Category Archives: Risk and Uncertainty

More on double deductibles

Professor Martin Grace argues that the so-called “double deductible” problem in Florida is more of a problem of high deductibles, where doubling just worsens the problem.  Why are deductibles high?  Professor Grace notes that for some time now, insurers have not been allowed to charge adequate rates, so rate regulations have provided the incentive for the private insurance industry to reduce their Florida windstorm exposure.  Since less risk is privately insured, more risk is borne by policyholders and government in various forms, including higher deductibles and state run risk pools.

Florida provides an interesting case study of dysfunctional regulatory policy.  As Professor Grace so capably documents, the regulatory process has effectively undermined the viability of private insurance and substituted in its place an ad hoc set of risk sharing arrangements which no one particularly likes and very few people understand.  Unfortunately, it appears that things may get worse before they get better.  The New York Times published an article about the “double deductible” problem the other day which enumerates some of the short term measures and longer term reforms that are under consideration.  One idea which has been floated is to provide a cash grant of $500 to everyone who has suffered unpaid insurance losses during the course of this hurricane season.  While such a measure may alleviate some of the short term financial “pain” for affected consumers, from a longer term perspective this is not sound public policy, since policies like this undermine consumer incentives to make prudent risk management decisions (see “Catastrophes and Moral Hazard: The Case of Florida Windstorm Risk“).  Actually, this is a classic case of a policy which may have favorable political implications but carries with it rather undesirable economic consequences.  Furthermore, Mr. Tom Gallagher, who is the head of the state’s Department of Financial Services, wants to get rid of multiple deductibles and substitute an alternative policy that would enable consumers to insure against aggregate losses and therefore only pay one deductible.  There’s nothing wrong with this idea so long as insurers are able to charge a premium which reflects the added risk and cost associated with such a policy. However, why stop there? Why not provide consumers with the option to choose between a policy based upon the current policy form, and the alternative policy proposed by Mr. Gallagher? This would encourage self selection, and therefore allow for more efficient and fair pricing. Besides offering consumers greater choice, such a policy reform would also promote market efficiency and enhance the insurability of Florida windstorm risk. In order to “fix” the Florida insurance market, regulatory reform needs to address pricing issues as well as policy forms.  If not, then over time consumers and the state will continue to suffer from an insurability problem.

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Reinsurance reinstatement option

With the entire furor over the so-called “double deductible” problem in Florida, a contractual issue is looming in the market for catastrophe reinsurance which may be much more significant economically. Insurers writing property insurance routinely purchase reinsurance coverage for the purpose of limiting their catastrophe exposures. When insurers purchase reinsurance, they must decide whether to pay extra for an option which automatically reinstates coverage after an insured event occurs. The default reinsurance contract pays for one insured event, and then the coverage disappears unless the insurer has purchased the option to reinstate. Insurers can select how many reinstatements they wish to have. Typically, the cost to reinstate coverage is roughly half the cost of the original reinsurance premium. For example, suppose a reinsurer quotes $100 for the default reinsurance contract which does not reinstate. Then the reinsurer might quote a price of $110 for a contract which reinstates once, $120 for a contract which reinstates twice, etc. Whenever reinstatement occurs, the reinsurer would charge the insurer an additional $50 premium.
Since it is rare that multiple hurricanes strike the same properties, many insurers will prefer to purchase the default reinsurance contract and retain the risk of a subsequent catastrophe. Unfortunately, this is likely to be the most popular strategy for the smaller, less solvent companies for two reasons: 1) since the “option to default” conveyed by the legal rule of limited liability is more valuable for such firms, smaller, less solvent insurers are likely to reinsure less than larger, moresolvent insurers by not purchasing the reinstatement option, and 2) by foregoing the purchase of the reinstatement option,this results in significant reinsurance premium savings. Furthermore, given the dynamics of the Florida insurance market (where, for a variety of reasons, many of the worst risks are covered by such companies), we may be looking at a much worse insolvency scenario for the Florida insurance industry than we might have otherwise expected.
I wish to thank my good friend and colleague, Dr. Richard Derrig, for pointing this problem out to me.

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The double deductible problem in Florida

In a statistical sense, the probability that the same property is damaged by multiple hurricanes is surely a rare event.  However, this is a situation which many property owners in Florida now face.  The print media is filled these days with examples of policyholders whose properties have sustained separate damages from Hurricanes Charlie and Frances who will likely have to pay two deductibles.  Hopefully this won’t become an n deductible problem; obviously whether n will be greater than or equal to two will depend upon how the rest of the hurricane season plays out.

While one cannot help but be sympathetic toward people who face such financial hardships, it is also important to think through this issue in a logical fashion. Under most property insurance contracts, claims and deductible payments are related to a specific insured event.  The insurance policy promises to make the property owner whole after an insured event occurs (where being made whole is defined as paying the difference between the property damage related to the insured event and the deductible).  Even if a policyholder suffers the misfortune of multiple (e.g., 2, 3, …, n) different hurricanes affecting the same property, contractually these represent multiple insured events, not one.  Consequently, n deductibles apply.  Similarly, a person who has the misfortune of being involved in multiple car accidents is not afforded the option of treating multiple accidents as one event; in fact, these are multiple events and each event has its own claim settlement process.

A useful way to think about the double deductible problem is to relate it conceptually to the World Trade Center controversy.  In that case, there was one insured event; specifically, a coordinated strike by terrorists on the two buildings.  Although it could be (and certainly was) argued that were two insured events, the court’s decision to treat it as one event appropriately came down to a question of policy language, which is why the “one event” position eventually prevailed in that case.  In the case of Florida homeowners insurance, multiple deductibles follow as a logical consequence of (state regulated) homeowners insurance policy forms which require separate claims and deductibles for damage on separately named storms.  From a contractual standpoint, Hurricanes Charles and Frances were clearly two different insured events, so two deductibles (or three if Ivan also ends up hitting the same property) would seem appropriate and consistent with standard policy form contract language and legal principles of insurance.

In all likelihood, the state of Florida will end up considering various regulatory reforms once this hurricane season is over.  Even Florida governor Jeb Bush has weighed in on this issue, suggesting that the double deductible is something that might need to be changed because of the financial hardship that this creates for many property owners.  In my view, a constructive approach would involve giving consumers the option to choose between a policy based upon the current policy form, and an alternative policy that would enable consumers to insure against aggregate losses.  Contractually, the latter policy type would closely resemble a typical health insurance contract which has a “stop loss” provision built in for aggregate losses.  Since the alternative policy would provide consumers with the opportunity of insuring against paying multiple deductibles, consumers could expect to pay more for the alternative policy than for the current policy.  Besides offering consumers greater choice, such a policy reform would improve market efficiency.  So long as these contracts are fairly priced, chances are that the worse-than-average risks would tend to gravitate toward the stop loss policy, whereas the better-than-average risks would tend to gravitate toward the current policy form.

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Catastrophes and Moral Hazard: The Case of Florida Windstorm Risk

An important public policy aspect of catastrophes such as hurricanes, floods, earthquakes and terrorist actions is the effect of public disaster relief on the incentives of private firms and individuals to make prudent risk management decisions.  Typically, economists are most worried by the possibility that public disaster relief, however well intentioned, may make matters worse in the long term by undermining incentives for firms and individuals to select economically efficient levels of private insurance and loss mitigation. 

A useful way to think about this problem is to consider what optimal risk management and insurance decisions might look like in a world without public disaster relief, and compare these decisions with the decisions that are likely to be made in a world with public disaster relief.  Since consumers fully internalize the costs and benefits of risk management and insurance decisions in the former case, but do not in the latter, the prospect of public disaster relief reduces consumers’ demand for private insurance and incentivizes consumers to underinvest in loss mitigation.  This is a classic example of the so-called “moral hazard” problem.  Moral hazard refers to the tendency for insured consumers to change their behavior in ways that increase the probability and/or size of claims.  It is an important issue whenever risk sharing occurs and the price at which risk is transferred is distorted in some fashion; e.g., in the form of subsidized insurance provided after the fact by public entities such as FEMA.

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Financial Implications of Hurricanes

Fortunately, the severity of damage from Hurricane Frances will likely be much less severe than what was anticipated in the later part of last week.  Then, forecasters were bandying about Andrew/911 level estimates; e.g., $20-$50 billion.  The three most prominent insurance risk management companies, AIR Worldwide, Risk Management Solutions and EQECAT, now estimate that insured losses from the storm will likely range from $2 billion to $10 billion, which still aren’t exactly “chump change”.  Combined with Charley’s insured losses of $7 billion, this is turning out to be a rather expensive hurricane season for the insurance industry.

The worst hurricane (in terms of total property damage and insured losses) was Hurricane Andrew, a Category 4 hurricane which hit Florida in August 1992.  Andrew caused $20.3 billion in losses for insurers (in today’s dollars) and caused a dozen insurance carriers to go bankrupt.  Andrew set in motion fundamental changes in the way that the insurance business is conducted in Florida.  Consider the following examples of private sector innovation:

  • Insurers (e.g., USAA) have begun to experiment with insurance securitization, where catastrophe risks are shared in capital markets rather than in the reinsurance markets. 
  • Companies doing business in Florida have begun to set up separately capitalized subsidiaries which theoretically could fail without taking their parents down (e.g., Allstate has such a subsidiary, called “Allstate Floridian”).  This strategy enables insurers to create financial firewalls between their Florida companies and the rest of their business organizations, thereby limiting the financial consequences of rate suppression and the risk of insolvency which would otherwise have to be borne by the parent company.

Furthermore, other mechanisms have been put in place which causes consumers and the state government to share more of the catastrophe risk.  Consider the following:

  • Florida Hurricane Cat Fund. After Andrew, Florida created a risk pool which provides catastrophe reinsurance for companies writing homeowners insurance policies in the state of Florida. Allstate will only pay out $425 million for Charley-related losses because the fund pays 90% of Allstate’s losses in excess of $305 million; thus Charley was a manageable loss for Allstate.  In comparison, Allstate’s net exposure to Andrew resulted in a $2.5 billion loss (in 1992 dollars) Similarly, State Farm is expected to pay out $200 million for Charley-related losses, compared with $3.7 billion for Andrew-related losses.  Similar stories apply for other major insurers with significant Florida exposure; e.g., companies such as Nationwide, St. Paul Travelers, CNA, The Hartford, etc.).
  • Insurer of Last Resort: Citizens Property Insurance Corporation. Because insurance price regulations have generally suppressed rates below their true costs, this has provided insurers with incentives to “cherry pick”; i.e., select the best risks, and refuse to cover higher risk properties.  Many of these higher risk properties have been picked up by the state-run Citizens Property Insurance Corp., created by the Florida Legislature in 2002 as an insurer of last resort. Interestingly, Citizens Property Insurance Corp. has become so “successful” that it currently insures 800,000 coastal homes that private insurers refuse to fully cover.  
  • Higher deductibles mean that consumers pay a higher proportion of claims. Some homeowners pay anywhere from 2-5% of windstorm losses, vs. the less than 1% typical for fire damage. Pre-Andrew, deductibles were typically specified in terms of absolute dollar amounts rather than percentages.

It will be interesting to see how this hurricane season plays out.  To date, the damages have been very manageable for the insurance industry.  However, if we have many more storms like Charley and Frances, this may have significant pricing and coverage implications for property insurance markets throughout the United States.  Historically, the capital shocks from major catastrophes such as Andrew and 911 caused insurance rates and reinsurance rates to rise and coverage levels to fall.  This is to be expected, since capital shocks result in capacity constraints in these markets, which in turn result in higher rates and lower coverage.

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Shameless plug for my teaching note entitled “Moral Hazard, Adverse Selection, and Tort Liability”

Following up on my previous blog entry from this morning, I would like to make a shameless plug for my teaching note entitled “Moral Hazard, Adverse Selection, and Tort Liability”. I wrote this teaching note this past spring for my risk management students at Baylor University. The note begins by providing a brief overview of the historical development of tort doctrines that are typically applied in the area of products liability. Since strict liability has become the prevailing legal doctrine in the area of products liability, I analyze some interesting (at least I find it interesting :-)) economic consequences of this legal rule. Specifically, strict liability tends to aggravate various moral hazard and adverse selection problems, which in turn adversely affects consumer welfare. The note concludes with a discussion of Professor Steve Magee’s interesting (and somewhat controversial) theory on the optimal number of lawyers in an economy. Please send me your comments about this note by emailing me at James_Garven@baylor.edu.

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Two good reads: “Trial Lawyers Inc.” and today’s WSJ article (editorial section) entitled “Liberal Loopholes”

Lately, I have been reading a report issued by the Center for Legal Policy at the Manhattan Institute entitled “Trial Lawyers Inc.”. Since the Manhattan Institute is a conservative think tank, not surprisingly the report is Shakespearean in its tone (you know the famous quote from Henry VI: “The first thing we do, let’s kill all the lawyers”). All kidding aside, the report is a very impressive survey on the state of the US tort system circa 2003. In my opinion, it provides a useful summary concerning the direct and indirect costs of the tort system, and it does a good job of identifying “traditional” areas of litigation (e.g., asbestos and medical malpractice), “high-growth” areas of litigation (e.g., mold), and future areas that are ripe for litigation (e.g., the fast food industry).

I also recommend an editorial page article in today’s Wall Street Journal entitled “Liberal Loopholes“. The article points out, among other things, that rich people (including some very prominent politicians) have a comparative advantage in avoiding taxation compared with the less affluent (because the rich can afford tax attorneys and complicated schemes to take advantage of perfectly legal “loopholes”). As a case in point, the article explains how during the mid to late 90’s, Senator John Edwards managed to shield 90% of his law practice income from the Medicare payroll tax by receiving this income primarily in the form of Subchapter S corporate dividends rather than in the form of a salary. Under the law, the former form of income is exempt from the Medicare tax, whereas the latter is subject to this tax. If I had been in Sen. Edwards’ shoes, I probably would have done the same, since the incentives to do so are extremely compellling (we’re not talking “chump change” here; Sen. Edwards managed to save $591,000 by implementing this strategy). The article points out the following irony, which fits with the tort reform message of this blog entry: “Mr. Edwards has claimed that he set up the subchapter S company to protect himself from legal liability. You know it’s time for tort reform when even the trial lawyers say they’re afraid of getting sued.”

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The Insurance Council of Texas 2004 Mid-Year Property & Casualty Insurance Symposium in Austin, TX

This week (Thursday, July 15, 2004), I will be attending the Insurance Council of Texas (ICT) 2004 Mid-Year Property & Casualty Insurance Symposium in Austin, TX, along with Baylor students Blake Holman and Charles Panicker. ICT is a trade association which, among other things, represents the interests of the Texas property-casualty insurance industry in the regulatory process and supports academic teaching and research in risk management and insurance. Indeed, ICT annually funds $5,000 in student scholarships at Baylor University, and donates comparable amounts at many of the major universities in Texas. The program for the symposium is located at http://www.insurancecouncil.org/symposium.asp.

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Home insurers see profits rise in Texas

In recent years, Texas has had one of the most dysfunctional homeowners insurance markets in the United States. To a large extent, this can be attributed to the combination of increased costs from mold claims coupled with various regulatory constraints. At the worst point (back in 2002), Farmers Insurance pulled out of the state, and State Farm adopted a policy of not taking on new business. Not surprisingly, this public policy crisis has resulted in Texas being able to claim (not proudly) the number 1 spot in the United States for having the most expensive homeowners insurance. Anyway, the homeowners insurance crisis set in motion various regulatory reforms, including the adoption of new policy forms which substantially limits mold coverage for most homeowners. We are now finally starting to see the fruit of this policy.

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