The Politics of Hurricane Insurance

MP McQueen has a front-page WSJ article today attacking property insurers for, um, well, it’s not entirely clear what they’re supposed to have done wrong. Apparently they use something called "computerized catastrophe modeling":

Crafted by several independent firms and used by most insurers, so-called cat models rely on complex data to estimate probable losses from hurricanes.

But regulators and other critics contend that the latest cat models — which include assumptions about various climate changes — are triggering higher insurance rates.

Does that language seem weird to you? The word "contend" implies that there’s something contentious here, but there’s no disagreement over the fact that insurance rates are rising, and that cat models help to set those rates.

Clearly, coastal homeowners and insurance regulators are unhappy about the rising rates. But the rising rates come as a result of a perfectly sensible decision: instead of basing their insurance premia solely on what happened in the past, insurance companies are now worrying much more about the future. This isn’t just a global-warming issue, either, although that’s part of it. It’s also a function of the fact that coastal areas have more homes and bigger homes than they ever did in the past, and that the cost of replacing or rebuilding those homes has also been rising stratospherically. If a hurricane ever hit a rich and heavily-populated part of the Atlantic seaboard, the total cost to the insurance industry could be orders of magnitude greater than the cost of Hurricane Katrina.

It’s true that insurers have been making healthy profits for the past few years. But that’s exactly what they’re meant to do: if they don’t make profits when there isn’t a catastrophe, they can’t pay out when there is one. But McQueen concentrates on the climate science, not the expected losses:

That sea-surface temperatures are rising is no longer much in dispute. There is also near-consensus that rising temperatures are linked to greater hurricane activity. However, scientists remain divided over how that may affect the number and intensity of hurricanes making landfall in the coastal U.S. A few climate experts believe global warming might actually cause fewer hurricanes to come ashore on the East Coast.

"No longer much in dispute"? Was it in dispute before? Is it still in dispute now, but not "much"? This kind of language implies more disagreement than there is on simple empirical data like sea-surface temperatures. And the teaser about the "climate experts" who think there might be fewer hurricanes in future is never resolved in the rest of the article: I kept on waiting for one of these experts to be named, or for some explanation of how this might possibly be true, but it never came. In any case, there’s no indication whatsoever that it’s in any way unreasonable for the insurers to embrace the scientific consensus rather than the handful of seemingly anonymous skeptics.

Then comes the "to be sure" paragraph, a clear signal that the author isn’t buying what the insurance industry is selling. In this case, that impression is reinforced by the fact that the models are described as "controversial":

To be sure, insurers themselves are facing higher rates from the reinsurance companies that backstop their claims. The reinsurers, and the financial ratings agencies that assess the health of carriers, are also using the controversial newer models.

So it’s not only the insurers. It’s also the reinsurers, and the ratings agencies. Aren’t we in the middle of watching the chaos which happens to the insurance industry when the financial-strength requirements of the ratings agencies aren’t stringent enough? Is McQueen really suggesting that they should stop using the best models available to them, just because those models result in higher insurance premia?

It would seem so. The arguments seem very backward-looking and blinkered:

State insurance regulators and consumer groups are beginning to push back, saying that some insurers are relying too heavily on their use of cat models. Such critics note that the industry managed to realize huge profits in recent years — despite record damages from back-to-back hurricanes in 2004 and 2005…

In May, Massachusetts officials denied a 25% rate increase that had been sought by the state-administered FAIR plan, its insurer of last resort. The request was "based in large part on a hurricane model that is not calibrated for Massachusetts weather patterns," state Attorney General Martha Coakley said in a statement. It "predicts the type of storms that have never made landfall in Massachusetts."

The lesson of 2004 and 2005 was not that insurers could make money even when hurricanes hit; it was that the insurance industry was very lucky that hurricanes hit poor areas rather than rich ones. As for the idea that a big hurricane has never made landfall in Massachusetts, is Coakley willing to backstop any insurance policy for a hurricane of unprecedented size doing just that? If insurers only needed to insure against the events which happened in the past, their life would be much easier. And while it might be true that no big hurricanes have made landfall in Massachusetts, the 1938 "Long Island Express" is a pretty good indication of what can happen that far north.

Coakley’s statement is also indicative of the parochialism which plagues the US insurance industry, which is regulated on a state-by-state basis rather than nationally. As a result, hurricane-prone states like Florida are in a pretty untenable position, while states further north on the Atlantic coast try desperately to delude themselves that because there haven’t been devastating hurricanes in the past, there can’t be any in the future.

My main problem with McQueen’s piece is that it implies the current insurance industry models are unscientific, without ever quite coming out and saying so.

The newer models have caused other skirmishes. Industry officials note that some models now attempt to estimate future losses over a shorter period of time. In doing so, they may also use selective historical data. One model, for example, was reprogrammed to give greater weight to years in which ocean temperatures were particularly warm and hurricane rates were high, such as the period from 1930 to 1945. That particular model resulted in higher loss estimates for the near-term.

J. Robert Hunter, insurance director for the Consumer Federation of America, says that the organization generally supports cat models, but only when they’re used in scientific ways. The longer-term models, he says, ensured "stable pricing so that no hurricanes would not lower prices much and multiple hurricanes would not raise prices much."

Doesn’t it make sense that if you want to model hurricane probabilities in the present, you should give extra weight to periods in the past when initial conditions were most similar to where they are now? And doesn’t it seem that Hunter’s conception of a "scientific" use of cat models is just one which results in "stable pricing"? That’s something more commonly known as assuming your conclusions.

To judge by this article, the response of regulators to the newest cat models is not to ensure that they’re as accurate as possible, but rather to simply ban them outright – something which simply can’t be helpful in the long term, especially since the reinsurers and ratings agencies are going to keep on using them regardless. I’m no fan of the property insurers generally: I think their behavior in the wake of Hurricane Katrina, when they started saying that everything was water damage and nothing was wind damage, was very low. But they do clearly operate under an enormous amount of political risk, and their incentives to simply get out of the Atlantic seaboard states altogether are very high. If regulators don’t work more constructively with the insurers, they risk ending up with no insurers at all.

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