09 September 2005

Flood Insurance.

The customary homeowner's insurance policy in the United States has exclusions for floods, earthquakes, war, mold, environmental contamination and intentional acts of the insured. Flood and earthquake insurance are typically purchased seperately by homeowners in areas identified as high risk from federal insurance programs. For flood insurance, high risk is typically identified as locations located in flood plains and not protected by Army Corps of Engineers certified levees.

The flood exclusion turns out to be quite problematic in practice, resulting in considerable litigation, beceause it is one of the most commonly arising departures from the general principal that a comprehensive howeowner's insurance policy will cover everything. It turns out that what constitutes a flood is not a straightforward matter. For example, early in my career, one flood exclusion case involved an irrigation canal far from a flood plain in arid Western Colorado, which was breached by clumsy construction work, causing water to gush into a small subdivision and cause considerable damage to many homes. Later in my career, a similar incident involving a breach in a municipal water supply storage facility took place near a mountainous portion of I-70, several hundred feet above then nearest stream. Many high rise buildings were filled with water a little more than a decade ago when a city worker drilled in the wrong place in downtown Chicago. And, of course, most of New Orleans, while below sea level, was behind Army Corps of Engineers certified levees.

The justification for excluding traditional floods in flood plains from homeowner's insurance, and instead diverting those risks to a federal program, is pretty clear. The flood component dwarfs the rest of the risk, losses in any individual event are usually very high, and you need a large national risk pool to make it work. Private insurance is designed to cover rare, unpredictable, isolated catastrophic events. Floods in a 50 year flood plain are not rare, unpredictable or isolated. But, it isn't at all obvious that the flood exclusion makes sense outside of those areas.

The risk profile for "freak floods" in areas which aren't in flood plains looks a lot like the risk profile of any manner of other insured risk like fires, tornados, and storms. If the freak flood risk were spread across virtually every homeowner's insurance policy in the nation, instead of only among people who elect flood insurance despite living outside a flood plain at a very high cost (typically because those individuals know something that the flood plain designators do not), the additional cost would be modest. And, since judges and juries often frown on insurance company attempts to characterize "freak floods" as falling within the exclusion and instead often look to interpretive techniques (like calling a flood storm damage or some other type of casualty), and as a result, those cases often result in considerable uncertainty and litigation costs.

The "freak flood" exclusion is less a matter of really principled analysis of the risks and benefits, than it is a crude knee jerk reaction to not wanting to bear heavy risks from ordinary floods in flood plains. A removal of this exclusion, outside of flood plains, would give our nation a more seemless safety net against those kinds of casulties at a modest cost per policy.

A similar argument can be made for earthquakes outside of known earthquake zones. The risk is modest, and it results in a number of "freak earthquake" claim litigations (although not as many as in the case of the flood exclusion) involving things like vibrations caused by nearby construction sites or a nearby collapsed mine, which aren't really what justified the exclusion. But, this is less urgent.

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