Insuring Against Natural Disasters: Possibilities for Market-Based Reform
In the 105th Congress, the House of Representatives has again taken up the issue of insurance for natural disasters. On June 25, the House Banking and Financial Services Committee votes on whether to markup legislation that would create a federal reinsurance program. As recent natural disasters demonstrate, Americans face an ongoing threat of potential devastation from a serious catastrophic event. Two disasters in particular, Hurricane Andrew in Florida in 1992, and the Northridge Earthquake in Southern California in 1994, seriously disrupted the markets for disaster insurance in these states. Following these events, insurers threatened to stop offering coverage, and consumers faced the prospect of not being able to insure their homes and properties.
Rising costs associated with recent catastrophic events were a shock to insurers and regulators. One factor in these rising costs is changing demographics. In the last 50 years, coastal areas in the U.S. have become more densely populated. As population has increased, so has the value of insured property in these areas. In addition, some scientists have noted that catastrophic events seem to occur in waves of greater or lesser intensity. This appears to be true for both seismic events as well as hurricanes. In both cases we may be entering periods of greater activity for catastrophic events. Another factor in rising costs is simply inflation.
Following the disasters of the early and mid-1990s, there was a contraction in the supply of both primary insurance and reinsurance. This was caused both by market factors as well as by government policies that exacerbated the supply problems. There is a limit to the total amount of coverage a company can write at any given time. This is an insurer’s capacity. After Andrew and Northridge, primary insurers and reinsurers faced an inevitable decrease in their capacity as they spent down their surpluses to pay for the unexpectedly high losses. Reinsurers, however, were far more successful in rebuilding their capacities than were primary insurers, due to the fact that reinsurers are under far fewer regulatory constraints.
One such constraint faced by primary insurers is rate regulation. Due to political considerations, some disaster-prone states have heavily regulated the rates charged by insurers, and have prevented insurers from raising premiums as much as they might like. Constraining the flexibility of rates discourages insurers from offering more coverage and limits the overall coverage available in the market.
States have also taken other counterproductive regulatory measures to attempt to compel insurers to continue to provide coverage. To prevent insurers from decreasing the numbers of policies they were writing, Florida imposed a moratorium on non-renewals, limiting the proportion of policyholders that insurers could"non-renew" for coverage. Setting up such a barrier to market exit creates a barrier to entry. Other insurers grow wary of entering a regulatory environment that they would be unable to leave. Programs such as the Joint Underwriting Associations in Florida also discouraged companies from entering, due to their dominance of the state’s market.
The taxation of insurer income also helped to contribute to the costs of providing insurance. Federal tax treatment failed to account for the fact that companies that insure against risks from natural disasters must pay for events that are irregular, infrequent, and difficult to predict. An insurer needs to build a surplus over time from which it can pay for the high costs of natural disasters. Current federal tax policies prevent that by taxing as profit all annual income in excess of that year’s liabilities and expenses. This prevents insurers from building surpluses as quickly and effectively as they can, and increases the risk of insuring against natural disasters, leads to greater insolvency risk, and discourages insurers from writing more coverage.
Private insurance markets have also, in some instances, faced limited demand for such coverage. Some homeowners go without such coverage even when it is available. This has particularly been true of earthquake insurance, which is usually sold as an additional coverage. Homeowners may determine that disaster-related coverage is not worth to them what it would cost. While there should be no mandate that they purchase such coverage, neither should there be any requirement that insurers or government bail out these individuals.
To help create a more resilient private market for insurance, states should permit open-competition rate-setting, the federal government should allow insurers to accumulate tax-deductible reserves to pay for natural disaster risks, and the federal government should amend its current disaster relief policies to encourage the purchase of disaster insurance.
The private sector is developing new securities to transfer risks. These new financial instruments, including catastrophe swaps, "contingent surplus" notes, "act-of-God" bonds as well as new derivatives products are all devices used for transferring or capitalizing the risk associated with natural disasters. While these products are all fairly new, they represent a promising new approach to obtaining the capital needed to fund catastrophe risks.
Allowing open competition rate-setting, in which premiums are determined through market competition, not regulatory oversight, would attract new insurers to disaster-prone states and encourage insurers in those markets to write more coverage. Insurers also need greater freedom to offer more flexible products such as higher deductibles or coinsurance. This would enable insurers, through premium incentives, to encourage homeowners to engage in loss-prevention and disaster mitigation. States should deregulate their own rate-setting. But, if states will not do this, then perhaps the federal government should consider preemption to force a deregulation of premium rates. Given current federal disaster policies, rate-setting by states affects not only their own residents, but taxpayers throughout the country.
Congress should recognize the need for insurers to build reserves to pay for disasters, and should allow insurers to build such reserves without paying taxes on the premiums devoted to building such reserves. These reserves should be voluntary on the part of insurers and reinsurers as well. Tax policies already allow insurers to write off past disaster losses against their federal taxes. Allowing them to accumulate reserves before the disaster takes place would be a far more efficient approach. Such reserves would decrease the financial risk of providing disaster-related insurance, help to make premiums more affordable, and "smooth" insurance availability, since insurers could fund disaster-related losses through these reserves, rather than from general surpluses.
One final reform that should be undertaken is to make eligibility for disaster relief payments contingent upon the possession of insurance coverage. Only homeowners that have purchased some amount of coverage would qualify for disaster relief. This would encourage property owners to purchase insurance and prevent homeowners from passing their risk on to the federal taxpayer, while avoiding a requirement that all homeowners purchase insurance coverage. Homeowners should retain the right to go without coverage if that is what they wish to do.
These reforms should help to provide greater stability and strength to the market for disaster-related insurance. And, ultimately, a vigorous and competitive private insurance market will best serve property owners in disaster-prone areas.