Coastal Insurability and National Wind Insurance
Nicholas Flores
Associate Professor and Department Chair
Over the past 15 years coastal areas along the Gulf of Mexico and Southern Atlantic seaboard experienced rapid population growth. With increased development comes increased exposure to property loss from hurricanes. Hurricane Andrew, which hit Southern Florida in 1992, proved to be a turning point for private insurers offering wind insurance to homeowners and small businesses. A large number of claims for wind damage occurring at once drove some smaller insurers out of business. Surviving insurance companies started refusing to write policies in areas close to the coast, causing an insurance crisis.
States responded by creating special state managed risk pools, usually referred to as wind pools, where insurance policies are written in high-risk areas and then state exposure is reduced through reinsurance or requiring private insurers operating in the respective states to take on this exposure as a condition for selling policies in other areas of the state. Hurricanes Katrina and Rita wreaked havoc on Louisiana and Mississippi insurers, for both state and private insurers. The Louisiana congressional delegation is seeking to expand federal insurance from covering floods through the National Flood Insurance Program (NFIP) to further covering wind damage from hurricanes. In this brief article I want to touch on how a national wind pool could enhance the economic efficiency of coastal insurance and how a national wind pool could diminish economic efficiency.
In considering a possible federal wind pool, it helps to begin with an overview of the NFIP. The NFIP was passed in 1968 and has three main provisions. First, when flood insurance is provided, it is almost always provided at actuarially fair rates where rates are determined by risk of flood to the specific property being insured. Actuarially fair rates equal the expected claims for a given policy during the year. Exceptions to actuarially fair rates are for some high-risk properties that were constructed prior to the establishment of area flood insurance rate maps. Premiums for these properties are among the highest within the NFIP, yet they are subsidized. Congress allowed for subsidization within this group in order to encourage participation and reduce this group’s dependency on disaster relief. Second, polices are only written in participating communities. Participating communities agree to restrictions on construction that include limiting new development in extremely high-hazard areas and making sure new structures are sufficiently elevated to lessen flood risk. Third, participation in the NFIP is mandatory for anyone who has a federally backed mortgage and lives in the 100- year flood plain. The 100-year flood plain is the area that would be flooded by flood events that have a 1 in 100 or less chance of occurring in a given year. The Federal Emergency Management Agency (FEMA) is charged with administering the NFIP, which includes mapping flood plains to determine risk, setting premiums, determining required measures for participating communities, and servicing claims. For structures built after the establishment of flood insurance rate maps, the NFIP is, in principal, designed to be financially sustainable over the long run since premiums are set at actuarially fair rates. Overall though, the NFIP is not actuarially sound because of the older structures in high-risk zones. In years when claims exceed NFIP reserves, FEMA has the authority to borrow from the U.S. Treasury and repay the loans over time through premiums. FEMA had to borrow nearly $20 billion following hurricanes Katrina, Rita, and Wilma.
The NFIP was designed to subtly force people who choose to live in flood-prone areas to manage their own risk exposure through insurance. Thus when flood losses occur, there are not massive costs imposed on the rest of society, those who do not choose to live in the flood plain. The NFIP has many critics and some claim that availability of flood insurance actually encouraged development of the nation’s flood plains. Admittedly, the NFIP has problems. People who live behind levies that are maintained by the Army Corps of Engineers are not considered to be in the 100- year flood plain. Lacking that designation, many residents dodge the NFIP mandatory provision. Hurricane Katrina demonstrated that levies fail and those lacking flood insurance faced financial ruin. Further, when people make a purchase offer on a house in the flood plain, they usually do not learn the exact amount of their flood insurance premium until closing. Flood insurance premiums for $100,000 of coverage can range from under $200 per year to over $4,000 per year. Upfront disclosure would definitely enhance the economic efficiency of the NFIP. Despite these failings, the NFIP provides a valuable instrument to help people manage their risk. Most importantly, the NFIP helps to keep flood losses of those who live in the flood plain from spilling over to other citizens who do not live in the flood plain. In a perfectly functioning economic system, the social costs of occupying flood plains are born entirely by those who choose to do so.
With high claims from recent events and predictions of increased storm intensity perhaps due to global warming, private insurers are writing even fewer policies in wind risk areas or they are significantly raising premiums. While many feel insurers are simply gouging consumers, insurance companies themselves are facing increasing costs. Most insurance companies that write policies in coastal states purchase reinsurance (insurance for insurers) in order to manage their own exposure to risk. The reinsurance industry uses catastrophe models provided by firms such as Risk Management Solutions or EQECAT to price risk. These models incorporate information on increasing storm intensity that translates into higher predicted risk. The reinsurance industry in turn charges higher reinsurance premiums to insurers when models predict increasing risk. When I speak with reinsurance executives, they point out that the supply of reinsurance is sufficient to cover state wind pools. However the premiums are high and will increase based on their analysis of the risk. What are the implications of a national wind pool on economic efficiency of coastal insurance? If we believe the reinsurance industry, there is not a supply problem and so state wind pools should be able to control their exposure at a potentially high price to policyholders. Under this scenario, a national wind pool makes little sense. If reinsurers’ assessment of risk is biased toward overestimation of risk, a national wind pool could help improve efficiency by offering wind insurance at more appropriate rates. However, given there is competition among reinsurers and among catastrophe modelers, I doubt a national pool can sustainably provide significantly lower premiums. In the long run, charging artificially low premiums runs the risk of insolvency, where claims exceed reserves. Requiring that the federal government absorb the losses would seriously undermine economic efficiency of coastal insurance since non coastal residents would likely be covering the hurricane property losses of coastal residents. This need not, however, be an absolute showstopper. A national wind pool could be set up to require the pool to borrow money when claims exceed reserves similar to the NFIP. Repayment of these loans would then fall on the pool’s policyholders through annual fees in excess of premiums. Any system of the sort I am suggesting would then require mandatory participation for people in coastal zones, similar to NFIP for those in flood plains. Otherwise people would opt out in order to avoid the loan liabilities. In order to enhance economic efficiency, a national wind pool would have to be actuarially sound, which precludes exemptions such as those allowed for older structures under the NFIP. Any subsidization, even if it were exclusively within the pool, would undermine efficiency.
Overall while Congress considers a national wind pool, it would be wise to focus first on market fundamentals and in particular supply and competition. Findings of under supply or inappropriate pricing may provide justification for a national wind pool. Focusing first on the high premiums at the expense of investigating market fundamentals will only undermine economic efficiency, with the most likely outcome being subsidization of the coastal lifestyle.