States Should Take the Lead in Stabilizing Disaster Insurance

Jul. 2—In the coastal Southeast it's hurricanes, in the Mountain West it's wildfires, and in Middle America it's unprecedented regional flooding and shifting tornado patterns. Across the country, homeowners are facing stiff increases in casualty insurance premiums. In some cases, affordable coverage simply can't be found.

Between climate change and escalating house restoration costs, it's become a bad business to sell insurance for major catastrophes that hit large geographical areas. The reinsurance market — where consumer-facing insurance companies cover their worst-case loss exposure — is either drying up or completely broken.

Ultimately, governments at all levels will need to address the industry's problems with a coordinated risk-sharing strategy to partner with the private sector where markets are failing. Without resorting to deficit budgeting, the public sector can help socialize the ruinous risks faced by individual property owners.

Last year, the casualty insurance industry was unprofitable in 18 states, compelling state regulators to approve whopping premium increases. Many properties in Florida have been hit with 125 percent premium hikes over the past five years. California homeowners recently received the unhappy news that the state's public earthquake insurance authority has quietly lifted the deductibles for restoring structures valued at 25 percent above the statewide median house price. That leaves owners of more than a million homes newly at risk for six-figure excluded-casualty losses if they were to be hit by anything like the 1994 Northridge quake — even if they are "fully" insured with maximum available coverage.

It's time for the entire public sector to step in, with a proven playbook building on and complementing longtime federal programs. Working with some 50 private insurance companies for 50 years, Washington has underwritten national flood insurance for property owners residing in locations prone to high waters, provided that their communities take precautionary measures in their land-use policies and building codes. Similarly, farmers are eligible for federal crop insurance to protect them from economic wipeouts and bankruptcy from drought, field fires, disease, pestilence, hail and frost damage, and even for unprofitably low prices for their products when harvested.

These are classic public-private partnerships whereby Uncle Sam provides the reinsurance coverage for catastrophic losses that private insurance companies alone cannot bear when the geographical swath of damages is so extensive that claims could wipe out their underwriting and capital reserves. These programs are not isolated to single states or regions. The National Association of Insurance Commissioners is well versed in how these programs operate.

Backstopping Private Insurance

To fill in the gaps that the private insurance industry alone cannot underwrite without risking bankruptcy in a worst-case multi-event scenario, the states need to promote the concept of an intergovernmental, federalist partnership.

Washington is already on the hook for disaster aid in most of the catastrophes that are declared eligible for federal assistance, primarily through grants and loans. Extending that role to a reinsurance program to backstop state-operated property insurance consortia with the private sector is a natural next step. Uncle Sam should help the states that help themselves, so that state-operated insurance and reinsurance programs are able to share extreme location-specific risks with the entire nation.

Where risk exposure and historical claims incidence are greater, as in hurricane, earthquake and wildfire territory, the most vulnerable states' programs will need to bear a higher cost than others where payouts are far less frequent. Otherwise South Dakota, Wisconsin and Idaho politicians will complain that they are subsidizing affluent Californians and Floridians. But with proper underwriting principles, an intergovernmental system can buttress the private insurance industry, providing both reinsurance and a new class of optional "gap" policies for homeowners who need a separate layer of affordable insurance below the ever-escalating standard deductibles that would otherwise wipe them out.

For example, a California homeowner unable to secure earthquake insurance for the first $150,000 of covered losses could purchase an intermediate layer of maybe $75,000 of federal gap insurance that would be payable for losses above that amount, for which the state's insurance fund would collect the add-on premiums and bear frontline underwriting exposure. If a state's widespread loss experience from an incident exceeds its total population-based federal program limits, then Uncle Sam would pick up the remainder of those claims as a national expense. Think of this as comparable to those federal crop insurance payouts to farmers when there is widespread drought in Kansas or Iowa.

Financing Options

States need not be required to participate in an intergovernmental insurance program, just as they are free to opt out of the Obamacare-expanded Medicaid program. But unless they have the good fortune to live in a state that rarely experiences significant disaster losses, governors and legislators who refuse to participate will ultimately do a disservice to their constituents. That would be like rejecting federal farm subsidies and crop insurance for their residents simply to dramatize political and fiscal conservatism. Opting out would most hurt the poorer people who can afford it the least, but would also inflict financial harm on unlucky middle-class homeowners who can no longer obtain traditional insurance with sufficient protection.

As we know, there is no free lunch when disasters strike. At the end of the day, Uncle Sam will need to find new funding sources to pay for its share of this added protection and burden sharing. Given that the most severe storm damages have a plausible connection to climate change and global warming, the most natural financing source for those claims would be a national carbon tax. Of course, that dog won't hunt in petroleum-producing states, and there is no causal link to earthquakes caused by tectonic shifts. So any federal funding package to underwrite natural disaster payouts with new taxes will face an uphill battle on Capitol Hill. A dedicated national online gaming tax — pairing random gambling winners with random disaster losers — might have a better shot at popular support for enactment.

An alternative model that puts the cost burden back on the insurance industry at large would be a federally imposed surcharge on the industry similar to the Federal Deposit Insurance Corporation's (FDIC) assessments on the banking industry when the agency's reserves are depleted from heavy losses resulting from multiple bank failures. In the FDIC model, the largest banks pick up most of the costs, and the same outcome is likely in a casualty reinsurance model.

Obviously, such a system would need to avoid subsidizing foolish companies' risky underwriting practices at the expense of prudent operators. The devil is in the details, but that is not an impossible assignment when the national interest and survival of an essential industry is at stake.

Where Pensions Come In

As counterintuitive as it may seem, there may also be a role for state and local pension funds to provide vital risk capital to the reinsurance industry through "cat bonds," which enable the companies to lay off some of their catastrophic storm and earthquake risks to hedge funds and institutional investors. Priced nowadays to yield double-digit returns, these bonds also offer an attractive form of portfolio diversification.

Obviously this is not a business line for dumb money; underwriting savvy is essential. An interstate public pension consortium with hard-headed expert advisers on retainer would be a wiser approach, without all the hedge fund baggage, fees and carried interest. To avoid large coinciding losses, state and local systems with heaviest risks in one sector, like earthquakes or hurricanes, could select a different loss category where they have less to lose locally, or they could pool risks with the larger consortium.

Insurance purchasers and their local communities will also need to take precautionary measures to qualify for better coverage under any such arrangements. Just as homeowners in floodplains are expected to mitigate their exposure to qualify for national flood insurance, the same concept will need to apply to other disasters. Owners who cannot mitigate their property's risks out of pocket will need access to low-interest federal loans to make complying improvements, such as earthquake retrofitting of older homes. Fiscally, it's smarter for Uncle Sam to be a lender than a philanthropist.

Ultimately, a pragmatic but outside-the-box approach is needed. No insurance company wants to abandon its well-established customer base only because it cannot rationally underwrite the high risks of catastrophic losses in disaster zones. The state insurance commissioners can work proactively to build industry support and fine-tune the economics so that burdens and costs are borne fairly.

If Congress is unwilling to step in, then the states will eventually need to establish a novel multi-state compact to achieve similar results on their own. Market forces are at work already, to reprice mounting risks, but they don't solve the problems of affordability and reliability that the federal crop insurance program has solved for farmers.

Without strong support from governors and state legislatures, as well as the private insurance industry lobby, these ideas will never gain enough support to clear Congress. But as the frequency of weather-related storms increases — and insurance gets even harder to afford — the need for practical, collective and intervening solutions will become more obvious.

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Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.

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