National Catastrophe Fund

I’m listening to the GOP debate on MSNBC, currently in the candidates-ask-each-other-questions phase, and unsurprisingly Giuliani posed a question on the concept of a national cat pool to to Romney (with McCain jumping in as his name was taken in vain).  Giuliani  posed his question to Romney,

A few thoughts:

• We just had more discussion on the concept than most MSNBC viewers have likely ever have been exposed to previously.
    
• Romney expressed “familiarity” with the problem via Massachusetts snowbirds.  I’m sure that folks living on Cape Cod and the Islands are feelin’ the love.  (Of course, considering what they think of the relative lack of capacity in that corner of Massachusetts…maybe he doesn’t want to associate with them.)
   
• I’m a little disappointed that the discussion didn’t acknowledge the magnitude of the expense involved (although McCain, in his rebuttal, at least raised the concern about lack of funding of current proposals).
   
• At least Romney did make a key point (looking beyond the Florida primaries) — that he didn’t want folks in Iowa to subsidize Florida risk.
   
• Interesting transition to the question of global warming at the tail of the insurance question (using threat to beach property as a segue).  Probably not a question that Republicans like to hear…but a big hat-tip to McCain for his observation on his cap-and-trade plan — “if global warming isn’t real, we leave the world cleaner for our children” (paraphrase).

Yesterday, I wrote about Hillary attempting to earn brownie points among Floridians by sponsoring the Senate version of the Homeowners Defense Act.

Well, I notice that the House has passed its version. From Business Insurance:

The House of Representatives has approved a bill that create a federal backstop for state catastrophe insurance pools.

The Homeowners’ Defense Act of 2007, which passed on a 258-to-155 vote Thursday, would create a National Catastrophe Risk Consortium. The entity would, among other things, issue securities and other financial instruments linked to the catastrophe risk in the capital markets.

As one might expect, there’s some criticism blossoming from within the industry. Still quoting BI:

“This legislation falls short in trying to address the problems in coastal insurance markets,” said Marc Racicot, president of the American Insurance Assn. in Washington in a statement issued after the vote. “It will not generate new private-sector insurance, reinsurance or capital market capacity, and is likely to encourage states to create thinly financed, state-run reinsurance facilities that will displace the private market and require a federal government bailout in the event of a catastrophe.”

“Government is not the right solution,” said Frank Nutter, president of the Washington-based Reinsurance Assn. of America, in a statement issued Friday. “The capital markets and the insurance/reinsurance industry have demonstrated their ability to meet natural catastrophe risk transfer needs of insurers and consumers when market dynamics are allowed to work. This legislation will do nothing more than disrupt the marketplace.”

Maybe it’s just a bit of pro-consumerism that’s briefly blossomed in me after my, um, chat with the health insurance folks earlier today, but there are times that I think industry reps are critical of consumer advocates and anti-insurance legislators out of pure habit more than anything else.

True, I have faith in the private sector doing, over the long term, a better job than government at many things, insurance included. However, the bits and pieces I’ve heard about the proposals seem like cause for very cautious optimism…and that, in turn, causes industry criticism to sound a little like folks resisting change because change is hard (and potentially disrupts market share).

You’d think that an entrepreneur or two would find ways to take insurer/reinsurer expertise and craft new products or solutions to take advantage of the potential new market.

Ours is an industry for which progress is achieved by being dragged forward, kicking and screaming.

A press release from Senator Clinton’s office, via All American Patriots:

Senators Hillary Rodham Clinton (D-NY) and Bill Nelson (D-FL) today introduced the “Homeowners Defense Act of 2007,” an innovative proposal to pool and diversify catastrophe risk to make disaster insurance for hurricanes, floods, fires and other natural disasters more available and affordable for American homeowners. The Clinton-Nelson bill is companion legislation in the Senate to the bill introduced in the House of Representatives by Congressmen Ron Klein (FL-22) and Tim Mahoney (FL-16).[...]

The Homeowners Defense Act focuses on stabilizing the catastrophe insurance market by expanding the private sector’s capacity to cover a natural disaster and helping states to better manage risk. The Clinton-Nelson bill establishes a Catastrophic Risk Consortium, a non-Federal entity, which states will have the option to join. States will participate by allowing their state-sponsored insurance funds to voluntarily bundle their catastrophic risk with one another in the Consortium. The risk would then be transferred to the private markets through catastrophe bonds issued by the consortium and negotiated reinsurance contracts. The bill also provides for federal loans to states impacted by severe natural disasters to help ensure a state fund’s liquidity in the event of a disaster. This bill will help facilitate and enhance homeowners’ access to insurance, which may ultimately result in lower insurance rates.

I thought I had mentioned the House equivalent bill previously, but sadly my Google-fu is lacking today, and I’m not finding that post. (Or, I could be imagining a post I didn’t actually write. It’s been a fun day today.)

If I had written the post I thought I wrote, I would have noted before that I find the idea intriguing. It’s voluntary, and it’s promoting some spreading of risk among residual pooling mechanisms that already exist, as well as facilitating alternative means to ensure the availability of capital to support capacity. It strikes me as a far better of an idea than attempting to require subsidization of Gulf and Atlantic wind risk by folks in the Great Plains by federal decree.

Also, I can’t help but notice that Hillary seems to be rather vocal in supporting a bill that presumably would attract the interest of voters in Florida…and that the major Democratic candidates for President are boycotting campaigning in Florida due to intraparty squabbling over primary scheduling.

Surely, that’s not coincidence.

While I was away on vacation the two-year anniversary of Katrina passed. In recognition of the anniversary, Zach Scruggs issued a call for things to “ensure that Katrina will never happen again”:

(1) Thousands of remaining cases filed by policyholders who were shortchanged by their insurers await resolution;

(2) Congress must repeal the “anti-trust” exemption given to the insurance industry (the only industry that has such an exemption) so that in the future Big Insurance Companies cannot conspire to raise premiums, deny claims after catastrophes, and cancel or boycott Mississippi or the coastal regions of the United States;

It should be noted that the industry’s anti-trust exemption is limited. We can pool information to facilitate ratemaking, for example, which provides additional credibility when it comes to assessing the risk of certain lines of business, opening the door to safer participation by smaller insurers, and lowering the threshold of internal data required to feel comfortable working with certain lines of business.

While the industry could live without that ability, it would add risk, discourage competition, and the like…but it wouldn’t be the end of the world.

(3) Legislation must allow people in coastal regions to purchase federal catastrophe insurance to cover ALL hurricane damage - both wind and storm surge. Katrina proved that the Big Insurance Companies will not cover ANY hurricane damage, even though they charge premiums for it;

I’m actually OK with the concept that there could stand to be some clarification when it comes to wind versus water issues. However, I suspect there’s an issue of folks not possibly wanting to pay for what insurers will need to charge to be commensurate to the level of risk. But let’s not mention that in this wish list, shall we?

Oh wait, you want the feds to provide cat coverage, and you presumably want the rates to be affordable. Shall we take care of that by inland folks subsidizing the risk of folks living in harm’s way, by additional deficit spending, or by simply printing more money?

(4) The federal government must exercise more control over the insurance industry. The current system whereby each state has a separate insurance commissioner to regulate Big Insurance is ineffective in protecting the public. It has allowed the companies to “divide and conquer” smaller states (and even big states like Florida) by coercing commissioners into approving massive premiums through threats of cancellation of coverage or boycott. It has also allowed them to get away with mass denials after catastrophes like Katrina through the same coercive methods.[...]

I’ll admit that the idea of federal regulation, in lieu of regulation by the the states has some appeal to me, although I suppose I should toe the industry party line and advocate a optional dual regulatory structure. Given the shifting of the balance of power towards the Dems, I suspect that federal regulation wouldn’t be quite as lassiez-faire as the concept was originally envisioned, but political risk is a fact of life when dealing with regulation.

Of course, I’m writing this message offline during my cruise (don’t yell at me, I do this recreationally), where I’m being treated to a couple of instances of “intelligent” bureaucracy courtesy of the federal government. For example, we have the trivia I encountered in San Juan, where the only building with central heat is the main post office, because federal regulations at the time specified that all such buildings have central heat…even though central heat doesn’t make sense in Puerto Rico. Or the immigration check we went through when we docked at St. Thomas, where we were paraded past three surly federal officers who casually glanced at our passports, even if we were staying on the ship.

The advantage cited most commonly with state regulation is that it enables insurance regulations to be tailored to local needs. Frankly, I’m skeptical that the feds would be able to be as flexible and responsive as the current regulatory structure permits…unless federal regulation actually implied a certain level of deregulation, and I doubt that’s what Scruggs is hoping for.

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.

It’s not every year that studies performed by actuarial consultants generate so much press.

A couple of months ago, I mentioned work Tillinghast has done looking at the potential impacts on the new Florida cat facilities if a storm were to hit — the conclusions being that current cost savings is being achieved at the risk of some hefty assessments in the future if a storm hits, and that inland Floridians were effectively subsidizing the risk of coastal south Floridians.

Now, in the past couple of days, there have been several articles about two new studies. (See: Insurance Journal, Jason Kennedy’s recent blog post for the Orlando Sentinel, and this article in the Sun-Sentinel).

Both studies were put together by Milliman. One was commissioned by PCI, to look at the impact of Florida’s reforms. PCI’s press release is here. I haven’t been able to track down a copy ot the study itself, but the conclusions are similar to the Tillinghast report — renters, auto insurance customers, small business owners, and residents of northern Florida will subsidize South Floridians through assessments if a hurricane hits, and the state will potentially be burdened with a need to borrow a lot of money if we were to see a bad storm season in that state.

The other study was put together by Milliman for a group calling itself Protecting America. An executive summary of the Milliman report is available for download at the Protecting America website. The big headline coming out of this study is that Milliman believes that $11.6 billion in savings could be generated for homeowners in key states if the feds were to form a national cat fund.

Reading the executive summary, the premise behind that take-away appears to be that the federal government can underwrite risk far more cheaply than insurers and reinsurers, given that the feds are an infamously not-for-profit operation, and given the feds’ ability to borrow money theoretically risklessly.

That’s a premise I don’t necessarily disagree with…but there is a certain element of risk, of variability that the feds ought to consider in any premiums. The nature and magnitude of that element is not discussed within Milliman’s executive summary. Neither is a discussion of to what extent a federal backstrop will create unfair subsidization from less cat-prone Americans to those who choose to live in harm’s way.

I could see that some level of subsidization is appropriate, be it at the state or federal level. For example, I could believe that a consumer living in Tallahassee derives some benefit (e.g., Florida’s lack of an income tax) by virtue of the state’s having such a vibrant tourist industry fueled by all these magnificent destinations constructed in hurricane-prone areas. If that’s true, it could be argued that the inland homeowner ought to help pick up a small part of the cat-prone property’s insurance cost.

I’d love to see a study done to measure those effects.

However, the lack of details in the second Milliman study’s documentation leaves me a bit uncomfortable. Specifically, I’d love to read more about the mechanism of funding the federal pool, or the sensitivity of the assumptions made.

I am not, however, going to get too excited yet about the potential of a federal cat fund. It’s been talked about for a long time…and given the expected contentiousness of the 2008 election cycle, I doubt that too many politicians will want to be connected with a bailout of the perpetually unpopular insurance industry.

Seen on the newswires:

The National Association of Insurance Commissioners said on Tuesday it is considering how several states could set up a fund to pay the costs of hurricanes and catastrophes.[...]

“A multi-state catastrophe fund will allow states to pool their risks in a tax-advantaged fund,” said Florida Insurance Commissioner Kevin McCarty, who heads the NAIC group studying the proposal.

It sounds interesting. However, I trust that you’ll forgive me if I feel paranoid about this turning into a plan for more states to wave their legislative magic wands to brush cat risk under the carpet and out of mind…until the next megastorm hits, anyway.