People have spent the past two weeks watching the unbelievable suffering in the wake of Hurricane Katrina, hearing the comparisons of the conditions in New Orleans to those in many developing nations, and witnessing the outpouring of sympathy and support in helping people rebuild their lives.
It has set in motion a mood that is, at its heart, noble -- or one with noble intentions, at least. We want to make things better for the people who are suffering.
And yet ...
We also must be vigilant in this time of grief and crisis that we do not overstep our own resources and become generous with other peoples' money. The long-term cost of making shortcuts in contract law for the benefit of the aggrieved will be phenomenal.
The limits of insurance
In the aftermath of Katrina, we're going to see a battle among insurance companies, various government entities, and those who have lost their homes and businesses. The outcome of this fight will have dramatic ramifications for all of us. If allowed to run beyond their legal limit, otherwise noble efforts to eliminate financial distress for those whose lives were affected by Katrina could prove to be extraordinarily destructive.
There is no "reconstruction fairy" set to swoop in and repair homes. What do exist are insurance companies that hold contracts in place of a magic wand. The contracts they hold are signed agreements that determine, in advance of any disaster, what types of damages will have to be paid and the premiums that need to be paid to cover those disasters. The reason this is an issue today is that the standard homeowner's insurance policy almost uniformly excludes flood coverage.
To fill in the gap, there is a federally administered National Flood Insurance Program. Yet the coverage, which can cost as much as $1,000 per year for a median-priced home, can be out of the reach of many Americans. As a result, even in New Orleans -- much of which sits below sea level and has not become a lake in the past only because of the vagaries of storms and the grace of some clever engineering -- most residents have not paid for flood insurance. Nor, in fact, have most residents of the Gulf coasts of Mississippi or Alabama.
According to an article in The Wall Street Journal, some people are saying that insurance regulators should attempt to compel insurance companies to pay flood damage claims even when they are explicitly excluded, given the public policy interests and the magnitude of the disaster. While we all should do our part to help those affected get back on their feet, this course of events would be a terrible path to follow.
The pitfalls of pricing policy
Let me spell out the insurance industry's creed in this regard: "Fool me once, shame on you. Fool me twice . fat (golf word) chance." Insurers have faced plenty of events in the past in which losses they did not countenance have suddenly risen up and bitten them, thanks to the principle of contra preferentum. Insurance law operates under this principle, which determines that any ambiguity in the contracts will go against the sophisticated party -- i.e., the insurers. In this case, flood exclusions might be at risk even if they are extremely explicit. But the work-around being countenanced seems to be that the ultimate cause of the floods in New Orleans wasn't rising water -- it was the breaks in the levees.
Insurance actuaries use complex probability models based on things like geographic location, preventive measures taken, and history to determine the likelihood and scope of an event such as a hurricane, fire, or car accident. They use these models to not only price premiums, but also to determine the amount of capital they need on hand to make their payouts. As you may now guess, these companies can find themselves in dire financial straits when confronted with an event they did not account for -- and even for events they did account for. After Sept. 11, 2001, it turns out that almost no insurers or reinsurers were building into their premiums the potential for terrorist attacks. But since they had not specifically excluded such attacks, either, they were on the hook for making payments. This is as it should be.
But what we're talking about in the case of Katrina is a type of damage (a flood) that is generally specifically excluded, with some people thinking that a proper course of action is to redefine the cause of damage from the direct cause (storm surge or rising water) to the proximate one (wind damage caused levees to break, or caused a storm surge). Doing so would allow many thousands more to gain coverage. It would also make large sections of the southeastern United States functionally uninsurable or, at a bare minimum, would cause property insurance rates -- which are already certain to go up -- to skyrocket.
Take Motley Fool Hidden Gems recommendation Montpelier Re
Just imagine what would happen to a company if regulators forced it to pay out claims for things that it had actually excluded. For the companies that would survive the payments to Katrina victims -- and not all of them would survive -- there is no chance that they would fail to build in "proximate flood" coverage into the premiums they charge. That's right, Charleston, S.C. -- flood coverage is specifically excluded, but because your hometown is vulnerable to hurricane-related flooding and because there is now precedent that, in the event of a grievous event, insurers are having to pay claims for "proximately caused" flooding, you may expect that your insurance company is going to build that risk of payment into your premiums. Draw a line, starting in, say, Atlantic City, N.J., and track down the coast all the way to Brownsville, Texas. The cost to provide non-flood flood insurance along the Gulf Coast is going to make your rates soar. Same with Johnstown, Pa., the Mississippi River valley, and any other flood-prone area. Once that work-around of the exclusion is breached, insurers will compensate for it. As they should.
Two left feet
In the wake of a disaster, financial issues of this kind are almost as awkward to discuss as is politics. The focus -- as it should be -- is square on alleviating suffering. Yet the only way to face down the awkwardness is to be rational.
This same kind of awful insurance awkwardness occurred following the attacks on the World Trade Center. Leaseholder Larry Silverstein and insurers such as Swiss Re had $3.5 billion hinging on whether the attacks constituted one occurrence or two.
Of course, there will be a flip side here. Just as there are entities that have every incentive to put as much of the damages as possible on things other than flooding, it should be obvious that insurance companies -- especially the ones at highest risk of default -- have an interest in attributing as much damage as possible to flooding. Let us be clear about this: Failure to pay legitimate claims is unconscionable. We agree with the spirit of contra preferentum, and as consumers we are hopeful that the state insurance commissions take an extraordinarily hard stance on companies that try to avoid claims. Solvency issues are no excuse.
Foolish final thoughts
Insurers, government officials, and -- most of all -- the folks affected find themselves in uncomfortable positions today. But the solution to this discomfort is not to overhaul the existing practices of insurers such as Montpelier, AIG
A housekeeping note
Bill Mann will be speaking at The Value Investing Congress in New York in mid-November. Other scheduled speakers include Joel Greenblatt, author of You Can Be a Stock Market Genius, John Mauldin of Millennium Wave Investments, and Richard Pzena of Pzena Investment Management.
Bill Mann is co-advisor for the Motley Fool Hidden Gems small-cap newsletter. Don't mistake him and Tim Hanson for Bill and Ted -- even though there is some resemblance. Bill Mann and Tim Hanson both own shares of Berkshire Hathaway. The Motley Fool has a disclosure policy.