David Rossmiller at Insurance Coverage blog has been keeping tabs on a bill that would expand the National Flood Insurance Program to also offer wind coverage.
The debate has been lively, with one Congressional staffer apparently calling into question an consulting firm’s professional ethics for daring to point out the potential expense of the proposal in an AIA-sponsored review.
(The review is fine, from my perspective, for what it is—assume rates are 20% inadequate, and calculate the size of potential deficit if the expanded NFIP is a monopoly, or is merely the victim of adverse selection. It’s a potential “bad but not worst case” scenario intended to drive debate, and to hopefully shift the outcome away from such a result, without actually discussing the odds of such an outcome. )
David’s most recent installment heads into a discussion of whether private insurance is an appropriate vehicle for mega cats. Quoting a quoted study, on the nature of low-frequency/high-severity events:
This type of loss is much more difficult for the insurance industry to handle because the usual pooling mechanisms do not apply. The events are simply not sufficiently frequent for the law of large numbers to operate. For this type of loss, the insurer is essentially in the same position as the policyholder in the usual insurance transaction, i.e., the insurer faces a loss that amounts to a high proportion of its resources and that is highly uncertain or unpredictable. Low-frequency, high-severity losses cannot be handled effectively by the insurance industry acting alone.
It sounds good…but I’m not completely certain that it’s completely applicable to windstorm cover.
I can accept the idea that private insurance isn’t well suited for extremely low-frequency / high-severity event coverage. A tremendous amount of capital must be available to draw upon to pay claims from such events. The providers of that capital expect a return from the use of that capital commensurate to the risk involved… and that in turn requires insurers to charge an unacceptably high premium to provide such a return. (Yes, I’m tremendously oversimplifying here.) This is why TRIA is important.
However, this isn’t, I think, why the NFIP was created. With the flood peril, you actually have a threat that is comparatively predictable. Topography and hydrology around insured properties is (for the most part)known. In fact, it’s known well enough, that only those folks who have a real risk of loss buy the coverage,which in a private market would drive rates up for consumers who retain coverage, which in turn incents the lower-risk folks among the remaining insured population to drop coverage….and the nasty cycle continues, giving rise to the notion that, at least for personal and small commercial risks, flood is an uninsurable peril.
However, windstorms—hurricanes in particular, are a bit more widespread. In aggregate, they are relatively predictable (if you believe the models), but in general the risk is widespread and more difficult for individuals to decide to opt-out of. The industry has sufficient capital to provide coverage for ordinary storms…and for the highest risk entities, there is for better or worse a residual risk market at the state level.
I don’t think there is a need to federalize windstorm risk in general. Expanding the idea of a backstop for mega-catastrophes, events that would essentially kill the industry (e.g. the dreaded Cat 4 hurricane making landfall immediately southwest of New York City), would be appreciated, as would creating a mechanism to accumulate future cat reserves in a tax-free or tax-reduced manner (I wouldn’t mind having to make filings to the IRS to support a cat reserve fund).
Actually, thinking as I write this, I suppose I wouldn’t necessarily object in principle to a federalizing or pooling of various state residual market programs—not necessarily as an “expanded NFIP”, but perhaps an “Über Beach Plan”—a national residual property insurance vehicle funded in a manner similar to state residual vehicles, with profits or shortfalls going to the industry in proportion to (market share less voluntary writings), and perhaps with mechanisms in place to incent insurers to take the risks.
OK, my inner Libertarian has an objection-in-principle to the idea…but aside from that, the idea of a pooling of residual markets could grow on me, particularly if the rates charged had at least some resemblance to the reality of the true risk associated with such exposure.