What Natural Disasters Can Teach Us About Insurance

Fractionally Legal V20 Looks at How Insurance Works When Disaster Strikes

Fall is basically here. It's one of my four favorite seasons, and I hope you all are enjoying it as much as I am.

I often discuss insurance issues with my clients in the context of whether their insurance policies are going to cover any loss or prospective loss. But the question I get in almost every contract negotiation is what it means when one of their customers or vendors comes back with requirements that they “waive subrogation.” What does that mean, and how does it work? I find that it's the type of thing that is hard to explain but easy to illustrate.

In this edition of Fractionally Legal, I’m going to illustrate how subrogation works by giving an example of how insurers, government agencies, and lawyers are trying to get homeowners compensated for their losses caused by the fires in Maui last August. It's actually super interesting and a lesson in how climate change is, well, changing everything.

And so, while you experience the long, warm autumn we’ve all become accustomed to in the Northeast, or the longer, more intense fire season we're forced to endure in California, or any climate-related changes you’re experiencing wherever you’re reading this, you can learn how climate change is also changing the way we insure our properties and businesses. It is fascinating!

As always, if there is anything I can do for you, please get in touch! Always happy to discuss the law or anything.

Climate Change is Making Insurance a Natural Disaster

One of the oldest forms of insurance is property insurance. If you lose your property (home, business, jewelry, car, depending on what you insure) and an insurable event happens (fire, flood, wind, earthquake, etc.), then your insurance company will replace your property (either in kind or in cash) up to the limit of the amount of insurance you purchased. As a business proposition, this all makes sense: everyone pays a little bit every year so the company can cover any single policyholder’s loss in any single year. Insurance companies make money when they invest the money and hope they did the math right regarding the probability of the event happening (and also distribute the risk by buying their own insurance through the fascinating world of “reinsurance”).

Basically, if you’re an insurance company, you don’t want to sell too much cheap life insurance to older people, and you don’t want to sell too much cheap homeowner’s insurance in places where natural disasters are likely to occur. Luckily, insurance companies have really good actuarial tables that tell them how many of their life insurance policies are going to pay out in any given year, and pretty good data on where natural disasters are going to happen.

Or at least they did. But what happens when huge, unexpected natural disasters start to happen more and more often? When areas that were expected to flood every hundred years flood every 10 years? Or a place that never saw fire now gets huge, uncontrollable fires every few years? One option, of course, is just to stop writing property insurance policies or charge huge premiums to customers in the affected areas—basically forcing everyone to “self-insure,” meaning that when disaster hits, you're out of luck unless you're rich enough to rebuild and recover with your own money. That is certainly one system, but there are lots of problems with it.

For one, it's a really bad option for society at large because it means that financing would be unavailable for homes and businesses in those areas. Lenders won’t allow you to collateralize loans with property that might disappear, and they won’t finance businesses that could get swept away in the next flood. Without insurance, the lender is taking too much risk. Can you really expect a loan to be paid back when the underlying property or cash-producing asset no longer exists? And if you really think about it, a lack of insurance means the government becomes the insurer. It would be unacceptable for thousands of Americans to become destitute due to natural disasters. The government will always help, but the private insurance market is essential. Otherwise, it's all on the taxpayers.

And now that we live in an era where natural disasters are more and more prevalent, we need to deal with how to pay for it all, lest we end up with massive displacement and a government that needs to print money to deal with the mounting costs. It's more important than ever to keep private insurance companies solvent. And that is where “subrogation” comes in.

Take a look at what happened in Maui, Hawaii, in August 2023. Remember those fires that devastated half the island in August 2023? All the homes and businesses that were destroyed had insurance, which was priced based on the likelihood that a huge fire would sweep through tropical and wet Hawaii. That is, it was not as expensive as it should have been. And then a massive fire swept through half the island. Insurance companies paid out $2.3 billion in losses for property they insured. Will they be offering fire insurance at competitive rates in Maui ever again? Unlikely—without some help from the law.

And here is where things get tricky and super interesting. When an insurance company pays a claim, they have a right of “subrogation,” which means they can step into the shoes of the insured and sue the person who caused the loss that they just paid for. It’s a little confusing, so an illustration is important. If a utility company’s negligence causes a massive fire that burns down your house, the fire is an insured loss. Your fire insurance company is going to pay for your house and all your possessions. But you, as the victim of the utility company’s negligence, have a lawsuit against the utility company. And so do all your neighbors whose homes also burned down. In Maui, hundreds of homeowners have sued the utility company, Hawaiian Electric, alleging that it caused the blaze that led to the loss.

Many of the contracts I deal with require that each party “waive subrogation.” Why? To avoid exactly this situation. The policyholders, in this case, homeowners, have an insured loss and a lawsuit against the person who caused the negligence. The insurance company paid the loss. And so did the wrongdoer. It's possible that the insurance company can get its money back from the policyholder because of the settlement with the wrongdoer, but allowing the insurance company to sue the wrongdoer would make it very unlikely that there would be a settlement, thus prolonging the dispute. And importantly, when the other party to the contract is the wrongdoer, not having a waiver of subrogation will cause the contracting parties to be in litigation with each other for years. That's not great. But, then again, by waiving subrogation, the insurance company loses the right to recover some of the money it paid and a source of revenue. Because insurance companies price their policies with the right of subrogation, a waiver costs money. If you don’t buy one, the insurance company has not waived its rights.

Returning to Maui, let's see how this works in practice. Hawaiian Electric and a few other defendants want to settle the cases with the homeowners and have offered $4 billion. But there is a problem: subrogation. Defendants like Hawaiian Electric won’t settle the claims unless the insurance companies waive their right to subrogation. Without the waiver, the defendants could make a payment to the victims and then, again, to the insurance company because the insurance company could prevail in its subrogation claims. In other words, the settling defendants would need to pay twice: once to the homeowners they settled with, and again to the insurance companies. That would be a big problem for the settling defendants. The insurance companies could get some money back from the homeowners under the settlement, but that is a hard process because much of the money from the settlement might not be paid to the homeowners but to reimburse the government for its costs, prevention of future disasters, and attorneys' fees. So, without the insurance companies agreeing to a waiver of subrogation (which they won’t do since the homeowners did not buy one), settlement would be scuttled, and homeowners would need to wait years for resolution. Whether Hawaiian law allows subrogation under the circumstances is currently an issue in front of the Hawaiian Supreme Court. That would settle the matter, and basically harm the insurance companies.

While most people are hoping that the insurance companies get the short end of the stick here and are forced to give the (free) subrogation waiver, it's not really fair, and it’s dangerous. Like our climate, the law is delicate, intricate, and interconnected. Small disruptions can have large, unforeseen consequences. In light of the important role of insurance in making it possible to finance development in an increasingly risky world, requiring these subrogation waivers after the fact (or deciding that insurers can be bound by a settlement they never agreed to) is one of those legal moves that can throw the whole system out of balance. And when we do that, we’re potentially making an unnatural disaster of our private insurance markets.

Keep building, keep thinking,

Jesse

Hi, and welcome to my newsletter! I’m Jesse Strauss, Your Fractional General Counsel. I’m a lawyer with a private practice based in New York City, helping clients in the United States and globally with their US legal needs. My expertise spans various areas, including raising funding rounds, employment issues, negotiating master service agreements, intellectual property, compliance, legal process management, and dispute resolution. My focus is on founding and nurturing great companies from seed to exit. Discover more at www.yourfractionalgc.com and book a complimentary 30-minute consultation at Contact Your Fractional GC. You can also follow me on Instagram and Threads @lawyerjesse, on TikTok @lawyerjesse, on X @lawyerjesse, on YouTube @lawyerjesse, and my Substack https://fractionallyyours.substack.com/ (follow me on nNotes), and on LinkedIn https://www.dhirubhai.net/newsletters/fractionally-legal-7147764173140103168/ .