A court case from the fallout of Hurricane Katrina in Louisiana could make it more expensive to buy earthquake insurance in California.
At issue is the obscure-but-immense realm of reinsurance, the mechanism by which insurance companies cover themselves by insuring their own policies. When U.S. District Court Judge Stanwood Duval Jr. ruled against 10 insurance companies in his New Orleans courtroom last week, he greatly increased their potential liability. With these companies likely headed to reinsurance companies to help spread that liability, the California Earthquake Authority may find their own reinsurance rates driven up.
“If this ruling holds, do you know what you’re covering and what you’re not?” said Alice Gannon, a member of the advisory panel of the CEA. She is also chief actuary of the United Services Automobile Association, a private entity that provides insurance to military personnel. “This could be very bad news for the insurance industry.”
The case itself had to do with flood coverage in homeowner’s policies. While most policies exclude natural flooding, or “acts of God,” the flooding after Katrina could be construed as an act of man. Duval ruled in favor of a group of New Orleans homeowners whose homes were damaged by water after levees broke. While there was some language in the policies precluding the policies from paying for flood damage, Duval said the wording was ambiguous and did not specifically exclude coverage for this event.
The ruling centers on the widespread belief that the New Orleans levee system was inadequately planned, built and maintained: the resulting flooding may not fall under “acts of God.” This would put the insurance companies in the position of paying out to policy holders, then pursuing the federal government or other responsible parties for the money–a situation known in the insurance industry as “subrogation.”
The ruling went against several private insurers, led by Allstate, the largest publicly traded insurer in the country. Duval reversed a lower court ruling. The insurers immediately appealed to the U.S. 5th Circuit Court. These insurance companies could be out billions if they lose, based on the size of the claims. Two insurers, State Farm Fire and Casualty Co. and Hartford Insurance, escaped the ruling because their policies specifically excluded flood damage regardless of cause.
But the money these companies would owe now isn’t the big issue–it’s the liability they could face in the future. Insurance policies typically run six months to one year. Thus, it will take up to a year for these companies to get the policies with the old wording off their books and begin moving people onto new policies that mimic the wording used by State Farm and Hartford.
If another serious hurricane hit during this time, these companies could be left holding the bag for tens of billions in claims that they never accounted for when they priced their policies, said Rex Frazier, president of the Personal Insurance Federation of California. In order to spread this risk around, they are likely to go to the big reinsurers, such as Transamerica and Munich Reinsurance. By contracting with reinsurers, insurance companies are able to sell policies for more than the value of their own assets.
With more companies bidding for an immense-but-finite amount of reinsurance capital, the CEA could be forced to pay higher reinsurance rates. This potential outcome hits at a time when the reinsurance industry already is evaluating rate increases due to the threats from climate change. The reinsurance sector is also still recovering financially from the 9/11 attacks.
“We don’t know what effect these changes are going to have,” said Nancy Kincaid, director of communications for the CEA. “It’s kind of a wait-and-see.”
The CEA is a pooling arrangement between the state and private insurers designed to shore the risk of offering earthquake policies. It grew out of the devastating 1994 Northridge earthquake, which bankrupted several insurers.
“There was no way to know how to price it under standard insurance coverage,” explained Bill Sirola, a spokesman for State Farm.
According to figures it released last month, the CEA has a claims-paying capacity of nearly $8.2 billion, up about $1 billion from a year ago. The fund is designed to be able to withstand two Northridge-sized events in a row and keep functioning, Frazier said.
“You would have to see the four horsemen flying across the sky before the claims-paying capacity of the California Earthquake Authority would be exhausted,” Frazier said.
But the CEA’s base capital is just under $2.5 billion. The capacity is supplemented by bonds and a pool of private insurer funds, but it is also largely supported by nearly $2.5 billion in primary and supplementary reinsurance coverage. The CEA pays about a $150 million a year for this coverage, meaning that even small rate changes could cost them several million dollars, Kincaid said. The CEA’s current reinsurance contracts run through 2007. They will be buying 2008 reinsurance in May, when it will be seen if there is any rate increase coming out of the Katrina case.
There is also the lesser concern that the ruling could shift new liabilities onto the CEA or private insurers. For instance, it widely has been predicted that a 6.5 magnitude or higher earthquake near the Delta could destroy dozens of levees and lead to widespread flooding. It is possible that an opportunistic attorney could try to go after to CEA or private homeowners’ policies for flood damages. While those in the industry say it is unlikely such a suit would succeed, such a case could still cost the state millions.
Frazier also noted that there is a far better established means of going after the state: the Paterno decision. According to this case, the state was liable for $464 million in damages caused by a 1986 levee-break in Yuba County because it had maintained the levees in question.
Many also say that Duval’s decision might not stand up, given his history of controversial rulings. Duval is the guy many conservatives picture when they think of “activist judges.” A 1994 Clinton appointee, he’s best-known for his 2000 ruling preventing Louisiana from issuing anti-abortion “Choose Life” license plates. This decision was overturned by the far more conservative Fifth Circuit, but the process took five years.
This decision is headed to the Fifth Circuit as well–and could head higher than that, given the shown willingness of both sides to keep filing appeals. In the meantime, the industry will be watching the case closely.
“This is based on Louisiana law,” noted Nicole Mahrt, public affairs director of the Western Region of the American Insurance Association. “California law and the contracts here could be completely different. It’s all kind of hypothetical.”
Contact Malcolm Maclachlan at