The many areas for dispute in the wake of Hurricane Katrina could mean years of litigation ahead, warns Ronald Gift Mullins

Residents and businesses of the Gulf Coast slowly started to crawl out from the devastation of wind and water wreaked by the Hurricane Katrina on 29 August 2005, just as Hurricane Rita hit the eastern coast of Texas, bringing additional billion-dollar insured losses. But even before the water had been pumped out of New Orleans, questions were being raised by policyholders and government officials whether the damage to homes and businesses resulted from the 140 mph winds of Katrina or from flooding following the 20 foot storm surge.

Keeping to the strict language of standard property policies which excludes recovering for damage caused by rising water, insurers and reinsurers will save billions of dollars, but such a stance could bring a hail storm of criticism and burdensome lawsuits. Adjusting claims more leniently may save insurers from public opprobrium and censure, but it would put them, their reinsurers and retrocessionaires on the hook for additional billions of dollars. Furthermore, overriding long-established exclusions in a property policy to fit the extraordinary circumstances of this catastrophe, may lead to permanent coverage modifications, which would significantly expand the liability of insurers, increase insurance rates substantially for property owners, throw up a barrier of resistance between insurers and reinsurers, and bring further disintegration of "follow-the-fortunes" precept.

Risk Management Solutions (RMS) said that after the New Orleans levees failed, "some 80% of the city was submerged in murky water." About 150,000 properties were flooded, making it "the most damaging flood in US history." RMS said that some $15bn to $25bn from flooding was included in its overall estimate of total insured losses, ranging from $40bn to $60bn. Because the ruin was so widespread and included flooding, catastrophe modelling did not enable insurers to quickly verify their losses. Some of the largest insurers in the US delayed releasing estimates of their losses until three weeks or more after Hurricane Katrina had struck. Most reinsurers, however, some citing its share as a percentage of total losses, announced claims amounting to some $13bn within a few weeks after the hurricane hit.

One advantage reinsurers have over primary insurers for estimating losses is that reinsurers have considerably fewer contracts or policies to consider. "A major primary insurer," said Bruce Ballentine, vice president/senior credit officer, Moody's Investors Service, "could face tens of thousands, or even hundreds of thousands, of home and auto claims, and possibly numerous commercial claims. In contrast, a major reinsurer would likely have just dozens of material treaties to consider, along with hundreds, or perhaps a few thousand, facultative contracts. The upshot is that the reinsurer might fairly quickly determine its maximum exposure - by adding up contract limits. This approach might not be practical for a major primary insurer."

Moody's expects reinsurers to have sizeable losses. According to Ballentine, reinsurers are likely to have limits on all contacts, limits per occurrence, per catastrophe and others, but, nevertheless "reinsurers will have a very large share of the total insured losses, because of the heavy commercial component, including damage to the offshore energy facilities and gaming industries."

Backing reinsurers are retrocessionaire programmes which can be triggered by a number of events - per occurrence, individual company loss, total industry losses. These programmes will mitigate losses for buyers of such protection but will exacerbate losses for major retrocessionaire writers. With Rita's damage, these programmes could be hit hard again.

Because of the flooding of much of New Orleans from breached levees and the scarcity of homeowners in Mississippi, Louisiana and Alabama who purchased flood insurance from the National Flood Insurance Program (NFIP), the insurance industry has already been alerted that political pressure and lawsuits may be exerted to force insurers to pay claims for some forms of water damage.

Mississippi Attorney General Jim Hood made clear in his recent announcement his plan to pressure the market into effectively voiding flood exclusions included in most property insurance policies. His aggressive approach has been softened somewhat by the state's Republican Governor Haley Barbour, who said he would rather negotiate with insurance companies to get more assistance for rebuilding homes that were not covered by flood insurance. The governor said he was concerned that the lawsuit could bankrupt some companies and drive insurers out of the state and emphasised the importance of viewing insurance policies as legal contracts. Mississippi Insurance Commissioner George Dale said he is requiring insurance companies prove water rather than wind-caused damage before denying an insurance claim.

Robert Wooley, Louisiana's insurance commissioner, met with insurers and reinsurers and called on the industry to pay all valid claims. Enter Mississippi Attorney Richard "Dickie" Scruggs, who lost his nearly million-dollar home in Louisiana to Katrina's storm surge. It was insured for $250,000, the maximum, with the NFIP. He is taking on insurers in a class-action suit to make them pay for losses defined as coming from wind-driven water.

Fitch Ratings believes the payment of significant flood-related losses would heighten its view of the industry's "deep pocket" exposures. Furthermore, though reinsurers are intended to "follow the fortunes" of their primary companies, Fitch believes it is highly likely reinsurers would dispute payment of any flood-related claims.

In the commercial arena, business interruption claims are also frequently contested. Any such disputes between insureds and primary insurers may spill over to involve reinsurers as well.

Brad Kading, senior vice president, Reinsurance Association of America, asked if reinsurers still follow the fortunes, said: "Reinsurers say they never willingly follow anything, but look to contract clauses. If there is a claim covered by a contract, appropriate terms of coverage govern how that contract is settled."

"There may be case law that affects contract interpretation," he said, "but a reinsurer is bound by what it contracted with its cedent for. Any disputes would be settled by negotiation, arbitration or litigation."

Because of the nature of the losses from Katrina, insurers and reinsurers will be in dispute, and reinsurance recoveries for primary insurers will not be so easily obtained without litigation, said Andrew Barile, a reinsurance consultant. "The coverage question between policyholder and insurer has compelled reinsurers to get away from the concept of follow the fortunes," he said. "Reinsurance company management has had to change, because of the past actions that led to the failure of a number of reinsurers."

Katrina is going to result in a lot of arm wrestling between primary and reinsurers, observed Tom Upton, managing director, Standard & Poor's, but noted it is "customary for primary and reinsurers to argue." Typically property losses are not usually long tail, but in this case, he stated, particularly if there is legal or regulatory action at the primary level, it may not be possible to resolve claims in a few months, and they may go on for years.

Adhering to the follow the fortunes doctrine under English law depends on whether and what form of that clause is in the reinsurance contract, said Vince Vitkowsky, a senior partner in the insurance group of Edwards & Angell, and under some forms depends on legal liability being established by the ceding company.

In the US, "there may or may not be a follow the fortunes clause implied in the contract," he said, "if it is not expressed. If there is such a clause in the contract, depending on the basis of liability, it remains to be seen how it will be applied to particular claims presentations."

He advised insurers to make sure they invoke and, if necessary, defend their exclusions and other limiting contract language, rather than rolling over to political or other pressures. "Eventually, it will help the cedent support the reinsurance presentation for payment," he said.

In a reflective conclusion to a presentation at the Reinsurance Rendez-Vous in Monte Carlo, Joe Plumeri, Willis Group chairman and CEO, in a reference to the devastation in New Orleans, said that for the industry to act heroically "... will mean that we are not about disputing claims but are about rebuilding lives."

Ronald Gift Mullins is a freelance insurance journalist in New York City.