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At War with the WeatherManaging Large-Scale Risks in a New Era of Catastrophes$

Howard C. Kunreuther and Erwann O. Michel-Kerjan

Print publication date: 2009

Print ISBN-13: 9780262012829

Published to MIT Press Scholarship Online: August 2013

DOI: 10.7551/mitpress/9780262012829.001.0001

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Catastrophe Risk and the Regulation of Property Insurance: A Comparative Analysis across States

Catastrophe Risk and the Regulation of Property Insurance: A Comparative Analysis across States

Chapter:
(p.24) (p.25) 2 Catastrophe Risk and the Regulation of Property Insurance: A Comparative Analysis across States
Source:
At War with the Weather
Author(s):

Howard C. Kunreuther

Erwann O. Michel-Kerjan

Publisher:
The MIT Press
DOI:10.7551/mitpress/9780262012829.003.0002

Abstract and Keywords

This chapter examines important regulatory institutions and policies, the advantages and disadvantages of different regulatory policies, the responses of regulators to market developments, and how they may act in the future. It first outlines the government framework that governs property insurance markets, including insurance regulation, before turning to market and financial regulation and their impact on property insurance markets subject to catastrophe risk. It then compares market conditions and regulatory policies in four states: Texas, Florida, New York, and South Carolina. The chapter also considers the wind-versus-water controversy and related litigation and concludes with a discussion of the administration of residual market facilities and other government insurance and reinsurance mechanisms in the four states.

Keywords:   regulatory policies, property insurance, catastrophe risk, Texas, Florida, New York, South Carolina, litigation, reinsurance

2.1 Introduction

The regulation of insurance companies and insurance markets plays a prominent role in the management of catastrophe risk. Each state exercises considerable authority over insurers’ entry and exit, financial condition, rates, products, underwriting, claims settlement, and other activities. Regulatory constraints and mandates in these areas can have significant implications for how property insurance markets function and property owners’ incentives to control their risk exposure. Although there are limits to regulators’ power, there is virtually no aspect of insurance markets and insurance company activities that they cannot attempt to control or at least influence. At the same time, prudent regulators seek to confine their intervention to areas where it is warranted and aids the proper functioning of insurance markets. Ultimately regulators cannot dictate market outcomes, but their policies can either support more efficient insurance markets or create significant market problems and distortions.

Regulators do not function within a political vacuum, though. They must work with the other branches of government, and most regulators that ignore political considerations tend to have a short tenure in office. In the tense atmosphere currently surrounding property insurance in hurricane-prone areas, regulators and legislators are subject to strong (p.27) pressures from different sides. Insurers have sought to raise their rates, adjust their exposures, and modify policy terms to cover their costs and manage their catastrophe risk. On the other side, coastal property owners and other groups such as developers and realtors with vested interests have voiced strong complaints about higher insurance premiums and the tighter supply of coverage. Unfortunately, in Florida, the political pressure from these groups has influenced government officials to employ unwise policies that further undermine the private financing of catastrophe risk and shift this burden to all insurance policyholders, as well as taxpayers in the state. In determining regulatory policies, government officials in some states seek a course that will neither destroy insurance markets nor devastate their political support—a path that may or may not prove to be attainable. Nonetheless, strong debate and differences of opinion exist among insurers, politicians, and other stakeholders about regulatory policies. It is necessary to understand both economic theory and political-economic reality in evaluating regulatory policies and how they might be improved.

This chapter outlines important regulatory institutions and policies, examines the pros and cons of different regulatory policies, and assesses how regulators have responded to market developments and how they may act in the future. It is not feasible to fully analyze all relevant developments in this chapter, but it establishes a framework that can be used to further evaluate regulatory policies. This chapter is intended to be a companion to chapter 3, which examines developments (structure, conduct, and performance) in property insurance markets affected by hurricane risk.

The next section reviews the government framework that overlays property insurance markets, which includes insurance regulation. Sections 2.3 and 2.4 examine market and financial regulation in greater detail and how they affect property insurance markets subject to catastrophe risk. This examination focuses on Florida, New York, South Carolina, and Texas. All coastal states are facing increased market pressures, but these states were chosen for this study in order to contrast a range of market conditions and regulatory policies. Section 2.3 also reviews the wind-versus-water controversy and related litigation. Section 2.5 evaluates the administration of residual market facilities and other government insurance and reinsurance mechanisms in the selected states.

2.2 Overview of the Institutional Framework for Government Intervention

A number of government institutions and policies affect property insurance markets and the management of catastrophe risk. The regulation of insurers and insurance markets is a principal area of attention and the primary focus of this chapter, but it is important to note the significance of other elements of the governmental framework, such as the legal system and tax policy. These different elements interact, and policies in one area can affect the objectives of other elements. Ideally, the full range of government institutions and policies should be coordinated to achieve the best possible outcomes in terms of the performance of insurance markets and efficient catastrophe risk management.

(p.28) Legislative, Regulatory, and Judicial Roles and Authorities

An extensive institutional structure has been developed to perform insurance regulatory functions in the United States. This structure is primarily based within the insurance departments of each state and their respective laws and regulations, policies and procedures, and resources. In addition, the National Association of Insurance Commissioners serves as a vehicle for individual state regulators to coordinate their activities and share resources to achieve mutual objectives. Furthermore, state legislatures and state and federal courts play important roles in the overall regulatory structure. The federal government also has selectively intervened in certain aspects of insurance regulation.2 This section reviews the roles and authorities of branches and levels of government that together determine how insurers and markets are regulated.

Each state, the District of Columbia, and the five U.S. territories has a chief government official responsible for regulating insurance companies and markets. This official has the authority and responsibility to ensure that insurance companies do not incur excessive financial risk or treat policyholders unfairly. More specifically, insurance commissioners oversee insurers’ admission and licensing, solvency and investments, reinsurance activity, transactions among affiliates, products, prices, underwriting, claims handling, and other market practices. Regulators also oversee insurance agents’ licensing and their market practices, along with certain other areas related to insurance company and market functions. However, insurance commissioners’ authority is limited in some respects, and various other public and private institutions are part of the insurance regulatory system. Regulators operate within a broader governmental framework that influences and constrains their actions.

Most commissioners are appointed by the governor (or by a regulatory commission) for a set term, or “at will,” subject to legislative confirmation. Ten states elect their insurance commissioners, who are more autonomous in the sense that they do not take orders from their governors (see table 2.1).

However, elected commissioners must still cooperate with their administrations in order to achieve their objectives. Elected commissioners directly seek voters’ political support, while appointed commissioners do this indirectly as part of their governors’ administrations. Some empirical studies suggest that states with elected commissioners tend to constrain insurers’ rates and other practices to a greater degree than states with appointed commissioners, but this effect appears to be small relative to the impact of other factors and is not necessarily the case for every state with an elected commissioner.

Commissioners can seek to exert considerable control over insurers’ conduct through the admission and licensing process. Insurers that fail to comply with regulatory requirements are subject to losing their authorization to sell insurance through the suspension or revocation of their license or certificate of authority. Commissioners may exact fines for regulatory violations that serve as a further financial inducement for compliance. Commissioners (p.29)

Table 2.1 State rate regulatory systems for homeowners’ insurance

State

Rating system

Commissioner selection

State

Rating system

Commissioner selection

Alabama

Prior approval

Appointed

Montana

File and use

Elected

Alaska

Flex rating

Appointed

Nebraska

File and use

Appointed

Arizona

Use and file

Appointed

Nevada

Prior approval

Appointed

Arkansas

File and use

Appointed

New Hampshire

File and use

Appointed

California

Prior approval

Elected

New Jersey

Prior approval

Appointed

Colorado

File and use

Appointed

New Mexico

Prior approval

Appointed

Connecticut

File and use

Appointed

New York

File and use

Appointed

Delaware

File and use

Elected

North Carolina

Prior approval

Elected

DC

File and use

Appointed

North Dakota

Prior approval

Elected

Florida

File and use

Appointeda

Ohio

File and use

Appointed

Georgia

File and use

Elected

Oklahoma

Use and file

Elected

Hawaii

Prior approval

Appointed

Oregon

File and use

Appointed

Idaho

Use and file

Appointed

Pennsylvania

Prior approval

Appointed

Illinois

Use and file

Appointed

Rhode Island

Flex rating

Appointed

Indiana

File and use

Appointed

South Carolina

Flex rating

Appointed

Iowa

Use and file

Appointed

South Dakota

File and use

Appointed

Kansas

File and use

Elected

Tennessee

Prior approval

Appointed

Kentucky

Flex rating

Appointed

Texas

File and use

Appointed

Louisiana

Flex rating

Appointed

Utah

Use and file

Appointed

Maine

File and use

Appointed

Vermont

Use and file

Appointed

Maryland

File and use

Appointed

Virginia

File and use

Appointed

Massachusetts

File and use

Appointed

Washington

Prior approval

Elected

Michigan

File and use

Appointed

West Virginia

Prior approval

Appointed

Minnesota

File and use

Appointed

Wisconsin

Use and file

Appointed

Mississippi

Prior approval

Elected

Wyoming

No file

Appointed

Missouri

Use and file

Appointed

source: NAIC, PCIAA.

(a) The Florida insurance commissioner is appointed, but the state treasurer is elected. In the past, the state treasurer has assumed a significant role in insurance regulation, but that does not appear to be the case in recent years.

also may intervene and seize companies that are deemed to be in hazardous financial condition. Other rules and regulatory actions can constrain or impose mandates on insurers’ rates, products, and market practices. However, insurers can challenge unreasonable regulatory actions in the courts and respond in other ways to lessen the negative effects of excessive regulatory constraints and mandates.

The measures available give regulators considerable leverage but not absolute power in attempting to force insurers to comply with insurance laws and regulations. Regulators may try to use this leverage to compel insurers to offer catastrophe coverage under more favorable terms to property owners. One way in which states may seek to exercise leverage to extract subsidies is by trying to require an insurer to withdraw from all lines in a state if they seek to withdraw from a particular line, such as homeowners’ insurance. However, insurers may raise legal challenges to such efforts. It also is not evident that an insurer has ever been forced to make such a withdrawal, but its threat may have had some effect on insurers. In addition, insurance commissioners can exercise public and political influence (p.30) in their visible role as consumer protectors and insurance experts. The governor and legislature typically look to the insurance commissioner for guidance on key policy issues and legislation, but can choose to enact laws counter to regulators’ preferences that regulators are compelled to enforce.

Private insurers also have options. Ultimately they can fully withdraw from a state if forced to take this action or find the regulatory environment intolerable. Also, an insurer exiting home insurance in a state may elect to exit other lines, because total withdrawal may be necessary from a business perspective—they may find it difficult to sell other insurance products to consumers if they are not willing to sell them home insurance. However, in considering withdrawal from a state, an insurer will balance various considerations, such as exit costs, their overall profitability in writing multiple lines of insurance, and their expectations regarding how and when regulatory policies may change for better or worse.3 In private insurance markets where consumers can choose among multiple insurers, it is difficult for regulators to force significant cross-subsidies over a sustained period. Furthermore, insurers can respond to regulatory policies affecting one area, say, rates, by making changes in other areas, such as underwriting or quality of service.

Hence, insurance commissioners are neither autonomous nor omnipotent and face a number of constraints in exercising their authority. Most important, regulators must act within the framework of insurance laws enacted by the legislature. Regulations promulgated by the commissioner are often subject to review and approval by the legislature. Regulatory actions are also subject to review and enforcement by the courts. Furthermore, legislatures can enact laws, and the courts can issue rulings that supersede the regulatory policies of insurance commissioners.4 Hence, although regulators can exert considerable power and influence over insurers, agents, and insurance markets, they are subject to various checks or overrides that can ultimately determine what regulatory policies will be, with or without their assent of insurance commissioners, and how those policies will affect market outcomes.

Overview of Insurance Regulatory Responsibilities

For the purpose of this chapter, insurance regulatory responsibilities are divided into two primary categories: financial regulation and market regulation. In theory, financial regulation seeks to protect policyholders against the risk that insurers will not be able to meet their financial obligations because of financial distress or insolvency. Market regulation, in its idealized form, attempts to ensure fair and reasonable insurance prices, products, and trade practices. Insurance producers (agents and brokers) also are subject to regulation. Financial and market regulation are inextricably related and must be coordinated to achieve their specific objectives. Regulation of rates and market practices affect insurers’ financial performance, and financial regulation constrains the prices and products insurers can reasonably offer. The balancing of market and financial regulatory objectives is especially relevant to catastrophe risk: less stringent solvency requirements can increase the supply of insurance, but insurers on the margin can be exposed to greater default risk.

(p.31) All U.S. insurers are licensed in at least one state and are subject to financial and market regulation in their state of domicile, in addition to other states in which they are licensed to sell insurance. Reinsurers domiciled in the United States also are subject to the financial regulation of their domiciliary state. The domiciliary state tends to take the lead in regulating the financial condition and risk of its domestic insurers, but other states in which an insurer operates can take actions that influence the regulation of the domiciliary state. This second layer of financial regulation, coordinated through the National Association of Insurance Commissioners, has sometimes forced the hands of domiciliary regulators in taking actions more quickly than they would have if they were not subject to pressure from other states.5 Of course, the regulation of single-state insurers is essentially immune from this second layer.

In markets that are not adequately served by licensed insurers, some U.S. insurers and non-U.S. insurers write certain specialty and high-risk coverages on a nonadmitted or surplus lines basis.6 These types of coverage are not subject to price and product regulation, because it is presumed that buyers in the surplus lines markets are more sophisticated and therefore better able to protect their own interests. States can control the entry of surplus lines carriers by imposing minimum solvency and trust requirements and supervising surplus lines brokers.

Some states are allowing nonadmitted insurers to provide catastrophe insurance coverage for some properties that are rejected by the voluntary market. This policy must be carefully considered and administered. Surplus lines are not regulated by regulators in the states they operate. Their claims also are not covered by guaranty associations if they become insolvent. Hence, there are additional consumer risks in obtaining coverage from surplus lines insurers, and this would be a greater concern for property owners with lower incomes and lower home values.

With the exception of financial oversight by their domiciliary jurisdiction, reinsurers are not generally subject to direct financial and market regulation. Reinsurers are, however, regulated indirectly through the states’ regulation of the primary insurers that are ceding risk to reinsurers. Regulators control whether a ceding insurer can claim credit for reinsurance on its balance sheet, which is conditioned on whether the reinsurer is regulated in the United States or, alternatively, posts collateral to back up its liabilities if it is a foreign reinsurer.7 Stiffer rules on when insurers can obtain credit for reinsurance can affect their capacity to handle catastrophe risk and supply insurance. The NAIC is considering proposals to ease collateral requirements for foreign insurers that have sparked a fierce debate that has not been resolved.

2.3 Market Regulation

Market regulation encompasses a number of different aspects of insurers’ activities, including these:

  • (p.32) Rates

  • Policy forms and terms (e.g., deductibles, excluded perils)

  • Underwriting practices (ability to decline or restrict coverage)

  • Marketing and distribution

  • Claims adjustment

This chapter focuses on the first three activities, which are the most critical areas associated with catastrophe risk issues, but it should be noted that regulatory policies governing other areas can be important also.

Rate Regulation

Rate regulatory systems and policies differ considerably among the states. Some attempt to impose binding constraints on rates, while others rely on the market to determine rates. Hence, the degree of regulatory stringency—how much regulators seek to suppress overall rate levels or compress rate structures—varies greatly among states. In turn, rate regulatory policies and actions can have significant effects on insurance markets. Suppression of overall rate levels or compression of geographical rate structures can compel insurers to tighten the supply of insurance, which decreases the availability of coverage. Also, these policies can reduce the incentives of those who are insured to optimally manage their risk from natural disasters. At the same time, economic and market forces can ultimately trump regulatory policies. Regulators cannot ultimately force market outcomes that are at odds with economic realities, (e.g., low rates and widely available coverage in the face of very high risk), without government replacing private insurers as the principal source of insurance coverage.

Types of Rate Regulatory Systems

One aspect of rate regulation is the type of system that state law establishes for particular lines of insurance. The various types of systems can be divided into two basic categories: noncompetitive rating (NCR) systems and competitive rating (CR) systems. In NCR systems, regulators can more easily seek to constrain rates below levels that insurers would otherwise charge but may choose not to do so. In CR systems, regulators in theory essentially rely on the market to set rates and do not attempt to constrain rates.

Table 2.1 shows the type of rating system in each state for homeowners’ insurance. Five types of rating systems are reflected in the table. Under a prior approval system, insurers must file and receive approval of their rates from regulators before they can be put into effect. Under a flex rating system, rate changes that fit within certain bounds (e.g., a 10 percent change) are typically subject to a file and use or use and file requirement; rate changes that exceed the bounds are subject to prior approval. Prior approval systems are generally placed in the NCR category. Flex rating systems fall into a gray area, and their categorization can be a matter of choice that could depend on the tightness of their bounds and how they are implemented.

(p.33) The other three systems are generally placed in the CR category. Under file and use systems, insurers are required to file their rates before they put them into effect but are not required to get approval of their rates before they become effective. Under a use and file system, insurers can put rates into effect and then file them with regulators at the same time or within a certain designated time frame. Under both systems, regulators can retroactively disapprove rates that have become effective, which necessarily requires an insurer to refund all or a portion of rate increases that they have implemented. Generally, under a file and use system, a regulator can tell an insurer that its rates will be disapproved before they become effective, which can preclude the need for refunds. Many states that have file and use or use and file systems have statutes that require regulators to issue a finding that the market is not competitive in order to disapprove insurers’ rates, but regulators can administer these systems to constrain insurers’ rates in a manner that effectively replicates a prior approval approach. One state, Wyoming, does not require insurers to file their rates with regulators and is labeled no file.

While the types of rating systems are typically placed into one of the two basic categories, one cannot infer how a state actually regulates rates by simply looking at its rating law. Some NCR states may seek to suppress rates below competitive levels, and other NCR states may effectively let the market set rates by approving the rates that insurers file. Furthermore, some so-called CR states may employ devices and policies that effectively attempt to constrain rates below what the market would set. Additionally, regulators may delay the approval and implementation of insurers’ rate changes that can have adverse effects on the market.

Rate Regulatory Stringency

The degree of rate regulatory stringency can vary among states and cannot be determined solely by their rating laws. Stringency is defined as the degree to which regulators attempt to suppress insurers’ prices below competitive levels, or the prices insurers would charge in the absence of regulatory constraints: the greater the relative difference between the rates that insurers seek to charge and what regulators allow, the more stringent we define the regulation to be.8 Hence, a state that allows insurers to charge only 50 percent of the rate levels or increases they would otherwise implement would be considered more stringent than a state that allows insurers to charge 90 percent of what the insurers chose to charge.

We also use the terms rate suppression and rate compression with somewhat different meanings. Suppression refers to regulators’ attempts to constrain overall rate levels for all classes of insureds. Compression refers to the attempts to constrain rate differentials between different risk classes (e.g., high-risk and low-risk territories for home insurance). Rate compression often results in rate suppression, as regulators will typically lower the allowed rating factors for the highest-risk classes while requiring no changes in the underlying base rate or rating factors for the low-risk classes.9 This ultimately lowers the overall rate level that an insurer can implement.10

(p.34) A number of factors affect regulatory stringency, including these:

  • The degree to which rate regulation is vulnerable to political manipulation. NCR systems tend to be more vulnerable to manipulation, although CR systems are not immune from political interference.

  • The underlying risk of loss. Higher risks and costs tend to put more pressure on regulators to constrain rates in response to political pressures.

  • Philosophies concerning regulation and the need to constrain insurers. Some states exhibit prevailing philosophies that call for stricter regulation, while others may be more willing to allow market forces to determine prices.

  • Economic leverage. The negative consequences of exiting a large market state such as Florida are greater for an insurer than they are for exiting a smaller market state such as Louisiana. Hence, regulators in large states may seek to extract greater concessions from insurers than regulators in small states.

  • Regulator selection. There is some evidence that elected regulators are more likely to engage in rate suppression and compression, but studies suggest that this has only a small effect.

  • Legislation. Legislatures enact the laws and often approve regulatory rules. Hence they can substantially influence regulatory policies.

It is difficult to develop objective empirical measures of regulatory stringency and obtain the data needed to calculate such measures. We have employed various proxies for regulatory stringency, as have others with some success, but the quest continues.11 This chapter presents a more anecdotal discussion of rate regulatory policies.

Rate Regulation in Florida

After Hurricane Andrew, Florida regulators resisted large rate increases and allowed insurers to raise rates only gradually over the decade.12 Initially this policy exacerbated supply availability problems because insurers were concerned about substantial rate inadequacy.13 Over time, as insurers were allowed to increase rates further, these concerns eased, although it appears that insurers believed that there was still some compression of rates in the highest-risk areas. By the beginning of 2004, most insurers probably viewed their rates as being close to adequate except in the highest-risk areas, and there was not substantial pressure to increase rates further. This began to change after the fourth major hurricane hit the United States in 2004.

By 2006, many insurers began to file their first major wave of rate increases in Florida. The magnitude of the increases filed varied among areas within the state based on insurers’ estimates of the inadequacy of their existing rate structures. High-risk coastal areas received larger percentage increases than low-risk areas. It appears that the initial wave of rate increases was largely approved or allowed to go into effect by regulators. However, as (p.35)

Table 2.2 State Farm Florida Insurance Company, Florida homeowners’ rate history, 1997–2006

New business effective date

Indicated

Filed for

Received

8/15/1997

42.6%

24.1%

24.1%a

1/1/2001

15.6

7.0

6.5

11/1/2001

14.5

14.3

14.3

5/15/2002

26.9

22.3

Disapprovedb

11/15/2003

6.9

6.9

6.9

9/15/2004

2.3

2.3

1.7

2/15/2005

11.1

5.0

5c

2/1/2006

8.6

8.6

8.6

8/15/2006

52.7

52.7

52.7

(a) Awarded at arbitration. Following consent order, stipulated that State Farm file no other rate increases for at least two years.

(b) Full 22.3 percent awarded at arbitration subject to several conditions, with a cap of 42.5 percent on individual rate increases through second year.

(c) FLOIR specifically requested that the company file for no more than a 5 percent increase.

some insurers filed a second wave of rate increases in the latter part of 2006, they began to encounter regulatory resistance.

The disposition of rate filings submitted by State Farm in Florida through 2006 is summarized in table 2.2. The overall rate-level changes filed by State Farm from 1997 to 2006 ranged from 2.3 percent to 52.7 percent. Two of the filings were challenged by regulators, but State Farm subsequently received its requested rate changes (with certain conditions attached) in arbitration. The largest increase filed, 52.7 percent, was approved by regulators and became effective as of August 15, 2006. We should also note that in several instances, State Farm filed for smaller increases than what was indicated by its actuarial analysis. This can happen for several reasons, including an insurer’s desire to soften the impact on consumers and its expectations with respect to what regulators are more likely to approve.

State Farm’s rate structure or rate relativities have also been subject to constraints, which we label rate compression. From 2002, its filed rate increases were subject to an individual policy premium cap, typically 42.5 percent. In its filing effective August 15, 2006, the Florida Office of Insurance Regulation (FLOIR) agreed to remove the cap, in exchange for limiting the maximum average base premium increase for any given territory to 165 percent.

More recently, in the latter half of 2006 and into 2008, further insurer rate hikes were challenged and disapproved or reduced by Florida regulators. For example, in the latter half of 2006, rate filings by Allstate, Nationwide, and USAA were challenged by regulators. The Allstate Group filed a 24.2 percent increase for Allstate Floridian and a 31.6 (p.36) percent increase for Allstate Floridian Indemnity. The approved increases were ultimately reduced to 8.2 percent for Allstate Floridian and 8.8 percent for Allstate Floridian Indem-nity.14 Nationwide filed for a 71.5 percent rate level increase that was disapproved, and it appealed the disapproval to a Florida arbitration panel, which ruled in favor of a 54 percent increase. USAA filed for a 40 percent increase but received only a 16.3 percent increase.

Most recently, the FLOIR has taken a position against any further rate increases. In November 2007, it issued a notice of intent to disapprove filings for homeowners’ rate increases of 43.4 percent for Allstate Floridian, 27.4 percent for Allstate Floridian Indemnity, 39.7 percent for Encompass Floridian, and 41.6 percent for Encompass Floridian Indemnity (all members of the Allstate Group).15 In July 2008, State Farm asked for a 47 percent rate increase, which they upped to 67 percent in December 2008. When the state insurance commissioner rejected these requests in January 2009, State Farm announced that it would leave the Florida homeowners’ insurance market over the next two years and would no longer offer homeowners’ coverage in Florida (Diamond 2009).

A combination of growing consumer displeasure over previous rate increases, as well as the lack of damaging hurricanes in 2006 and 2007 (see chapter 1) probably began influencing regulators’ resistance to additional rate hikes. The further hardening of regulatory policies was foretold in Florida’s 2006 elections and was manifested in its early 2007 legislative session. Early in 2007, Florida enacted legislation that sought to increase regulatory control over rates and roll back rates based on changes in the Florida Hurricane Catastrophe Fund (FHCF). The new legislation expanded the reinsurance coverage provided by the FHCF, and insurers were required to reduce their rates to reflect this expansion of coverage, which was priced below private reinsurance market rates. This requirement applies even if an insurer does not purchase reinsurance from the FHCF. In 2008, Florida enacted legislation that will change its rate regulatory system from file and use to prior approval and eliminate its arbitration mechanism for resolving rate disputes between insurers and regulators.

Rate Regulation in Other States

Disputes between insurers and regulators over rates have tended to be less significant in other coastal states than in Florida. This may be largely because insurers have filed for smaller increases in these states, and previous rates have been lower than in Florida. However, one has to be careful in making overly broad statements about the regulatory environments in these other states because each has its own story.

Of the three other states selected for this study, Texas may be the most prone to rate filing disputes between regulators and insurers. In May 2006, State Farm filed for an overall rate level increase of 11 percent (23 percent in Dallas County), which was disapproved by regulators. In the latter part of 2006, the state’s windstorm pool requested a 20 percent rate increase, but regulators reduced it to 4.1 percent. In the summer of 2007, Allstate filed a (p.37) 5.9 percent rate increase, and Farmers filed a 6.6 percent rate increase. The insurance department indicated that it would not approve either increase. Farmers chose to withdraw its rate filing, while Allstate has indicated that it will implement its rate increase under the state’s file and use rating system.

In reflecting on the situation in Texas, several factors are likely influencing regulatory policies. First, in the early 2000s, many insurers filed for significant rate increases because of concerns about mold claims and the increase in weather-related risks. Second, like Florida, Texas has a large insurance market and hence is in a position to try to exercise greater leverage in controlling insurers’ prices. Third, Texas has had a long legacy of taking a fairly tough position on insurers’ rates and other actions.

In South Carolina and New York, we have not been able to find any reports on individual insurers’ rate filings and their disposition, which suggests that there have not been significant disputes between insurers and regulators on any rate increases that have been filed. A January 2007 report by the South Carolina Department of Insurance noted that the largest approved overall rate level increase in 2006 was 12.4 percent, with increases for coastal areas ranging from 50 to 65 percent.16 Insurers and regulators may not be in exact agreement on rates in these states, but the lower level of risk and market pressure would be expected to narrow the disparity between the rates that are filed and the rates that are approved.

Comments on Rate Regulatory Policies

In summary, Florida has exhibited the greatest degree of regulatory stringency toward property insurance rates, but its behavior is consistent with its economic and political situation. Rates in coastal areas of Florida were already high, and consumer and voter tolerance in these areas has been strained by the most recent waves of rate increases. Property insurance rate regulation has tended to be more moderate in other states subject to hurricane risk, even after the 2004–2005 storm seasons. Risk and cost pressures have been lower in these states, which decreases the tension between insurers’ rate needs and what regulators are willing to approve. Finally, regulators in states with smaller markets have been able to exercise less leverage in seeking to extract rate concessions from insurers.

Rate regulation in coastal states remains fluid as this book is being written. The United States avoided damaging hurricanes in 2006 and 2007, but the 2008 storm season has been more active with several hurricanes striking the Atlantic and Gulf Coasts. It is too soon to tell how these developments will affect insurance markets and regulation. Although regulators appear to be more permissive in states other than Florida, there also may be limits to their tolerance of higher rates.

Issues concerning the pricing of property insurance in coastal areas and its regulation are likely to continue. Insurers argue that the rate increases are necessary, while consumer advocates argue that the rate increases are excessive and should be restricted by regulators. Advocates of binding regulatory constraints on insurers’ rates might offer at least a couple (p.38) of arguments to support their point of view. One argument might be that insurers are “overreacting” to recent losses and have overestimated the increase in hurricane risk. A second argument might be that the lack of regulatory constraints allows too much volatility in insurers’ pricing and that regulators need to dampen this volatility.

Some initial responses to these arguments are warranted. It is true that appropriate risk estimates and rate levels and structures are subject to some subjectivity and different opinions. Most experts would probably agree that risk modelers’ and insurers’ risk estimates are imperfect owing to parameter uncertainty. However, insurers voluntarily commit their capital to underwriting property exposures in high-risk areas, and their ability to charge what they believe to be adequate rates affects their willingness to continue to commit capital to such a risky venture. Insurers could be right or wrong and their rates may swing depending on their perceptions and risk appetite, but this is inevitable in the face of catastrophe risks characterized by great uncertainty if reliance on private insurance and reinsurance is to continue.17

Although it may take some time, market forces and competition should ultimately establish a new equilibrium in terms of prices and the supply of insurance if legislators and regulators can loosen the reins on the market. However, pragmatists understand that political-economic factors may not permit this to happen, especially in states subject to significant market pressures, such as Florida. When and where a new equilibrium would be established will also be affected by hurricane risk projections and storm activity over the next several years.

Regulation of Underwriting and Insurance Policy Terms

Regulation of underwriting and insurance policies can have a significant impact on hurricane-prone insurance markets. The regulation of underwriting (e.g., the rules insurers use to select or reject applicants, insurer decisions to reduce the number of policies they renew or new policies they write) can be somewhat difficult to specify because of the complexity and opaqueness of this aspect of regulation. Some aspects of the regulation of policy terms, such as the maximum wind and hurricane deductibles that insurers are allowed to offer, are more readily discernable, but other aspects may be obscured in the policy form approval process. The regulation of these two areas can be intertwined. For example, regulators may allow insurers to offer a high wind deductible, but may not allow them to mandate a high deductible as a condition for renewing an existing policy or writing a new one.

Regulation of Underwriting

States have different ways to regulate insurers’ ability to use their discretion in accepting new insurance applications or renewing existing policies. At a minimum, regulators may prohibit the use of certain underwriting criteria (e.g., the age of a home or its market value), but the regulation of underwriting can extend significantly beyond such minimum (p.39) prohibitions. Regulators may constrain insurers’ underwriting discretion by more broadly limiting the criteria they can use in underwriting, or interfering with insurers’ attempts to reduce their portfolios of exposures to more manageable levels. While there has been some regulatory resistance to insurers’ decisions to reduce their exposures, there is generally little that regulators can do to prevent such reductions in the long term.

Regulators may seek to impede or challenge insurers’ decisions not to renew policies or not write new policies by requiring them to justify their decisions. The only leverage that a state can employ is to attempt to force an insurer to exit all lines of insurance if it seeks to reduce its property insurance exposures, although an insurer can raise constitutional challenges to such a scenario. This can result in a situation that neither side desires to see taken to its ultimate limit, but each must be prepared to do so in order to exercise bargaining power. The game often involves rate regulation, with insurers responding to rate filing disapprovals by tightening their underwriting criteria for providing coverage in high-hazardprone areas. Alternatively, regulators may approve a rate increase conditional on an insurer’s agreement to continue to insure a prescribed number of high-risk homeowners.

For example, Florida questioned State Farm’s announced decision in 2007 to drop approximately 50,000 homeowner policies in high-risk coastal areas (of its total Florida homeowners’ book of business of approximately 1 million policies). Regulators issued subpoenas to State Farm officials requiring them to appear and discuss their plans at a hearing in November 2007. The scope of FLOIR’s review of State Farm’s actions and plans was expanded to include its nonrenewals, multiline discounts, and withdrawal from the condominium business.18 Subsequently, in negotiations with the FLOIR regarding rate adjustments, FLOIR agreed to terminate its inquiry into the nonrenewals and related issues, and the hearing was not held.

In January 2008, Florida regulators also suspended Allstate’s license to sell auto insurance, contending that the company failed to supply documents they requested concerning its pricing and underwriting decisions. Allstate opposed the suspension in court, and after a number of legal rulings it appeared that the FLOIR would prevail. The suspension was lifted on May 16, 2008, when the Florida Insurance Commissioner, Kevin McCarty, announced that Allstate had complied with the document request. This was followed by the resolution of remaining disputes between the FLOIR and Allstate in August 2008.

Another issue that has recently arisen is whether an insurer can require a homeowner to buy auto insurance from the insurer as a condition for being able to buy homeowners’ insurance. There have been some media reports of insurers employing this requirement, but it is not clear how widespread this is or whether this is something that regulators would allow. It is common for insurers to offer premium discounts to insureds who buy their auto and home insurance from the same company, but this is a different practice, and states generally allow it.

New York is one state that has recently barred insurers from nonrenewing home insurance customers in coastal areas who are not willing to buy their auto and life insurance (p.40) products as well. The New York action was prompted by complaints from consumers who received nonrenewal notices from their insurers that cited this reason, among others, for the nonrenewal. Several insurers indicated that they would stop the practice and renew the insureds that they had dropped. According to the New York Insurance Department, insurance tying requirements are prohibited by state law.19

Another aspect of underwriting is insurers’ movement of some of their exposures into standard or nonstandard, as well as single-state, companies within their groups. One of the factors prompting this development is that standard and nonstandard companies are allowed to have higher rate structures, and some insurers prefer to use this approach rather than expand their rate structures within their main, or “preferred,” companies. Hence, it is a way in which an insurer can effectively raise rates for certain insureds without filing a rate increase that may be disapproved or reduced by regulators. This tactic would be prompted by regulatory constraints on an insurer’s need to raise the rates of its preferred company. Regulators may seek to control this tactic by confining the criteria that insurers may use in accepting or declining insureds for coverage in their preferred or lowest-rate companies.

The movement to single-state companies by national insurer groups is motivated by the desire to make the financial performance attributable to a state more transparent and obvious rather than mixing it with the financial results from other states. Also, if a single-state company were to become insolvent, the parent group could let the company go and not attempt to bail it out with funds from other companies within the group. Although this has not occurred to date, some insurer groups may wish to retain this option if the losses of a single-state company were large enough to significantly affect the financial condition of the group, especially if regulators in the state had constrained the company’s rates or engaged in other efforts to manage its exposures.

In its recent legislation, Florida has sought to restrain the use of single-state companies and the segmentation of Florida losses from insurers’ experience in other states. The legislation prohibits the further establishment of single-state insurers by national groups and requires insurers to sell homeowners insurance in Florida if they sell it in other states. These actions could discourage new insurers from entering the state and existing insurers from remaining in the state.

Regulation of Policy Terms/Provisions

Another area in which regulators may constrain insurers’ preferences is policy terms, such as wind or hurricane deductibles. Insurers are allowed to offer up to 10 percent wind or hurricane deductibles in Florida for homes with dwelling coverage limits between $100,000 and $500,000.20 There is no limit on hurricane deductibles for homes with dwelling limits in excess of $500,000. Maximum allowed wind and hurricane deductibles can range up to 25 percent in other coastal states. Higher deductibles allow insurers to better manage their catastrophic risk exposure and losses, and also allow some homeowners to lower their premiums further by accepting more of the risk.

(p.41) Another issue is insureds’ ability to have wind coverage excluded from their policy, or allowing insurers to offer wind and hurricane exclusions. Florida’s 2007 legislation made this option more readily available to buyers of homeowners’ insurance. While insureds can obtain significant premium savings by opting for a wind exclusion, it does place them in a position of retaining any wind losses they might suffer. Presumably lenders would not allow someone with a home mortgage to opt for a wind exclusion, but it would be an option for homeowners without a mortgage.

Other Areas of Market Regulation: The Wind-Water Controversy

Insurance programs for residents in hazard-prone areas in the United States are segmented across catastrophe perils. Standard multiperil homeowners’ and commercial insurance policies typically cover damage from fire, wind, hail, lightning, winter storms, and volcanic eruption, among other common noncatastrophe perils. Coverage for flood damage resulting from rising water is explicitly excluded in homeowners’ insurance policies, but coverage for these losses is available through the National Flood Insurance Program (NFIP) (see chapter 4 for more details on the NFIP). Despite the fact that the NFIP was created over forty years ago, some homeowners contend that they were not aware of this exclusion.21

Insurance disputes following hurricanes inevitably arise over the cause of damage. What portion of the loss is due to wind (covered by a standard homeowners, policy) and what damage is caused by rising water from storm surges or flooding? Hurricane Katrina brought the wind-water issue to the fore since a number of residents in the area had homeowners’ insurance but not flood coverage, and their damage was at least partially caused by rising water, not wind. By law, lenders (and others associated with home mortgages) are compelled to require flood insurance for homes in designated (hundred-year) flood zones. However, compliance with this law may not be complete. Furthermore, homeowners who do not have conventional mortgages or have homes outside designated flood zones often do not purchase flood insurance.22 In addition, even those who did have flood insurance and suffered large losses from the rising waters were able to cover only a portion of their losses with their claim payments, because the NFIP’s maximum coverage limit on the structure only (not including contents) is $250,000 for residential buildings, and these homeowners did not purchase excess flood coverage from private carriers (see chapter 4).

Following Hurricane Katrina, many residents disputed their insurers’ assertions that the damage to their homes was caused totally or partially by rising water, contending that it was due to winds from the hurricane. Some property owners also contended that they were not aware of the flood exclusion in their homeowners’ policy and that the exclusion was not sufficiently clear or enforceable. In fact, many lawsuits were filed in Gulf Coast states following Katrina and other hurricanes. Most of these requested that the courts overturn flood exclusions in their homeowners’ policies. In a ruling on an Allstate Insurance Company case in April 2006, Judge L. T. Senter, Jr., of the U.S. District Court for the Southern District of Mississippi ruled that “the inundation that occurred during (p.42) Hurricane Katrina was a flood, as that term is ordinarily understood, whether that term appears in a flood insurance policy or in a homeowners insurance policy. The exclusions found in the policy for damages attributable to flooding are valid and enforceable policy provisions.”23 This ruling was viewed as a setback to a class-action lawsuit filed by Mississippi’s attorney general, Jim Hood, who claimed that homeowners’ policies should provide protection against water damage even though there are explicit clauses in the contract that excludes these losses.

State Farm also faced lawsuits in Mississippi contending that the company was responsible for covering flood losses from Hurricane Katrina for which it claimed it was not liable. Although State Farm eventually won its case, it was a costly process and led it to discontinue selling new policies on homes and small business in the state.24

In Louisiana, a group of thirty individuals and one corporation alleged that their real and personal property was damaged or destroyed by the inundation of water into the City of New Orleans that followed Hurricane Katrina. They brought a putative class action against thirteen insurance companies, asserting that their losses were covered by their respective insurance policies. The plaintiffs specifically alleged that “any damages attributable to the levee failures are the result of improper and/or negligent design, construction [or] maintenance of the levees by various third parties and or third party negligence,” and also alleged that “the damage caused by water entering the City of New Orleans … due to the breaches in the levees … neither falls within the subject insurance policies’ exclusions of ‘flood.”’ Several other water damage exclusion cases involving levee breaches were consolidated into the In re: Katrina Canal Breaches Consolidated Litigation in the U.S. District Court for the Eastern District of Louisiana.

In November 2006, the U.S. District Court for the Eastern District of Louisiana released an eighty-five-page ruling by Judge Stanwood Duval in several consolidated cases in which plaintiffs argued that flood damage “arising out of all levee breaches which occurred in the aftermath of Hurricane Katrina” should be covered, since such flooding is not specifically excluded in the policies. In contrast to the previous case, this judge cited “ambiguous language in the water damage exclusions in some policies” and denied insurers’ attempts to have the lawsuits dismissed.25 Indeed, the court held that the exclusion language in several of the policies was insufficiently clear with regard to damage caused by flooding that resulted from man-made causes. The case was in appeal for nine months; on August 2, 2007, the Fifth Circuit Court of Appeals overturned the lower district court’s decision in the In re: Katrina Canal Breaches Litigation. The court of appeals held the flood exclusions in the various policies were not ambiguous despite the fact they did not distinguish between flooding caused by an act of God and flooding caused by an act of man.26

Despite these rulings, litigation has not ended. Even with the federal court’s affirmation of the validity of flood exclusions in insurers’ policies, there are still disputes between insurers and claimants regarding the allocation of losses to the wind and flood perils. The (p.43) uncertainty associated with the courts’ ex post reinterpretation of insurance policy terms and language and the adjudication of claim disputes substantially increases insurers’ risk. The rates charged for homeowners’ insurance policies did not account for the payment of flood losses because of the flood exclusion. This places insurers in a difficult position. Being forced to pay for unanticipated flood losses will result in adverse financial consequences. If they file for rate increases to reflect this increased risk, they may not be approved. If rate increases are approved, insureds who have purchased a flood insurance policy through the NFIP will be paying for redundant coverage.

2.4 Financial Regulation

Regulators also are responsible for regulating insurers’ solvency and financial condition, including their level of catastrophe risk. Regulators are placed in a position of balancing solvency requirements with their desire to reduce the magnitude of rate increases and preserve the availability of insurance coverage. In markets subject to tight supply and high costs, regulators may sometimes tip the balance further in favor of improving “availability and affordability,” since this is the greatest and most immediate concern of consumer-voters.

This kind of regulatory trade-off is especially relevant to Florida given the market pressures it has faced. Beginning in the mid-1990s, Florida allowed start-up insurers to write a large block of exposures in high-risk areas. In fact, many of these start-up insurers drew a significant amount of their initial capital from payments they received for taking policies out of the residual market. There were also some existing small regional insurers that entered or expanded their writings in the Florida market to absorb the exposures shed by other insurers. These insurers can seek to purchase large amounts of reinsurance to bolster their capacity, but there may be limits to how much they can reduce their risk from writing large concentrations of high-risk exposures. Even the most generous catastrophe reinsurance contracts may still require the ceding insurers to retain a significant amount of risk at lower layers that can be supported only by surplus associated with a more diversified portfolio of exposures.

Fortunately, the lack of significant hurricane losses until 2004 enabled the start-ups to escape their “precarious” position if they chose to do so. They were allowed to drop the policies they took out of the residual market after three years. An analysis by Grace, Klein, and Liu (2006) indicated that a number of the start-ups substantially reduced their coastal exposures as they were able to do so and sought to increase their geographical diversification across the state to lessen their catastrophe risk. Certain other insurers appeared to exit the Florida market entirely. However, the data indicate that other Florida-concentrated insurers substantially increased their writings, which necessarily increased their exposures in high-risk areas.

(p.44) The diversification strategy appeared to work for those start-up insurers that employed it; none of these were bankrupted or even impaired as a result of the 2004–2005 storm seasons. However, five of the Florida insurers that retained or expanded their concentration of high-risk exposures were placed in receivership after the storms. One could advocate differing opinions on how stringent solvency regulation should be for insurers that are absorbing a large number of high-risk exposures. On the one hand, less stringent solvency regulation allows more companies to absorb high-risk exposures, which eases pressure on established insurers to retain these exposures. On the other hand, more lenient solvency requirements can result in insolvencies, with the associated costs passed on to solvent insurers and their policyholders.27 From a public policy perspective, allowing small or regionally concentrated insurers to underwrite an excessive number of high-risk exposures creates several problems, including moral hazard among overly exposed insurers, as well as diminishing their insureds’ incentives to better control their disaster risk.

While new or smaller regionally concentrated insurers can provide some relief, their capacity tends to be limited, and it is questionable whether they are positioned to safely absorb large concentrations of high-risk exposures. A more prudent strategy would encourage more national, geographically diversified insurers to each assume digestible shares of high-risk exposures at adequate rates. Florida appears to be relying primarily on the first strategy as forty new insurers (generally single-state or small regional companies) have been licensed to write property insurance in the state since 2006.

2.5 State Insurance Mechanisms

There are three types of state-run or state-sponsored insurance mechanisms: residual market mechanisms, state insurance or reinsurance funds, and guaranty associations. The administration of all three types of mechanisms can have significant implications for the functioning of insurance markets and the management of catastrophe risk. This chapter focuses primarily on residual market mechanisms, but the other mechanisms are discussed briefly. The discussion of residual markets starts with some general observations followed by a more detailed review of developments in the four states examined in this book.

Residual Market Mechanisms

General Observations

Although residual market mechanisms may be headed by nonregulators, legislators and insurance regulators effectively control much of what these mechanisms are allowed to do in terms of setting rates and other actions. The principal property insurance mechanisms are state insurance companies, windstorm and beach plans, and FAIR Plans.28 FAIR Plans, which operate in more than thirty states, provide full coverage for residential properties that are unable to secure coverage in the voluntary market. Florida has the Citizens Property Insurance Corporation, which also provides full coverage or wind coverage for residential (p.45) properties.29 Windstorm and beach plans exist in several coastal states and provide wind coverage only in certain designated high-risk coastal areas.

The administration and regulation of residual market facilities can have significant effects on property insurance markets, and vice versa. The important aspects of residual market administration include rates, eligibility requirements, available coverages, and coverage provisions. Suppressing or compressing residual market rate structures, lenient eligibility requirements, and generous coverage terms can cause significant problems. In turn, suppressing or compressing insurers’ rates can tighten the supply of insurance in the voluntary market and force more properties into the residual market.

One problem is the excessive growth of a facility’s exposures. It is not uncommon for these facilities to insure 1 to 2 percent of the residential properties in a state. At this level, the facilities are small enough that they do not impose a large burden on the voluntary market or create other problems. In this scenario, residual market mechanisms truly play the role of a market of last resort. They provide coverage to a small portion of property owners that are unable to secure coverage in the voluntary market.

However, when residual market mechanisms are substantially larger than this, they can impose a significant burden on the voluntary market and potentially lead to the infamous downward spiral in which they continue to grow and cause the voluntary market to implode. Residual markets can also function as a temporary safety valve in the event of supply shocks, but excessive regulatory constraints on the voluntary market or mismanagement of residual market mechanisms can create long-term problems.

A second problem caused by poor residual market policies is that it can have an artificial depressing effect on voluntary market prices: the residual market rates can effectively impose a ceiling on what private insurers can charge. Also, if availability problems are caused by regulatory constraints on the voluntary market, then at least part of the facility’s large book of exposures is artificially created. A third problem is that the residual market’s insureds’ incentives to lower their disaster risk can be diminished if they do not pay the full cost of the risk they incur. Fourth, a facility can experience financial shortfalls that are assessed back to voluntary market insurers and insureds. Additional short-term growth of residual market mechanisms may be unavoidable during periods of market instability and adjustment, but using them as a long-term source of coverage for a large number of properties can unnecessarily sustain problems in the voluntary and residual markets.

The regulation of the voluntary and residual markets can become self-reinforcing and lead to the snowballing effect characteristic of the downward spiral. As the residual market grows at inadequate rate levels, it imposes increasing assessments on a shrinking voluntary market, which causes the voluntary market to shrink even further. This kind of scenario is most common for auto and workers’ compensation residual markets, where the full results of regulatory mismanagement become manifest within a fairly short period of time. This would also be the case for the noncatastrophe component of property insurance voluntary and residual markets. However, the situation is different for the catastrophe risk component of these markets. The highly variable nature of catastrophic losses can enable regulators (p.46) to suppress residual market rates, but the effects of this policy can be delayed. The timing of voluntary market assessments will be tied to the timing of catastrophic losses. Hence, the assessments can come in chunks when hurricanes occur, which further contributes to the instability of property insurance markets subject to catastrophic loss shocks.

Florida’s Residual Market

Florida’s property insurance residual market mechanism, the Citizens Property Insurance Corporation, has experienced significant growth in recent years, with legislative changes in 2007 accelerating that growth. In concept, a residual mechanism should be an insurance source of last resort for property owners who cannot obtain insurance in the voluntary market. Florida’s legislation substantially departs from this concept. The significant changes fall into three categories: changes to Citizens’ ability to compete with the voluntary market, changes in Citizens’ rates, and changes in Citizens’ authority to make “emergency assessments” to cover funding shortfalls.

A number of legislative changes were made to expand the coverage offered by Citizens and allow it to compete with the voluntary market.30 Importantly, consumers are allowed to purchase a policy from Citizens if a comparable policy would cost 25 percent more in the voluntary market; this was reduced to 15 percent in 2008 legislation. Furthermore, the legislation rolled back Citizens’ rate increases that were to become effective at the beginning of 2007. Also, the legislation allowed Citizens to decrease rates further in 2007 and precluded it from raising rates until 2008. The 2008 legislation extends the freeze to 2009. The Citizens Property Insurance Corporation Mission Task Force has recently recommended a statewide average rate increase of 10 percent for Citizens that would be implemented in 2010. The Task Force also recommended that rates increase no more than 15 percent in any given territory, and no more than 20 percent for any given policy. The Florida Insurance Council noted that the recommended rate increase would be far less than that required to make Citizens’ rates actuarially sound (Best Wire 2009). Finally, Citizens’ assessment base was expanded from just property lines of insurance to include all lines of business except workers’ compensation, medical malpractice, accident and health, the national flood insurance program, and the federal crop insurance program.

Figures 2.1 to 2.2 plot the growth of the residual market in Florida over time for personal residential property and partially reflect the acceleration of its growth caused by the 2007 legislative changes. These figures show respectively the number of policies and the amount of insurance in force, for full-coverage and wind-only (also called high-risk) coverage. Prior to 2002, the residual market in Florida was administered by the Florida Residential Property and Casualty Joint Underwriting Association and the Florida Windstorm Underwriting Association. The latter provided only wind coverage on coastal homes in certain designated areas, while the former provided full coverage or transferred the wind risk to the wind pool in areas where it operated. In 2002, these two bodies were combined into the Citizens Property Insurance Corporation. Figure 2.3 shows the relative penetration of Citizens as a percentage of total statewide premiums. (p.47)

Catastrophe Risk and the Regulation of Property Insurance: A Comparative Analysis across States

Figure 2.1 Florida property insurance residual market: Number of policies: 1993–2007.

source: FRPCJUA, FWUA, PIPSO, CPIC

Catastrophe Risk and the Regulation of Property Insurance: A Comparative Analysis across States

Figure 2.2 Florida residual property insurance market exposure: 1993–2007.

source:FRPCJUA, FWUA, PIPSO, CPIC

(p.48)
Catastrophe Risk and the Regulation of Property Insurance: A Comparative Analysis across States

Figure 2.3 FAIR Plan penetration (percentage of total statewide premiums).

source: Data from Property Insurance Plans Service Office (PIPSO).

We can see that both parts of Florida’s residual market for property insurance have increased substantially over this time period. The number of full-coverage (labeled as “Other”) policies and the associated insurance in force skyrocketed after Hurricane Andrew and then fell from 1995 through 2000 as the start-up insurers took policies out of the facility and pressure on the voluntary market eased. This trend reversed in 2001 when the start-up companies shed policies (after their three-year requirement ended), followed by the storm seasons of 2004–2005 that reasserted greater pressure on the voluntary market. The number of wind-only policies increased until 1998 and then dropped and has essentially leveled out in the area of 400,000–450,000, but the amount of insurance (exposure) has steadily increased over the entire period.

As of December 31, 2008, Citizens had 629,467 Personal Lines Account (PLA) policies and 445,200 High Risk Account (HRA policies).31 There were 9,570 policies in its Commercial Lines Account (CLA). Its exposures (i.e., amount of insurance in force) as of March 31, 2007, (the latest date for which these data are available) were $156.4 billion for PLA policies, $192.1 billion for HRA policies, and $85.8 billion for CLA policies. The total number of CPIC policies has fallen from its high of 1.4 million in October 2007 to under 1.1 million in December 2008, but much of this decline appears to have been achieved through a depopulation scheme discussed below. Figure 2.3 also reveals that Citizens’ market share (based on premiums) increased from 11.5 percent to 18.3 percent from (p.49) 2002 to 2006.32 Its relative market share is presumably much higher at the time of the writing of this chapter. For purposes of comparison, we also calculated and show the residual market shares in New York and Texas, which have been much smaller than in Florida.

Florida has sought to reverse the tremendous growth of its residual market with an ambitious takeout plan. Based on current information available from FLOIR’s website, it has identified ten insurers that have committed to remove more than 637,000 policies from Citizens.33 The companies vary in size with surplus amounts ranging from $9.5 million to $59.6 million. The consent order issued by the FLOIR for each insurer indicates that the FLOIR will review each company’s reinsurance program, catastrophe modeling, and financial statement projections in determining how many policies it will be allowed to remove from Citizens.34

These actions appear to have temporarily reversed Citizens’ growth, but it is not clear that this will prove to be a sustainable strategy. The takeout companies are predominantly small, regional, or single-state companies with limited geographic diversification. Hence, there is a question as to whether they will be able assume substantial amounts of coastal exposures and preserve their financial viability. These insurers can bolster their surplus with reinsurance, but there are limits to how much reinsurance they can purchase. If the FLOIR imposes stringent catastrophe risk management requirements, this could limit the actual number of policies and exposures removed from Citizens. If the FLOIR imposes less stringent requirements, it could permit more takeouts, but there will be greater questions about the financial viability of the takeout companies.

A question related to the size of the residual market is how its share of property exposures differs in various parts of the state. We would expect availability to be tighter and the residual market relatively larger in the highest risk areas. This is demonstrated in table 2.3

Table 2.3 Citizens Property Insurance Corporation personal residential and high-risk statistics: 2003 and 2008

December 31, 2008

December 31, 2003

Policies

% total

Exposures

% total

Policies

%total

Exposures

%total

Personal-residential total

Dade, Broward, Palm

207,532

32.9

51,496,947,952

41.1

239,461

62.5

40,635,887,869

80.3

Beach, and Monroe

Rest of state

421,935

67.1

74,629,643,333

53.9

143,819

37.5

19,390,910,445

38.3

Total

623,467

100.0

126,126,591,285

100.0

383,280

100.0

50,586,798,314

100.0

High-risk: wind only

Dade, Broward, Palm

216,021

57.3

122,900,165,308

56.8

276,067

63.7

68,286,388,540

63.5

Beach, and Monroe

Rest of state

161,065

42.7

93,283,216,697

43.2

156,989

36.3

39,328,420,045

36.5

Total

377,086

100.0

216,183,382,006

100.0

433,056

100.0

107,614,808,585

100.0

source: CPIC.

, (p.50) which shows Citizens’ policies and exposures for personal residential and high-risk policies for Dade, Broward, Palm Beach, and Monroe (DBPM) counties (combined) and the remainder of the state for 2003 and 2008.

We can see from table 2.3 that the number of policies and amount of exposures insured by Citizens in its personal-residential account increased from 2003 to 2008 in the DBPM counties but decreased relative to its percentage of total policies and exposures. The same is the case for high-risk exposures. Still, these counties continue to account for a large share of the policies it insures.

This leads to several observations and comments. One would expect a certain increase in the number of policies and the amount of insurance or exposures resulting from the construction of more homes, as well as increases in policy limits. However, Citizens’ growth is exceeding that of the voluntary market, indicating that it is writing a growing share of all property exposures in the state. It appears that the 2007 legislative changes to Citizens (perhaps coupled with tightening constraints on private insurers) contributed to its growth. Between the end of 2006 and October 31, 2007, Citizens’ personal residential policies increased from 743,592 to 944,719—a 27 percent increase in just nine months. During this same period, the number of its high-risk policies increased from 403,509 to 427,586.

What is most striking is Citizens’ growth in other areas of the state beyond the DBPM counties. It appears that prior to the 2004 and 2005 storm seasons, other coastal areas were not as great a concern to insurers as southern Florida was. This perception appears to have changed significantly after 2003. Hence, other coastal areas experienced a greater change in terms of insurers’ adjustment of their exposures—an adjustment that Dade, Broward, Palm Beach, and Monroe had already experienced prior to 2004. This probably reflects insurers’ recognition that the other coastal areas faced a much higher level of hurricane risk than they had previously assumed. Of course, the vulnerability of other coastal areas was demonstrated by the path of several hurricanes in 2004 and Hurricanes Katrina and Rita in 2005. Hence, these other coastal areas apparently suffered a greater decrease in the availability of coverage than southern Florida did. Another likely factor contributing to Citizens’ growth, especially outside the southern part of the state, is its transformation into a competitive source of insurance.

As a result of its substantial claims obligations arising from the 2004–2005 storm seasons, Citizens incurred large funding shortfalls: $1.6 billion for 2004 and over $2 billion in 2005. The 2004 shortfall resulted in a 6.8 percent surcharge on all homeowners’ premiums in the state (recoupment against all other insurers in the state, which then passed all or a portion of it to their policyholders). The Florida legislature appropriated $715 million in 2006 to reduce Citizens’ assessments needed to cover its 2005 deficit. The remainder of the deficit will be collected over a ten-year period in “emergency assessments” on premiums written statewide that will be passed on as surcharges to policyholders. As noted above, most lines written by property-casualty insurers are now subject to assessments. The premium (p.51) surcharge in 2007 was 2.5 percent, and surcharges in subsequent years are expected to be approximately 1.5 percent.

Residual Mechanisms in Other States

The landscape for residual markets in other target states has been shifting, although not to the degree that has occurred in Florida. It is important to note certain structural changes that occurred in Texas and Louisiana. Texas has had a wind pool for a long time, but it created a FAIR Plan only in 2003. Louisiana combined its FAIR Plan and wind pool in 2004 in a new entity, the Louisiana Citizens Property Insurance Corporation, that is structurally similar to Florida’s Citizens. Table 2.4 provides data on the number of habitational policies and total exposures for all state FAIR Plans for 1992, 2003, and 2006. Between 1992 and 2006, the number of policies in the state FAIR Plans throughout the country increased by 177 percent and their exposures increased by 722 percent. Table 2.5 provides comparable information for state wind pools.

Texas

Prior to 2003, Texas had relied on a unique system to deal with property insurance availability problems. Instead of using a FAIR Plan, it permitted the existence of an “unregulated” (or less regulated) property insurance market alongside a “regulated” insurance market. In the unregulated market populated by Texas Lloyds companies, insurers were allowed greater pricing freedom than in the regulated market. The unregulated market was intended to function as the market of last resort for property owners who could not obtain full coverage through the regulated insurance market. At the same time, the Texas Windstorm Association functioned like a conventional wind and beach pool, offer-ing wind coverage in designated high-risk areas.

In the early 2000s, Texas suffered from property insurance availability problems due primarily to issues related to mold claims and other non-hurricane perils. This caused the movement of a large number of property owners from the regulated to the unregulated market. These owners experienced a significant increase in their premiums because prices were much higher in the unregulated market. The resulting consumer dissatisfaction and public concerns prompted Texas to establish a FAIR Plan that would be subject to greater government control than the unregulated market. As can be seen from table 2.4, the Texas FAIR Plan accumulated 120,536 policies by the end of 2003, with the number dropping to 109,461 policies by the end of 2006. The size of the plan has been relatively small compared to the total state market, with its market share based on premiums of only 0.7 percent at the end of 2006. This small percentage of homeowners’ policies in the Texas FAIR Plan is likely the result of the ability of insurers to adjust their rates and manage their exposure to mold claims.

The Texas wind pool essentially doubled from 1992 to 2003, from 51,638 policies to 106,273 policies, then remained at that level through 2005 and increased to 140,375 policies in 2006 (table 2.5). The pool has remained a relatively small but growing portion of (p.52)

Table 2.4 State FAIR Plans: Habitational policies and exposures, 1992, 2003, and 2006

2006

2003

1992

Policies

Exposures ($000s)

Policies

Exposures ($000s)

Policies

Exposures

State

Number

Percent change

Amount

Percent change

Number

Percent change

Amount

Percent change

($000s)

California

193,615

2.2

50,577,001

25.1

189,486

63.7

40,423,805

114.3

115,767

18,866,588

Connecticut

4,682

26.6

768,728

57.1

3,698

−38.2

489,282

NA

5,985

754,943

Delaware

2,963

10.9

295,795

48.6

2,671

43.3

199,015

159.5

1,864

76,679

Florida*

1,409,587

267.8

408,837,779

575.0

383,280

160.2

60,566,798

562.8

147,315

9,137,395

Georgia

28,167

−3.4

3,114,897

19.6

29,165

160.8

2,605,112

291.0

11,181

666,322

Illinois

9,970

−33.8

769,000

−27.8

15,068

−6.2

1,065,549

69.1

16,069

630,297

Indiana

3,633

−25.8

300,953

−20.9

4,898

60.2

380,278

324.1

3,058

89,662

Iowa

1,425

1.6

97,079

−18.7

1,403

29.5

119,403

335.6

1,083

27,414

Kansas

9,659

83.9

416,676

71.1

5,252

−1.0

243,511

90.2

5,303

128,062

Kentucky

14,040

15.4

141,533

12.9

12,163

−67.9

125,332

−49.8

37,857

249,756

Louisiana*

NA

NA

NA

NA

118,514

2753.0

9,819,994

5604.9

4,154

172,132

Massachusetts

216,074

87.6

68,607,352

156.7

115,185

124.1

26,725,429

442.1

51,403

4,929,965

Michigan

73,952

−30.0

10,186,674

−44.9

105,610

−42.1

18,493,317

−18.2

182,287

22,611,624

Minnesota

8,600

−41.5

1,839,520

39.7

14,712

NA

1,316,637

NA

4,104

152,970

Mississippi

12,080

NA

661,360

NA

NA

NA

NA

NA

NA

NA

Missouri

8,928

−10.2

421,162

−3.6

9,945

−51.5

436,721

16.1

20,520

376,084

New Jersey

41,974

−19.9

5,440,130

−6.2

52,405

4.8

5,796,676

56.9

49,981

3,694,897

New Mexico

12,687

6.7

671,920

22.3

11,894

−1.0

549,451

−45.6

12,014

1,010,068

New York

60,797

−7.3

12,927,080

27.7

65,603

0.0

10,119,750

86.8

65,617

5,417,273

Ohio

59,983

−13.2

11,309,456

−15.4

69,088

327.9

13,374,287

4551.7

16,145

287,511

Oregon

4,225

−27.0

322,196

−26.8

5,785

−17.8

439,967

49.9

7,034

293,527

Pennsylvania

37,386

−17.7

2,079,026

1.4

45,443

−39.1

2,050,500

−19.0

74,657

2,530,159

Rhode Island

21,708

66.1

4,728,942

816.8

13,067

103.1

515,815

18.3

6,433

435,878

Texas

109,461

−9.2

13,320,285

12.2

120,536

NA

11,871,417

NA

NA

NA

Virginia

37,058

27.9

3,944,094

41.3

28,984

105.6

2,790,798

428.4

14,098

528,169

Washington

90

−39.2

33,346

−33.7

148

−79.1

50,291

−23.0

709

65,288

West Virginia

1,364

3.3

50,392

16.8

1,320

−16.1

43,129

22.9

1,574

35,102

Wisconsin

5,191

−12.9

NA

NA

5,959

12.2

NA

NA

5,313

NA

Total

2,389,299

66.9

601,859,916

185.8

1,431,282

66.1

210,612,264

187.8

861,525

73,167,765

(*) Florida figures reflect all policies for 2006; full-coverage policies for previous years. Louisiana figures include both “FAIR Plan” policies and “Coastal” policies.

source: Insurance Information Institute, CPIC, and LCPIC.

(p.53)

Table 2.5 State wind/beach pools, 1992, 2003, and 2006

2006

2003

1992

Policies

Exposures ($000s)

Policies

Exposures ($000s)

Policies

Exposures

State

Number

Percent change

Amount

Percent change

Number

Percent change

Amount

Percent change

Number

($000s)

Alabama

NA

NA

NA

NA

3,065

5.5

339,858

80.3

2,904

188,513

Florida

NA

NA

NA

NA

433,056

609.1

107,614,809

1336.3

61,074

7,492,298

Louisiana

NA

NA

NA

NA

8,881

27.2

481,890

163.1

6,984

183,159

Mississippi

28,880

122.9

5,369,509

485.0

12,955

164.9

917,935

198.7

4,891

307,315

South Carolina

27,082

52.4

11,179,099

179.9

17,776

114.0

3,993,548

211.9

8,306

1,280,331

Texas

140,375

32.1

38,313,022

220.0

106,273

105.8

11,972,502

119.4

51,638

5,455,790

Total

NA

NA

NA

NA

582,006

328.6

125,320,542

740.7

135,797

14,907,406

source: Insurance Information Institute, PIPSO.

(p.54) the total state market, increasing from 1.08 percent in 2003 to 1.63 percent in 2006. The pre-2003 growth was likely the result of coastal development in Texas coupled with the general tightening of the supply of property insurance in coastal areas. Its more recent growth is likely the result of insurer retrenchment following the 2005 storm season exacerbated by regulatory resistance to rate increases.

South Carolina and New York

Both South Carolina and New York have experienced some increased market pressure in their coastal areas, but this pressure is considerably less than what Florida and other Gulf Coast states have experienced. South Carolina has a wind pool but not a FAIR Plan, and New York has a FAIR Plan but not a wind pool.

The South Carolina Wind and Hail Underwriting Association, the official name of its wind pool, has continued to grow over time because of increased coastal development and increasing hurricane risk. It wrote 27,802 policies and $11.2 billion exposures in 2006. Still, its market share has remained low, ranging from 0.34 percent to 0.62 percent over the 2001–2006 period. This reflects the small size of South Carolina’s coastal market in relation to the total state market.

The South Carolina Department of Insurance has reported increasing problems with the availability of property insurance in coastal areas.35 As noted above, this is a fairly localized problem for South Carolina, as coastal properties represent a relatively small portion of the total property exposures in the state. Still, coastal availability problems prompted the state to expand the areas covered by the wind pool effective June 1, 2007, and to revamp the pool’s rating structure to accommodate the changes.

It is more difficult to assess how much hurricane risk has affected New York’s FAIR Plan, if at all, based on publicly available information. The size of its FAIR Plan has remained fairly steady and relatively low over the years and is probably driven more by urban insurance availability issues than coastal insurance problems. It wrote 60,797 policies and just over $12.9 billion in exposures in 2006. In relative terms, the market share of the FAIR Plan remained less than 1 percent during the 2001–2006 period.

There has been discussion of creating a New York wind pool, but apparently coastal insurance availability issues have not been significant enough to compel the legislature to create such an entity. There have been reports of some insurers reducing their exposures in New York coastal areas, but no evidence of widespread and substantial cutbacks.

State Insurance Funds

Two states, California and Florida, have special insurance funds designed to bolster the supply of catastrophe coverage. As discussed, the California Earthquake Authority (CEA) provides earthquake coverage at a primary level to property owners in California. The Florida Hurricane Catastrophe Fund (FHCF) provides catastrophe reinsurance to primary insurers underwriting property coverage in the state. Both mechanisms were created in response to major crises in the supply of insurance that occurred after severe disasters. (p.55) The CEA was established following the Northridge earthquake, and the FHCF was established after Hurricane Andrew.

A discussion of the arguments for and against state insurance and reinsurance funds is beyond the scope of this chapter, but the perspectives can be summarized briefly. Proponents of the FHCF contend that it helps to fill a gap in private reinsurance capacity or provides reinsurance at a lower cost (or both). Indeed, the FHCF was established with the support of major insurers in the state. It should be noted that the FHCF can accumulate tax-favored reserves (an option not available to U.S. insurers and reinsurers) and can also access credit supported by local bonding authorities. This inherently reduces its costs relative to private reinsurers, but also invites political manipulation of its rate structure.

Opponents of mechanisms like the FHCF question the need to augment private reinsurance, raise concerns about crowding out private reinsurance, and cite the potential for financial shortfalls that can lead to assessments on insurers/consumers or taxpayers (or all of these depending on how the mechanism is designed. Indeed, the FHCF did need assistance to cover its losses from the 2004 and 2005 hurricane seasons, and insurers have grave concerns about 2007 legislative changes to the FHCF that increase the amount of coverage that it provides.

Under its mandatory coverage program, the FHCF will reimburse a fixed percentage of a participating insurer’s losses from each “covered event” in excess of a per event retention and subject to a maximum aggregate limit for all events. The fixed percentage can be 45 percent, 75 percent, or 90 percent at the option of the insurer. (See chapter 13 for a more detailed analysis of the operation of the FHCF.) The event retentions and limits vary by insurer according to a formula based on FHCF premiums. There is also an optional coverage below mandatory program that provides more limited coverage to certain eligible companies. The cost of FHCF coverage to a participating insurer is based on its estimated share of the FHCF’s expected losses and expenses.

An important provision limits the FHCF’s obligation to pay losses to the sum of its assets and borrowing capacity. This was initially set at $11 billion, increased to $15 billion in 2004, and increased to $27 billion in 2007 for a “temporary” period of three years. If the FHCF losses exceed its total funding capacity, each insurer would be reimbursed on a pro-rata basis from the funds available according to its share of the premiums paid into the fund for that contract year.

The FHCF is funded by premiums paid by participating insurers and investment income on invested reserves. It also can borrow funds up to a specified limit and impose emergency assessments on other property-casualty insurance premiums in the state if necessary to repay debt. The emergency assessments apply to all property-casualty and surplus lines insurers for all lines except workers’ compensation, accident and health, medical malpractice, and national flood insurance premiums. These assessments are limited to 6 percent for a single contract year but can rise to 10 percent depending on “unused assessments” in prior contract years.

(p.56) The 2004 and 2005 storm seasons required the FHCF to make payments to insureds that tapped and reduced its financial reserves. As of December 31, 2006, it had paid $3.678 billion for losses arising from the 2004 hurricanes and $3.6 billion for losses arising from the 2005 hurricanes. The ultimate estimated payment obligations are $3.95 billion for 2004 and $4.5 billion for 2005 (based on its audited financial statement for year-end June 30, 2007). These loss payouts led to a funding shortfall that prompted FHCF to issue $1.35 billion in revenue bonds to cover the shortfall and $2.8 billion in pre-event notes to provide liquidity for the 2006 storm season.36 The bonds will be repaid from a 1 percent emergency assessment for six years on all policies renewed after January 1, 2007.

With the coverage expansion authorized by the 2007 Florida legislature, there are concerns that significant hurricane losses could lead to more emergency assessments on all applicable insurance premiums written in the state (recoupment). (See chapter 13 for an analysis of FHCF’s exposure to different scenarios of hurricane.)

Guaranty Associations

All states have an insolvency guaranty association (GA) that is intended to cover the claims obligations of insolvent insurers. A state’s GA is important because it could experience severe stress if one or more insurers with substantial claims obligations became insolvent because of a catastrophe. Many state GAs face some catastrophe risk, but Florida’s experience is particularly noteworthy. The Florida Insurance Guaranty Association’s (FIGA) funding capacity is supported by assessments on property-casualty insurance premiums in the state that are limited to 2 percent annually. Hurricane Andrew resulted in eleven insolvencies, and the corresponding demands on the guaranty fund exceeded its capacity. The guaranty association was forced to fully exercise its 2 percent assessment authority, and the legislature authorized it to assess an additional 2 percent to repay funds borrowed to cover its capacity shortfall. The association ultimately paid off its debts in 1997.

FIGA has been covering the claims obligations of the Poe Group insurers, which became insolvent after the 2005 hurricanes, and Vanguard, which was placed in receivership in 2005. This has prompted it to exercise its full 2 percent assessment authority to cover its costs for these claims obligations; another 2 percent emergency surcharge was approved in October 2007. In its most recent statements, FIGA reported that it is responsible for handling approximately 46,162 Poe claims with a total cost of $988 million. Both figures were FIGA records and exceeded the number and cost of claims arising from the Hurricane Andrew insolvencies. FIGA has not yet published any information on claims obligations for Vanguard, which was placed into liquidation on March 27, 2007.

The experience from Hurricane Andrew in 1992 and the 2004 and 2005 storm seasons reflects the GA’s vulnerability to catastrophes and the potential pass-through of insolvent insurers’ obligations and risk to other insurers. This risk is increased by the financial vulnerability (p.57) of small Florida insurers with large concentrations of exposures in the state that are not offset by geographical diversification in other parts of the country.

Hence, insurers with significant premium writings in the state, even in lower-risk areas and lines of business, retain a secondary exposure to catastrophe losses through their potential obligations to the guaranty fund. Insurers are often allowed to add rate surcharges (extending the burden to policyholders) to cover their GA assessments, but for economic reasons, the burden is effectively shared between insurers and policyholders. Furthermore, there is the potential for externalizing some losses to other states, as each state GA is responsible for covering the claims obligations of an insolvent insurer in its jurisdiction, even if the insurer is domiciled in another state. In other words, in the case of the insolvency of a multistate insurer, insolvency costs caused by the regulators in one state can be transferred to other states because of the insolvent insurer’s unpaid claims obligations in those states that will be covered by their respective GAs (ultimately insurers, policyholders, and taxpayers). Taxpayers also pay a portion of an insolvent insurer’s claims obligations, as insurers are allowed to deduct guaranty fund assessments from their federal income taxes. These issues involving catastrophe risk and GAs are not confined to Florida but apply to any state where catastrophic losses could cause insurers to fail.

2.6 Conclusion

The severe storm seasons of 2004–2005 and insurers’ resulting reassessment of hurricane risk and related actions (e.g., raising rates, reducing their exposures) have prompted regulatory reactions in various states. Market pressures and regulatory policies vary among these states. Florida, which faces the greatest risk, has employed regulatory policies that have significantly interfered with market forces. The other states have tended to be more permissive in terms of allowing market adjustments, but they may tighten their rate regulation and other restrictions if market conditions do not improve. Florida’s actions will likely expose insurance policyholders and taxpayers in the state to significant financial assessments should the state be struck by more hurricanes in the near future. To date, other states have not followed Florida’s course. Florida needs to reevaluate the economic soundness of its current policies, but this reappraisal may not occur until the state experiences another severe hurricane.

The story of catastrophe risk and insurance regulation continues to be written. States that are successful in supporting private insurance markets and other beneficial policies such as mitigation to deal with the hurricane risk may be able to avoid major market dislocations and provide a reasonable supply of catastrophe insurance coverage. Continued research is important to strengthen our understanding of the drivers and effects of government policies and how public action can support the efficient management of catastrophe risk.

(p.58) Summary

This chapter examines the regulation of property insurance markets affected by catastrophes, particularly the risk of hurricanes and tropical storms. The severe storm seasons of 2004–2005 and insurers’ resulting reassessment of the hurricane risk in coastal areas have raised a number of issues and a range of regulatory reactions in various states.

This chapter also reviews and assesses the areas of regulation that affect insurance markets, with a focus on the four states studied in depth: Florida, New York, South Carolina, and Texas. Market pressures and regulatory policies vary among these states. Florida faces the greatest hurricane risk, and its regulatory policies have interfered with market forces to the greatest extent. The other states have tended to be more permissive in terms of allowing market adjustments, but there is a chance that some may tighten their regulation if rates continue to rise and the supply of insurance is further reduced.

Notes:

(1.) This chapter is drawn from a more detailed analysis of market conditions in coastal states by Grace and Klein (2007).

(2.) The McCarran-Ferguson Act (enacted in 1945) still serves as the principal federal statute that establishes the framework for state and federal roles in regulating insurance. The act delegates most of the regulatory authority to the states but also retains the authority of the federal government to supersede state regulation where it specifically chooses to do so. Over the years, the federal government has imposed laws and policies in certain areas and could do so in the future. Legislation to create an optional federal regulatory charter for insurers has been introduced but not enacted. Other legislation has been introduced to establish a federal reinsurance program for natural catastrophes, and related bills and proposals have been introduced or discussed.

(3.) Grace and Klein (2007) documents insurer withdrawals from Florida.

(4.) One example is the Florida legislature’s enactment of a moratorium on policy terminations following Hurricane Andrew.

(5.) Klein (1995).

(6.) Surplus lines or nonadmitted insurers typically are not licensed in the states in which they write business and are subject to less regulation than licensed insurers. Regulators permit surplus lines insurers to underwrite certain insurance coverages or risks for which the supply of coverage from licensed insurers is deemed to be inadequate.

(p.371) (7.) U.S. regulators are considering changes to this policy that would reduce collateral requirements for foreign reinsurers based on some system of grading the financial condition of the foreign reinsurer or the quality of its regulation. See Klein and Wang (2007). Recently New York and Florida proposed to revise the collateral requirements they impose on non-U.S. reinsurers.

(8.) Researchers have sought to measure regulatory stringency and its effects in different ways. This research suggests that greater stringency may have some effect on the net price of insurance, at least in the short term, or other effects that tend to have negative impacts on consumers.

(9.) In theory, insurers might seek to charge higher rates to low-risk insureds to partially or completely offset the effect of constraints on rates for high-risk insureds.

(10.) Technically the change in an insurer’s overall rate level is calculated as the exposure-weighted average of the changes in the rates for each rate classification.

(11.) For example, one proxy used is the difference between the rate levels that insurers have filed versus the rate levels that regulators have approved. Another proxy has been survey-based insurer ratings of the regulatory environment in various states. Both measures are imperfect, but some studies have revealed fairly robust results when different stringency measures are tested. See Klein, Phillips, and Shiu (2002).

(12.) This might be labeled as the sticker-shock effect. In normal markets, rate increases less than 10 percent tend not to encounter significant resistance. In markets hit by a major hurricane, consumer and regulatory tolerance may even be somewhat greater. However, there is a limit to this tolerance even in markets that are subject to high hurricane risk.

(13.) Grace, Klein, and Kleindorfer (2004).

(14.) Earlier in 2006, Allstate Floridian received a rate increase of 16.3 percent, and Allstate Floridian Indemnity received a rate increase of 24.4 percent.

(15.) In August 2008, Allstate reached a settlement with the FLOIR on disputes regarding its pricing and underwriting. Under the terms of the settlement, Allstate agreed to lower its rates 5.6 percent, write 100,000 additional policies over the next three years, and pay a $5 million fine.

(16.) South Carolina Department of Insurance (2007).

(17.) Proponents of government catastrophe reinsurance might contend that such programs would help to lower and stabilize rates, but insurers’ views on the need for such programs differ, and this book does not attempt to resolve this debate.

(18.) “Fla. Subpoenas State Farm over Nonrenewal Plans” (2007).

(19.) “N.Y. Stops Insurers from Tie-Ins for Coastal Customers” (2007).

(20.) As an element of comparison, the federal National Flood Insurance Program, which covers homeowners against flood, has a maximum $5,000 deductible, independent of the level of coverage (see our analysis of homeowners’ choice of flood deductible in chapter 4).

(21.) There is an understanding between private insurers and the federal government that the NFIP should be the source of flood coverage up to the limits provided by the program. Private insurers then may sell excess flood coverage over the NFIP limits.

(22.) There has been some criticism of the adequacy of federal flood mapping.

(23.) Buente v. Allstate. Civil Action No. 1:05CV712 LTS-JMR L.T. Senter, Jr., Senior Judge, April 11, (2006).

(24.) Treaster (2007).

(25.) In Re Katrina Canal Breaches Consolidated Litigation, No. 05-4182 (E.D. La. Nov. 27, 2006).

(26.) Property Casualty Insurers Association of America (PCIAA); Lehman Brothers Equity Research; Insurance Information Institute.

(27.) Some established insurers may still find this preferable if insolvency costs are spread broadly across all insurers and other lines. Also, state and federal laws allow insurers to recover at least some of their guaranty association assessments through rate surcharges or tax credits or deductions.

(28.) FAIR is the acronym for Fair Access to Insurance Requirements.

(29.) Louisiana established a similar mechanism in 2004.

(30.) Milliman (2007).

(p.372) (31.) Information obtained from CPIC’s Web site at http://www.citizensfla.com.

(32.) These data are somewhat imprecise in that they reflect Citizens’ percentage of all property insurance premiums in the state. Also, the Florida data reflect only the residential property JUA in 2001 and Citizens’ market share, 2002–2005, based on all of its premiums, including those for high-risk policies previously insured by the Florida wind pool.

(33.) Information on FLOIR’s takeout plan can be accessed at http://www.floir.com/TakeoutCompanies.aspx.

(34.) In the matter of Citizens Property Insurance Corporation, Case No. 94539-08, Order Approving CPIC’s Personal Residential and Commercial Residential Non-bonus Takeout Plans, http://www.floir.com/pdf/Executed_Order.pdf (July 24, 2008).

(35.) South Carolina Department of Insurance (2007).

(36.) Florida Hurricane Catastrophe Fund (2007).