State Farm Loss In Katrina Insurance Coverage Case Has Potential Downside For Virginia's Coastal Communities

Yesterday, a Mississippi jury ordered home insurer State Farm to pay $2.5 million in punitive damages to a couple whose house was destroyed by Hurricane Katrina. The highly publicized award--along with ongoing legal proceedings on the Gulf Coast in hundreds of other lawsuits--has the potential to make a big impact on other coastal communities, including in Virginia.

First, the good news for insurers: the decision is not as bad as press reports would tend to indicate. The federal district court judge in the case, L. T. Senter, Jr., ruled that State Farm would not be required to pay for damage caused by water, including storm surge. (Some plaintiffs along the coast have pursued the dubious claim that because a hurricane storm surge is caused by wind, it's not "flood" damage; this is a ridiculous argument made by people who should've purchased federal flood insurance, but didn't, and now want the rest of us with homeowners insurance to bail them out.)

However, Judge Senter also ruled that in a case involving both wind and flood damage, the insurer is on the hook for the portion of the damage caused by wind. Significantly, he held that in a case of mixed damage, the burden of proof would shift to the insurer to prove what portion of the damage was caused by water. In this particular case, the homeowners alleged that Katrina's winds--including a tornado--destroyed their house and then the storm surge carried the debris away.

The court granted judgment to the couple (taking the case away from the jury) on the fundamental issue of whether State Farm had proven that water damage caused ALL the damage, which would be the only way State Farm could deny any payment. Judge Senter agreed that State Farm had proven that water caused some of the damage, but faulted the insurer for providing "no proof" of what portion of the damage was attributable to wind versus water. Therefore, he ruled that State Farm was liable for the full amount of the policy: $223,292. He then let the jury decide whether to impose punitive damages.

In the end, the rulings are pretty narrow and fact specific. State Farm needed an expert witness to quantify the amount of damage from water versus wind, and having failed to provide that evidence, the insurer lost.

Clearly, there will be an appeal. The case will now go to the conservative and business oriented Fifth Circuit Court of Appeals, which covers the hurricane prone states of Texas, Lousiana and Mississippi. There are several ways State Farm could win on appeal. First, the appellate court could fault the lower court's purely legal decision to shift the burden of proof to State Farm. Second, the court could reverse the judgment on the ground that the trial court should not have entered a directed verdict--i.e., taken the case away from the jury--on whether State Farm had carried its burden of proof. Reversal on that basis would require a new trial.

Finally, the appellate court could reverse or reduce the punitive damages--and is likely to do so--on the ground that with such novel legal issues and with clear evidence of at least some water damage, State Farm did not act in bad faith. Even if the punitive damages stand, the appellate court is likely to reduce the amount of the award to around $1 million based on existing precedent that punitive damages should not generally exceed four times the amount of compensatory damages.

In short, this one case has a long way to go.

Now, what does the case mean to other homeowners in hurricane-prone regions? It surely means a further escalation in insurance rates and is likely to accelerate the number of insurers who simply won't offer coverage in such areas. That is not welcome news for homeowners, developers and governments in coastal communities.

In the end, we are all better served by very clear rules on insurance related to hurricanes. Damage to homes caused by water, including storm surge, should be the province of flood insurance, which is expensive--and should be! Why should the rest of us subsidize people--many of whom are wealthy--who choose to live, or have vacation homes in--such dangerous areas? On the other hand, damage from wind should be covered by standard homeowners policies, which presumably will be priced to the hazard.

(Typically, storm surge damage in a hurricane will be limited to homes located within a couple hundred yards of the ocean or a connected body of water, such as a bay or river; storm surges often completely destroy a structure. In contrast, wind damage can occur hundreds of miles inland, but usually doesn't destroy a building--with some exceptions: see Hurricane Andrew in Homestead, Florida. It is also easier to design and build structures that will withstand hurricane force winds, and price their insurance accordingly.)

Mixed cases--like the one above--will always be dicey. It might be better to have clear rules and allocations for such cases so that everyone, insurer and homeowner, knows in advance what will happen in such instances. (And insurance can then be appropriately priced.)

The bottom line for Virginia's numerous coastal residents: victories by Gulf Coast insureds in litigation over Katrina will probably cost you more money. And, as always, especially in dealing with insurance companies, buyer beware! Review your policy now and make sure you have the coverage you think you're getting. (If it's inexpensive, then you're probably poorly covered.)