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Texans have many reasons to worry about hurricanes. Two large storms struck the state last year, insurance rates have risen steadily in most coastal areas, the state-mandated wind insurance mechanism faces severe problems, and residents have seen an ever increasing percentage oftheir income going to pay for property insurance.
The call for elected representatives to “do something” is understandable.
Recently,members of the Legislature led by Rep. Craig Eiland (D-Galveston) introduced a proposal that would set up a state “backstop” — a fund that insurance companies themselves could draw on to pay claims following a major catastrophe. The backstop, financed through special taxes on insurance policies, would theoretically help keep insurance rates down by reducing the amount that private insurers have to pay fortheir own reinsurance policies. (Reinsurance is insurance for insurance companies.)
It may sound good, but it won’t work. In fact, it’s likely to raise insurance rates, undermine a vital private industry, and, possibly, get the state into financial trouble.
To begin with, the money to pay for the “backstop” will need to come from insurance customers so, unless insurers already feel their rates are too high (hint: they don’t), it’s quite possible that rates will go up by the amount of the taxes and perhaps more. In Florida, the only state to experiment with a backstop of its own, most companies filed for rate increases on top of the taxes assessed to pay for Florida’s catastrophe fund.
And, as a matter of insurance policy, a state-run backstop proposal won’t save money. Here’s why: Buying insurance makes economic sense because insurers can manage risk across a broad pool of non-correlated risks. Within the United States, insurers can pool the risk of hurricanes striking Galveston or Houston with the risk of damage from earthquakes in California. Since the two events are unlikely to happen at the same time, insurers can afford to pay lots o fmoney in claims for a hurricane striking Texas because they probably will not have earthquake losses at the same time. Through international reinsurance arrangements, likewise, insurers can pool risks of hurricanes in Texas with earthquakes in Japan and cyclones in the Southern Hemisphere.
A Texas-only backstop, on the otherhand, will focus all its risk in Texas’ coastal counties. In order to break even, it will have to charge more than private reinsurers need to: It does nothing to spread the risk.
The result is that a backstop will either prove worthless — its product will cost more than what the private market provides — or more likely, the proposed Texas backstop will impose massive liabilities on the state, and unfairly cause the noncoastal counties in Texas to subsidize those adjacent to the state’s beaches. Florida’s existing Catastrophe Fund does sell reinsurance for less than what is available in the private market — but this is precisely why its promises have been called “illusionary” and a “ticking time bomb.” By charging less than needed to cover its risks, Florida’s state run Catastrophe Fund has just about $3 billion in hard assets to support its potential liability of almost $30 billion. It might well have to issue $26 billion in bonds, all at once, in order topay for a major storm. (No state has ever sold more than $11 billion inbonds at the same time.) With bond markets essentially frozen, Florida would consider itself lucky to find buyers for $3 billion worth of bonds. If Florida tried to pay out what it might need to following a major storm, a real possibility exists that the state could end up in bankruptcy court. Already, the largest Florida-only insurer has challenged the state on the grounds that the catastrophe fund coverage is essentially fraudulent.
Florida’s mistakes should not be exported to any other state. But there’s a better way. Rather than risking the state’s fiscal future, Texas’ elected representatives should take steps to help residents help themselves. It should let risk rather than political factors determine insurance rates, reinforce public infrastructure against hurricanes, and imitate successful Florida and South Carolina programs that help residents strengthen their homes against storms.
These are the far more sensible ways to address Texas’ insurance challenges, but the state doesn’t need a hurricane catastrophe fund. It’s just a bad idea.
Lehrer is a Senior Fellow at the Competitive Enterprise Institute, where he directs the Center for Risk, Regulation and Markets