California’s Right to Repair Act trips up homeowners insurer’s subrogation claim against builder

March 25, 2014

Insurance LawIn an increasing number of states, owners of new homes who discover construction defects must use statutory mechanisms to resolve their dispute with the builder. The impact of these statutes on the subrogation rights of homeowners insurers has been overlooked. The recent case of KB Home Greater Los Angeles, Inc. v. Superior Court, in addressing this issue, raises significant red flags for insurers.

Dramatic Facts; Quick Action

The facts of KB Home illustrate dramatically the need for homeowners insurance. While the insured was away, a property manager discovered a water leak on the second floor of the home. The manager contacts the owner, and the owner contacts his homeowners insurer (Allstate). The insurer rushes to the rescue—it hires a contractor to remove the water and repair damage to drywall and carpets. Only then did Allstate notify KB Home of its intent to seek reimbursement of its costs under a subrogation action.

The court ruled Allstate lost its subrogation right when it so expeditiously went to the aid of its insured. The Right to Repair Act establishes a step-by-step prelitigation procedure for resolution of construction defects in new residences. The owner must notify the builder of the defect. The builder is allowed to inspect, then has the option of either repairing the defect or offering damages. Because KB Home did not receive notice of the defect until after Allstate had effectuated repairs, the builder was deprived of its rights under the Act and the subrogation action was barred. The court skirted Allstate’s argument for an “emergency” exception to the notice requirement, stating: “Since no notice was given in this case, we need not determine what would constitute reasonable notice under the Act.”

Implications for Homeowners Insurers

The holding of KB Home raises logistical red flags for homeowners insurers. Allstate clearly had the infrastructure in place to respond aggressively to emergency situations so as to minimize damage and effectuate repairs. There is no suggestion in the court’s opinion that the insurer did not act diligently to protect its insured’s interests.

Yet for an insurer to preserve its subrogation rights requires overcoming several organizational and legal hurdles.

First, the insurer must determine which residences are subject to the Act. California’s Right to Repair Act applies to “new residential units” purchased on or after January 1, 2003.  The insurer must first determine the date of the sales agreement: a new residence is not subject to the Act if the sales agreement was signed on December 31, 2002, but it is subject to the Act if the agreement was signed on January 2, 2003.

Second, once an insurer determines a residence is subject to the Act, it must be able to identify the builder and know how to contact it. While the insured should have this information, in an emergency situation the insured may not be easy to find.

Third, the notice to the builder must include a description with “reasonable detail” of the nature and location of the defect.  Acquiring this information will require close cooperation with the insured.

Fourth and most fundamentally, the insurer’s need to comply with the Act so as to preserve its subrogation rights sets up a potential conflict between insurer and insured where application of the Act is subject to dispute. Not surprisingly, several unresolved legal questions exist as to application of the Act. For example, the Act applies only to “new residential units,” but how is “new” to be defined? Is it limited to only the original purchaser or does it extend to subsequent buyers? Also, does the Act apply when the defect causes physical damage to the rest of the house, or only when the insured’s damages are limited to economic losses?

An insurer faced with a claim that raises an unsettled legal question is placed on the horns of a dilemma: Assume the Act does not apply and rush to the insured’s aid or provide the builder with notice even while suspecting that the builder (or actually, its insurer) will deny responsibility under the Act. The insured, who may well feel whip-sawed between the two insurers’ competing claims,  may respond with a bad faith claim against its own insurer. In sum, the choice for the homeowners insurer may be preserving its subrogation rights versus inviting a bad faith claim—hardly a desirable situation.

 

Marc M. Schneier is a national authority on construction law. Since 1983 he has been the Attorney Editor of Construction Litigation Reporter published by Thomson Reuters.