Do We Really Want Actuarially Sound Insurance Rates? Let's Go Ask the Wizard

Dorothy: Now which way do we go?
Scarecrow: Pardon me, this way is a very nice way.
Dorothy: Who said that?
[Toto barks at scarecrow]
Dorothy: Don’t be silly, Toto. Scarecrows don’t talk.
Scarecrow: [points other way] It’s pleasant down that way, too.
Dorothy: That’s funny. Wasn’t he pointing the other way?
Scarecrow: [points both ways] Of course, some people do go both ways.

The push to reauthorize the National Flood Insurance Program (NFIP) is on and I’m feeling a little frisky. This particular post has been in the making since June (actually early March) much to my partner Nowdy’s occasional consternation with me for not helping others see it. However, the creativity it takes to author posts comes in streaks for me, especially when the subject matter is complicated.  I can uncomplicate things a bit now with the help of the Scarecrow and a few others that were willing to stick their necks out as we journey to Oz.

Politics is about nuance and IMHO on March 4, 2008 Dr Edwin Duett of Mississippi State University entered the political fray when he proclaimed it was time we began talking to each other instead of past each other. The “we” of course is the paying public and some of the pols who represent us like Gene Taylor and the insurance industry. “Fair enough” I thought, as progress can only result through communication but I was later taken aback when I heard Dr Duett say to the consumers present, “You do not want to pay actuarially sound rates.” (as required by HR 3121 for multi peril coverage).  Needless to say when the program concluded I made a beeline for Dr Duett to inquire exactly what constituted actuarilly sound rates for wind insurance. He directed me to what we pay the wind pool as a good approximation.

In my opinion Dr Duett couldn’t satisfactorily answer my follow up questions about the built in profitability for the reinsurance behind the wind pool rates which would be absent in HR 3121. He did give me his card and told me we would have to disagree (which puzzled me as I asked questions) and to email him if I wished to continue the discussion.  I favor my own sources in academia however and never followed up with Dr Duett.

Commissioner Chaney had a talking point though which he later repeated to a joint Chamber/Rotary club luncheon in Bay St Louis in April 2008. I suspect he has been using the line a good bit. For the record Dr Duett prefers subsidized rates for coastal homeowners since we subsidize natural disasters anyway. From a public policy perspective that notion is a non starter and thus a preserver of the status quo.

So on one hand we have our insurance commissioner Mike Chaney telling us we can’t afford HR 3121, while others in the industry like our own Claimsguy tell us all we want is a handout and HR 3121 will be glorified welfare. Such is the way with people that are skilled in building straw men, the rhetoric sounds good until we peek under the scarecrow’s shirt. To assist I’ve enlisted the help of the big bad wolf who will huff and puff and blow the straw men in….

We start with Sam Friedman’s blog and W Anderson Baker III, a New Orleans based insurance agency president who wrote a piece on New Orleans for the National Underwriter.

Congress will apparently not add catastrophic wind coverage to the National Flood Insurance Program. I’m sure that makes sense. It was obvious no one was going to accept the premise that the pricing would have been actuarially sound, which set up the argument that one group of people would be subsidizing the lifestyle of others, and even though our entire tax system is based on this premise, that’s an argument for another day.

However, accepting the premise that people on the coast would have had their rates subsidized, I would ask: Who gets to live in New Orleans?

With due respect to both Mr Friedman and Mr Baker I thought the piece was hollow as the author accepts the failure of the insurance marketplace while faithfully awaiting a mythical market to return and fix the problem. Mr Baker must not have received the memo that private insurers are figuring out ways to leave America’s coastline and the taxpayers are already left holding the bag as Dr Duett correctly pointed out back in March. Perhaps that “bag” was not mentioned since it also adds to Mr Baker’s no doubt considerable income which would explain his belief that the Wizard will invent a true market based solution to coastal America’s insurance problems absent government money. In the meantime he won’t have to worry about commoners for neighbors.

Holman Jenkins Jr of the Wall Street Journal was similarily inspired to write on the subject of insurance and New Orleans yesterday:

Just add it to the list. Final liability for more and more of life’s risks is being assumed by the federal government, i.e., taxpayers. Investment banks and hedge funds now aspire to be “too big to fail.” Washington has completed its monopolization of the mortgage business and the student loan business. Car companies in a financial bind? Congress is ready to become their lender of last resort too.

New Orleans is just one city. Miami, Houston and Long Island are all a typhoon away from losses greater than Katrina’s $140 billion. One-third of Katrina’s damages were covered by private insurance. In the event of a Hayward Fault earthquake of 7 or higher, San Francisco and vicinity would be thwacked with losses upwards of $165 billion — of which only 10% are insured. Guess who will pick up the tab? And why not. Perversely, all such commitments seem a drop in the bucket compared to $85 trillion in unfunded Medicare liability.

The interesting thing to me is despite acknowledging the coastwide risks Jenkins seems to think only New Orleans needs “the medicine” of an insurance industry induced non developed coastline. Will he be writing the same thing of Manhattan as Hanna bears down on the eastern seaboard or if terrorists strike a major blow there again? Somehow I think not.

No doubt local voters and politicians would decry it as a crime if New Orleans were forced to become a smaller, higher city because of such “greedy” behavior by insurance companies. The rest of us would see it as a sign of hope for our economic future after all.

Indeed we are left to ponder the multitude of assumptions these writers and others made in reaching their conclusions. The same assumptions underpin the thinking of Holman Jenkins, Mr Baker, Dr Duett and Commissioner Chaney in saying actuarially sound premiums are too expensive to allow meaningful redevelopment of the Katrina coast. I do agree that in economics that there is ultimately no such thing as a free lunch. To me the trick is to figure out how much lunch costs and unlike Holman Jenkins Jr and the rest I don’t trust the pricing we currently get from a dysfunctional marketplace.

Pricing risk in the form of an insurance contract is a function of assumptions. It’d be fair to say the assumptions aren’t wild guesses and represent the best statistical methods available. In the property and casualty lines the major assumptions used for pricing relate to the weather based risks like the risk the wind damage particular to a geographic location for wind policies. In addition to that, the capital required to make good on a policies comes at a cost as well.

In the area of cost of capital it was Brian Martin who educated us by linking a University of Pennsylvania study which spoke on the issue of the cost of capital for large catastrophes:

The Wharton Risk Center excuses the prices as necessary to ensure high rates of return for investors, but in doing so acknowledges that coastal rates are 5 to 10 times higher than the estimated losses.

What this doesn’t say is that it is not economically rational to pay for insurance that costs 5 to 10 times more than the expected loss.

MANAGING LARGE‐SCALE RISKS IN A NEW ERA OF CATASTROPHES

From the preface, page vii:

16. Due to the unpredictability and sizable losses associated with catastrophes, insurers need to allocate more capital to cover the losses in the tail of the probability distribution. The need to secure an adequate rate of return on capital is not sufficiently understood. In particular, the prices charged for catastrophe insurance must be high enough, not only to cover the expected claims and other expenses, but also to cover the costs of allocating capital to underwrite this risk. For truly extreme risks, the resulting premium can be as much as 5 to 10 times higher than the expected loss, so as to provide investors with a fair return on equity and also maintain the insurer’s credit rating.

19. Reinsurers consider both the expected loss and the variance of losses in their portfolio when pricing different layers of coverage. An analysis of different layers of reinsurance for a constructed portfolio of all the homeowners policies in Florida reveals that the average annual loss decreases with higher layers (because they are less likely to occur), but the variance of the losses increases. This leads to a higher price per dollar of coverage for the higher layers, which are normally associated with truly catastrophic losses.

So is it possible to have cheaper rates than the private marketplace and still have actuarilly sound rates? Absolutely, if good assumpions are used to calculate risk coupled with the low cost of capital provided by Uncle Sam’s full faith and credit.

And while we are talking about assumptions used in pricing how do we know the ones used by insurance companies in setting rates are not rigged to support artificially high rates? The Wall Street Journal finally tackled the subject (subscription required) long covered here on Slabbed with big assists from Sam Friedman. You can find our posts on this subject here, here, here, and here among other places:

Scientists say the jury is still out on whether rising sea temperatures will cause more hurricanes to hit U.S. coastlines. Yet some insurance companies are boosting premiums based on assumptions that they will. Others are withdrawing from coastal communities altogether……….

Helping to drive these developments is a little-known tool of the insurance world: Computerized catastrophe modeling. Crafted by several independent firms and used by most insurers, so-called cat models rely on complex data to estimate probable losses from hurricanes.

But regulators and other critics contend that the latest cat models — which include assumptions about various climate changes — are triggering higher insurance rates.

Starting in the early 1990s, cat models began to replace the industry’s older tools. Previously, insurers based their rates and underwriting policies largely on historical records of past claims. The turning point in methodology came after 1992, when Hurricane Andrew wrought damages in excess of $15.5 billion and left about a dozen insurers insolvent.

The original purpose of cat models was to help stabilize the insurance market and ensure affordable coverage in risky areas. To do this, the first versions used historical weather data to project long-term future losses.

In the wake of the punishing 2004 and 2005 hurricane seasons, many cat models saw drastic revisions. Rather than take a traditional longterm view, some attempted to estimate what might happen in the next several years. Modelers also factored in dramatically higher rebuilding costs when a large area is hit. The result: big premium hikes and higher deductibles.

Underlying the newer cat models are scientific theories that rising sea temperatures will result in more intense, and possibly more frequent, hurricanes. The hypotheses suggest that catastrophic hurricanes like 2005’s Rita, Wilma and Katrina weren’t an aberration, but rather the shape of things to come.

Large reinsurance companies, such as Swiss Re and Munich Re, were early converts to theories of global warming and cite warming of the earth’s oceans when predicting massive damages from future storms.

“Losses from hurricanes and tropical storms have risen along with sea temperatures,” says Eberhard Faust, a climate scientist at Munich Re. “This is [the assumption] from where all the modelers start.”

That sea-surface temperatures are rising is no longer much in dispute. There is also near-consensus that rising temperatures are linked to greater hurricane activity. However, scientists remain divided over how that may affect the number and intensity of hurricanes making landfall in the coastal U.S. A few climate experts believe global warming might actually cause fewer hurricanes to come ashore on the East Coast………………

Some scientists, like Chuck Watson, contend that cat models may fail to take into account such scientific uncertainty. A geophysicist, he advises the Florida Commission on Hurricane Loss Projection Methodology — a state panel that reviews insurer models. Cat models, he says, use assumptions about variables like air pressure and wind velocity that can’t be known precisely. As a result, the models can be overreaching in their conclusions and “are not being properly applied” by some insurers, he says.

Perhaps the most prominent critic to surface is Karen Clark, an economist who founded one of the first cat-modeling firms two decades ago. Today, she warns about the programs’ misapplication.

After Katrina, she attended insurance-company meetings to discuss “what went wrong” and concluded that there were more problems with how insurers were using the models than with the models themselves.

Companies that rely too heavily on cat-model data “are subjecting their businesses and their customers to the volatility of computer models,” says Ms. Clark, who now runs a Boston cat-model consulting business. “The models are being used as if they produce definitive answers rather than uncertain estimates.” Ms. Clark says she advises clients to use them in conjunction with other factors, such as broad historical data.

The bottom line for me is those that buy into the notion that our wind pool pricing is the actuarilly sound rate are the ones taking a huge leap of faith. The results of that leap have been paid for off the backs of the working man and at the expense of those that can least afford it.

It seems to me this is where the rubber meets the road. The public policy decision to rebuild has been made. Mr Baker well pointed out the reasons behind that public policy decision in the case of New Orleans in his piece on Sam Friedman’s blog. And the reasons for rebuilding here would also be true in the case of places like Tampa, Charleston, Miami or New York.

Those who stake positions on the right will be the first to tell you government has limitations. Private industry, even those with anti trust exemption like insurance have limitations too.

sop