More than 18 months after Hurricane Katrina devastated the Gulf Coast, the state of Mississippi finds itself in a legal battle over homeowners' insurance that may take longer to clean up than the hurricane debris. Thousands of Mississippians have seen their houses reduced to concrete slabs and want somebody to pay. Both government-subsidized and private insurance programs have failed to adequately fund rebuilding. Legislative proposals and lawsuits have poured out, and the state Democratic party has begun running television commercials blaming Republican governor Haley Barbour for the scores of Mississippians "still living in trailers."

In this uncertain environment, the state's largest insurer, State Farm, has stopped issuing new homeowners' policies, and its second largest, Allstate, has cut back. All others have stopped writing new wind insurance policies along the Gulf Coast. Because they expose a key inconsistency in America's mixed private-government insurance system for coastal areas, these events herald a stark choice for the whole country: Either homeowners will take responsibility for their own homes or taxpayers will become the nation's major source of homeowners' insurance.

Mississippi's Democratic attorney general, Jim Hood, a bĂȘte noire to much of the insurance industry, told me that he sees a simple bottom line: "The current system is a giant conflict of interest. It can't last. In the long term, I believe that the market should be able to solve the problem and that we should do away with the federal flood [insurance] program altogether."

Throughout the country, conventional homeowners' policies don't cover flooding. Along the Gulf Coast, private coverage for wind damage often proves unaffordable. In addition to private homeowners' policies, most people in hurricane zones can therefore avail themselves of both federally-backed flood insurance and state-sponsored wind insurance.

On paper, this public-private system looks sensible; subsidized wind and flood insurance both arose in situations of clear need. When the state created the Mississippi Windstorm Underwriting Association (popularly, the "wind pool") in 1987, some Gulf Coast homeowners paid as much for wind insurance as for mortgages. Before Congress created the National Flood Insurance Program in 1969, likewise, virtually no conventional private insurance companies wrote flood policies, because only people with severe flood risks would have purchased them. Today, to ensure the federal program spreads risks broadly, most flood-plain homeowners with mortgages face a mandate to purchase flood insurance. In theory, both the federal flood program and state wind program must charge premiums high enough to support themselves without taxpayer infusions.

It doesn't work that way in practice. Both the federal flood insurance program and the Mississippi wind pool regularly raid their respective treasuries. Stabilizing Mississippi's wind pool in the wake of Katrina required Gov. Barbour to divert $50 million in federal grants while the state legislature debated a bill to provide even more money and new rules. The wind pool itself proposed a 400 percent hike in homeowners' premiums. The federal flood insurance program faces similar problems: Although almost everyone who has bought a flood-prone home in the last 30 years has had to purchase flood insurance at some point, not everyone kept their policies current. Coastal Mississippi had the lowest participation rate on the Gulf. The area had avoided flooding in previous storms, and many erroneously believed that their homeowners' policies would cover flood damage.

But Katrina wreaked havoc throughout the state. Even 18 months after the storm, pockets of devastation remain. "Within a quarter mile of the coast, it's still utter desolation," says Billy Hewes, a Mississippi Republican state senator and insurance agent who represents hard-hit Harrison County.

Angry homeowners have turned to the courts after insurance companies denied claims. One lawsuit from two Biloxi homeowners had particularly sweeping consequences: In January, federal judge L.T. Senter Jr. ordered State Farm to pay a $223,292 claim and $2.5 million in punitive damages to Norman and Genevieve Broussard. The case and a cascade of similar claims contributed to State Farm's decision to stop writing new policies in Mississippi.

The Broussards' situation was typical of homeowners' complaints. Faced with an entirely destroyed house, the Broussards filed a claim. State Farm said that flooding--explicitly excluded from its policies--had caused the damage and provided expert testimony in court to back this up. The Broussards claimed their home collapsed because of wind damage that State Farm should have covered. The problem is, there's almost no way to know what caused the damage. Senter based his ruling on the common law principle that courts should resolve insurance-contract ambiguities in favor of the insured. A proposed class action settlement that soon followed seems likely to get both federal and state approval: Under it State Farm and other insurers will likely have to pay billions in claims that they never expected to.

In the long term, this situation is untenable. Faced with the risk of similar payouts, State Farm and other large insurers will have little choice but to continue their pullback. Attorney General Hood has proposed following the lead of Florida, New Jersey, and a handful of other states and forcing State Farm to sell home owners' policies if it sells any other type of policy in the state. Even he, however, calls this a "temporary, short-term fix to stabilize the situation." Barbour has pooh-poohed the idea, and it seems unlikely to move forward.

Legislation to bail out Mississippi's wind pool may offer a fix only until the next major storm. "Mississippi is the freckle on the end of the tail of the dog," says Larry Cox, director of the University of Mississippi's insurance program. "We just aren't big enough to support [a wind-insurance program]. In the long term, it needs to be multi state." Cox argues that an all-South wind insurance pool might work, and Mississippi insurance commissioner George Dale has expressed interest in the idea. Tom Quaka, the president of Mississippi-only Brierfield Insurance, fears that even an improved Mississippi wind pool "will need some more changes after the next big storm." Even a multistate wind pool might eventually need a bailout.

Thus, an all-government solution looms. Rep. Gene Taylor, a Democratic congressman from Mississippi, has started pushing a bill to create federal "multi-peril" insurance, adding wind storms to the federal flood program. For all intents and purposes, this would displace a massive part of the private homeowners' insurance market everywhere. Although it has little chance of moving forward at the moment, the bill has attracted an ideologically mixed set of sponsors including extreme liberal Maxine Waters of California and Republican rising star Bobby Jindal of Louisiana.

A Congressional Research Service report has sharp criticism of Taylor's proposal. In particular, CRS insurance analyst Rawle King observes that a new federal insurance program would displace private wind insurance even in places where such coverage "is cheap and plentiful" and would impose an enormous unfunded mandate on taxpayers. King points out that Congress would be tempted to keep yearly premiums low and then ramp up "emergency" spending to bail out the program after disasters.

But proponents of an increased federal role raise a valid point: In true catastrophes like Hurricane Katrina, it's nearly impossible to determine exactly what caused damage. In areas with small numbers of insurers, supposedly "independent" adjusters do most of their work for a single company, creating a potential conflict of interest. The very existence of government flood and wind pools creates a moral hazard: Under the current system, it's possible for insurance companies to collect premiums for "safer" coverage while sticking taxpayers with the serious bills.

The alternatives to an ever-larger government role involve difficult choices. Over 20 percent of the properties currently in the federal flood insurance program could not be built today with ordinary financing and insurance. At least in Mississippi, the same goes for many properties in the state wind insurance pool. A rational market would likely demand unaffordable yearly premiums for these "nonconforming" properties. Unless lenders and local governments do more to encourage flood insurance purchase, furthermore, premiums would likely rise sharply in a private market even for safer but still flood- and wind-prone properties.

Hazard mitigation efforts--ranging from razing houses to purchasing flood prone land and transforming it to parks--offer some hope of saving nonconforming properties. Letting insurance companies apply for federal charters like those offered to banks could also lead to a more healthy spreading of risk, more regulatory competition, and, thus, lower long-term rates for "conforming" but still flood-prone properties.

Avoiding a government takeover of homeowners' insurance, however, means that some people will have to move, sell for less than expected, or assume massive personal risks. In the end, the situation in Mississippi demonstrates a simple fact: The United States faces a logic that leads either to all private or all public property insurance. Anything in between is becoming untenable.

Eli Lehrer is a senior fellow at the Competitive Enterprise Institute.

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