Professional liability ripples

November 6, 2005

urricane Katrina has long gone, but the aftereffects of the mighty storm are likely to linger for a very long time. Rita and Wilma have compounded the mess. The direct losses are staggering. The latest preliminary figures from the Insurance Services Office’s Property Claim Services unit estimates U.S. P/C insurers will pay $34.4 billion in insurance claims to “help victims of Hurricane Katrina rebuild their homes and businesses, making this storm the costliest U.S. catastrophe ever.” Some 900,000 claims have been filed in Louisiana alone, totaling-so far-$22.6 billion. As the Property Casualty Insurers Association of America pointed out, those claims do not include losses to utilities, agriculture, oil drilling platforms and property insured under the National Flood Insurance Program; those are now estimated at another $22 billion. The industry definitely has D and C.

How many of those claims will eventually be rejected, in whole or in part, i.e. “-R,” is still unknown, but, based on the experience of past disasters, they will be numerous, and they won’t be limited solely to the “wind vs. flood” controversy.

Huge as they are, the total amounts of those claims will eventually be tallied. Louis Castoria, an assistant managing partner in the San Francisco office of the law firm of Wilson, Elser, Moskowitz, Edelman & Dicker LLP, noted at a seminar at last year’s Professional Liability Underwriting Society Conference, that the disaster also creates secondary exposures.

“It’s like when you throw a rock into a pond; there is first a splash and then concentric ripples spreading out,” Castoria said. He had just described L, “the ripple effect.” Admittedly perhaps not as revolutionary as Einstein’s E=mc, but for professional liability specialists, it’s a very relevant observation.

Those “ripples” are the number of professional liability exposures that disastrous events like Katrina trigger. Did a building fall down because it was improperly, designed or built? Should the real estate broker who sold it have disclosed known defects? Did the agent who insured it write sufficient coverage? Did he explain how flood insurance works and how to obtain it?

These and similar potential liabilities will eventually surface along with all of the litigation as to coverage questions and damage estimates.

The widespread and costly damages make Katrina a first magnitude disaster. The Insurance Information Institute dispatched Loretta Worters, vice president, to the Gulf Coast soon after Katrina vacated the premises. Reached on her cell phone, Worters described what she found in New Orleans and Southern Mississippi. “The devastation is greatest in the poorer areas,” she said, “especially in St. Bernard’s Parish and the Ninth Ward.” She estimated that average property values for individual homes in these areas were between $40,000 to $70,000; other areas have property worth up to $150,000.

The values make a difference. “Flood coverage has not been part of standard homeowners’ policies since 1968,” Worters said, “when the NFIP was instituted. Since then it’s [flood damage] been excluded. It’s not part of the industry, and there are no reserves to cover it.” The NFIP limits are $250,000 for each structure with an additional $100,000 for contents. The costs range from around $300 annually in areas of minimal risk to between $600 to $700 in higher risk areas. Lower cost dwellings would therefore largely have been covered, if-and that’s the problem-their owners had bought flood coverage from the NFIP.

“Many of them didn’t,” Worters continued, “even $600 is quite a bit of money for many people, and so they ignored the warnings.” She pointed out that Louisiana’s Insurance Commissioner has been issuing regular bulletins about the potential threats from floods, but “these were either ignored by the media, or people simply didn’t pick up on them. It’s very sad as most of the damages have been caused by flooding, not winds.”

Owners of more expensive property may have a different problem. Excess flood coverage is available-Lloyd’s, Fireman’s Fund, Chubb and AIG write it, among others-but an NFIP policy is a prerequisite to obtaining an excess policy, and depending on the terms of the excess policy not everything may be covered. Worters also indicated that commercial coverage seemed to be more inclined to include flood protection, simply because “from a business perspective it’s not prudent not to have it. Most companies have ‘opt out provisions’ [if a business doesn’t want flood insurance].”

Insurance agents as target

This situation leaves a number of professionals in New Orleans and other areas hit by Katrina and Rita, quite vulnerable to the ripple effect.

“It’s typical where parties are unable to obtain compensation to make them whole that they look elsewhere for a way to get back on their feet,” said Sally Coombes, technical director, professional liability claims at Fireman’s Fund. “It’s a natural tendency I call the ‘Echo cat;’ they look for secondary liability.” Insurance agents are one of the primary targets for this second wave of claims. “Given the loss, the claim and the rejection the next question is, ‘Why didn’t I have coverage?,'” said Coombes, who first noticed the phenomenon about 10 years ago after the Northridge earthquake.

Bruce Eisler, senior vice president at Liberty International Underwriters, who specializes in architects and engineers professional liability, agreed. “The genesis or basis for professional liability claims is that someone’s expectations have not been met,” he said. Eisler, who is also experienced in handling professional liability claims, indicated that, whatever the original cause might have been-storms or some other disaster-the claims are made because the person making them feels they are entitled to be reimbursed for what they have lost.

That question also occupies Robert Sargent, president of Hartford-based Tennant Risk Services and a board member of the National Association of Professional Surplus Lines Offices. Although he cautioned that it was too early to speculate on how many claims might be filed, he expects quite a few. “From the number of people [reported to be] flood damaged, there’s been a big accumulation of losses, but most of these claims are small,” he said.

Sargent sees that as an additional problem. “The [cumulative] defense costs involving many small lawsuits will be high. You don’t need all that many to make it expensive. For example, multiply the cost of defending one legal action, say $5,000, by 20 and you’re up to $100,000.” This will put pressure on future professional liability coverage. “The underwriters will have a problem,” Sargent continued. “It will take a few years to again show reasonable estimates.”

Design and construction ripples

Sargent, Coombes and Castoria all agree that insurance agents and brokers are going to be among the first to be hit by the ripple effect, but other professions will be affected too.

“The cat echo or ripple effect brings to light claims that have never been the subject of a lawsuit,” Castoria said. “For example, construction and design faults. Was the structure perhaps not designed properly to withstand the storm, or were their faults in its construction?”

Eisler said that he hasn’t yet seen any claims, but, “given the huge concentration of claimants,” he anticipates they will arrive. “I’ve seen the devastation, the destroyed buildings, the fallen bridges, and I expect to see claims,” he said.

Insurance brokers, however, tend to become involved in secondary litigation perhaps more frequently than other professions for two reasons. Firstly, as hindsight is always 20/20, “you frequently hear-‘of course I would have paid the premium,'” Castoria said. It doesn’t matter what kind of coverage-flood, business interruption, higher limits, or whatever.

Secondly, “when the carrier denies a claim, the agent or broker is named in the ensuing lawsuit in case the insurance company is proven right,” he continued. “The real issue may be between the company and the policyholder,” but by bringing in the intermediary-along with anyone else-all those who may be liable are present in one lawsuit. Frequently the plaintiff’s lawyer may actually “want the broker to help in the suit against the carrier,” Castoria added.

Coombes pointed out questions of valuation are another common source of litigation. Using the Oakland Hills fire as an example, she said “many limits were inadequate, they weren’t enough to cover the replacement cost of the home, or parts of the loss were excluded.” An agent therefore has a duty to ascertain what the replacement value of the property is, and to advise the policyholder accordingly.

This is but one more example of the increasing reliance being placed on agents, especially independents. “Insurance agents have a duty to observe a certain standard of care, if a risk is foreseeable, or could be anticipated, then they should so advise their client,” Coombes continued.

Her observation highlights the greater exposures insurance agents are now subject to. In order to better serve their clients, most independent agents are no longer just order takers, but frequently assume the role of financial advisers. They are therefore also deemed to have accepted the higher burdens placed on anyone who takes on a professional responsibility. When people rely on their advice, they run the risk of incurring liability when they fail to provide comprehensive information covering all aspects of a client’s potential risks.

Clarification of duties

All professionals, including insurance agents, should face this responsibility realistically, and take certain steps towards protecting themselves. Agents must know their business and have adequate professional liability coverage for openers. After that, implement preventative measures.

“An agent or broker needs to be clear about what duties they’ve undertaken,” Coombes said. “What’s offered and what’s not. If you undertake to ‘assess [a client’s] risks’ it implies a duty to assess every potential exposure.” An agent should therefore delineate what he’s going to do and what he hasn’t been asked to do.

Castoria emphasized the necessity of providing full information, of informing a client about potential risks. For example, an agent in the Midwest with customers in a flood zone should tell them about the NFIP. Similarly in areas prone to hurricanes, earthquakes, wildfires (and later mudslides), extreme weather conditions, or other hazards, agents should make sure clients are informed of the risks.

Coverage checklist

“Use a checklist,” Castoria said, “then tell people about the risks and the policies that cover them, and do it in writing.”

Coombes concurred: “An agent should document everything in writing-what terms are accepted and what’s rejected.” Failure to do so can have adverse consequences. “Juries are inclined to side with the client,” Coombes said, “unless there’s some documentation, indicating that certain coverage or policy limits were offered and rejected. Besides,” she added, “it’s in an agent’s interest to offer broader coverage-multi-peril, instead of just fire insurance, or business interruption, for instance.”

Eisler emphasized the need to be thorough in dealing with clients, whether you’re designing a building or insuring one. “Explain what’s available, what the choices are. If it’s declined document it. Maybe even have the client sign off on it.” He noted that, although following these procedures may not shield the professional from a lawsuit, it certainly makes it easier to defend one. He also indicated that following a disaster like Katrina a number of measures will be taken to strengthen building codes and regulations. “All insureds should get involved in that process,” he said, “and then they should make sure that they meet or exceed those standards.”

In order to properly observe and document their actions professionals have to balance protecting themselves and potentially alienating their clients. Many of them, especially insurance agents, are justifiably worried about sending letters to their clients that are full of legalese. This isn’t what’s required. “In the legal profession we write very specific ‘retainer letters,'” Castoria explained, “but basically what needs to be said is ‘here’s what you’ve asked me to do,’ in normal English. Confirm what’s been done, but also point out what you haven’t been asked to do; it’s just good business.” Although he didn’t specifically mention it, having copies of those letters or e-mails makes it a lot easier for attorneys like Castoria to defend their clients, if they’ve been named in a secondary lawsuit.

E&O beyond disasters

Although the immediate focus is on the fallout from Katrina, Rita and Wilma, natural disasters aren’t the only catastrophes that can trigger secondary liability exposures.

“There are no E&O claims unless there’s an underlying loss,” Sargent said. “In that sense they are sort of a derivative type loss.” When a certain event affects large numbers of people, the consequences create the ripple effect. Castoria pointed to the large number of lawsuits against securities brokers and financial advisers following the 2000 stock market crash. “A huge number of claims were filed, similar to what happens after a hurricane or a flood. [It was the difference] between one building burning down and a whole subdivision going up; all shareholders suffered losses.” Another terrorist attack would also trigger secondary exposures, just as the Sept. 11 attacks did.

He and Coombes see a looming E&O challenge in the area of cyber liability coverage. “It’s a question of when, not if,” Castoria said. “The Y2K problem was a warning, but at least it had a date. I don’t know when it will happen, but when it does there will be a ripple effect. It’s different from fire and flood losses; it’s not bricks and mortar, but intellectual property and business records. [Their destruction or theft] could cause a financial disaster with a lot of professions involved; the ripple effect will hit computer consultants in particular.”

The ripples aren’t confined only to the courtroom. “When you have this many disasters in so short a time, it results in diminishing global capacity,” Castoria said. “Reinsurance capacity tightens, and as a result less [primary coverage] goes to the global reinsurers. This affects not only professional liability, but property and other lines as well.” As a result, he predicted that primary professional liability policies might well see lower recovery limits imposed. “Suppose you want $500,000 in coverage, but you can only get $100,000. If you want the extra $400,000, you have to go to the surplus lines market through an MGA or a wholesaler.”

This in turn raises additional problems. “What if the surplus lines carrier isn’t licensed, and therefore isn’t covered by a state guarantee fund,” Castoria queried. Under those circumstances can you place coverage with that carrier without running a risk? Castoria also pointed out that excess and umbrella policies may well contain terms that don’t match with those in the primary policy, making it harder to collect.

Are there any more “ripple effects?” Probably, but in most cases they won’t be immediately apparent. Massive disasters, like this year’s hurricanes, seem capable of causing a multitude of surprises; maybe the formula can help those professionals with potential exposures spot them.

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