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.

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.

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.