Insurers dealing with Katrina losses are caught between a rock and a hard place — more accurately, between flood and wind-driven rain. Generally, under typical homeowners policies, flood-caused loss is excluded but wind-driven rain and other windstorm-caused loss is covered. The Mississippi attorney general, under pressure from leading members of the plaintiffs’ mass-tort bar, has brought suit seeking to force insurers to pay claims, notwithstanding the terms of the insurance policies.
There is historical precedent for insurers’ paying claims following mass disaster in derogation of policy terms. The story is told famously of Cuthbert Heath, an underwriter at Lloyd’s of London, who following the San Francisco earthquake cabled his US attorneys saying: “Pay all our policyholders in full irrespective of ther terms of their policies.” And there seems to be little doubt that this decision of C.E. Heath helped establish the positive reputation (deserved or not) Lloyd’s enjoyed in the US for many, many years.
But there is a key difference between Heath’s cable and the complaint filed by the State of Mississippi: Heath’s commitment of capital was voluntary. The Mississippi action seeks to void insurers’ policy defenses and extract the insurers’ money involuntarily.
The state will argue that its action is not a taking of the insurers’ capital because the policy terms are void ab initio. But what the state’s argument highlights is the failure of its insurance-regulatory scheme. Mississippi should not have permitted insurance policies to be issued in the state with flood exclusions if such exclusions are so violative of public policy. Besides arguing on the merits that the exclusions are proper, insurers will argue that voiding them constitutes a taking of property (meaning that the taxpayers will then fund the losses).
If for some reason the insurers are compelled to make these payments, the insurers may well be stuck with the costs and unable to pass the costs onto their reinsurers. So the comment by a plaintiffs’ bar attorney, Mr. Richard Scruggs, is misplaced: “The Philadelphia lawyers wrote these things to protect the insurance companies and most of the risk have been spun off in worldwide reinsurance markets. What I want is for some Swiss gentlemen to be very nervous about rebuilding the Gulf Coast.” (Regulators of Katrina-Torn States Grapple With Wind vs. Flood Assessments, BestWire (Sept. 12, 2005)).
The European reinsurers probably have little to fear — other than the threatened insolvency of their customers (i.e., the insurers). This is because if the insurers follow the precedent of C.E. Heath the reinsurers will deny reinsurance recovery on the ground that the payments were voluntary or ex gratia – that is, were made to enhance goodwill and the like but were not compelled by the terms of the ceded coverage. (The directors and officers of the insurers that make such voluntary payments no doubt will be sued by their shareholders for mismanagement and corporate waste.) Alternatively, the reinsurers will argue that the expropriation of capital by Mississippi and perhaps others is not reinsured, notwithstanding “follow the fortunes” clauses. See Commercial Union Assur. Co. v. NRG Victory Reinsurance Ltd., 1996 Folio No. 1350 (English App. March 16, 1998).
At all events, the Mississippi lawsuit is an extreme example of regulation by litigation and only underscores a massive failure of the Mississippi insurance regulators and the Mississippi state legislature to ensure that their citizens are protected financially through insurance mechanisms, were that their intent. (Of course, not all Mississippi citizens purchase homeowners, renters or other first-party property insurance — it is not a mandatory coverage like auto often is.) No doubt the Katrina losses substanially will be socialized in some manner: whether it be done through the tax system and thus publicly or the insurance system and thus privately. But changing the rules on an after-the-fact basis and attempting to paint the insurers as the bad guys simply is not fair.
To be sure, the losses suffered by the citizens of the affected communities are mindboggling. And while tapping — or taking — insurers’ capital may be expedient, that doesn’t make it right. Although responding to Katrina poses a challenge to America, one hopes that Americans’ values were not blown or washed away at the same time.