New state-based approaches to catastrophe insurance

by R.J. Lehmann on April 12, 2012

Earlier this year, the National Conference of Insurance Legislators – a nonprofit association that gathers state lawmakers who sit on insurance committees in their various legislatures – chose to allow their 17-year-old National Disaster Catastrophe Fund Model Act to sunset, rather than renewing it for use in the states’ 2012 legislative sessions. A relic of the post-Andrew, post-Northridge era of catastrophe insurance madness, the model had outlived its usefulness and the one extant state cat fund, the Florida Hurricane Catastrophe Fund, is hardly a “model” that any other state should wish to replicate.

Nonetheless, there remain issues of both affordability and availability of property insurance with which many catastrophe-prone states must grapple, and it’s understandable that lawmakers in these areas should wish to be seen as doing SOMETHING to address those issues.  And so, NCOIL’s Property and Casualty Committee is seeking input from a variety of parties, all in hopes of crafting a new and better-informed approach to natural disaster issues that states could take.

Together with my colleagues Eli Lehrer and Alan Smith, I authored a response that represents how we here at The Heartland Institute’s Center on Finance, Insurance and Real Estate think about these issues. You can read the full text at this link, but I thought here, I’d just replicate the eight bullet point recommendations that cap our report.

  • Regulators should allow insurers to set risk-based rates.

Regulators who have attempted to micro-manage property insurance prices or impose onerous exit provisions have seen the inevitable result: the flight of private capital from their markets. Private insurers should be granted the freedom to adjust property insurance rates to reflect risks they see, as well as the flexibility to adjust rates based on criteria they deem important. This could mean bundling discounts, where insurers agree to give priority to consumers who purchase both cat-exposed property coverage and less cat-exposed auto coverage. It could mean a variety of mitigation discounts. And it should certainly mean the ability to choose among catastrophe models for rate-setting and underwriting purposes.

  • Public agencies should set clear rules and limits for post-disaster assistance.

The urge to help those impacted by disaster is universal and perfectly understandable. However, governmental assistance that too closely replicates the benefits of insurance coverage will prove counter-productive. If citizens know they can count on disaster relief comparable to what they’d receive from an insurance company, the moral hazard will naturally cause consumers to eschew purchasing insurance. Post-disaster assistance should be limited to repairs to public infrastructure and true humanitarian relief (food, clothing, temporary shelter, medical assistance) to those who really need it.

  • State and local lawmakers should adopt sensible building codes and land use policies.

To counter both the natural tendency to underinvest in mitigation and the negative externalities associated with shoddy construction, it is appropriate for state and local governments to call for clear, limited, and reasonable zoning and land use restrictions, and cost-effective building code requirements. Code and land use regulations should be enforced consistently and applied only where there is demonstrable evidence that expected loss reductions would recoup the upfront costs in a reasonably short time frame.

  • Mortgage lenders should require appropriate catastrophe insurance coverage.

In response to problems of broad underinsurance, countries like France and New Zealand have created a mandatory property insurance program in which all citizens are required to take part. While this would address free rider and adverse selection problems, we think broad insurance mandates are not appropriate. However, mortgage loans issued by state-chartered banks, thrifts, credit unions, and other lenders should require properties to maintain appropriate insurance coverage, just as federally related loans already must. Indeed, there is evidence the low take-up rate of earthquake insurance in California would largely be solved if the federal government-sponsored enterprises required earthquake coverage just as they do flood and windstorm coverage in areas prone to those catastrophes. There also must be consistent and effective enforcement of both existing federal requirements and any new state requirements.

  • Insurance contracts must be transparent. Insurance regulators must be responsive.

While insurers should enjoy greater flexibility to bring new products to market and charge rates they deem appropriate, there is likely more regulators could do to promote transparency in coverage and ensure companies act in good faith. Recent research by consumer advocates suggests some insurance markets lack mechanisms that would permit informed consumers to choose policies on the basis of differences in coverage.  Consumers could use more information about what coverages are available, which they will be likely to need, and what perils are typically excluded from a standard policy. Regulators also need to hold insurers’ feet to the fire to pay claims promptly and in good faith. If consumers do not trust their claims will be resolved, or do not understand what their coverage entitles them to, they will be less likely to buy insurance.

  • States have a responsibility to educate the public about natural disaster risks.

States need to provide more information, not only about insurance coverage, but about catastrophic risks more generally. This includes developing effective emergency response programs, as well as longer-term community awareness outreach efforts regarding the costs and likelihood of a variety of disaster scenarios.

  • Residual market insurers should be a last resort.

Coverage by wind pools and other residual market entities should be limited to those who cannot obtain coverage in the private market. This can be assured by requiring such entities to charge rates exceeding those in the private market. In addition, to avoid offering perverse incentives to the insurance producer community, commissions paid to agents and brokers by these entities also must be less than those in the private market. Finally, to protect taxpayers and avoid costly post-event assessments, state insurance programs should rely on pre-event financing to the greatest extent possible, including private reinsurance and catastrophe bonds. Ideally, given the elevated risk profiles of such insurers, they should be structured to at all times hold enough surplus and capital on hand to handle a 1-in-250-year catastrophe.

  • State catastrophe funds should not be considered an option.

General purpose state-run reinsurance programs, such as the Florida Hurricane Catastrophe Fund, serve to concentrate catastrophe risk within a state instead of spreading it through the global reinsurance and capital markets. Such structures are inherently dangerous, and NCOIL should be commended for allowing its cat fund model act to sunset earlier this year. In addition, as a means of supporting the ability of states to regulate insurance, NCOIL should oppose any sort of national catastrophe fund or bonding mechanism.

Following all of these recommendations would not, of course, eliminate the potential for catastrophic natural disasters impacting a state property insurance market. It would, however, better align incentives for all parties involved, better prepare citizens for tragedy, better protect sensitive environmental areas, and reduce overall risks to those that provide the best, most cost-effective, paths toward opportunity.

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