NEW ORLEANS—Policyholders and insurers are watching litigation surrounding Chinese drywall and awaiting clarity on how coverage will respond to losses related to the controversial building material.

Already under way in New Orleans is a key trial that will help shape how hard property/casualty insurers will be hit by claims related to Chinese drywall. In the case, the Hernandez family vs. Knauf Gips A.G. et al., the court must consider how to interpret exclusions in homeowners policies.

In a related development Friday, the U.S. Consumer Product Safety Commission issued interim remediation guidance that calls for gutting homes with the problem drywall. The guidance calls for removing the drywall, electrical components and wiring, gas service piping, and fire suppression and alarm systems.

Hernandez also extends beyond drywall to include plumbing, wiring and appliances, which the court must decide if they should be replaced as well. The plaintiffs in Hernandez are seeking $200,000 in remediation costs, which include replacement of drywall, corroded wiring and plumbing. The home cost about $176,000 when it was built in 2006.

Knauf has proposed $58,000 in remediation costs, according to court documents.

While other suits on the issue have already gone to court, the Hernandez case reportedly is the first contested trial and viewed as a bellwether property damage case for thousands of other suits.

“These initial trials give courts and interested parties an idea of what the value of the claims are,” said Stephen Herman, trial attorney for the Hernandez family and partner with New Orleans-based Herman, Herman, Katz & Cotlar L.L.P. “These trials will provide guidance, and I expect people to be litigating for indemnity for a long time.”

More than 2,000 complaints related to Chinese drywall have been filed U.S. courts, most in the Southeast, according to Moody's Investors Service.

At issue is more than 500 million pounds of drywall imported into the United States between 2004 and 2007, when the housing market peaked and the Southeast was rebuilding after Hurricane Katrina. Most of the drywall was traced to Chinese subsidiaries of German manufacturer Knauf Plasterboard Tianjin Co. Ltd.

The CPsC said it has received more than 3,000 drywall-related consumer complaints (see box). “Completed studies show a connection between certain Chinese drywall and corrosion in homes. CPSC is continuing to look at long-term health and safety implications,” it said in issuing last week's interim remediation guidance. Homeowners have complained of noxious smells and upper respiratory problems related to the drywall.

In the Moody's report, Chinese Drywall Exposure Manageable for U.S. P&C Insurers, the rating agency said insurers could face significant property damage claims and litigation costs related to Chinese drywall. Moody's analysts noted, however, that bellwether litigation will determine the ultimate claims picture.

“I think some insurance companies will see the weaknesses in their coverage defenses and may decide to step up and provide coverage, while others may dig their heels in and let the courts decide,” said Frank Armstrong, Tampa, Fla.-based national director of construction claims with insurance brokerage Willis HRH. “We are still in the very early stages of coverage litigation.”

In one early decision, a judge ruled last month that Audubon Insurance Co., a subsidiary of American International Group Inc., cannot cite policy exclusions as an “affirmative defense” to deny coverage of a Chinese drywall-related claim.

In Simon Finger and Rebecca Finger vs. Audubon Insurance Co., a New Orleans Parish Civil District Court judge ruled that the Baton Rouge, La.-based insurer's exclusions for pollution; gradual or sudden loss; or faulty, inadequate or defective planning did not apply to substandard building materials under an all-risk homeowners policy. Audubon is expected to appeal.

Meanwhile, a federal judge in Norfolk, Va., last month dismissed claims filed by Virginia Beach-based homebuilder the Dragas Cos., ruling its insurance policy with Builders Mutual Insurance Co. did not cover the cost of remediating homes built with Chinese drywall.

According to court documents, Dragas spent more than $5 million to repair 73 condominiums in Chesapeake and Virginia Beach, Va. Raleigh, N.C.-based Builders Mutual argued the builder's decision to remediate the homes was voluntary and that the insurer was not obligated to pay.

Builders Mutual is awaiting the judge's ruling on whether it must pay for damages arising from lawsuits against Dragas over the drywall and whether the insurer must defend the builder in those lawsuits.

Rodney J. Taylor, Orlando, Fla.-based managing director of Aon Corp.'s environmental services group, said the average claim is roughly $300,000 or $400,000 per home, rather than the $100,000 it would typically take to remediate the work.

Mr. Taylor and others said the extent of insured losses will hinge largely on how courts interpret policy exclusions.”I'm not sure insurance companies are going to step up and pay the damages,” he said.

Courts' interpretation of pollution exclusions likely will vary by state, experts say. Rachel Boles, San Francisco-based consultant for Towers Watson & Co., said Louisiana, for example, is generally more consumer- and plaintiff-friendly when addressing the pollution exclusion, while Florida tends to interpret the exclusion in favor of insurers.

“My impression is that the pollution exclusion in Louisiana is a weak argument,” said Mr. Herman. “I think the Finger case was pretty much an expected result.”

The litigation likely will drive up insurance costs for homeowners, builders and product distributors, said Ron Kozlowski, Hong Kong-based senior consultant with Towers Watson. “A lot of insurers, when pricing their policies, did not anticipate something like this happening,” he said.

Observers also expect underwriters to start putting exclusions in policies that would rule out coverage for any potentially toxic drywall.