This Lawsuit Could Put Your Insurer Out of Business

As a professional in the insurance industry, I often sit across the table from clients and explain to them that one of the things their policy does not cover is flood damage, defined as water from outside the building coming in. Now if the wind blows off your roof and rain damages the interior, that's one thing. But if you're merely in the wrong place at the wrong time and water flows into the building from outside, you're on your own. This is a common exclusion in nearly all property policies, and the reason why flood insurance is offered by the Federal goverment to homes and business in flood-prone areas.

Now the Attorney General in Mississipppi, and a local tort lawyer legend whose home was damaged in the storm, have teamed together to sue insurers demanding that they pay for flood damage which was specifically excluded in their insurance contracts. Their reasoning is pretty tortured, and of course, none of these carriers has collected a dime in premium for flood coverage. If this lawsuit is in any way successful, insurance rates will take off as insurers, who manage to remain in business following the newly covered losses, seek to regain their financial stability by collecting the missing premium from the remaining pool of policyholders. Although a successful lawsuit would benefit the pool of property owners who did not have the foresight to purchase flood insurance, it would surely put some companies out of business and make it all the more expensive for the rest of us.

President Bush has promised to rebuild the Gulf Coast "higher and better" than before. But that task is going to be far more difficult if Mississippi Attorney General Jim Hood and his tort lawyer pals succeed in rewriting private insurance contracts after the hurricanes have hit.

For decades private insurers have had flood exclusions in their contracts--which is one reason the federal government decided to offer its own flood insurance. Yet Mr. Hood now says these exclusions are "unconscionable," and he is suing private insurers to cover all of Katrina's costs. Hot on his heels is tort kingpin Dickie Scruggs, whose own home was damaged and who promises to sue the industry for what he claims are deceptive business practices.

Wading through this muddled thinking takes some effort, but the first thing to understand is why insurers have flood exclusions. The simple reason is that floods are not a typical insurable risk. The entire point of insurance is to spread risk by collecting premiums from a large group of people who pay into a pool, which is then used to compensate the relatively few who suffer accidents. Floods don't work that way. The only people who buy flood insurance are those who are very likely to be flooded, making it impossible to spread risk. Floods also tend to wipe out entire regions, causing extraordinary losses. And they often result in repeat losses, because people rebuild in flood-prone areas.

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Both men are demanding that private insurers pay for Katrina flood damage, though the companies never collected one dime of flood premiums over the years and have no such reserves. As it is, insurers may be on the hook for $60 billion. Sticking them with flood damage could add another $15 billion to the tab, which would certainly send several insurers into bankruptcy.

Insurance companies that survived would have to assume that flood liabilities are now theirs to pay, regardless of the contracts they write. They'd then have to charge everyone in the region higher premiums--by one estimate, as much as $500 a year--to cover this flood risk. Or they could take the more rational option of fleeing a state where contracts aren't worth the paper they're written on.

In other words, Mr. Hood is guaranteeing that victims of the next hurricane will have even less financial protection than Katrina's. And he's complicating the entire reconstruction effort by raising the cost of insurance for the contractors, union workers, homeowners and businesses that are all going to need liability and/or property and casualty insurance before they rebuild. The attorney general is a Category 5 destructive force all by himself.

The company that I work for will pay out millions in related costs to Katrina and Rita victims, but if this lawsuit is successful, policyholders in all areas, whether flood-prone or not, will pay a heavy price as their premiums soar. In addition, companies will simply make the decision not to write policies in areas where flooding may occur, which will reduce the pool of potential insurers, and increase the costs of obtaining insurance from the remaining ones.

Contracts are supposed to mean things, and if a company's insurance agreement can simply be rewritten at the whim of the courts, and without having the ability to collect the lost premium, the entire industry will be at risk.