November 25, 2009

Home Warranty Insurance:

While our American readers go on holidays to eat turkey and watch football, we're shifting our focus to how the governments of New South Wales and Ontario have gotten deeply involved in new home warranties. Both require those warranties to be insured, but that hasn't worked out as well in Australia as it has in Canada.

With most Americans headed home for the holidays on this half-day Wednesday, the rest of this week will be largely U.S.-less. So while they're out of the office, we're continuing our tour of the home warranty industry with stops this week in Australia and Canada.

On this segment of the tour we'll take quick snapshots of a home warranty insurance program that is falling apart in New South Wales, Australia, and another home warranty insurance program in Ontario, Canada, that's doing just fine, thank you for asking.

New South Wales and Ontario are the respective Californias of their nations. Not only are they the largest in terms of population and economic activity, but they're also the pacesetters in terms of national trends. As in the United States, insurance in Australia (and Canada) is regulated at the state (or provincial) level, not at the federal level. And as in the U.S., some states do fine as regulators while others run into trouble. New South Wales is one of the states in trouble.

In general, the governments in both countries have delved deeper into home warranties than American legislators have ever dared to venture -- even in California. Both have set up systems where the warranties of both inept and insolvent builders are honored by government-sanctioned policies -- essentially a reinsurance scheme for the product warranties of new homes.

We're not suggesting it's a model for the U.S. Far from it. It just is something we thought the 22% of Warranty Week's readers who are not Americans might enjoy reading about during this Thanksgiving recess. One government's home warranty system seems to work well (Ontario), while the other's seems to be falling apart (New South Wales).

And as peculiar as mandatory warranty insurance laws might sound to Americans, consider that both collision and liability insurance are required for U.S. cars bought on a loan. And for an ever-brief period this year, some auto warranties were guaranteed by the U.S. Treasury Department. In other words, even American governments require insurance and reinsure warranties when circumstances require it.

The Land Down Under

In Australia, the different states choose different ways to guarantee the warranties of new home builders. But rather than 50 states, the Australians have only six states and two territories. All state governments except Queensland and Tasmania require homebuilders to secure a home owner's warranty insurance policy from any of several insurance companies that write such policies. These state laws generally compel builders to take out a policy on behalf of their clients for all work valued over $12,000.

One problem is that while homebuilders' warranty insurance is mandatory in New South Wales, it is becoming harder to find after the departure of two of the five policy writers: Lumley and CGU. Another problem is that its coverage is secondary, in that it pays claims only in the event that a homebuilder can't or won't honor a valid claim. So it forces the homeowner to exhaust all other options before claims are paid.

In New South Wales, the Home Building Act of 1989 requires that insurers providing home warranty insurance in the state must be approved by the Minister for Fair Trading. The five companies that have qualified are:

In other Australian states, coverage is available from these companies but is not mandatory, or if it is mandatory, it is the first to pay claims. In NSW, however, the policy pays claims only if the builder disappears, dies, or goes broke. So it's coverage of last resort.

Underwriters Leave the Market

But all is not trading fairly in New South Wales. On July 1, Lumley General announced its intent to leave the home owner's warranty insurance business across Australia. It stopped issuing new policies on July 1, 2009, and stopped renewing existing policies on October 31. Its exit from the market should be completed by July 1, 2010.

Then CGU announced on July 17 that it too was leaving the market. It stopped taking on new customers immediately, and said renewals would stop on November 30.

So as of next week only three carriers will be writing home warranty insurance policies in Australia: Calliden, QBE, and Vero. A builder cannot start building until he has coverage. If he can't get coverage he can't start building. And as one out of every four builders can't find coverage. That's a problem.

Kelly Burke, who writes the Consumer Affairs column for the Sydney Morning Herald, has been a constant critic of the New South Wales home warranty insurance scheme. In two recent columns, she predicted then derided the collapse of the program, with malice aforethought.

In an October 30 column, she called it "junk insurance," though that specific tag was attributed to her unnamed sources. Burke said the epithet was justified by a recent report which found that almost half of all the program's claims were rejected in 2007-08, compared with a rate under 2% for other types of personal and commercial insurance.

It's the government's problem now. A week after her column, the New South Wales state government announced that it would be taking over the home warranty insurance program. In a November 10 column about the nationalization of the fund, Burke's descriptions of the program ranged from "widely derided as worthless" to "the worst performing insurance product operating in Australia."

"A crisis had been looming since the departure of two of the five insurance providers, Lumley and CGU, earlier this year," she wrote. "Up to a quarter of NSW builders had faced the prospect of walking away from the industry or working illegally without cover by the end of the year."

A Last Resort

The main problem, Burke suggests, was the "last resort" nature of the program. In order for a homebuyer to collect on a claim from the fund, he and/or she must exhaust all other options first. "Only when something goes awry do they learn the policy that cost them several thousand dollars only covers them if their builder has died, absconded, been declared insolvent or after the home owner has gone through a protracted and costly legal battle and the builder ignores the compensation order," her second column states.

As a result, she predicts, the government may collect over $40 million a year in premiums but may pay out as little as $1.6 million a year in claims, "due to the highly restrictive circumstances under which those claims can be made." And that's a 4% loss ratio, which is pretty low for an insurance product.

Insurance industry representatives beg to differ. First, they point out that policies such as Calliden's have an AU$500 per claim deductible that the builder has to pay. Second, even the New South Wales ombudsman concluded in a report that 45% of claims are covered (or were, in the year until June 2008). And that was a criticism! Third, these policies run for seven years, so it's no surprise there would be an imbalance between up-front accruals and first-year claims on brand new homes. If one looks at claims paid over the full life of the warranty, the loss ratio will be far above 4% over years two through seven.

Lumley General, one of the companies exiting the market, made sure to give its customers time to make the transition. Robert Swinton, communications manager for Wesfarmers General Insurance Ltd., trading as Lumley Insurance, basically said the company decided that this particular product wasn't going to be part of its future. Its exit in no way is a commentary on how the program operates. But because it's a government program, the company is trying to close the door as gently as possible, not letting it slam in anyone's face.

Orderly Exit from the Business

Robert Swinton

"Because this works with state governments," Swinton said, and because it's required of builders in several states, "we wanted to be clear that we're doing this in a responsible manner. So the message that you're seeing there is about the end users: the consumers. We're saying there's consumer protection provided by this cover. We're not joining those who criticize the cover because it doesn't do certain things. Instead, we're taking a commercial decision that we will take an orderly exit from the business."

Swinton said Lumley will now concentrate on other lines of commercial insurance such as fleet motor policies, engineering and liability insurance, and general business insurance. Home warranty insurance, written primarily in Victoria and New South Wales, made up only 2% of its overall business.

"It's a statutory form of cover," he said. "In other words, if you build a home, or renovate a home, you must take this form of insurance out." A builder cannot simply issue a product warranty. That warranty has to be insured by a third party.

"It's been a political issue," Swinton said. "This form of cover, for certain builders, has been unpopular, for a number of reasons." Chief among them is that insurance isn't free. And it also places the insurance company as a gatekeeper for a company's growth. Take silly risks and expand too fast and the insurance company might decline to insure some of your riskier projects. Can't get coverage, can't take big risks. So the insurance requirement acts as something of a brake on the market, with the underwriter acting as the governor.

One wonders whether it's a coincidence or a consequence that real estate in Australia nor Canada neither rose as fast nor fell as hard as in the U.S., Ireland and UK. In the U.S., the gatekeeper was the sale of collateralized mortgage obligations. When that circus ended, so did liquidity. In Ireland, the gatekeeper is the difficulties in securing local planning permission. Even a famine era ruin with a chimney is valuable, because a new home could be passed off as a renovation of an existing one. In the UK, the banks were more careful and the buyers more reserved, but they inflated their bubble anyway. But in neither country was third party warranty insurance a regulating factor in the risk management process.

"Over here, the downturn has been nowhere near as severe as it's been in the U.S. or in the UK," Swinton said, "particularly in the property area." So don't go comparing New South Wales to California. Or to Wales, for that matter. After China, Australia was one of the first to declare the recession over.

There were some similarities, however. After the downturn began, the Australian government began issuing cash payments to first-time home buyers, and opened other stimulus spending programs aimed at builders. Still, some builders went broke. Just this month, builder Capital Homes went into liquidation, leaving 27 customers with unfinished homes and 18 more with unstarted homes, and owing AU$1.13 million to suppliers and AU$400,000 to subcontractors.

Yes, some builders went broke, but it wasn't ever described as a crisis. And Swinton stressed that neither the downturn nor the more recent recovery had much to do with Lumley's decision to exit the homebuilding warranty insurance market. That was a purely commercial decision.

The Story in Ontario

In Ontario, it's quite the opposite story to tell. There, the Tarion Warranty Corp. administers the Ontario New Home Warranties Plan Act, which calls for builders and vendors of new homes to be licensed by the company and to enroll each new home prior to construction. Every new home sold in the province must be registered with Tarion, a privately-held company with a government-sanctioned monopoly.

Besides collecting premiums from builders for the province�s mandatory new home warranty program, Tarion is also tasked with regulating the home building industry. It hunts down illegal builders who have not paid for warranty coverage, and operates an anonymous hotline where Canadians can call in tips if they suspect there may be illegal building in their region. The hotline can be accessed 24 hours a day at 1-800-786-6497.

Tarion also has its own enforcement team, which includes a number of former police officers, who work with municipal officials and others to uncover illegal building in Ontario. Tarion states on its Web site that during 2008, their efforts led to 379 convictions and $851,000 in fines being levied by the courts.

Still, the company estimates that roughly 10% of the claims it pays are coming from homes built by illegal builders. In those cases, Tarion must pay the claims even though it never received any premiums from the builders. All new homes in Ontario are covered by the warranty program regardless of whether the builder is registered or the home is enrolled. But the illegal builders are in big trouble if they're caught.

Threw the Book at Him

In August 2009, Darin J. Burns of Greely, Ontario was given a 45-day jail sentence in one court, and fined $25,000 in another court after he was found guilty in both places of illegal building. He failed to properly enroll just one home in each city. But they threw the book at him. However, he also left both homeowners with half-finished houses and huge liens on their properties, and failed to pay contractors, and didn't appear at either trial.

In a press release issued at the time, Robert Mitchell, Tarion's director of industry and government relations, said the builder "showed a total lack of respect for both the homeowners and trades people. He entered into contracts to build the homes, saw them to about 50 per cent completion, then abandoned the projects �- leaving the homeowners stranded and the trades people empty-handed."

Reached this week by telephone, Mitchell explained how Tarion provides three essential services to the Ontario market. First, it regulates the industry, setting minimum standards for construction, competence, and financial stability of the builder. Second, it guarantees that homebuyers will not lose their deposits should something happen to a given builder. And third, it guarantees that the builder will honor valid warranty claims for up to seven years after sale. So whatever anxiety there may be over lost deposits or worthless warranties has been eliminated from the marketplace.

Tarion, he said, is officially a "delegated administrative authority," -- a private company that has been granted a monopoly by the government of Ontario to implement the details of the new home warranties law. It collects premiums from builders on a sliding scale, starting at CA$385 (plus 13% tax) for homes selling for under CA$100,000, reaching CA$1,000 (plus tax) for homes priced over CA$500,000, and CA$1,500 (plus tax) for homes priced over a million dollars. The average warranty policy premium is around $800, Mitchell added.

He also stressed that it's not all about fixing mistakes. Tarion also has a role to play in setting pre-sale quality levels. "All new home construction has to meet certain benchmarks in terms of compliance," Mitchell said. It's Tarion's job to make sure the builders understand the building codes in Ontario, so that the homes they build will pass inspection.

Buy, Then Build

In Canada, new homes are typically bought before they're built. The buyer picks their home then pays for it. So there's little risk that a newly-built home will go unsold. So that reduces the risk to the builder. However, that also means that buyers must make a deposit on a home before it is build. This increases the risk to the buyer. So Tarion also insures their deposits, sometimes for up to two years. If something happens to the builder before the home is finished, Tarion will refund the deposit to the buyer.

Over the past two years, Mitchell said he doesn't think the existence of programs like Tarion did much to reduce the impact of the recession. Then again, what if there was no Tarion? Perhaps the absence of such programs might have reduced confidence a bit, particularly when it comes time to make deposits on a yet-to-be-built home? One can never say, because Tarion has been operating for decades. And as Mitchell noted, it learned some important lessons during the last recession before this.

"I wouldn't say the effect has been as dramatic as it has in the United States," Mitchell said of the current downturn. "I would say the construction industry in Canada was much better prepared for this recession, as they were stung quite badly by the recession in the late 80s/early 90s. So they didn't have the same exposure [this time] in terms of inventory."

In fact, the housing recession is pretty much over in Canada. According to the Canadian Real Estate Association, the average price of a Canadian home sold in October was CA$341,079, a 20.7% increase from a year ago. Sales volumes in units sold grew an incredible 41.5% from October 2008, leading some to suggest that the rebound has now given way to a bubble. One reason may be mortgage rates, which now average 4.55%, down from 5.41% a year ago. Another is that the Canadian market never really fell that far to begin with.

"We build differently in Canada. We build on a presale model," Mitchell noted. "Our new home market is pretty much all presale. That is to say, you go into a sales trailer, or a sales pavilion, and you look at an artist's rendering of the house, and you look at the floor plans, and the choice of elevations, and you buy a home on spec. And then you take receipt of the house when it's completed."

That being said, there have still been some spectacular recent collapses in Ontario real estate. In Toronto, financing for the Number One Bloor luxury condominium and hotel complex, located at the busy downtown intersection of Yonge Street and Bloor Street, fell apart before construction even began. "But when that collapsed," Mitchell said, "no one was terribly upset, because their deposits were all protected."

No Role in Existing Home Sales

Tarion and other provincial home warranty programs, while they reduce the risks of buying a new house or condo, have no role to play in existing home sales. And none is expected. "At the current time, there hasn't been any discussion of providing a warranty on resales," Mitchell said. However, he did point out that the seven-year warranty issued on a new home is fully transferable to a second owner. "It stays with the home," he said, no matter who owns it during the first seven years. The seller or the realtor will usually pass this news to the buyer, along with instructions on how to make claims. No special registrations or additional payments are required.

Mitchell said that when a claim comes in, the first line of defense is to have the builder respond. If for some reason that's not possible, perhaps because the builder is unwilling or unable, Tarion will go to the marketplace to arrange for a response. Or, it may pay a cash settlement to the homeowner, and allow them to select a contractor to respond. And in some rare cases, Mitchell said, particularly when multiple dwellings are affected, Tarion will look for a builder or a contractor to take over the entire warranty management project on an ongoing basis. But usually, by then the builder has been red-flagged anyway.

"We monitor the industry," Mitchell said. "And if we have builders that continually show poor performance and after-sales service -- if they're delivering homes that we have to come in and make a lot of secondary repairs to, because they're not functioning properly, then we're going to take that builder out of the market."

Overall, the Canadian housing market is much more heavily regulated than in the U.S. A builder can't even begin construction until the home has been registered with an agency such as Tarion in Ontario or its equivalent in another province. And then there are numerous taxes, fees and charges that must be paid before construction can begin.

"The nature of the model is to provide as much protection as we can for the consumer. But it beneficial to the industry as well." Bottom line, builders create jobs, and builders pay taxes. So it's in the government's interest to keep the industry healthy, and keep the buyers buying.

In this recession, at least, the builders, sellers, and financiers in Canada didn't get as carried away as perhaps they did in the U.S. So the hangover was much less severe. Still, there was a downturn, and it did cost Tarion some money.

"I don't want to mislead you. It has been stressful for us," Mitchell said. "But it certainly hasn't jeopardized our solvency. Not at all," he said. "We took a hit, but we recovered much more quickly than we thought we would."

Warranty As More Than Compliance

Carol Smith

Carol Smith, an expert on customer service in the homebuilding industry, editor of the newsletter Home Address, and author of the book Beyond Warranty: Building Your Referral Business (ISBN: 9780867186321), frequently travels across the U.S.-Canada border to attend meetings about homebuilding trends.

Reached by phone after a recent meeting in Toronto, she told Warranty Week that while no U.S. state is yet considering a Tarion-like warranty insurance plan, many states are plotting ways to get involved in new home warranties. "The problem we get into is the unanticipated consequences of the programs they put into place," she said. And each state is different. Some set minimum durations for new home warranties. Others go further. Some do nothing. There's no consistency.

"The Canadians have approached it differently. I'm not sure which system is better, but I can tell you from the standpoint of the homeowners the Canadian system is at least more consistent." Even so, she notes that some critics have called the provincial home warranty protection systems a "hodgepodge."

Smith said she's most familiar with the programs in the provinces of Ontario and Alberta, and she said they both seem to offer adequate protection to the consumer. Both make seven-year warranties mandatory for new homes, and both require the builder to insure those warranties. If they need any improvement, she said, it's in the way they communicate to inform and alert homeowners and buyers about their rights and protections. And that goes for the builders as well as for their underwriters.

In both the U.S. and Canada, Smith said she sees a massive opportunity for builders to turn warranty into something more than a mere cost of doing business. It has a potential to become a way to raise customer satisfaction, to differentiate a builder, and to increase good word-of-mouth and hopefully, to increase referral sales as those happy customers talk with friends and family.

Elevating the Role of Warranty

"Builders are leaving bags of money on the table if they don't elevate warranty to the level that it needs to be elevated to," Smith said. "And I'm talking about rethinking the caliber of people we hire for that role, and paying them at a level commensurate with, minimally, the superintendants and project manager people. Warranty staff can be the conscience of the company. They can influence purchasing decisions, design decisions, supervision, scheduling, and so forth in the field, so they can deliver a better product, and hand the product over with fewer defects to begin with, and reduce the amount of warranty work that needs to be done."

Smith said many builders still see warranty work as a "necessary evil," and they hope that the closing turns out to be the last time they need to interact with the buyer. "In fact, what should happen is the builder should stay in touch with that customer, and continue to educate them, continue to socialize with them, continue to service their home through warranty," she said. And even after the warranty expires, the goodwill can continue, leading to additional referral sales.

In a perfect world, builders on their own would want to provide a high-quality product and a high level of warranty service. Programs like Tarion would not be necessary. But in the real world, not every builder always sees the light. Some might choose to take advantage of the lack of regulation to take the money and run.

"Sometimes I think builders need a little bit of a nudge to do the right thing," Smith said, "and that's where government has a role: to ensure that consumers who perhaps didn't make the wisest choice of building companies get the protection that they deserve, and at least the minimum of service that they need for their new home. There's always that human element. You can't legislate courtesy. You can't legislate morality."

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