The Perfect Storm: Hurricanes, Insurance, And Regulation
Copyright 2009 ProQuest Information and LearningAll Rights ReservedCopyright 2009 American Risk and Insurance Association, Inc. Risk Management and Insurance Review
Spring 2009
PERSPECTIVES ARTICLES; Pg. 81 Vol. 12 No. 1 ISSN: 1098-1616
52759
13730 words
THE PERFECT STORM: HURRICANES, INSURANCE, AND REGULATION
Grace, Martin F; Klein, Robert W
ABSTRACT
The intense hurricane seasons of 2004 and 2005 caused considerable instability in property insurance markets in coastal states with the greatest problems occurring in Florida and the Southeast. Insurers have substantially raised rates and decreased their exposures. While no severe hurricanes struck the United States in 2006 and 2007, market pressures remain strong given the high risk still facing coastal states. These developments generate considerable concern and controversy among various stakeholder groups. Government responses have varied. In Florida, political pressures prompted a wave of legislation and regulations to expand government underwriting and subsidization of hurricane risk and constrain insurers' rates and market adjustments. Other states' actions seem more moderate. In this context, it is important to understand how property insurance markets have been changing and governments have been responding to increased catastrophe risk. This article examines important market developments and evaluates associated government policies. We comment on how regulation is affecting the equilibration of insurance markets and offer opinions on policies that are helpful and harmful.
INTRODUCTION
The risk and cost of natural disasters and their effects on insurance markets and associated government policies are elements of an interesting and important story about the interplay of economics and politics.1 It is a story that may contain some familiar as well as peculiar elements to students of political economy. In our opinion, the high degree of uncertainty associated with disaster risk challenges insurers and its opaque nature enables politicians to shift risk more easily and obtain greater subsidies for those exposed to disasters.2 Also, we believe that the notion that natural disasters are "acts of God" and beyond the control of their victims can affect the regulatory and poUtical climate facing insurers. Such a story is now unfolding with the increased threat of hurricanes striking the United States and the response of insurance markets and government officials to this threat.
</p> The intense hurricane seasons of 2004 and 2005 caused substantial instability in property insurance markets in coastal states with the greatest pressure occurring in Florida and the Southeast.3 Other coastal states exposed to hurricanes also have experienced some market pressures and changes.4 The increased risk of hurricanes striking the United States prompted significant changes in these same markets beginning in the early 1990s but the particularly intense hurricane activity during 2004-2005 has led to another round of market adjustments.5 Both the loss shocks of the 2004-2005 storm seasons as well as insurers' belief that hurricane risk has increased have been major drivers of the recent market adjustments. The fact that a severe hurricane did not struck the United States in 2006 and 2007 was a welcome relief allowing insurers and reinsurers to replenish some of their lost capital but the risk of more hurricanes remains high and is still driving conditions in property insurance markets. Unfortunately, the reprieve of major storm activity in the United States was not permanent, as the 2008 storm season produced several hurricanes that struck the United States.
Recent developments have generated considerable concern and controversy among various groups of stakeholders. In the face of increased risk and uncertainty, insurers have sought to adjust their rates and exposures in order to ensure their economic viability in the short and long term. Reinsurers also made substantial adjustments; their prices increased as new capital flowed in to replace recent losses and respond to the increased demand for catastrophe reinsurance (Guy Carpenter, 2008). Presently, it appears that affected property insurance and reinsurance markets have probably undergone most of the adjustments necessary but the situation is fluid. There are indications that some insurers believe their rates are still inadequate in Horida due to regulatory constraints.6 There is considerable anecdotal evidence that many affected property owners are concerned about sharp premium hikes and the diminished availability of coverage.7 Although the relatively benign storm seasons of 2006-2007 were a welcome relief to insurers and others, they also appear to have undermined public acceptance of insurers' rate increases as well as strengthened political pressure on government officials to constrain insurers' actions and to ease conditions for consumers.8 This was reflected in a wave of legislative and regulatory actions in Florida in 2007 and 2008 aimed at lowering the cost of insurance to coastal property owners.9 Some of these changes expanded the state's underwriting and subsidization of catastrophe risk and others sought to place tighter constraints on insurers (Milliman, 2007). Unfortunately, we believe these measures are undermining private markets and the private financing of catastrophe risk. We also note that coastal politicians are making a strong push for the federal government to underwrite a significant portion of hurricane risk.10
This article examines how insurance markets have changed and government policies have evolved. Our main focus is Florida - the center of this "perfect storm" - where market pressures are strongest and regulatory-legislative responses are particularly severe. We also discuss developments in other selected coastal states that offer interesting similarities as well as contrasts to Florida. These other states are Mississippi, Louisiana, South Carolina, and Texas and are the states that appear to face the most significant hurricane risk issues next to Florida. We offer observations on how the interplay of economics and politics influences the management of catastrophe risk.
The next section of this article briefly reviews the environmental, economic, and regulatory context for hurricane risk and property insurance and examines the structure and performance of property insurance markets. We then describe and evaluate significant regulatory actions and other government policies. We conclude with a summary of our key observations.
HURRICANE RISK AND INSURANCE MARKETS
Nature, Economic Development, and Insurance
To understand developments in property insurance markets in coastal states, one must understand the natural and economic environments in which these markets function.11 The natural environment comprises short- and long-term weather patterns and cycles principally, the frequency and intensity of tropical storms and hurricanes striking different areas (Holland and Webster, 2007). The natural environment interacts with the important aspects of the economic environment - the growth and geographic distribution of commercial and residential property development (Pielke et al., 2008). Together, these circumstances heavily influence the property exposed to hurricanes and the demand for and supply of insurance.
History and meteorological science document the cyclical nature of weather patterns and storm activity. Hurricane frequency and intensity increased during the period 19201950 and then fell during the next three decades (see Figure 1). Storm activity intensified again starting in the late 1980s through the present (National Oceanic and Atmospheric Administration, 2006). Within these long-term cycles, short-term factors can affect the number, intensity, and paths of storms in any given year.
During the active storm cycle in 1920-1950, coastal areas were less developed so storms striking these areas caused less property damage. During the next three decades, there was considerable economic growth in these areas but storm activity had lessened and does not appear to have impeded growth.12 Hence, considerable development occurred when hurricane losses and insurance prices were relatively low. It also appears that insufficient attention was paid to hazard mitigation (e.g., bunding hurricane-resistant homes), which has further contributed to the catastrophe risk problem.13
Consequently, the pressure on property insurance markets rose because of economic development in areas subject to greater hurricane risk. While insurers and reinsurers are expected to expand the supply of insurance to meet this greater demand, they increase their vulnerability to catastrophe losses if they increase their concentration of exposures in high-risk areas. This pressure can strain existing risk transfer and diversification mechanisms and reduce the availability of insurance coverage for those seeking it.
More storms and extensive economic development have caused economic losses from hurricanes - insured and uninsured - to escalate dramatically over the last 15 years, as shown in Figure 2. Hurricane Katrina was the most expensive natural disaster to date with insured losses of over $40 biUion and total economic losses exceeding $100 billion, but much larger losses could occur if a severe hurricane struck a larger metropolitan area such as Miami.14 Insurance markets reverberate from these loss shocks but their effects on estimates of the nature of the risk that insurers face, arguably, is the most critical factor that influences market conditions (Froot and O'Connell, 1997).
Entries, Exits, and Market Concentration
We begin our analysis by looking at shifts in the market positions of leading writers of homeowners insurance in Florida in Table 1. In this table, we focus on the voluntary market and do not include the residual market. We can see that there have been dramatic changes in the Florida market since 1992. The top two groups in 2006 - State Farm and Allstate - were also the top two groups in 1992. However, their combined market share dropped from 50.9 percent to 29.2 percent. These two insurers have significantly reduced their relative presence in the Horida market (as measured by premiums). It is also interesting to note that while State Farm's market share actually has increased since 2000, Allstate's share declined from 11.2 percent to 7.8 percent. This appears to be consistent with Allstate's stated intention to substantially reduce its concentration of exposures in high-risk areas to a level that it believes is more economically viable.15 Other mid-tier insurers have remained in the top 20 but some have moved up in the rankings while others have moved down.
Another significant development has been the entry /expansion of some insurers as other companies have retrenched or withdrawn from the market. Ten of the top 20 groups in 2006 entered the market after 1995. This reflects several phenomena. Two important factors were the startup of several new insurers in Florida during the 1990s and entries by other established insurers. Another group of companies has entered the market since 2005, according to the Florida Office of Insurance Regulation (FLOIR), although none of these companies appears in the top 20 writers in 2006.16 The retrenchment or exit of some insurers created opportunities for other insurers to fill the gap. Also, several of the large national groups established Florida subsidiaries that now underwrite all or most of their homeowners business in the state.
Entry into the Florida market carries significant risk, especially for insurers with all or most of their exposures concentrated in the state. This was demonstrated by the rapid rise of the third and fourth leading groups in 2005 - the Poe and Tower Hill groups. Poe was hit hard by the 2004 and 2005 storm seasons and is currently being liquidated by regulators.17 The Tower Hill Group was also stressed by the recent storm seasons and was downgraded by A.M. Best.18 Two other Horida insurers-Horida Select and Vanguard-were seized by regulators due to their insolvency/impairment resulting from the recent hurricanes. This alustrares the drawback of relying heavily on local or regional insurers to fill large gaps left by larger, national insurers. Smaller insurers can bolster their capacity with extensive use of reinsurance but this comes at a cost along with some retention of risk at a primary level that is unavoidable.
In 1992, on an aggregate basis, insurers' Horida homeowners' premiums accounted for 8.1 percent of their total homeowners premiums countrywide. By 2006, this number increased to 19.6 percent. Of course, Horida insurers do not pool their exposures in one bucket. Hence, the mean or median Horida/countrywide premium ratio among Horida homeowners' writers may be more telling. In 1992, calculated at the group level, the mean Horida/countrywide premium ratio was 6.6 percent and the median was 18.4 percent. In 2006, the group-level mean ratio had increased to 53.8 percent and the associated median ratio had increased to 66.2 percent. The shift to less geographically diversified insurers also is apparent in looking at the top 20 writers (at a group level). In 1992, only one of the top 20 insurers wrote 100 percent of their homeowners' premiums in Horida.19 In 2006, 9 of the top 20 insurers wrote 100 percent of their homeowners' premiums in Horida.
The story of the Poe companies is a good example of the "go for broke" strategy that some insurers employ when they encounter financial difficulty.20 Poe insured more than 300,000 homes with most concentrated in the high-risk areas of Palm Beach, Broward, and Dade counties. Despite major losses from the 2004 storms and declining capital, Poe added more poUcies in 2005, gambling that it would not incur more storm losses. Such gambling is encouraged by a regulatory system in which an insurer can shift its losses to the state (i.e., insurance consumers and taxpayers) through insolvency guaranty associations and to other creditors.21 An insurer's owners reap the potential upside of such gambles and stick the pubUc with the potential downside.22 The downside scenario became fact when the Poe companies became insolvent after the 2005 storm season generating approximately $988 milUon in payments (as of year-end 2007) by the Florida Insurance Guaranty Association (HGA) for 46,162 claims from Poe's poUcyholders (FIGA, 2007). We were unable to find any evidence that Florida regulators attempted to constrain Poe's actions until 2006.
Several national and regional insurers entered or increased their market presence but their market shares were still relatively modest in 2006, i.e., less than 3 percent. This may reflect a more viable strategy of acquiring or maintaining small, digestible shares of a large but risky market by more broadly diversified insurers.
The structure of the homeowners insurance market looks somewhat different when the state's residual market mechanism is included-the Citizens Property Insurance Corporation (CPIC). Table 2 shows the CPICs direct premiums written, market share, and market rank for the period 2000-2006. We can see from this table that the CPICs market share increased from 2.2 percent in 2000 to 16.1 percent in 2006. Its market rank rose from ninth to second over this same period. The growing market share of the CPIC reflects its increasing importance in the total (voluntary and residual) homeowners insurance market in Florida. When the 2007 financial data become available they may reveal that the CPIC's market share has further increased.
The changes in the voluntary market's concentration in Florida and in the other selected costal between 1992 and 2006 are shown in Table 3. The combined market share for the top four groups (CR4) in Florida decreased from 55.3 percent to 39.2 percent. The combined market shares for the top eight insurers (CR8) also declined over this period but to a lesser degree as this measure reflects more insurers who have experienced smaller cuts in their business as well as some insurers who have increased their business. These changes track with the decline of the Herfindahl-Hirschman Index (HHI) from 1,440 in 1992 to 695. Market concentration in Florida, as measured by the HHI, was lower with the inclusion of the CPIC until 2006 (see Table 2). In 2006, the HHI with the CPIC included was 749 compared to 695 without the CPIC.
The decline in market concentration and the relative changes for the market leaders versus the mid-tier insurers is consistent with what we would expect to see based on the greater risk and higher cost of retaining large amounts of high-risk exposures (Klein and Kleindorf er, 2003). Less concentration implies that there is a greater dispersion of TABLE 3
Market Concentration in Selected States Homeowners Insurance: 1992 and 2006
exposures among carriers in Florida that could be viewed as a positive development in terms of greater diversification of risk. In markets subject to disaster losses, lower concentration levels may be a necessary condition to allow insurers to maintain their catastrophe exposures at manageable levels.
One caveat to the observation about market deconcentration in Florida is the movement of exposures from national carriers to smaller state or regional insurers that are not pooling risk across a diversified base of countrywide exposures. There is a limit to how much these insurers can diversify risk even with extensive use of reinsurance. Singlestate companies within national groups can receive support from their affiliates in the event of large losses, but as we explain below, these national groups cannot engage in sustained cross-subsidies of their Florida insureds.23
Market structure changes appear to be much less significant in other states. In these other states, the data indicate the emergence of only two to three new insurers (since 2000) that are now among the top 20 writers in these markets (see Grace and Klein, 2007b). The relatively greater stability in these other state markets may reflect several factors. One is that insurers' plans to adjust their positions are not fully implemented and revealed by the 2006 data. Another factor may be that insurers see less of a need to reduce their business in these states. Some of these states also appear to be taking a less restrictive approach to regulation than Florida (at least for the present) that may be helping insurers to retain a greater presence in these states. We should also note that the proportion of coastal exposures is considerably lower in these states than in Florida and, hence, coastal risk would be expected to have less of an effect on insurers' statewide market shares.
Table 3 also reveals that the other selected states have experienced less significant changes in market concentration than Florida. The combined market of the top four insurers and the HHI has declined in all of the coastal states shown. However, in all but Florida, the top eight insurers increased their combined share of the market over the same period. The decrease in the CR4 measure suggests that the very largest insurers have decreased the amount of business they are writing but this pattern has not extended to the top eight writers. The decline in the overall market concentration in the other states (as measured by the HHI) reflects a more even distribution of the market beyond the largest insurers. This could be due to the increasing market penetration by smaller insurers and/or the decisions by mid-tier insurers (beyond the top eight) to decrease their business in these states.
Insurer Exposure Patterns
Another important part of the story is the distribution of insurers' shares of exposures (the amount of insurance coverage) in different areas in a state. Table 4 compares the company-level HHI (based on the amount of insured homeowners property) by county in Florida between 1997Q1 and 2006Q4 (coastal counties are shown in bold type).24 Table 5 compares the exposure-based market shares of the 20 leading insurers in Broward, Dade, Monroe, and Palm Beach counties (combined) between 1997 and 2006 at a group and company level. We see several important developments in these data. The first is a tendency toward decreased concentration in the higher risk counties (along the coasts). The second is that several leading insurers in the state have decreased their shares of exposures in the four southeastern counties that are considered to be among the highest risk counties in the state. We also observe that new insurers have moved in to underwrite a significant proportion of exposures in the four southeastern counties.
Another observation is that the start-up insurers that formed in the mid-1990s had been forced to write a large share of portfolios in high-risk areas as they took policies out of the residual market mechanism (see Grace et al., 2006). However, when the 3-year requirement on retaining these policies expired, the majority of these insurers dropped a significant portion of their high-risk exposures, which returned to the residual market or were underwritten by other entrants like the Poe and Tower groups. This action may have been motivated by concerns about the risk associated with retaining a substantial concentration of high-risk policies in coastal areas.
Prices
The price of home insurance is a primary area of interest and concern. Figure 3 shows trends in the average homeowners insurance premium in five coastal states from the first quarter of 2002 to the first quarter of 2007. We calculated the average premium (total premiums divided by insured house-years) for each quarter in the series. We can see from this figure that Florida has experienced the greatest increase in its average premium-from $723 to $1,464-among the six states. Louisiana experienced the second greatest increase in its average premium from $785 to $1,271.
An important caveat to the indications of these average premium trends is that they reflect the weighted distribution of the premium increases on all policies in the underlying data. An alternative approach to measuring substate differences and changes in prices is to calculate an average rate per $1,000 of coverage. This approach is less affected by differences in the amount of insurance but still confounds other coverage terms with rates.25 We employed this approach using county-level data available for Florida and our calculations for the years 1997 and 2006 are reflected in Table 6. The results are quite revealing as the county with the highest rate in 2006 was Monroe with a rate of $34.46; the county with the lowest rate was Clay with a rate of $2.49. Monroe also experienced the greatest relative increase-81.6 percent-from its rate of $18.98 in 1997. This reflects the high level of risk in Monroe County, which includes the Florida Keys.
Another way to compare home insurance prices is to look at the premiums insurers would charge for a hypothetical home policy in different areas within a state. Table 7 shows descriptive statistics for current premium comparisons for Florida. These premium comparisons are posted by the FLOIR on its website and apply to a hypothetical policy home.26 Using the data from these comparisons, we computed the maximum, minimum, mean, and median premiums for each county. These figures are intended to provide some indication of the difference in how much a homeowner would pay for insurance depending on his or her location. The great variation in the hypothetical premiums reported by each company for a given location prompts us to focus on measures of central tendency, i.e., mean and median premiums, for each location. We discuss issues raised by this variation below.
Table 7 reveals significant price differences among insurers in each county-reflected by the difference between the minimum and maximum premium-as well as significant differences among counties-reflected by the means and medians for each county. The highest median premium-$3,658-is in Monroe County and the lowest premium-$801-is in Duval County (which includes Jacksonville). In other words, a typical homeowner might expect to pay a premium four times higher in Monroe County than he or she would pay in Duval County, all other things equal. Of course, the actual experience of homeowners could vary somewhat from the indications provided here.
The significant variation in premiums among companies in a given county warrants some discussion. There could be several reasons for the variation. One is that insurers' rate structures vary. A second factor could be the possibility that some insurers have rates on file for every location in the state but may not be actively writing business in some locations, especially if their rates are far below what they consider adequate. A third factor could be differences in the coverages offered by insurers as well as differences in their underwriting standards. There could be other reasons for the variation that are less obvious.
Grace and Klein (2007b) also examine substate price differences in other selected coastal states. While they find a similar pattern in these states, the relative magnitude of the price increases and the relative differences between coastal and noncoastal rates are substantially lower in these states than in Florida. In sum, all of these price measure comparisons tell a common story. The price of homeowners insurance is: (1) much higher in coastal areas than in noncoastal areas, and (2) the price of insurance has substantially increased, especially in the highest risk areas. Of course, this is no great surprise but our calculations reveal some of the magnitude of the differences and changes in Florida and help to explain why property owners in high-risk areas have voiced their discontent about the rising cost of insurance and have pressured legislators to lower this cost.
Availability of Coverage
The availability of insurance coverage also is an important performance outcome and an area of attention and concern to property owners, government officials, and other stakeholders. Economists tend to use insurance availability indicators such as the size of the residual market, noting that there are several factors confounded in residual market shares (Klein, 2008). As we show and discuss in our evaluation of regulatory policies, the residual market for property insurance has greatly increased in Florida. It accounts for a significant portion of the homeowners insurance market, most of which are the highest-risk coastal exposures (Insurance Information Institute, 2007, 2008c).27 Residual markets have also grown in other coastal states, but to a much lesser degree (Insurance Information Institute, 2007, 2008c; Klein, 2008).
Although several factors affect the size of a residual market, it appears that the availability of coverage in Florida's voluntary market has tightened considerably. How this situation will evolve in the future will also depend on several factors, including insurers' assessment of hurricane risk, changes in capacity, the supply and price of reinsurance, and regulatory actions. However, we note that the Florida experience is similar to the experience of certain other states in lines of business such as auto insurance and workers' compensation insurance where strict price regulation has been accompanied by large residual markets (Klein, 1995). If regulators suppress rates below what insurers consider to be an adequate level, the supply of insurance will tend to decrease and more consumers may find it difficult to find coverage in the voluntary market and will turn to the residual market for insurance. For example, constraints on rates in the voluntary market for auto insurance coupled with subsidized residual market rates in South Carolina caused the residual market facility to grow and account for 42 percent of the state's insured vehicles in 1992 (Grace et al., 2002). Cummins (2002) contains other state case studies describing similar scenarios occurred in Massachusetts and New Jersey.
Profitability
Firms' profitability is an important market performance outcome. In an efficient, competitive market, long-run profits would be expected to provide firms a "fair" rate of return equal to their risk-adjusted cost of capital.28 The problem in insurance markets, especially in lines like homeowners insurance, is that profits can be highly volatile from year to year. In other words, insurers can earn low or negative profits in some years and what appear to be high profits in other years. Still, over the long run, average or cumulative profits would be expected to approximate a fair rate of return.
This is close to being the case in homeowners insurance markets that are subject to "normal" weather-related perils, but hurricane-prone markets are subject to much greater volatility and much longer "return periods." Insurers might have been prepared to handle an occasional severe hurricane (e.g., a Hurricane Andrew-level event every 10-20 years) but not the back-to-back multiple-event years experienced in 2004 and 2005.29 Even the relatively frequent occurrence of less severe hurricanes, e.g., $1-$10 billion events, can drive insurers' state and regional results deep into the "red" and keep them there for some time.
There are several different profit measures that are used in insurance; we focus on "profits on insurance transactions" (PIT), which is a measure published by the National Association of Insurance Commissioners (NAIC) by line and by state (see NAIC, 2007). This PIT measure includes direct premiums earned, incurred losses, all expenses, investment income attributable to loss and premiums reserves (not surplus), and estimated federal taxes on the income earned (or tax credits on negative income). The resulting profit (loss) is divided by direct premiums earned to produce a profit rate.
Figure 4 plots cumulative profits (losses) for homeowners insurance in Florida and the Southeast for the period 1985-2006-each year represents accumulated profits and losses from previous years. The Southeast measure in this figure comprises all states in this region of the country including Alabama, Florida, Georgia, Louisiana, Mississippi, North Carolina, South Carolina, and Texas. We can see from this figure that insurers on the whole have remained under water since 1992 in Florida and over the entire period for all Southeastern states combined. Cumulative losses decreased over the period until 2004 but then increased with subsequent intense storm seasons. On a cumulative basis as of the end of 2006, insurers were $11.1 billion in the red (since 1985) on their Florida's homeowners business (representing -23.8 percent of cumulative premiums earned). Hence, insurers perceive that they are again deep in the hole with respect to their Florida and Southeast operations and it will require a sustained period of positive profits to raise their long-run profits to adequate levels.
Of course, historical losses might be viewed as sunk costs and irrelevant to insurers' decisions regarding the future. However, if an insurer believes that this history will repeat itself-i.e., it is likely to continue to incur losses over the years ahead and is unlikely to earn a fair rate of return on a long-term basis-then it might be reluctant to continue to maintain the same level of operations.
Ultimately, insurers would be expected to attempt to reach a position where they believe they will generate reasonable profits over the long term and not put the solvency of their companies at significant risk or create cross-subsidies from their insureds in low-risk states to their insureds in high-risk states.30 Until they reach that position, it is reasonable to expect that there will be further market changes. A number of factors will affect if, when and where a new equilibrium will be reached. These factors will include actual loss experience, medium- and long-term weather forecasts, risk assessments and the confidence in them, and regulatory and other government policies and actions.
POLITICS, POLICIES, AND REGULATION
The regulation of insurance companies and insurance markets plays a prominent role in the management of catastrophe risk. Each state exercises considerable authority over insurers' entry and exit, financial condition, rates, products, underwriting, claims settlement, and other activities. Further, the balancing of market and financial regulatory objectives is especially relevant to catastrophe risk-less stringent solvency requirements can increase the supply of insurance but insurers on the margin can be exposed to greater default risk. Regulatory constraints and mandates in these areas can have significant implications for how property insurance markets function and property owners' incentives to control their risk exposure. It is important to note that government policies and actions are not determined solely by insurance regulators; legislatures, the courts, and governors also play a role.
The cost and availability of property insurance has been a potent issue in many coastal areas, none more so than Florida. Insurance was a primary issue in Florida's 2006 legislative and governor's elections and elected officials were well aware of coastal voters' expectations for the 2007 legislative session.31 It should also be noted that coastal property owners are not the only group concerned about insurance. There are many interest groups with strong economic interests in coastal development, e.g., developers, builders, realtors, other business owners, etc. that exert pressure on the political process and government policies. As 2005-2006 insurance rate increases began to bite and affect real estate markets, this pressure intensified.32
Rate Regulation
Rate regulatory systems and policies differ considerably among the states. Some attempt to impose binding constraints on rates while others rely on the market to determine rates. This is reflected in both the types of rate regulatory systems that states employ and how these systems are implemented. In practice, it appears some prior approval states allow the market to determine prices and in some competitive rating systems regulators attempt to constrain prices (Klein, 1995). Hence, the degree of "regulatory stringency"-how much regulators seek to suppress overall rate levels or compress rate structures-varies greatly among states and cannot be inferred solely from their rating systems.
In turn, rate regulatory policies and actions can have significant effects on insurance markets. Suppression of overall rate levels or compression of geographical rate structures can compel insurers to tighten the supply of insurance, which decreases the availability of coverage. Also, these policies can reduce insureds' incentives to optimally manage their risk from natural disasters. At the same time, economic and market forces can ultimately trump regulatory policies. Insurance is essentially a voluntary business. Regulators cannot force market long-term outcomes at odds with economic realities, e.g., low rates and widely available coverage in the face of very high risk, without the government replacing private insurers as the principal source of insurance coverage. The effects of rate suppression have been documented in a number of studies.33
A number of factors affect regulatory stringency and are reflected in our evaluation of regulatory policies.34 These factors include, but are not limited to:
* The degree to which rate regulation is vulnerable to political manipulation-prior approval systems tend to be more vulnerable to manipulation although competitive rating systems are unlikely to be immune from political interference (Harrington, 1992).
* The underlying risk of loss-higher risks and costs tend to put more pressure on legislators/regulators to constrain rates in response to political pressures. Also, regulators are more likely to disapprove large rate increases (higher than 5-10 percent) than small rate increases.
* "Philosophies" concerning regulation and the need to constrain insurers-some states exhibit prevailing philosophies that call for stricter regulation while others may be more willing to allow market forces to determine prices (Meier, 1988).
* Economic leverage-the negative consequences of exit from a large market state are greater for an insurer than they are for exit from a small market state. Hence, regulators in large states may seek to extract greater concessions from insurers than regulators in small states.
* Regulator selection-there is some evidence that elected regulators are more likely to engage in rate suppression and compression but studies suggest that this has only a small effect (see, e.g., Besley and Coate, 2003).
* Legislation-legislatures enact the laws and often approve regulatory rules and hence can substantially influence regulatory policies.
After Hurricane Andrew, Florida regulators resisted large rate increases in one swipe and only allowed insurers to gradually raise rates over the decade.35 initially, this policy worsened supply availability problems because insurers were concerned about substantial rate inadequacy (Grace et al., 2004). Over time, as insurers were allowed to further increase rates, these concerns eased although it appears that insurers believed that there was still some compression of rates in the highest-risk areas. By the beginning of 2004, most insurers probably viewed their rates as being close to adequate except in the highest-risk areas and there did not appear to be substantial pressure to further increase rates.36 In fact, in early 2004, the FLOIR naively reported that the insurance market was operating well (FLOIR, 2004). This perception began to change as more hurricanes hit the United States in 2004.
By 2006, many insurers began to file their first wave of significant rate increases in Florida.37 The magnitude of the rate increases filed varied among areas within the state based on insurers' estimates of the inadequacy of their existing rate structures. Highrisk coastal areas received larger percentage increases than low-risk areas. It appears that the initial wave of rate increases were largely approved or allowed to go into effect by regulators. However, as some insurers began to file a second wave of rate increases in the latter part of 2006, they began to encounter greater regulatory resistance. More recently, in the latter half of 2006 and beyond, further insurer rate hikes have been challenged and disapproved or reduced by Florida regulators (Klein, 2008).
A combination of growing consumer displeasure over previous rate increases as well as the lack of damaging hurricanes in 2006 and 2007 has likely influenced regulators' resistance to further rate hikes. The further hardening of regulatory policies was foretold in Florida's 2006 elections and was manifested in its early 2007 legislative session. In early 2007, Florida enacted legislation that sought to increase regulatory control over rates and roll back rates based on changes in the Florida Hurricane Catastrophe Fund (FHCF). The new legislation expanded the reinsurance coverage provided by the FHCF and insurers were required to reduce their rates to reflect this expansion of coverage. This requirement applies even if an insurer does not purchase reinsurance from the FHCF.
Depending upon their pre-2007 position, insurers filed either a rate decrease to comply with the 2007 legislative requirement or a combination of a rate increase (to correct existing rate inadequacies) and a rate decrease to comply with the 2007 legislation. However, the FLOIR challenged the rate increases for being unnecessary as well as the filed rate decreases for being too small relative to their estimates of how much insurers should be cutting their rates because of implied FHCF reinsurance costs. Other actions by regulators and the legislature have turned up the heat on insurers to pressure them to lower their prices (Klein, 2008).
As a general observation, it appears that disputes between insurers and regulators over rates have tended to be less significant in coastal states other than in Florida (Klein, 2008).38 This may be largely due to the fact that insurers have filed for smaller increases in other states and previous rates in these states have been lower than in Florida. However, one has to be careful in making overly broad statements about the regulatory environments in these other states as each has its own particular story. For example, in Texas, regulators have challenged a number of recent rate filings by insurers, although it appears that the relative difference between what insurers have filed and what regulators are willing to approve is smaller in Texas than in Florida. Louisiana has tended to approve insurers' rate filings for the most part as part of a strategy to minimize the disruption of the supply of insurance in coastal areas.
Other Market Regulatory Policies
Regulators can constrain many other aspects of insurers' market activities beyond pricing, which can have further effects on the sustainability of their operations (Klein, 2008). For example, regulation of underwriting and the policy terms that insurers can use have a significant impact on hurricane-prone insurance markets. The regulation of underwriting-e.g., the rules insurers use to select or reject applicants, insurer decisions to reduce the number of policies they renew or new policies they write-can be somewhat difficult to specify because of the complexity and opaque nature of this aspect of regulation. Some aspects of the regulation of policy terms, e.g., the maximum wind/hurricane deductibles that insurers are allowed to offer, are more readily discernable but other aspects may be obscured in the policy form approval process. Generally, it appears that insurers have been allowed to substantially increase the maximum wind/hurricane deductibles they are allowed to offer, but there has been greater regulatory interference with their underwriting decisions.39
Regulators may seek to impede or challenge insurers' decisions to nonrenew policies and not write new policies by requiring them to justify their decisions. The only leverage that a state can employ is to try to force an insurer to exit all lines of insurance if it seeks to reduce its property insurance exposures. It is not clear that regulators would prevail in such an effort but they may threaten such action. In Florida, for example, insurance regulators suspended Allstate's license to sell any insurance, contending that the company failed to supply documents they requested. Allstate opposed the suspension in court and after a number of legal rulings it appeared that the FLOIR would prevail. The suspension was lifted on May 16, 2008 when the Rorida Insurance Commissioner-Kevin McCarty-announced that Allstate had complied with the document request.
Another aspect of underwriting is insurers' movement of some of their exposures into "standard" or "nonstandard" as well as single-state companies within their groups. In its 2007 legislation, Florida sought to restrain the use of single-state companies and the segmentation of Florida losses from insurers' experience in other states. The legislation prohibits the further establishment of single-state insurers by national groups and requires insurers to sell homeowners insurance in Florida if they sell it in other states. These actions could discourage new insurers from entering the state and existing insurers from remaining in the state.
As noted above, other aspects of insurers' activities are regulated such as marketing and distribution, the servicing of policies, and claims adjustment. The regulation of claims adjustment can be especially relevant in the context of catastrophe risk. Following a disaster, regulators may pressure insurers to make more generous claims payments and pay claims more quickly.40 Disputes over "wind versus water" damages have been particularly contentious following the 2005 storms (and also arose to some extent in 2004) and have led to a number of lawsuits (Wharton School, Georgia State University, and Insurance Information Institute, 2008). The potential for regulators to pressure insurers on claims payments and litigation increases the uncertainty that insurers face in assessing and pricing catastrophe risk. This greater uncertainty can prompt insurers to further boost their rates or reduce the supply of insurance, which can have negative repercussions for many insureds.
Financial Regulation
Regulators also are responsible for regulating insurers' solvency and financial condition, including their level of catastrophe risk. Regulators are placed in a position of balancing solvency requirements with their desire to lower the magnitude of rate increases and preserve the availability of insurance coverage. Easing entry into a market and other financial regulatory requirements could help to increase the supply of insurance. In markets subject to tight supply and high costs, regulators might tip the balance further in favor of improving "availability and affordability" given this is the greatest and most immediate concern to consumer-voters in high-risk areas.
This kind of regulatory trade-off is especially relevant to Florida given the market pressures it has faced. Beginning in the mid-1990s, Florida allowed start-up and other small insurers to write large blocks of exposures in high-risk areas. These insurers can purchase reinsurance to bolster their capacity but there are limits to how much they can reduce their risk from writing large concentrations of high-risk exposures (Grace et al., 2006). As we discussed above, many of the start-up insurers established in the mid-1990s eventually exited the market or diversified their exposures across the state. However, five of the insurers that retained substantial concentrations of high-risk exposures were placed into receivership after the 2004-2005 storms.
The fact Florida regulators allowed insurers to write large concentrations of high-risk exposures raises questions about the adequacy of the companies' financial oversight. It should be noted that U.S. regulatory capital requirements do not consider catastrophe risk (Klein and Wang, 2007). Further, there is no uniform policy or standard across the states that require insurers to rigorously assess and manage their catastrophe risk. We should note, however, that Florida rules do require insurers taking policies out of the CPIC to submit reports and analyses related to their catastrophe risk management.
While new or smaller, regionally concentrated insurers can provide some relief, their capacity tends to be limited and it is questionable whether these small insurers are positioned to safely absorb large concentrations of high-risk exposures. We believe that a more prudent strategy would encourage more national, geographically diversified insurers to each assume digestible shares of high-risk exposures at adequate rates. Unfortunately, it does not appear that policies in Florida are encouraging this kind of development. Louisiana appears to be employing a safer two-prong strategy-encouraging existing insurers to stay and attracting new insurers both national and regional in scope.41
State Insurance Mechanisms
State insurance mechanisms play a prominent role in the underwriting, pricing, and management of catastrophe risk. There are three types of state-run or state-sponsored insurance mechanisms: (1) residual market mechanisms, (2) state insurance or reinsurance funds, and (3) insolvency guaranty associations. The administration of all three types of mechanisms can have important implications for the functioning of insurance markets and the management of catastrophe risk.
Residual Market Mechanisms
The administration and regulation of residual market facilities can have significant effects on property insurance markets and vice versa. These mechanisms include Fair Access to Insurance Requirements (FAIR) plans, wind/beach pools, and special corporations that write both full and wind-only coverage.42 The important aspects of residual market administration include rates, eligibility requirements, available coverages, and coverage provisions. Suppressing or compressing residual market rate structures, lenient eligibility requirements, and generous coverage terms can cause significant problems.43 In turn, suppressing or compressing insurers' rates can tighten the supply of insurance in the voluntary market and force more properties into the residual market.
Florida's property insurance residual market mechanism, the CPIC, has experienced significant growth in recent years and the 2007 legislative changes appear to have further contributed to that growth.44 In concept, a residual mechanism should be an insurance source of last resort for property owners who cannot obtain insurance in the voluntary market. Florida's legislation substantially departs from this concept. The significant changes fall into three categories: (1) changes to the CPIC's ability to compete with the voluntary market, (2) changes in CPIC rates, and (3) changes in the CPICs authority to make "emergency assessments" to cover funding shortfalls. Combined, these legislative changes contribute to the size of the CPIC, undermine its "self-funding" based on the premiums it collects, and increase the size and scope of its assessments on other insurance buyers to cover its funding shortfalls (Klein, 2008).
Figure 5 plots the growth of the residual property insurance market in Florida over the period 1993-2007. "Wind" refers to policies that reside within the high-risk account (HRA) of the CPIC, most of which are wind-only policies.45 "Other" refers to all other policies in the CPIC that reside in its personal lines account (PLA) and commercial lines account (CLA); most of these policies provide full coverage. We can see from this figure that both parts of the Florida property insurance residual market increased substantially over this period. "Other" policies rose dramatically after Hurricane Andrew and then fell from 1995 through 2000 as the start-up insurers took policies out of the facility and pressure on the voluntary market eased. This trend reversed in 2001 when the start-up companies shed policies (after their 3-year requirement ended), followed by the storm seasons of 2004-2005 that reasserted greater pressure on the voluntary market. Windonly policies increased to approximately 500,000 in 1995 and then fell and leveled off in the area of 400,000-450,000 policies.46 The CPICs total exposures (amount of insurance in force) have increased steadily from $103.2 billion in 2001 to $434.4 billion in 2007 (as of May 31).
As of June 30, 2008, the CPIC had 722,735 PLA policies, 446,191 HRA policies and 9,791 CLA policies.47 The total number of CPIC policies was 1,180,908. Its exposures (i.e., amount of insurance in force) as of March 31, 2007 (the latest date for which these data are available) were $192.1 billion for HRA policies and $242.1 billion for PLA and CLA policies. The total number of CPIC policies has fallen since its high of 1.4 million in October 2007, but this has been achieved through a depopulation program discussed below.
Florida has sought to reverse the tremendous growth of its residual market with an ambitious takeout plan. Based on current information available from FLOIR's website, it has identified 10 insurers that have committed to remove more than 637,000 policies from the CPIC.48 The companies vary in size with surplus amounts ranging from $9.5 million to $59.6 million. The consent order issued by the FLOIR for each insurer indicates that the FLOIR will review each company's reinsurance program, catastrophe modeling, and financial statement projections in determining how many policies it will be allowed to remove from the CPIC.49
These actions appear to have temporarily reversed the FCPICs growth but it is not clear that this will prove to be a sustainable strategy. The takeout companies are predominantly small, regional, or single-state companies with limited geographic diversification. Hence, there is a question as to whether they will be able assume substantial amounts of coastal exposures and preserve their financial viability. These insurers can bolster their surplus with reinsurance but there are limits to how much reinsurance they can purchase. If the FLOIR imposes stringent catastrophe risk management requirements, this could limit the actual number of policies and exposures removed from the CPIC. If the FLOIR imposes less stringent requirements, it could permit more takeouts but there will be greater questions about the financial viability of the takeout companies.50
A question related to the size of the residual market is how its share of property exposures differs in various parts of the state. We would expect that availability would be tighter and the residual market relatively larger in the highest risk areas. This is demonstrated in Table 8, which shows CPIC policies and exposures for the personal lines, high-risk, and commercial lines accounts for Dade, Broward, Palm Beach, and Monroe (DBPM) counties (combined) and the remainder of the state for 2003 (December 31) and 2007 (March 31). We can see from this table that the number of policies and amount of exposures insured by CPIC in its PLA account increased significantly from 2003 to 2007 in the DBPM counties but decreased relative to the CPICs total PLA policies and exposures. In the HRA account, the number of policies decreased but the amount of exposures increased in the DBPM counties. However, both figures remained relatively the same in terms of their relative portions of HRA policies and exposures. Overall, these counties continued to account for a large share of the policies and exposures insured by the CPIC. Other coastal counties likely account for most of the remainder of the CPIC's policies and exposures and have contributed to its growth.
There is no "free lunch" in the financing of catastrophe exposures through residual markets and this was demonstrated in CPICs losses from the 2004-2005 hurricanes. As a result of its substantial claims obligations arising from these storms, the CPIC incurred large funding shortfalls of $1.6 billion for 2004 and over $2 billion in 2005 (CPIC, 2008). These shortfalls are being covered by assessments on insurance consumers and state general fund appropriations. Unfortunately, this scenario will likely be repeated when more hurricanes strike the state.
The landscape for residual markets in other selected states has been shifting in recent years although not to the degree that has occurred in Florida.51 Table 9 provides data on the number of habitational policies and total exposures for all state FAIR plans for 1992, 2003, and 2006 (Atlantic and Gulf Coast states are highlighted in bold type). Table 10 provides comparable information for state wind pools. The data indicate that growth in residual market mechanisms has been largely confined to Southeastern and Gulf Coast states. However, the absolute and relative growth of residual markets in these other states is considerably less than in Florida.
Government Insurance Funds
The Florida Hurricane Catastrophe Fund (FHCF) provides catastrophe reinsurance to primary insurers underwriting property coverage in the state and was established following Hurricane Andrew. A discussion of the arguments for and against state insurance/reinsurance funds is beyond the scope of this article, but the different perspectives can be summarized briefly. Proponents of the FHCF contend that it helps to fill a gap in private reinsurance capacity and also provides reinsurance at a lower cost. It should be noted that the FHCF can accumulate tax-favored reserves (an option not currently available to U.S. insurers and reinsurers) and can also access credit supported by local bonding authority. This inherently reduces its costs relative to private reinsurers but also invites political manipulation of its rate structure.
Opponents of mechanisms like the FHCF question the need to augment private reinsurance, raise concerns about crowding out private reinsurance, and cite the potential for financial shortfalls that can lead to assessments on insurers/consumers and/or taxpayers depending on how the mechanism is designed. Indeed, the FHCF required assistance to cover its losses from the 2004-2005 hurricane seasons and insurers have concerns about 2007 legislative changes to the FHCF that increases the amount of coverage that it provides.52
An important provision limits the Fund's obligation to pay losses to the sum of its assets and borrowing capacity. This was initially set at $11 billion, increased to $15 billion in 2004, and increased to $27 billion in 2007 for a "temporary" period of 3 years. If the FHCF losses exceed its total funding capacity, each insurer would be reimbursed on a pro rata basis from the funds available according to its share of the premiums paid into the fund for that contract year.53
The FHCF is funded by premiums paid by participating insurers and investment income on invested reserves. It also can borrow funds up to a specified limit and impose emergency assessments on all property-casualty insurance premiums in the state if necessary to repay debt. The emergency assessments apply to all property-casualty lines of business except workers' compensation, accident and health, medical malpractice, and national flood insurance premiums. These assessments are limited to 6 percent for 1 single contract year but can rise to 10 percent depending on "unused assessments" in prior contract years.
The 2004 and 2005 storm seasons required the FHCF to make payments to insurers, which tapped and reduced its financial reserves. As of December 31, 2006, it had paid $3.7 billion for losses arising from the 2004 hurricanes and $3.6 billion for losses arising from the 2005 hurricanes. The ultimate estimated payment obligations for these 2 years are $3.95 billion for 2004 and $4.5 billion for 2005 (based on its audited financial statement for year-end June 30, 2007). These loss payouts led to a funding shortfall that prompted it to issue $1.35 billion in revenue bonds to cover the shortfall and $2.8 billion in preevent notes to provide liquidity for the 2006 storm season (FHCF, 2007). The bonds will be repaid from a 1 percent emergency assessment for 6 years on all insurance policies in the state renewed after January 1, 2007.
The FHCF's financial structure (as of July 2008) is summarized in Table 11. The FHCF has a "postseason" claims paying capacity of $22.9 billion but most of this is bonding authority-it currently has a projected 2008 calendar-year ending fund balance of $3.6 billion. With the coverage expansions provided in the 2007 Florida legislation, there are concerns that significant hurricane losses could lead to more emergency assessments on all applicable insurance premiums written in the state.54
Some Florida legislators are probably aware of the shift of substantial amounts of risk from private markets to the state that could have adverse political implications. When state mechanisms suffer significant deficits from future hurricanes, there will be more assessments on all insurance consumers in the state and possibly more bailouts from the state's general fund that will be borne by taxpayers. We believe that this increases the motivation of politicians in Florida and other coastal states to advocate the creation of some form of federal catastrophe insurance/reinsurance mechanism, which would assume a significant amount of hurricane losses.55 Ultimately, this is the most effective way to obtain subsidies from noncoastal consumers and taxpayers as such subsidies are very difficult to achieve and sustain through private insurance markets. As would be expected, not all federal legislators are enamored with such proposals and their political prospects are uncertain. From a normative perspective, one might make an argument that a federal catastrophe mechanism would have several advantages for pooling and financing catastrophe risk (see, e.g., Litan 2006). However, there are legitimate questions about the need for federal financing and concerns that its pricing would be subject to political manipulation which would adversely affect all taxpayers.
Guaranty Associations
All states have insolvency guaranty associations that are intended to cover the claims obligations of insolvent insurers. A state's property-casualty guaranty association (GA) is important because it could experience severe stress if one or more insurers with substantial claims obligations became insolvent because of a catastrophe. The Florida Guaranty Association's (FIGA) funding capacity is supported by assessments on propertycasualty insurance premiums in the state that are limited to 2 percent annually but can be increased by the legislature on an emergency basis. Hurricane Andrew resulted in 11 insolvencies and the corresponding demands on the guaranty fund exceeded its capacity. The guaranty association was forced to fully exercise its 2 percent assessment authority and the legislature authorized it to assess an additional 2 percent to repay funds borrowed to cover its capacity shortfall. The association ultimately paid off its debts in 1997 (Lecomte and Gahagan, 1998).
FIGA has now been covering the claims obligations of the Poe Group insurers and Vanguard. This has prompted FIGA to exercise its full 2 percent assessment authority to cover its costs for these claims obligations; another 2 percent emergency surcharge was approved in October 2007.56 In its most recent statements, FIGA reported that it is responsible for handling 46,162 Poe claims with a total cost of $988 million. It is important to note that both figures were FIGA records and exceeded the number and cost of claims arising from the Hurricane Andrew insolvencies.57
The experience from Hurricane Andrew and the 2004-2005 storm seasons reflects the guaranty association's vulnerability to catastrophes and the potential pass-through of insolvent insurers' obligations and risk to other insurers, insurance consumers, taxpayers, and others. This risk is increased by the financial vulnerability of small Rorida insurers with large concentrations of exposures in the state that are not offset by geographic diversification in other parts of the country.
Hence, insurers with significant premium writings in the state, even in lower risk areas and lines of business, retain a secondary exposure to catastrophe losses through their potential obligations to the guaranty association. Furthermore, there is the potential for externalizing some losses to other states, as each state guaranty association is responsible for covering the claims obligations of an insolvent insurer in its jurisdiction, even if the insurer is domiciled in another state. The ultimate burden of insolvency costs, of which guaranty assessments are only a part, are shared by various stakeholders. These issues involving catastrophe risk, guaranty associations, and insolvency costs are not confined to Florida but apply to any state where catastrophe losses could cause insurers to fail.
CONCLUSIONS AND FURTHER RESEARCH
Our analysis of developments in the Florida and other state homeowners insurance markets confirm and measure the significant changes that are occurring as a result of increased hurricane risk. There has been substantial market restructuring in Florida but significantly less so in other states. The largest writers have been decreasing their exposures and these markets are becoming less concentrated. For the most part, the greater dispersion of exposures across a broader group of insurers is a necessary and healthy development. However, in our opinion, Florida relies too heavily on small, geographically concentrated insurers that could be severely stressed by future hurricanes.
Insurance rates have increased significantly as the availability of coverage has tightened, particularly in the highest risk areas. As with market restructuring, Florida has experienced the greatest changes in prices and availability; the trends in other states have been much less severe. On a cumulative basis, the 2004-2005 storm seasons drove insurers' homeowners insurance profits deep into the red and the long-term recovery of the industry will depend heavily on future hurricane activity.
Market changes have been met by a wide range of governmental reactions. Florida appears to face the greatest risk and pressure and its regulatory policies have interfered with market forces to the greatest extent among the coastal states. Other states have tended to be more permissive in terms of allowing market adjustments but there is a risk that some may tighten their regulation if market conditions do not improve. In our opinion, Florida's actions have significantly worsened conditions in its property insurance markets and will expose most insurance consumers and taxpayers to significant risk and further assessments when the state is struck by more hurricanes.58 Hopefully, other states will not follow Horida's course and it will also reevaluate the economic soundness of its current policies. Unfortunately, such a reevaluation may not occur until the state's voters experience more negative consequences of those policies. Further, it is not clear that coastal states will be successful in their quest for a federal insurance/reinsurance mechanism to absorb a significant amount of the catastrophe risk they face.
The story of catastrophe risk and insurance regulation continues to be written. Every state facing hurricane risk exposure will continue to deal with some level of market pressure. We believe that those states that seek to and are successful in supporting private insurance markets and other beneficial policies (e.g., mitigation) may avoid major market dislocations and ultimately see their markets stabilize and provide a reasonable supply of catastrophe insurance coverage. However, the situation remains fluid both in terms of the market conditions and government actions. FOOTNOTE
1 Hurricane risk can be defined in different ways. A simple definition of hurricane risk is the expected average annual loss from hurricanes. A broader definition would include various dimensions of the estimated probability distribution for hurricane losses, e.g., its mean, variance, and long right-hand tail. One could also include "parameter uncertainty" in the definition of hurricane risk. FOOTNOTE
2 Moss (2002) studies the political economy of the government's assumption of risk with insights pertinent to disaster risk. Meier (1988) and Klein (1995) consider alternative theories of regulatory behavior in terms of their application to the insurance industry. The themes in this literature are reflected in our examination of the political and regulatory climate for property insurance in hurricane-prone states.
3 We support this observation in our discussion of market conditions in Florida in contrast with other Southern coastal states. As we wiU show, Florida has been subject to the greatest rate increases and market restructuring among coastal states. Grace and Klein (2007b) and Klein (2008) further document market pressures in Florida.
4 For a discussion of states other than Florida, see "Higher Insurance Costs Hit U.S. Coastal Living." International Herald Tribune, September 2006. The article states that "coverage has tripled in some cases on Cape Cod . . . and have risen as much as 50 percent on Long Island."
5 Lecomte and Gahagan (1998) and Grace et al. (2003) examine insurance market conditions in Florida following Hurricane Andrew.
6 In July 2008, State Farm filed for an overall rate increase of 47.1 percent for homeowners insurance in Florida. A spokesperson for the Florida Insurance Council was quoted in a newspaper article as stating, "It won't be surprising if additional companies make rate filings . . . the vast majority of companies have continually told us that their rates are inadequate." See "More Insurance Rate Hike Requests Predicted," Palm Beach Post, July 17, 2008. Florida Farm Bureau, for example, asked for a 28.4 percent rate increase in late July 2008. See "State Probes Farm Bureau Rate Plan," Daytona News Journal, July 30, 2008. FOOTNOTE
7 Consumer discontent has been reflected in town hall meetings, rallies, legislative hearings, and letters to the editor that are documented in Florida newspapers. See, for example, "Rising Rates a Top Priority for Most Voters, Poll Shows," Tampa Tribune, October 26, 2006; "Rally Cries for Insurance Relief," St. Petersburg Times, October 8, 2006; and "Homeowners Rip Insurance Package," Palm Beach Post, July 25, 2006.
8 Daniels et al. (2006) examine public policy issues associated with Hurricane Katrina and its aftermath. Quigley and Rosenthal (2008) address a broader set of issues associated with various disaster threats.
9 The vehicle for the 2007 legislation was Florida House Bill 1-A (2007). The vehicle for the 2008 legislation was Florida Senate Bill 2860 (2008).
10 See, for example, the testimony of Kevin McCarty for the The National Association of Insurance Commissioners before the Subcommittee on Housing and Community Opportunity of the House Committee on Financial Services (March 27, 2008). FOOTNOTE
11 See Grace and Klein (2007b) for a more detailed discussion of this topic and references supporting the summary observations offered here. FOOTNOTE
12 Information on coastal population trends can be obtained from the National Oceanic and Atmospheric Administration NOAA website at www.noaa.gov. Insurance Information Institute (2008b) also discusses coastal development.
13 The damages caused by Hurricane Andrew demonstrated problems with the enforcement of building codes intended to make homes more resistant to strong winds. See "New Building Code Brings Cost and Confusion," Sf. Petersburg Times, August 19, 2002. Following Hurricane Andrew there have been strong efforts to improve the mitigation of the hazards associated with hurricane risk, including but not limited to establishing stronger building codes, as discussed in Wharton et al. (2008).
14 See "Storm Scenarios Take Hard Look," Sf. Petersburg Times, June 8, 2006.
15 See, for example, "Allstate Won't Renew 106,000 PoUcies," Miami Herald, January 5, 2007. FOOTNOTE
16 As of May 7, 2008 the FLOIR reported that 39 property insurers have entered Florida since January 2006. See "Insurance: Big Risks, Big Payoffs," Tampa Tribune, May 7, 2008. Information on Florida market entrants can be accessed at http://www.floir.com/ac/New% 20Companies/index.aspx.
17 See "Court Approves Liquidation of Poe Companies" South Florida Business Journal, June 1, 2006, found at http://www.bizjoumals.com/southflorida/stories/2006/05/29/daily22.html April 20, 2008. FOOTNOTE
18 The Tower Hill Group writes business in four Southeastern states but most of its business is concentrated in Florida. A.M. Best lowered the ratings for Tower HUl Preferred Insurance Company and Tower Hill Prime Insurance Company from A to B on June 23, 2006. A.M. Best's rationale for the downgrade was the companies' "significant dependence on reinsurance, geographic concentration of risk with exposure to hurricanes, and unfavorable operating performance" (see A.M. Best, 2007a).
19 This observation is not evident in Table 1 but is based on our determination of the top 20 insurers in 1992 using the same source of data-the National Association of Insurance Commissioners financial database-used for aU the calculations in Table 1.
20 See "Insurance Failures Spawn New Levy on Horida PoUcies," Palm Beach Post, October 30, 2007.
21 This includes federal taxpayers throughout the country (Barrese and Nelson, 1994).
22 Willenborg (2000) discusses this problem associated with guaranty associations. FOOTNOTE
23 Even if the national insurers attempted to impose cross-subsidies from non-Florida to Florida consumers, market forces and other states' regulators would not allow such subsidies. FOOTNOTE
24 We were able to obtain data on insurers' exposures by county by year/quarter for Florida from the FLOIR. "Exposure" in these data refers to the "amount of coverage," which is based on the limits on the policies that insurers write. For residential policies, this includes the coverage limits for the dwelling, other structures, contents, and loss of use. FOOTNOTE
25 Various additional factors would be expected to affect the amount of insurance coverage, including changes in the replacement cost of homes. Some of the increase in the average premium is likely due to increases in replacement costs and the corresponding effect on policy limits. FOOTNOTE
26 The premium comparisons are for a 5-year-old Florida concrete block home with a current replacement value of $150,000, a $500 nonhurricane deductible, a 2 percent hurricane deductible, no claims, and no wind mitigation discounts. FOOTNOTE
27 Our estimates indicate that it accounted for 16.1 percent of homeowners' insurance premiums in the state in 2006; the figure for 2007 could be higher given its continued growth. Figures from the Property Insurance Plans Services Office (PIPSO) indicated that the CPIC accounted for 18 percent of total habitational policies in the state in 2006 (PIPSO, 2007). FOOTNOTE
28 The term "long run" can be ambiguous in the context of catastrophe risk. In homeowners insurance markets not subject to catastrophe risk, 5-10 years might be sufficient for insurers to balance their profits and losses. However, in homeowners insurance markets subject to catastrophe risk, it may take much longer for profits and losses to balance (presuming that rates were set at adequate levels). This makes it difficult to assess whether profits approximate a fair rate of return over the long run.
29 This view is reflected in a number of media accounts of insurers' concerns about the validity of the risk models they were using and subsequent changes in catastrophe models used to measure hurricane risk. See, for example, "Modeler Says Heightened Hurricane Activity Increases Modeled Annual Hurricane Losses by 40% in Southeast U.S.," BestWire, March 23, 2006. FOOTNOTE
30 Given the competitiveness of home insurance markets in the various states, it would be difficult for insurers to sustain substantial cross-subsidies. The payers of such subsidies would be expected to seek out insurers with lower rates that were not engaging in cross-subsidization. FOOTNOTE
31 See, for example, "Insurance Hikes Whips Up Demand for Legislation," Bradenton Herald, July 20, 2006 and "Rising Rates a Top Priority for Most Voters, Poll Shows," Tampa Tribune, October 26, 2006.
32 See, for example, Maya Roney, "Hunting for a House in a Hurricane Zone," Business Week, September 12, 2007. The article quotes a National Association of Realtors economist as saying recent insurance price increases have driven down home prices by $20,000. FOOTNOTE
33 For a selection of case studies in the automobile insurance market see Cummins (2002). Harrington (2002) provides a comprehensive analysis of the effects of price regulation in auto insurance.
34 Meier (1988) and Klein (1995) discuss the factors influencing rate regulatory poUcies. Klein (2008) provides a more extensive analysis of how these factors play out in the regulation of property insurance markets vulnerable to hurricanes.
35 This might be labeled as the "sticker-shock" effect. In normal markets, rate increases less than 5 percent tend not to encounter significant resistance (Klein, 1995). In markets hit by a major hurricane, consumer and regulatory tolerance may even be somewhat greater. However, there is a limit to this tolerance even in markets that have been subject to significant hurricane losses. FOOTNOTE
36 This observation is based on the authors' discussions with insurers.
37 See Florida Office of Insurance Regulation, Approved Property and Casualty Rate Changes YTD at http://www.floir.com/DataReports/DataReports.aspx (July 24, 2008).
38 Klein (2008) provides detaUed information on the disposition of insurer rate filings in Florida, Texas, and Louisiana, upon which the observations in this section are based. Observations on the disposition of rate filings in other Southeastern coastal states are based on media reports (or the lack of them). Generally, the local press and the trade press report significant rate increases filed by insurers and the regulatory disposition of these rate filings. FOOTNOTE
39 Klein (2008) discusses and documents the nature of this interference in greater detail. For example, some states limit or prohibit the use of certain underwriting criteria, such as the age of a home and/or its market value, a history of prior claims, the insured's credit score, etc. Also, some states issued moratoriums on policy cancellations/nonrenewals following major hurricanes. Further, some states have increased prior notice requirements for insurers electing to nonrenew policies in a specified area due to concerns about hurricane risk. Also, some states may limit the size of the wind deductible that an insurer can require as a condition for writing a new policy or renewing an existing policy. FOOTNOTE
40 For example, Florida requires insurers to report data on their handling of hurricane claims and subjects insurers to claims audits. While these measures may not explicitly require insurers to pay claims more quickly or offer higher settlements, they can be used to apply implicit pressure. These requirements are specified in Rule 690-142.015 Standardized Requirements Applicable to Insurers After Hurricanes or Natural Disasters issued on June 12, 2007. The FLOIR also performs targeted market conduct examinations of insurers' handling of hurricane claims, which can result in sanctions if regulators determine than an insurer has failed to adjust and settle claims in an appropriate manner. For example, the FLOIR accused Nationwide of underpaying 2004 hurricane claims and forced the company to review how it handled these claims. See "Nationwide Agrees to Review Hurricane Claims in Florida," Columbus Dispatch, October 15, 2005. The Florida governor also set deadlines for insurers' settlements of 2004 hurricane claims. See "Deadline Is Set for Insurers to Settle Storm Claims," Palm Beach Post, October 27, 2004. FOOTNOTE
41 This is reflected in statements by Louisiana's Insurance Commissioner Jim Donelon and insurers' perception of the different regulatory climates in Louisiana and Florida. See "Louisiana Insurance Commissioner Courting More Insurance Companies," Associated Press State and Local Wire, April 22, 2006 and "Insurers: New Louisiana Laws Are Lesser of Two EvUs Compared With Florida," BestWire, July 9, 2007.
42 FAIR plans exist in 32 states and supply full property coverage to insureds who cannot obtain coverage in the voluntary market. Wind/Beach plans provide wind only coverage for properties in designated coastal areas.
43 This was demonstrated in the state case studies for auto insurance in Cummins (2002). FOOTNOTE
44 Following the enactment of Florida's 2007 legislation, the number of CPIC policies in its personal lines account increased from 805,327 as of March 31, 2007 to 944,719 as of October 31, 2007. These figures are based on CPICs archived monthly exposure and premium reports available from its website at https://www.citizensfla.com/index.cfm. Milliman (2007) provides a more detailed review of the full scope of Florida's 2007 legislation.
45 A small portion of FIRA policies is labeled as personal residential multiperil policies. FOOTNOTE
46 Prior to the creation of the CPIC in 2002, residual market wind-only policies were placed in Florida's wind pool-the Florida Windstorm Underwriting Association. Full-coverage policies were insured through the Florida residential property JUA.
47 Information obtained from CPIC's website at http://www.citizensfla.com.
48 Information on FLOIR's takeout plan can be accessed at http://www.floir.com/TakeoutCompanies.aspx.
49 In the matter of Citizens Property Insurance Corporation, Case No. 94539-08, Order Approving CPIC's Personal Residential and Commercial Residential Non-Bonus Takeout Plans, http://www.floir.com/pdf/Executed_Order.pdf (July 24, 2008). FOOTNOTE
50 Most of these companies are not rated by A.M. Best because they do not meet its minimurn size or years in business requirements (A.M. Best, 2007b).
51 It is important to note certain structural changes that occurred in Texas and Louisiana. Texas has had a wind pool for a long time but it only recently created a FAIR Plan in 2003. Louisiana combined its FAIR Plan and wind pool in 2004 in a new entity titled the Louisiana Citizens Property Insurance Corporation (LCPIC) that is structurally similar to Florida's CPIC. FOOTNOTE
52 See "Best Makes Bleak Assessment of State-Backed Insurers," National Underwriter, May 19, 2008.
53 See Summary of Conference Committee Report on Hurricane Preparedness and Insurance (2007) http://www.sbafla.com/mcf/pdf/legislatÃon/Surnmaryofconferencereport.pdf (July 24, 2008). FOOTNOTE
54 Information on the FHCF was obtained from its website at http://www.sbafla.com/fhcf and its latest financial report (FHCF, 2007).
55 See, for example, "U.S. Will Bail Out Florida CAT Funs, Says Ex-Senator," National Underwriter, May 16, 2007. FOOTNOTE
56 The emergency surcharge is expected to be implemented in March 2008 and last for 15 months and raise $315 million to handle additional costs from the Poe and Vanguard insolvencies. See "Insurance Failures Spawn New Levy on Florida Policies," Palm Beach Post, October 30, 2007.
57 FIGA has not yet published any information on claims obligations for Vanguard, which was placed into liquidation on March 27, 2007. One can see a list of the assessments at the FIGA website at http://www.figafacts.com/assessments.asp (July 24, 2008). FOOTNOTE
58 Fitch Ratings issued a special report in March 2008 in which it expressed serious concerns about the Florida homeowners insurance market and its negative financial implications for insurers writing business in the state (see Fitch, 2008).
Martin F. Grace
Robert W. Klein
Martin F. Grace, James S. Kemper Professor, Department of Risk Management, Georgia State University, P.O. Box 4035, Atlanta, GA 30302-4035; phone: 404-413-7469; fax: 404-413-7516; email: [email protected] Robert W. Klein, Associate Professor and Director of the Center for RMI Research, Georgia State University, P.O. Box 4036, Atlanta, GA 30302-4036; phone: 404-413-7471; fax: 404-413-7516; e-mail: [email protected] This article was subject to double-blind peer review.
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IMAGE GRAPH, FIGURE 1, U.S. Hurricane Strikes By Decade: 1921-2006IMAGE GRAPH, FIGURE 2, Insured Losses for U.S. Catastrophes ($Billions): 1985-2007IMAGE TABLE, TABLE 1, Changes in Leading Insurers' Market Share Florida- 1992, 2000, 2005-2006IMAGE TABLE, TABLE 1, Changes in Leading Insurers' Market Share Florida- 1992, 2000, 2005-2006IMAGE TABLE, TABLE 2, Florida Market Structure With Citizens Property Insurance CorporationIMAGE TABLE, TABLE 4, Florida Homeowners Exposure Company Level HHIs by County in 1997Q1 and 2006Q4 Counties Ranked in Descending Order of HHIIMAGE TABLE, TABLE 4, Florida Homeowners Exposure Company Level HHIs by County in 1997Q1 and 2006Q4 Counties Ranked in Descending Order of HHIIMAGE TABLE, TABLE 5, Leading Insurance Groups and Companies in Broward, Dade, Monroe, and Palm Beach Counties: 1997Q1 and 2006Q4IMAGE TABLE, TABLE 5, Leading Insurance Groups and Companies in Broward, Dade, Monroe, and Palm Beach Counties: 1997Q1 and 2006Q4IMAGE TABLE, TABLE 5, Leading Insurance Groups and Companies in Broward, Dade, Monroe, and Palm Beach Counties: 1997Q1 and 2006Q4IMAGE GRAPH, FIGURE 3, Average Homeowners Premium Trends: 2002Q1-2007Q1IMAGE TABLE, TABLE 6, Florida Homeowners Insurance Rates per $1,000 by CountyIMAGE TABLE, TABLE 7, Homeowners' Premium Comparisons in FloridaIMAGE TABLE, TABLE 7, Homeowners' Premium Comparisons in FloridaIMAGE GRAPH, FIGURE 4, Homeowners Insurance Cumulative Profit Rates (% of Direct Premiums Earned) for Florida and Southeast States: 1985-2006IMAGE GRAPH, FIGURE 5, Florida Property Insurance Residual Market Number of Policies: 1993-2007IMAGE TABLE, TABLE 8, Citizens Property Insurance Corporation Personal Residential and High-Risk Statistics: 2003 and 2007IMAGE TABLE, TABLE 9, State FAIR Plans: Habitational Policies and Exposures 1992, 2003, and 2006IMAGE TABLE, TABLE 9, State FAIR Plans: Habitational Policies and Exposures 1992, 2003, and 2006IMAGE TABLE, TABLE 10, State Wind/Beach Pools 1992, 2003-2006IMAGE TABLE, TABLE 11, Estimated FHCF Claims Paying Capacity ($Billions)
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