Insurance Journal began posting the testimony I gave on insurance scoring (5/21/2008) last week here. The comments posted by viewers are "funny." Some of the less-informed comments appear to come from insurance agents (CIC, etc). It is interesting that agent compensation comes primarily from premium volume, not underwriting results. I wonder if this affects their opinions. IJ and Mynewmarkets.com are posting the testimony in 4 or 5 parts.
We normally think of Cats as step function events--everything is fine then a disaster occurs. However, is it possible to manage the death by 1000 cuts type of Cat? This would be one where each individual event is not that big, but at the end of the" day" a Cat has occurred. This paper suggests that it is possible to manage these types of risks.
"Improving Humanitarian Response to Slow-Onset Disasters Using Famine Indexed Weather Derivatives"
Agricultural Finance Review, Forthcoming
SOMMARAT CHANTARAT, Cornell University - Department of Economics
Email: sc384@cornell.edu
CALUM G. TURVEY, Cornell University - Department of Applied Economics and Management
Email: cgt6@cornell.edu
ANDREW G. MUDE, Cornell University - Department of Economics
Email: agm26@cornell.edu
CHRISTOPHER B. BARRETT, Cornell University - Department of Applied Economics and Management
Email: cbb2@cornell.edu
This paper illustrates how weather derivatives indexed to forecasts of famine can be designed and used by operational agencies and donors to facilitate timely and reliable financing for effective emergency response to climate-based, slow-onset disasters such as drought. We provide a general framework for derivative contracts, especially in the context of index insurance and famine catastrophe bonds, and show how they can be used to complement existing tools and facilities in drought risk financing through a risk layering strategy. We use the case of arid lands of northern Kenya, where rainfall proves a strong predictor of widespread and severe child wasting, to provide a simple empirical illustration of the potential contract designs.
As the last post showed I didn't see many papers. There were too many new beers to taste! I also had the pleasure of having lunch with David Rossmiller. A good time was had by all. We didn't even spend that much time talking about Katrina, Mississippi, Mr. Scruggs, music lyrics or the other supporting cast of the recent troubles. Thank you for lunch David and the next one is on me.
Riskprof will be posting more regularly now that school is supposed to start. Lars, Ty and I were out in Portland, OR for the American Risk and Insurance Association's Annual Meeting. Papers can be found here.
Here are a few I thought were interesting. There were probably others but I did not get to see them.
An Economic Analysis of Single versus Multiple Jurisdictional Regulation –
The Case of Risk Retention Groups
J. Tyler Leverty
July 28, 2008
ABSTRACT
Insurers are regulated by states. However, a small subset of firms, risk retention
groups (RRGs), are subject to single entity regulation. This paper attempts to
determine the effect of duplicative regulation by isolating those firms that have the
opportunity to choose between single- or multiple-jurisdictional regulation. The
results reveal that there is significant increased regulatory compliance costs
associated with multi-state regulation and these costs influence firms’
organizational structure decisions. In addition, regression estimates suggest that a
move to a single-jurisdictional regulatory framework would result in a 24 percent
reduction in total expenses for the average firm. Moreover, results show that the
higher compliance costs associated with multi-jurisdictional regulation leads to a
higher per unit costs of insurance. Overall, there are significant benefits associated
with moving away to a single entity regulatory framework.
Time Magazine takes a look at Florida ...
Greetings from Florida, where the winters are great!
Otherwise, there's trouble in paradise. We're facing our worst real estate meltdown since the Depression. We've got a water crisis, insurance crisis, environmental crisis and budget crisis to go with our housing crisis. We're first in the nation in mortgage fraud, second in foreclosures, last in high school graduation rates. Our consumer confidence just hit an all-time low, and our icons are in trouble--the citrus industry, battered by freezes and diseases; the Florida panther, displaced by highways and driveways; the space shuttle, approaching its final countdown. New research suggests that the Everglades is collapsing, that our barrier beaches could be under water within decades, that a major hurricane could cost us $150 billion.
I was in London two weeks ago and saw a play called Avenue Q. The opening song is entitled "It Sucks to be Me" (YouTube version potentially NSFW). One could easily change this song to it "Sucks to be Florida" and if you watch the video, even Gary Coleman would agree.
What is interesting about the above litany of sucks is that most are the result of choices the State of Florida made. Water was purposefully under priced to promote development; insurance is under priced and the industry is being driven from the state; pro growth policies are encouraging water use and increasing property risk and inappropriate land use (in the sense that not all costs are being considered in land use decisions); the tax system is designed that non-Floridians pay for general governmental services; and elderly wealthy retirees who were courted by low taxes directed at them do not have interest in paying for schools; and finally constitutional homestead exemptions make school tax revenues too insufficient for current needs. These are all policies made by the people of Florida. The big problem, as a non-Floridian, is that the rest of the country may be asked to bail the state out from its predicament. That potential bail-out would be a mistake of epic proportions as then the state will never have an incentive to get its fiscal house in order.
Update: Lynn Kiesling links to this Forbes article on the under pricing of water by David Zetland. Under pricing is not just a problem in Florida's insurance market, but in many markets nationwide.
By now everyone is aware of State Farm's recent 47.1 percent rate increase for Florida Homeowners insurance. I received a number of e-mails about it including one from State Farm which pointed me to two items. The first is their background information about the rate increase (here). The second is a link to a Time Magazine article on Florida which I will discuss in a separate post.
First things first.... Florida requires insurers to offer mitigation discounts. The idea was provide incentives to make one's home more wind resistant. These include shutters and roof straps which are supposed to reduce the loss to a home from wind. One of the rationales for the increase in SF's premiums was because the mitigation rebate program has become too successful in the sense that many people are now qualifying for it. According to the SF backgrounder..
A vastly larger number of properties are receiving the discount than could have been anticipated when the "My Safe Florida Home" program began. To date, more than 260,000 properties have qualified for the discount and we expect the number to grow to more than 300,000. In some cases, the discount exceeds 90 percent of the windstorm portion of the premium. These developments have triggered a significant and unanticipated decrease in State Farm Florida's projected revenue for 2008, 2009, and beyond. (my emphasis added).
I wonder if anyone is able to accurately price the mitigation credit? Probably not as the sum of the credits seem to haven eaten into the total wind premium. This would not be a problem if the remaining wind premium was able to cover the actuarial costs of a storm. This 90 percent ratio is an amazing fact and I wonder how much of it has to do with the (in)ability of SF to price these mitigation credits properly or whether state regulatory mandates exist which reduce the ability of pricing them effectively. Are other companies are having the same problem?
People tend to forget that the national State Farm company is a mutual (which means that the policyholders are the owners of the company)*. So, if SF asks for an ordinary rate increase, it is not "raking profits" off its customers as the owners are the customers. In addition, when it asks for an extraordinary increase (in terms of percentage), it is still not ripping off its customers as any residual profit is returned as a premium rebate. No one really seems to understand this as people are saying that the rate request is outrageous. However, it will be interesting to see how this is played out.
SF also puts in a nice dig at the state's expense by saying it (SF) has to be the responsible company since it does not have the ability to coerce people to pay later...
Unlike a state-run insurer (Citizens) or re-insurer (Florida Hurricane Catastrophe Fund) that can issue bonds, levy assessments, and impose taxes to fund losses after an event, State Farm Florida cannot charge customers after the fact. It needs adequate capital up front to have the resources necessary to pay claims in a timely manner.
*NB. I have an insurance policy with SF.
My former GSU colleague Arthur Brooks is named AEI President replacing Chris DeMuth. Congrats Arthur.
Last week we had a great conference at the AEI hosted by Peter Wallison. The program and papers are here. Video is here. I sound so much better on fast forward! Bob Klein and I also were interviewed by Ray Lehmann and Sean Carr at AM Best for a podcast (we show up about 5 mins into the podcast). The Brookings Institution will be publishing a book edited by Bob Klein and myself that will be out in about 9 months.
Also see:
Nationwide Mutual Insurance Co is lobbying Congress for permission to sell flood coverage in its homeowners policies. This is exciting. Their proposal indicates that they plan to sell flood insurance at the same price as NFIP policies, but with the option of buying additional coverage above the limits. An interesting aspect of their proposal is they want their expanded policies to be exempt from state regulation. Clever.
This IJ article points out that Mr. McCain and some governors (two of which are mentioned as possible running mates) are at odds over a national disaster fund. If we just focus on one principle that is supposedly an important part of the flood insurance program and apply it to the potential federal disaster plan -- that we do not have subsidies between high risk and low risk consumers -- the benefit of a national disaster plan evaporates.
If there is no subsidization from low risk to high risks, then there is no need for a federal backstop. The private market behaves this way currently. So what Florida really wants is to be subsidized. It is that simple as a subsidy will keep economic development going as it it makes commercial and residential development in the state more attractive. Realistically, there is no way that the relatively low risk states will want to be part of subsidizing Florida's residents. However, because of Florida's electoral college votes we may end up subsidizing Florida anyway.
