Monday at the AEI’s Katrina Liability discussion, a number of us talked about the rules of contract interpretation unique to the insurance industry. Essentially because of the potential for an antagonistic relationship (at the time of a claim) between the insurer and the insured, courts have adopted construction rules which act in the insured's favor. For example, if there are ambiguous terms, then the terms are interpreted to favor coverage over non-coverage. I do not have a particular problem with this concept as it is supposed to force the drafter to write less ambiguously. Outside of the insurance contract this makes tremendous sense, but if we place the realistic regulatory and litigatory environment insurers in which the actually operate over the insurance contract we have an almost completely different animal.
A second unique aspect of insurance contract interpretation is the “reasonable expectations test.” This is based on the fact that insurers are held to cover what the consumer reasonable expectations were, not what is written in the contract. This is troublesome because everyone’s reasonable expectations about what is covered after the fact is different from the reasonable expectations set before the fact. Contracts should be interpreted based on the prior to the claim understanding of the contract and not one made up to increase coverage after the fact.
A major problem is that the insurers do not have unfettered control over the contract language. The language of the flood exclusion comes from court cases and regulatory interpretations that have found their way into the current contract. Each contract has a text book of case law backing it up. At the very least, this interaction of previous court decisions and regulatory scrutiny should preclude allegations of over reaching, unconscionability, intentionally misleading customers, or of violating state consumer protection laws. The Mississippi Insurance Commission approved the contract language. Currently this approval means nothing as a defense in a contract dispute. One would think that the insurer would get at least a presumption of validity if the contract is approved by the state. Thus, the ambiguity rule and the reasonable expectations test really have no place in the modern insurance contract dispute as the contract is not written by either the policy holder or the insurer. The courts and the state have tremendous influence over the form of the contract. Thus, the plain meaning should have an important role.
A similar, but quite important point is that Mississippi approved the rates under which the contract is written. Thus, the State knows if there is a flood exclusion, the rates do not cover flood and the insurers have not reserved against flood. This is especially troublesome given the fact that absolutely no homeowners insurer covers flood. Even in its wildest dreams insurers never thought they could reasonably (or unreasonably) be expected to cover flood — given that the federal government advertises that it is the sole source of flood cover and subsidizes the coverage which completely kills the market for private flood insurance. In fact, if the firms put an extra charge for potential contract ambiguity over whether the insurer would have to pay claims outside of the contract, the State Insurance Commissioner would likely deny it when examining the pricing assumptions.
Finally, large numbers of people did buy flood insurance as they understood the risk. If we allow courts to rewrite contracts or make them permanently ambiguous, then we undermine incentives for the careful consumers and insurance markets could fail. Insurance law commentators argue that it is permissible to undermine contracts when it is in the interest of public policy. However, who is the public being served here? It is only current claimants and perhaps trial lawyers. They only reflect a small number of the “public”. The existence of contract law protects the long run insurance markets. If we abrogate legitimately executed exclusions, then insurers will not be able to price risks for the next contract. If there is no next contract, then we have no insurance market. Thus if we abrogate contracts in favor of current claimants, then the interests of future claimants are at risk and we are all future claimants!
Consumer advocates seem to believe that incentives don’t matter. In fact, Monday’s panelist, Ms. Joanne Doroshow, suggested that the insurance industry hullabaloo over Hurricane Andrew was a big show complete with tears and gnashing of teeth. She felt that since there still is an industry serving the state that their concerns were just a show. (I am paraphrasing just a bit.) But, at the same time she suggested that the Gulf Coast insurance regulators needed to adopt emergency rules to keep the industry from leaving and non-renewing policies. She suggested that regulators should do what Florida did after Andrew. Florida is not a market we want to emulate as companies and capacity have left the state leaving the state owned People’s Citizen's Property Insurance Corp. as the second largest bearer of hurricane risk. This means that the Florida taxpayers are the risk bearers rather than private capital markets. A number of companies left Florida this year after last year's losses, in part, because they did not think they could get regulatory approval to charge sufficient premiums to cover their risks. Florida’s market is not healthy and its practices should not be imported by other Gulf Coast regulators.
Providing insurance is voluntary. No one can force a company to provide insurance in the long-run. There are no monopoly common carrier obligations on insurers, yet the industry in general is being asked to cover losses it excluded with understandable language. This language when read with the entire contract should still allow insurers to exclude a well defined risk. Consumers have to look at the contract and have to be held to some standard prior to a loss. Allowing the courts to rewrite the contract is another good Samaritan problem, but it may lead to the long-run destruction of catastrophic insurance markets.
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