Insurance Ex Machina: A Significant Federal Decision in New Orleans on Post-Katrina Litigation

To date, the insurance litigation arising out of Hurricane Katrina has unfolded along largely unremarkable lines. Insurance companies and policyholders have asserted unrealistically narrow or broad interpretations of insurance contracts, reflecting their immediate interests; federal courts have been inundated with thousands of cases; and judges have patiently untangled complex procedural and substantive strands of insurance law, so as to balance the reasonable expectations of policyholders against insurers' need for certainty.

Two weeks ago, this process disintegrated as a result of an 85-page thunderbolt hurled down by a federal judge in New Orleans - who ruled in favor of policyholders on very unconvincing grounds. While those harmed by Katrina may deserve compensation, it should come from the government, or those at fault, not from companies that explicitly included prominent flood exclusions in their policies.

The Post-Katrina Insurance Cases: Policies That Typically Had Flood Exclusions

Katrina brought into sharp relief the problems of flood insurance - and specifically, the problem that a huge number of homeowners were completely uninsured against a flood.

Private homeowners contracts exclude flooding from coverage, though insurance against flooding may be purchased through the federal government. Accordingly, in the event of a hurricane, those policyholders who have only bought private insurance routinely find themselves arguing with insurers over the relative contributions of wind damage, which is covered, and flooding, which is not. These cases are legally and factually complicated, but are being managed in Mississippi and elsewhere.

Thousands of policyholders in New Orleans lost their homes when inadequately designed and constructed levees gave way, or were overtopped by the lake waters they were intended to restrain. Because the levees themselves lent tangible (if illusory) assurance of safety to residents who built and maintained homes in the shadow of their protection, many did not purchase flood insurance. Thus, pointing to the standard exclusions, insurers denied coverage for damages that they believed was essentially flood, not wind, damage.

Because there is no practical way to compel the federal government to pay for risks it has not consented to take, policyholders directed their attention to their insurers - and ultimately went to court.

The Risk of Ambiguity Lies with the Insurer, But Are These Contracts Ambiguous?

Insurance law reflects and deepens the function of insurance: to spread risk. It does so by allocating to private insurers the risks of ambiguity in the contracts that they themselves write. (It is a standard principle of contract interpretation that contracts are construed against the drafter.) If a term is unclear - and many seemingly-mundane words are, given the limits of language - the insurer may be bound to provide coverage it did not expect to offer, and for which it may have collected no premium. But the rationale is that since the insurer wrote the contract, any ambiguity in the contract is best laid at the insurer's door, not that of the policyholder. This dynamic is a central feature of insurance law, and is generally controversial only among insurance companies and their attorneys.

In the post-Katrina litigation, New Orleans policyholders (including Xavier University) argued that the term "flood" in their policies' exclusions could mean either natural floods, or flooding created by human error. If so, then the flood exclusion could be restricted to one of these two meanings - say, "natural" floods - thus preserving coverage for flooding caused by the breached levees as the result of human error. In this type of insurance contract, if a type of harm isn't clearly excluded, it's legally included.

The natural/artificial distinction has some appeal, despite the fact that there is nothing in the language itself that draws this distinction. One could imagine a water main that bursts, causing extensive flooding over a small area. The average person likely would not think of this as a "flood," and the federal flood insurance program wouldn't, either.

Judge Duval's Decision - And Why It Is Wrong

In his lengthy opinion in the case, the New Orleans-based federal judge who heard the cases, Judge Duval, considered a variety of cases from around the country posing the natural/artificial distinction (typically a burst water main), which often ruled for policyholders because of this ambiguity. The problem, which Judge Duval did not appear to appreciate, is that none of these cases resemble the unique circumstance created by a defective flood-control barrier.

When an insurer evaluates a risk, it takes account of the context in which that risk arises. So do the reasonable expectations of policyholders. A water main or pipe could burst anywhere; it is not particularly likely to occur among, say, houses with stucco exteriors. Flood risks are different. Flood losses are not only highly correlated among closely situated homes, but they are much more likely to occur when those homes are situated near bodies of water. Policyholders accordingly pay more for flood coverage - at least when that coverage is actually contemplated by the insurance contract.

While insurance policies vary slightly around the country, no insurer would have expected liability for a levee breach in New Orleans - particularly since insurers withdrew from the flood insurance business after the 1927 flood destroyed levees up and down the Mississippi River. If there exists in the legal imagination an image that represents the essence of a "flood," this is it.

Similarly, one has difficulty imagining Judge Duval's hypothetical "reasonable policyholder" actually drawing an inference of coverage from the language of the policy. Such a consumer would be an unusually tireless sort (reading insurance policies is fun only for insurance law professors, and even then, not always), as well as pretty incurious. What, exactly, should the reasonable person make of the following notice, customarily given to insurance purchasers in flood-prone areas: NOTICE! This policy does not cover flood loss? If a curious, unstinting consumer actually read his policy all the way through to the flood exclusion, and actually entertained the precise question Judge Duval suggests is "reasonable" (Does a broken levee's flooding count as "flood loss"?), might not a reasonable person, living near a levee in a city that sits below sea-level, address a question or two to his insurance agent?

The distinction breaks down another way, too. Judge Duval contrasted levee breaches with those that were merely overtopped. The latter, he explained, resulted from natural flooding, but the former, being man-made, were rescued from non-coverage by the distinction.

This is unpersuasive. The whole point of a levee is to restrain bodies of water. Thus, the distinction Judge Duval drew would be entirely meaningless in any context other than the emerging insurance law of New Orleans. Although a punctured levee is perhaps more obviously defective, probably due to construction problems, an overtopped levee is simply defective in another way - it is poorly designed.

Litigation presently underway among residents, the New Orleans Levee Board and the U.S. Corps of Engineers will eventually establish the exact causes of failure. Undoubtedly, moral blame and legal liability ought to attach to the incompetents who built these structures. But the risk of such incompetence is exactly what property insurers and their consumers did not think was covered by private insurance.

Many insurers merit criticism for their post-Katrina conduct; a number of insurance professionals have made ill-informed and irresponsible assertions about the function of private insurance and denigrated the vital role courts play in assuring that policyholders receive substantial value for the most complicated agreements they will ever sign. I have not hesitated to point out that, all things being equal, insurers would generally prefer to pay less than they in justice owe - a characteristic that has expressed itself fully in the Katrina litigation.

Unfortunately, Judge Duval's opinion does much more than force the insurers to do justice: It actually succeeds in transforming the caricature of judicial activism into reality. Left to stand, it represents a high-water mark in creative insurance interpretation, which New Orleans residents will be free to ponder as insurers withdraw from a market they are judicially forbidden from defining. Within days of the ruling, St. Paul Travelers announced it was getting out of the commercial insurance business in New Orleans. Travelers has stated this move is unrelated to Judge Duval's opinion, and perhaps this is correct. However, insurers will not fail to see that uninsured natural catastrophes become privately insured judicial catastrophes in New Orleans.

Although the essence of insurance is uncertainty, the first requirement of the business of insurance is certainty. Judge Duval has wisely certified his opinion for immediate appeal on the grounds that "there is a substantial ground for a difference of opinion" as to the correct interpretation of the law. All policyholders - not just the thousands tragically caught uninsured by this disaster - have a vested interest in seeing the Court of Appeals correct this mistake.