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October 11, 2005

Flood Insurance by Fiat?

By Walter Olson

Reprinted from the Wall Street Journal, September 24, 2005

Sometimes it takes a good lawyer to get an insurance company to pay up on the promises it made. But if you want insurers to pay billions on promises they never made—risks they were at pains to avoid underwriting, never collected premiums for, and never set aside reserves against—then a pair of very special lawyers, Jim Hood and Dickie Scruggs, are at your service.

In case you're arriving late, insurance pros worldwide stood transfixed last week at the news that Mr. Hood, the elected attorney general of Mississippi, and his ally Mr. Scruggs, the Pascagoula wheeler-dealer known for his role in the $246 billion tobacco litigation, were suing to invalidate—as "unconscionable" and contrary to public policy—the standard flood exclusion in every Magnolia State homeowner's contract. Assuming ordinary readings of policy language, the early estimates have insurers on the hook for a record $40-$60 billion in Katrina payouts. Knock out the flood exclusions and that exposure will increase by many billions more—scores of billions if the principle gets applied in Louisiana.

Wouldn't that bust some otherwise solvent insurers? Sure, but Mr. Scruggs—a key donor to many politicians and judges in his state, as well as brother-in-law of former Sen. Majority Leader Trent Lott—isn't worrying. "I'd rather see an insurance company go broke than the tens of thousands of my friends and neighbors in Mississippi, Alabama, and Louisiana go bankrupt," BestWeek has him saying.

There are some genuine, knotty issues that will arise in resolving Katrina coverage. Ambiguous policy language, unsettled issues of state law, situations in which a structure was damaged first by wind and then by floodwater—all will fuel litigation by policyholders, some of it meritorious. But that's quite a different question from whether clear and long-standing contract language should be tossed in the wastebin.

The flood exclusions, Mr. Hood asserts, were hidden "in the fine print" of coastal residents' policies. If so, it was some of the most publicized fine print in history. "Homeowner's insurance doesn't cover flood damage"—blares the warning on one of the federal government's own consumer-affairs Web sites. In fact, the well-known exclusion dates back decades and has been generally respected by courts.

"Unconscionable"? Contrary to "public policy"? The exclusion prevails in all 50 states, including those states—Mississippi is one—where regulators must okay the offering of new standard policies. Mississippi's insurance authorities, like their counterparts elsewhere, had green-lighted the flood exclusion, amid little controversy.

Then there's the federally sponsored flood insurance program, which exists in large part because storm surge perils in hurricane country are considered too severe to insure commercially at politically palatable rates. For years, insurance agents and the government have urged property owners to buy that added coverage. But why should they bother, if the Hood/Scruggs arguments are to be taken seriously? Can't their ordinary homeowners' policies just be redefined retroactively as covering the risk?

Criticized in the past for his close ties to the state's powerful trial lawyers, Mr. Hood has often been at odds with Republican Gov. Haley Barbour (with whom he is not obliged to coordinate his activities). In a way, Mr. Hood is simply taking to an extreme the failings of that familiar category of public official, the grandstanding state attorney general. Every element is there: the headline-chasing, the demonization of unpopular businesses, the cozy relationship with private attorneys suing those same businesses, the posturing about being on the "people's" side at the expense of any coherent or defensible legal principle.

It's hardly a coincidence that it was Mr. Hood's predecessor, Mike Moore, who, in league with Mr. Scruggs, dreamed up the disgraceful $246 billion state tobacco/Medicaid caper. Back then, some businesspeople seemed to imagine cigarette makers were going to be the first and last targets of the emerging AG/trial-lawyer axis. They weren't.

Insurance spokespeople ordinarily issue muted responses when politicians attack, but not this time. "You cannot have a capitalist economy where contracts are ignored," noted Robert Hartwig of the Insurance Information Institute, who said Mr. Hood's lawsuit is "an affront to the Constitution and sets a horrendous precedent." So, can't State Farm, Allstate and others cite Article I, Section 10 of the U.S. Constitution, which provides that "No state shall. . . pass any. . . law impairing the obligation of contracts"? Unfortunately, the Supreme Court in Blaisdell, a 1934 New Deal case, gave states free rein to nullify contracts so long as "the legislation is addressed to a legitimate end and the measures taken are reasonable and appropriate to that end." If you think that guts the originally intended protection, maybe you're part of that "Constitution in exile" movement we keep being warned about.

Should the Hood-Scruggs theory be taken seriously, the bankrupting of some insurers and the diversion of money from insureds in other states will only be the start. The wider problem would be that both reinsurers and primary insurers are likely to head for the hills rather than underwrite future conventional policies in Mississippi, or indeed any jurisdiction judged capable of electing a Hood to high office. At a minimum, they're likely to demand a steep premium to compensate for legal risk.

Alarmist? Mississippi insurance commissioner George Dale is already worried that as panicked insurers pull out of the state, first-time customers—such as construction contractors moving into the area—will be among the earliest casualties: "Contractors got to have insurance; they can't build without insurance."

We've had the natural disaster. Let's hope it's not followed by legal disaster.

Mr. Olson is a senior fellow at the Manhattan Institute and author of The Rule of Lawyers (St. Martin's, 2003).

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