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By Amy v. Puelz, Ph.D. and Bob Puelz, Ph.D.
After a natural disaster such as Katrina, many individuals and businesses finally call upon the language of their insurance policies to speak to the issue of whether damage suffered is covered and, if so, how much will the insurer pay? If the insurer does pay, the question of how insurance rates and contracts will be affected by catastrophic claim payouts is of concern. Historically, negative public perceptions of "insurance" and "claims adjusters" have been reinforced by consumers once they learn that their policies don't pay or their claims will be contested by their insurers. The possibility of being priced out of coverage, or of having no available coverage in future years if large payouts do occur, adds to negative perceptions.
Consumers seem to forget that the very purchase of insurance yields a benefit even if a claim is never filed. While it is true that a benefit of insurance may be its anxiety-reducing feature prior to a loss, it is only a textbook benefit for many consumers who may have to buy insurance originally because of a third-party mandate, whether it is their lender or the law. Anecdotally, post-claim is when the benefits of insurance are measured by most; thus claim denial can be a particularly emotional event for those who are uninformed or uneducated about their insurance contracts. One outcome of the information gap is that litigation often follows among asymmetrically informed parties, leaving the issue of fairness to the court. 1
What is the current state of fairness, and how might it apply to potential claimants who were in the path of Katrina? The vast gray area of how a claim is appropriately handled is of interest not only to those affected by the hurricane tragedy but to all since if one has no insurance for the assets destroyed by Katrina, the only recourse is governmental or charitable reimbursement. How might that gray area be defined? To begin, we note that the gray area has a fluid boundary depending on insurance contractual language vis-à-vis the actual event. If a peril is defined simply as a "hurricane," then an insurer might rightfully argue that a hurricane is not insured under a contract when "hurricane" is not listed as a covered peril or is specifically excluded. However, if a claimant reasonably believed that a hurricane was a covered peril within the complicated insurance contract, should the insurer be required to cover losses due to a hurricane?
The distinction between flood and wind is important in the Katrina context and is not a trivial concern to most claimants. Policyholder claimants who read their property insurance contracts will likely find that wind damage is covered but flood damage is specifically excluded. For the latter coverage to explicitly exist, a supplemental contract, issued in conjunction with the National Flood Insurance Program (NFIP), should have been purchased. Whether coverage implicitly exists is the issue left to the courts. While the insurance industry is careful to assert that the relevant insurance contract does not cover and never has covered floods, particular claim scenarios are often more complicated. 2 Thus, as noted recently by Adam Scales, insurance contracts are complex. The courts often bring a reasonable-expectations doctrine to coverage interpretation, and once these elements are brought to bear on specific facts, policyholders usually receive the benefit of the doubt. 3 Scales also points out that courts tend to find for the claimants when a covered cause contributes damage, even though an uncovered cause has also contributed.
The impact of Katrina on coverage rates and contract language is of concern to the broad spectrum of insurance consumers. Although insurers cannot adjust present rates to make up for Katrina losses, they may have the economic need to adjust rates based on the new loss severity and probability information. Thus it is likely that consumers in hurricane-prone areas will find new coverage rates higher than pre-Katrina rates. How insurers interpret this new loss information and how they allocate its impact may result in state regulators and/or legislators stepping in and arguing against rate adjustments. The balancing process between the insurer's economic viability of selling insurance in a particular area and the political pressures to keep coverage affordable for consumers will likely play out in the courts. We only need to look at the recent problems with homeowners' insurance in Texas to know the importance of weighing the benefits of market solvency versus the costs of increasing insurance prices.
Additionally, courts will most likely play the primary role in determining an insurer's coverage liability for excluded flood damage when normally included wind damage plays a role in the economic loss.4 The gray area will be defined case by case and state by state, and these results will set a precedent for future storms. We anticipate that if the insurers' liability regarding flood damage is significantly increased as a result of legal action resulting from Katrina, the effect will be broad-based without regulatory intervention. Publicly, the industry has acknowledged that if insurers are compelled by the courts to pay for flood damage, "insurance prices around the country will have to rise." 5
As stakeholders in post-Katrina insurance outcomes assemble, we think there are a few pertinent questions relevant to potential litigation.
1. When the insurance contract was entered into, did the insurer require the policyholder to acknowledge an understanding of the contract and its covered perils?
2. When the insurance contract was entered into, did the policyholder know about the existence of the NFIP? If so, what was the policyholder's understanding of why the NFIP exists?
3. In a press release by the Insurance Information Institute, there is a statement that "the insurance industry will fulfill its commitment to its customers." How is the commitment understood by the consumer? Moreover, did insurance consumers receive representations from their insurers about coverage or commitment?
In addition to these questions, it may be of use to take a more scientific approach to the issue of predicting claim outcomes before litigation is pursued. Both insurers and legal representatives have a vested interest in the results of such an approach. 6 From an insurer's perspective, the attributes of settled claims vis-à-vis litigated claims may yield important insights into practical claim-settlement strategies. Whether claimants should value litigation ultimately comes down to the chances that possible benefits exceed the cost of pursuing litigation. Knowledge of those factors that are correlated with successful litigation will be extremely useful.
In sum, current and future litigation in courts post-Katrina will no doubt have a significant impact on all aspects of the insurance market. The scope and future of federally funded programs such as the NFIP, and the legal ramifications of excluded causes of loss in insurance contracts, may reshape the market. Beyond the courts, however, it is apparent that contractual innovations and partnerships between public and private parties are necessary to create workable solutions for future catastrophic events such as Hurricane Katrina. Equitable knowledge of the risks in a contracting relationship is a reasonable goal to be pursued.
1. Mediation opportunities sanctioned by the regulatory authority of Louisiana (http://www.ldi.state.la.us/whats_new/Hurricane%20Mediation%20Program%20brochure.pdf) and Mississippi (http://www.doi.state.ms.us/katrina/mediationqa.pdf) do exist.
2. As stated by the industry, "Flood losses have never been covered under any homeowners insurance policy." See http://www.disasterinformation.org/disaster2/facts/katrina_faq/.
3. See http://writ.news.findlaw.com/commentary/20050919_scales.html.
4. Mississippi filed a complaint seeking to void homeowner policy flood exclusions (http://www.ago.state.ms.us/insurance.pdf).
5. See http://www.iii.org/media/hottopics/additional/katrina_faqs/.
6. "The Effect of Legal Rules on the Value of Economic and Non-Economic Damages and the Decision to File," Mark Browne and Robert Puelz, Journal of Risk and Uncertainty (August 1999) 18: 189-213.
Dr. Amy Puelz is an associate consultant with RHA, Inc., specializing in risk assessment and financial modeling. Her Ph.D. areas combine management science and finance, and she has served as a faculty member at Emory University, the University of Memphis and Southern Methodist University.
Bob Puelz is the Dexter Professor of Risk Management and Insurance in the Cox School of Business at Southern Methodist University, and is a member of the Real Estate, Insurance and Business Law faculty. He holds BS and MA degrees from the University of Nebraska and a Ph.D. from the University of Georgia. At Cox since 1992, he has consulted on issues surrounding Lloyd's of London, insurance agency valuation, life insurance contract interpretation, and insurance business standards and practices.
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