Abstract
Our analysis begins with an overview of the structure and performance of the catastrophe insurance markets under our microscope. We are interested in how these markets are structured in terms of the number and size distribution of insurers, entry and exit conditions, insurers’ geographic concentration and the types of policies purchased by consumers. We then consider how market structure interacts with market performance in terms of pricing, profitability, availability of coverage and other dimensions. We begin with a description of the insurance products that are sold in the markets we study and the special problems that catastrophe risk imposes. We defer a discussion of the regulatory structure to Chapter 3.
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Notes
While several property-liability insurance lines are affected by natural disasters, it is apparent that residential property insurance markets face the most significant risk and have experienced the greatest problems (see Grace, Klein and Kleindorfer, 1998).
HO8 policies cover a more limited set of perils than other policy forms and theft coverage is restricted to property on the premises with a limit of $1,000.
As we will explain below, in 2002, Florida combined its wind pool and its joint underwriting association for residential property insurance into one entity.
Private insurers may offer earthquake coverage to homeowners, but it is unusual for a private insurer to underwrite a full non-federal flood policy for a home.
When the Coverage A limit is less than 80 percent of the replacement value of the home, typical policy provisions allow insurers to adjust partial losses on a pro-rata basis based on the ratio of the actual limit to the value of the home. Underinsurance proved to be a chronic problem in the 1990s, and insurers have sought to encourage policyholders to raise their policy limits to adequate levels. Also, for “guaranteed” replacement cost policies, insureds are typically required to set the Coverage A limit at 100 percent of the estimated replacement cost of the dwelling.
Dwelling fire policies account for only about 2.6 percent of the homes insured in Florida and 0.6 percent of homes insured in New York (NAIC, 2001a).
Modeling companies have estimated that Hurricane Andrew would have caused $75 billion in losses if it had made landfall some 50 miles further south, striking Miami and its resort hotels on the coast directly.
These modeled loss estimates were provided by AIR Worldwide Corporation. The estimates cited here assume that there would be a “demand surge” phenomenon. The equivalent PMLs for the earthquake peril are $43 billion (100-year return period) and $98 billion (500-year return period). See Appendix B for AIR’s explanation of these catastrophe loss estimations.
One aspect of this problem is the intertemporal risk problem posed by catastrophes. Insurers must rely on premium flows that are relatively stable over time, but low-frequency, high-cost catastrophes require them to call on a large amount of capital to pay claims when a disaster occurs (Russell and Jaffe, 1997).
Insurers are somewhat reluctant to offer significant premium discounts for mitigation when regulators prevent them from charging adequate rates.
See Grace, Klein and Phillips (2001) for a discussion of the use of Special Purpose Reinsurance Vehicles (SPRVs) to facilitate securitization of catastrophe risk. See Kunreuther and Bantwell (2000) for a discussion of the structure of securitization vehicles for catastrophe risks, and some possible reasons for the large price differentials for these vehicles relative to other financial instruments with similar risk/default characteristics.
Russell and Jaffee (1997) point out that insurers’ inability to set aside catastrophe reserves to fund infrequent, but severe losses from natural disasters is a major problem. Under current accounting rules, insurers have to accumulate additional capital to fund future catastrophe losses that is subject to expropriation.
In the U.S., unlike the situation in Europe and elsewhere around the world, insurers are not permitted to establish reserves for future catastrophe losses on a tax-deferred basis. Some have advocated that U.S. taxation be changed to allow tax-deferred catastrophe reserves.
In the wake of September 11, many reinsurers have opted to limit or exclude coverage for losses due to terrorism from the reinsurance contracts they offer primary insurers. See Kunreuther (2002) for a discussion. In November 2002, President Bush signed the Terrorism Risk Insurance Act of 2002 into law. That law provides a federal reinsurance backstop for commercial insurance markets but provides no such backstop for personal insurance markets. Absent the availability of private reinsurance or a federal terrorism reinsurance mechanism for personal insurance, primary insurers have sought the option to exclude coverage for losses due to terrorism from the policies they offer, but state regulators have declined to approve such exclusions.
These concentration measures are somewhat crude indicators of catastrophe risk exposure as they are based on statewide data on premiums written. An insurer’s market share could vary significantly among different areas within a state with different degrees of catastrophe risk.
For example, suppose an insurer group did not write any homeowners insurance in Florida in 1992, but subsequently acquired an insurer group that did write homeowners insurance in Florida in 1992. In our analysis, we would show the acquired insurer as exiting the market and the acquiring insurer as entering the market.
Insurers operating at a national level can enter a particular state if market conditions warrant it.
One way in which regulators can impose an exit barrier is by requiring an insurer to exit all lines of business in a state if it wishes to exit a particular line, such as homeowners or auto insurance. Other ways include restrictions on insurers’ freedom to cancel or non-renew policies.
Each company within a group must file and obtain approval for its own rates. The different companies within a group may have different rate structures-lower rates for low-risk insureds and higher rates for high-risk insureds.
Indeed, the supply of homeowners insurance tightened in many states in 2001 and 2002, due to several factors, including substantial net losses suffered by insurers in the late 1990s.
This same approach has been used in other problem markets, such as auto insurance in New Jersey.
This does not imply that a group would necessarily abandon a single-state insurer if its surplus was exhausted by a catastrophe, but the group would be in a position to make a strategic decision as to whether it was in the group’s interest to bail out the subsidiary. Allowing a state-specific subsidiary to go insolvent could cause irreparable damage to the image of the surviving members of the group and, hence, would likely be undertaken only as a last resort in an extreme situation.
Spatial economies refer to the efficiencies gained from serving a larger number of policyholders who are geographically proximate. This could lower the average expense per policy in terms of underwriting, distribution, advertising and adjusting claims.
The latter development could have been prompted by insureds’ desire to ensure that their policy limits more fully covered the value of their property, as well as insurers’ diligence in encouraging adequate limits.
Several things may have occurred. Some insureds may have increased their fire and wind deductibles by the same amount. Other homeowners likely opted for higher fixed or percentage wind deductibles, which tend to result in higher deductible levels measured in dollars. Also, if the policy limit increased with a given percentage deductible, the deductible would increase in dollar terms.
The demand for additional ordinance/law coverage may be greater in Florida due to upgrades in building codes to make homes more resistant to hurricanes.
These data are only available for the period 1996-1999. If we were able to trace the increase in average premiums from the time of Hurricane Andrew to the present, we would have a greater appreciation of the impact of catastrophe risk on average premiums. We should note, however, that the increase in average premiums could be mitigated by insureds opting for larger deductibles and other options that would lessen premium increases. In fact, average premiums in the three jurisdictions actually fell from 1997 to 1998. Based on other price indicators discussed below, we believe this is due to changes in the amount of insurance purchased (e.g., selection of higher deductibles), rather than decreases in insurers’ rates. We should also note that the Florida average premium is moderated by premium levels in low-risk areas in Florida.
Data from the Florida Department of Insurance website suggest that rates continued to increase after 1996 and the difference between coastal and inland rates also widened.
The loss ratio is the “purest” indicator, as it does not include allocations of company-wide expenses and non-premium income. However, to interpret loss ratios one must have some benchmark in mind that implicitly involves assumptions about appropriate expense and profit loadings and associated investment income.
Both the PIT and the estimated ROE can be misleading in that they are affected by earnings on investments and realized capital gains. In years when insurers are forced to sell assets and record large realized capital gains accumulated during preceding years, it can make them appear more profitable than they really are when viewed from a long-term rate of return perspective.
The high relative volatility of profits in homeowners insurance is demonstrated in Grace, Klein and Kleindorfer (1998).
States other than Florida also suffered some losses from Hurricane Andrew after it moved through Florida to other areas, but Florida suffered most of the financial losses that were incurred. Hurricane Iniki also struck in 1992, contributing to the increase in the countrywide loss ratio and the unprofitability of homeowners insurance.
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Grace, M.F., Klein, R.W., Kleindorfer, P.R., Murray, M.R. (2003). An Overview of Catastrophe Insurance Markets. In: Catastrophe Insurance. Topics in Regulatory Economics and Policy, vol 45. Springer, Boston, MA. https://doi.org/10.1007/978-1-4419-9268-0_2
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