; we call someone to take responsibility. In addition to a repair person, the architect and contractor will probably be notified. And most assuredly, someone will call one or more insurance companies.

Among the biggest building failure stories of the last decade in the United States are the Hyatt Regency Walkway collapse in Kansas City which killed 113 and injured 186 the l’Ambiance Plaza collapse in Bridgeport, Connecticut, which killed 28 construction workers, and the MGM Grand Hotel blaze in Reno which killed 85 people. Not as dramatic and consequently not as well reported as the initial death and destruction are the billions of dollars of claims faced by the insurance industry and others. At the other end of the building failure spectrum are the leaky roofs, cracked floors, and clogged sewers which kill or injure no one and merit not a single inch of newspaper coverage, but in aggregate cost may exceed the loss from the more spectacular calamities.

Losses relating to roofing leaks are by far the most numerous, followed closely by losses from leaks or unexpected deterioration in other defective building components such as exterior cladding, windows, doors, and balcony decks. In addition to the obvious cost of repairing the leaks and any damage to finishes and contents, there are often significant costs incurred in repairing hidden structural damage such as decayed wood framing, corroded metal framing, or rusted concrete reinforcing. Completing the list of common building failures are poor drainage, earth movement or foundation settlement, inadequate heating, cooling, plumbing, or electrical systems, and defective fire-resistive or earthquake resistive systems.

Although the nature of failures is often uneventful, the cost is not. A typical condominium related building failure claim can be in the tens of millions of dollars. A recent example in the San Francisco Bay Area was so severe that an 80-unit complex was razed to the ground and reconstructed from scratch at a cost of $6.5 million, not including additional hundreds of thousands of dollars for litigation related costs.

The fact that the vast majority of buildings function generally as intended is a tribute to this unique industry. Building failure is nevertheless a widespread and costly burden on society. This is not just a problem for the insurance industry. The costs and inconveniences affect everyone.

There is little dispute among knowledgeable students of building failure about its causes and the appropriate solutions. What is lacking in the way of a remedy is a catalyst to influence change in the construction industry production cycle. The insurance industry is in a unique position to act as this catalyst, to both influence and benefit, from a reduction in the incidence and cost of building failure.

The end result may have to be a fundamental shift in the way Americans perceive the relationship between initial cost and expected performance, including the useful life, of buildings–perhaps something closer to the northern Europeans who traditionally build for the ages rather than the moment.

Defining The Problem

A. Why Do Building Failures Occur?

Building failure doesn’t occur randomly, nor does it occur for no apparent reason. Those who investigate it find that most cases share common characteristics or substantial similarities. Eight building types account for 80 per cent of reported incidents: multi-family, educational, office, health, retail, lodging, warehouse, and assembly. Apartment buildings and condominiums experience the highest number of performance problems. In California, particularly, the instance of building failure in condominiums and subsequent litigation has become legendary.

A 1987 study by the California Department of Real Estate indicated that one third of the common interest associations surveyed statewide reported major defects in the original construction. For associations without developer representation, the rate of defects was even higher. Thirty-seven percent reported major construction defects. Only thirteen percent reported no defects.

Other multi-family and tract residential projects as well as light commercial and tilt-up industrial buildings are also hard hit by building failure. According to the one study, the Northeast has a higher incidence of building performance problems than other parts of the country.

Maintenance and repair of existing buildings such as reroofing and repainting also generate substantial instances of failure. Developments in product technology, such as new roofing systems and materials; cement additives for concrete, mortar, and stucco; and exterior wall finish systems have been frequent culprits in losses totaling hundreds of millions of dollars. The use of traditional materials in new and untried applications has also resulted in unanticipated failures.

Unsophisticated owners such as amateur real estate developers and investors who are not technically familiar with the construction process often fall victim to their own ignorance by simply not knowing what it takes to adequately design and construct a building. Architects and engineers involved in building failure are often found to have been taking on more projects than experienced managers can adequately supervise or designing building types or systems with which they have had little or no prior experience. Failures often may have been preventable if the design had provided a full range of administrative services during the construction phase. Even if architects and engineers have not been paid or contracted to provide such services, they are usually sued for the omission in building failure litigation.

B. How is the Insurance Industry Affected?

Although experts say it is difficult to tell if the incidence of building failures has increased over the last several years in the United States, there is a perception that the amount of litigation and insurance claims losses related to building failure was. Claim and litigation targets include not only first party insurors of building owners and occupants, but the entire array of parties involved in the construction process, including architects, engineers, contractors, building product manufacturers, developers, lenders, and real estate brokers. In 1986, a study indicated the claims against architects and engineers had risen in 10 years from 11 per 100 insured to 44 per 100, although these have recently fallen off to 30 per 100 in 1989.

Coverage affected by building failure claims includes not only property damage, but also personal injury, professional liability, product liability, and completed operations. Insurance companies have become the victims of building failure in their role as lenders or investors in problem-plagued properties. Claims paid nationwide for some aspect of building failure are in the hundreds of millions of dollars annually.

It can be persuasively argued, however, that the insurance industry is not adversely affected by the rate of building failures. Like the casino that must send out some winners to keep the rest of the gamblers betting, the insurance industry must have losses to keep the premiums coming in. So long as the cost of adequate premiums does not outstrip the public’s ability or willingness to pay, the level of losses may be of little interest to the industry.

C. Building Failure Litigation

Construction claims litigation is uniquely complex. A typical case which is usually settled before reaching a jury trial may involve court mandated pre-trial status or settlement conferences, or mini-trials attended by one hundred or more attorneys, experts, and insurance carrier representatives. All parties to construction litigation can agree on one thing–it would have been far less expensive to have constructed the project with an appropriate level of quality in the first place than to mitigate it after the claim is paid off. Attorneys, experts, and insurors who regularly participate in building failure litigation generally agree that there must be a way for the construction industry to reduce losses due to building failure.

The insurance industry and the legal profession are obviously involved with building failure. They are supported by a growing coterie of architects, engineers, and contractors who investigate, act as expert witnesses, and design and construct repairs for building failure. The trend toward institutionalization of failure is demonstrated by the recent establishment of an organization of more than one hundred individuals in the building industry calling itself the Western Construction Consultants Group, which was recently chartered in the San Francisco Bay Area. The common interest shared by its membership is providing some technical service related to building failure.

Whether economic relief is sought through litigation, an insurance claim, or both, the cost of repair is usually assumed by either a deep pocketed lender, who probably wound up with the property through foreclosure, or an insuror. The owner seldom recovers the full cost of repair and thus becomes another contributor through payment of legal fees, higher maintenance costs, reduced property values, or a portion of the ultimate repair costs. Insurance and lender losses are eventually passed on to society in the form of insurance premiums, interest rates, or taxes to fund such activities as the Federal savings and loan bailout. The principal beneficiaries appear to be the legal profession, the claims industry, and their technical consultants who orchestrate this transfer of funds.

D. Who Is Responsible?

What segment of the construction industry could best lead the way toward sounder construction with fewer or less expensive failures? To ascertain the opportunities for quality control, it is first necessary to understand how the key components of the construction industry interrelate. The industry could be characterized as a circle like the classic chicken and egg riddle, with no discernable beginning or end.

One of the reasons that building failure cases are usually settled out of court goes beyond complexity and expense. The prevailing shotgun approach implicates virtually every party who was involved in a failed building regardless of culpability. Most insurers are predisposed to pay nuisance dollars rather than work through a thorough investigation and determination of actual cause. Because so few cases are tried in court, the reasons for failure remain murky and are publicized neither to the general public nor to the building industry. One result is repetition of the same mistakes year after year.

1. The Marketplace

A good place to start to dissect the building industry construction cycle is the market need or user demand that drives it. In a competitive marketplace, perception is usually more important than reality. Like selecting breakfast cereal in a supermarket, we are often more sensitive to the package than to the contents. If two homes are constructed across the street from each other identical in all outward respects, except that one has better and more expensive foundations, seismic resistant structure, fire protection, exterior paint systems, roofing, and plumbing, it is highly unlikely that the better constructed unit will be able to command a significantly higher price than the other. It could be argued to the potential purchaser that the higher priced unit will result in lower long-term maintenance costs and carries fewer risks of damage due to wind, fire, or earthquake, but it is unlikely he will be swayed. Except for the sophisticated or image-conscious corporate user, the response is similar. Office space goes for “x” dollars per square foot, and to spend more than that would be difficult to justify economically. The marketplace, then, is often the lowest common denominator and defines a level of quality that may not reflect the lowest life cycle cost or the optimum level of risk management.

2. The Developer or User

Based on the economic characteristics of the market or the accepted allowable cost of non-speculative product, the developer or user moves to initiate a project conforming to a predetermined need. Under the surface of most building failure cases involving speculative development can be found an attempt to conform to the appearance demanded by the marketplace while executing the project at a significantly lower cost than the competition. If we were talking about achieving this savings through efficiency and innovation, it would be merely capitalism and entrepreneurship functioning in the marketplace. What usually happens instead is a grab for the proverbial “free lunch” consisting of low or deferred design fees, cheap but inexperienced contractors, and new but untested building products. This leads to corner- cutting by all members of the construction team to attempt to recap losses due to inadequate planning in the early stages of the project. Contractors, design professionals, and others often end up paying the price for savings of developers whose greed may have initiated the problem.

3. The Design Team

Construction failure is most prevalent in speculative construction where pressure by the marketplace keeps construction costs low and pressure by developers keeps design fees low. Architecture is a very competitive profession where remuneration is often as much in the form of intangible artistic rewards as it is in cash. Salaries for entry level graduate architects are usually among the lowest in any field and are probably close to the bottom in proportion to total hours of college level education. Architects are often paid less to design and provide construction administration services for new buildings than real estate brokers are paid merely to sell them. This squeeze on design fees is both self-imposed by the architectural profession and externally imposed by a competitive marketplace. The result can be drawings and specifications that are not as complete, well coordinated, and as well researched as they could be. Unfortunately, the early period of a project where astute planning can exert the highest influence on quality is usually squeezed the hardest.

The end result in speculative construction projects is that detailing during the design process is seldom up to the standard it should be. The benefits of construction phase services by the architect, which can contribute greatly toward quality control, are seldom fully utilized in order to reduce total project costs which begin to be depleted during the construction phase. Although fees for government work may not be any higher than for other types of construction, the in-house reviews and checks by the contracting agencies maintain a level of design and construction quality that would substantially increase fees if the same services were routinely provided by the design professionals.

4. The Contractor

Lack of knowledge and relevant experience, inadequate supervision, and lack of trained mechanics provide the usual context for construction failures. Although the range of available construction techniques and materials continues to expand, and higher technology processes and systems are continually being adopted for building construction, the way workers in all trades of the construction industry are trained and kept abreast of technology has not kept pace. Except for some union members, construction workers often get no formal training. Their trade is learned on the job–often from someone who lacks adequate experience to be a teacher. Most construction trade unions no longer provide the same rigorous apprenticeship training system as in the past. As a result, it is not at all unusual to find contractors, subcontractors, and workers on the jobsite who have not read the project specifications and have no familiarity with detailed industry standards incorporated into the specifications by reference. There is often a vast gap between the quality of construction envisioned by the architect and the quality that is actually constructed.

5. The Building Material Manufacturer

Unlike pharmaceuticals, new building products are often crash marketed and highly promoted without adequate testing. The promise of reduced construction costs has enticed developers as well as other builders into some incredibly expensive, product-related construction failures in the last decade. Flash-in-the-pan materials such as “Dual 80” roofing (a two-ply built up roofing system), “Sarabond” (a mortar additive), and “Rescon” (an exterior stucco-like wall system using gypsum board) have become the stuff of legend for construction failure investigators and have cost their manufacturers and their manufacturers’ insurors hundreds of millions of dollars in claims-related losses.

6. Regulation

Building codes began from a concern initially limited to life safety but evolved to include issues related to preserving property values as well. In the process, they have come to be falsely regarded by many as defining an optimum level of construction quality rather than the minimum level they were intended to set. Perhaps the most damaging myth about the building construction process is that the local building inspector is assuring that the project meets the building code.

While the standard plan check and jobsite inspection process may prevent some catastrophic failures, the level and frequency of inspection is seldom sufficient to prevent the most common types of failure. In fact, the charge of the building official is only to provide limited spot checks of a project. Parties to the construction process are assumed to be knowledgeable, earnest, and committed to good construction quality. The victims of multi-million dollar construction failures never quite understand why their local government failed to protect them, or at least tip them off to the risks they were taking.

7. The Product

The completed building or “product” is, like the chicken, where the cycle ends. Or is it, like the egg, where it begins? The public’s demand for the level of quality in the product would seem to define the marketplace, assuming the public is capable of distinguishing the qualitative differences among similar projects. Are they willing to pay for the benefits up front, or like riverboat gamblers, are they willing to accept the risk of future losses in exchange for a lower ante to get in the game? One thing is certain under the present system–once the building project is sold or occupied, failure usually becomes the problem of someone’s insurance company.

Raising Quality To Reduce Losses

A. Tuning Up the Construction Cycle

What mechanisms are available to lower the frequency and overall cost of construction failure? Presumably this could be done through either incentive or regulation. The cost effectiveness of increased regulation either through more rigorous codes or more rigorous government agency inspection is suspect. The incentive approach is worthy of further examination. Lenders, insurors, and the related cost of building operation are three peripheral influences on the construction cycle that can play an effective role in creating a product with a lower potential rate of construction failure claims.

B. Building Operation and Maintenance

Estimates of the total cost of operating a building over its life reach as high as three times the original construction cost. Sophisticated owners who build for their own use or long-term investment are most likely to employ some type of life cycle cost analysis. This may result in selecting building systems and defining the appropriate level of design and construction services for reasons other than initial cost. It is these same sophisticated users who are most likely to employ some program of routine, preventative maintenance to wring the optimum life out of building components. The wide ranging incorporation of energy conservation measures into buildings in the late 1970’s was largely driven by a desire to lower operating costs, although most of the more practical and economical aspects of the technology were also incorporated into the regulatory process.

Buildings offered by developers for the competitive marketplace do not have the same linkage between life cycle costs and construction costs that owner-occupied buildings have.

C. Intervention by Lenders

Lenders have already begun to increase their intervention and effectiveness in the business of construction quality control as a result of disastrous failure problems which came back to haunt them through foreclosures. In fact, some failures may have contributed to or caused foreclosures. There are numerous instances where lenders have ended up with residential condominium projects with fully disbursed loans which require several million dollars of repairs to put into a habitable condition. The growing trend in the lending industry is to conduct comprehensive and technically detailed pre-loan and pre-acquisition reviews (sometimes known as due-diligence evaluations) by knowledgeable consultants. These studies are adequately funded and then fully digested by corporate buyers and institutional lenders prior to closing loans or acquisitions. These comprehensive documents have replaced the “windshield appraisal” techniques and recycled “boiler plate” reviews of the 1970’s and early 1980’s that were consigned to the file with little consideration in evaluating the “deal”.

D. Intervention by the Insurance Industry

The insurance industry historically seized a major role in manipulating the quality of construction. Creation of Underwriters Laboratory, Inc., in 1894 and Factory Mutual Research Corporation (serving the Factory Mutual System created in 1835) are examples of insurance industry leadership in loss prevention. Their original emphasis was on improving technology related primarily to the prevention of fire and wind damage. The insurance industry was also a germinal force in the development of early building codes.

This was an auspicious beginning, but with a few exceptions the opportunities for leadership by the insurance industry currently far exceed the motivations. Some insurance industry sources believe that competition for up front premium dollars and inadequate underwriting standards have resulted in excessive claims and unnecessary long term losses. Industry representatives generally reject any suggestion that they become a catalyst for change in what they perceive as the “social” issues of building construction failure. The insurance industry sees itself simply as a business that reflects the level of risk defined by other segments of society.

One exception is Factory Mutual which funds fire research and sells risk management, including incentives to reduce losses. Another exception is Design Professionals Insurance Company (DPIC) which exemplifies the way that professional liability segment of the industry has in the last decade begun to take an interventionist approach to loss control.

In the mid-1980’s, the market for professional liability insurance for architects and engineers in the United States had been reduced to two companies, DPIC and CNA. Whether this was a function of rising construction claims or unrelated internal problems and maneuvering in the industry is still being debated. Although the market has widened toward the end of the decade, the cost and availability of professional liability insurance is no longer taken for granted, particularly for firms with involvement in high-risk and speculative projects such as residential condominiums. DPIC has taken its concern beyond the marketplace and into the drafting room by instituting a hands-on risk reduction and quality control program which offers substantial premium reductions for participating design firms.

Through premium reduction incentives, constraining the availability of insurance at any price for high risk buildings, and by funding and promoting building technology research, the insurance industry is in a unique position to substantially reduce the occurrence of building failure. Premium reduction incentives can operate on multiple components of the building cycle, including users, developers, design professionals, contractors and building products manufacturers. Several innovative ideas for insurance industry leadership in failure reduction have been floated but have not been adopted.

In the mid-1980’s, the Interprofessional Council on Environmental Design began advocating a concept called Unified Risk Insurance that would insure all the risks of a construction project rather than the individual risks of the participants. One advantage would be to promote better communication and allocating of responsibilities among the project team and shift the emphasis from proving fault to uniting the participants in dealing with problems before they occur or before they become serious.

Jacob Field, a New York City consulting engineer who has probably investigated more failures than anyone in the world has tried unsuccessfully for many years to interest U.S. insurance companies in offering owners the kind of comprehensive structural insurance, similar to fire insurance, available in Belgium, France, and Holland. In those countries, technical control bureaus financed by the insurance companies review and approve the design and construction. On the basis of the technical bureau’s certification, insurance companies underwrite a policy for a period extending ten years after completion. An owner who wants insurance at a reasonable price has an overwhelming incentive to ensure quality during the entire design and construction process. As a private organization, the technical control bureau can operate with efficiency lacking in a public agency.


A significant reduction in the number and cost of construction failures will likely be achieved only by an increase in expectations of the consumer born of increased awareness or by outside intervention of peripheral players such as lenders and insurors. The first cost of certain types of buildings will probably rise, but the net cost to the consumer occupying the building over the long term will almost certainly drop or at least be more predictable.

It is time the insurance industry take into account the use of proven and accepted standards of quality for design and construction of insured buildings that go beyond the minimum standards of building codes. Better quality as demonstrated by buildings with better weather resistance, fire safety and seismic safety in construction should be significantly recognized. Clearly, it will require a missionary zeal by the insurance industry to assure quality previously deferred to others.