Mystery Insurance Costs
Recently, I observed a group of scientists pondering their Florida windstorm insurance costs. The argument went as follows: Since 2005, no major hurricanes have made landfall in the US and therefore, the insurance industry has not suffered a large US hurricane loss. As a result, the reinsurance market is awash with cash and it's pushing the costs of their product (i.e. reinsurance) down. So, why haven't residential insurance costs decreased?
This argument assumes that reinsurers' too much money problem is a product of not enough hurricanes. I have heard different things. Some say, no- the two are unrelated. Reinsurers have too much money because they are doing wonders with their investments. Some say, yes- no hurricane losses means a lot of money getting dusty in the corner. I think it's probably two sides of the same argument because money pulled in from premiums is invested to make more money.
The reinsurance 'soft market' was noted around 2007 just after catastrophe modelers introduced a 'new normal' view of hurricane losses that was substantially greater than previous views of risk. So, the sequence of events goes like this:
Very large 2004 and 2005 losses -> model changes -> large rate hikes -> soft market
It's a little too linear for one not to jump to the conclusion that the money reinsurers have is not at least in some or large part related to a dearth of major US hurricane losses which tend to be costly for the industry or rather, substantial changes to risk models based on theory about the future which has yet to pan out. Either way, why hasn't the cost of windstorm insurance decreased?
Here are some ideas....
When reinsurance is (relatively) cheap, primary insurers can transfer their risk to reinsurers and build profit. As reinsurance rates go down, the primary insurer can take more and more risk and transfer it to reinsurers. They can keep insurance costs constant but really they have to raise them the more risk they take. I forget what the technical term is but it's a thing where at some point as you accrue more of a similar risk you can't keep costs constant. In any case, the end result: despite lower costs on the reinsurance market, policy costs stay the same and perhaps increase.
Around 2013, as the soft market really started to affect reinsurance pricing, the Florida CFO, Jeff Atwater, demanded the Florida Insurance Commissioner Kevin McCarty explain why policyholder costs were not decreasing. McCarty responded,
In a time when reinsurance rates are dropping, an insurance company may choose to purchase more reinsurance. In fact, several Florida property insurance companies are being required by their rating agency to buy more reinsurance than they initially planned to purchase. This is likely to keep rates up and move additional premium and exposure to reinsurers. The additional coverage is added protection to ensure claims are paid in a time of a catastrophic event.
So, this way you can make profit, become more 'robust' to shock, and shift risk to other entities. In short, insurance works much like a game of hot potato.
Just three years later, primary insurer rates are still at a stand still in Florida or increasing and the story as to why has changed.
A couple of months ago, Citizens Property Insurance Corporation (CPIC), the FL residual market for wind, proposed another rate hike. The basis for hike is
"Water-loss trends connected to runaway AOB-based litigation threaten to reverse Citizens’ depopulation efforts as private insurance companies begin raising rates or dropping policyholders, forcing them to return to Citizens."
Sink holes were very much en vogue just a few years ago as a reason to increase rates. So we know the reasoning changes. It's not static.
CPIC stated the following:
Citizens has closely monitored water damage claim cost trends that have skyrocketed since late 2013 and almost exclusively driven actuarially sound rate increases in South Florida in 2015 and 2016.
Among other things, the FLOIR report found that:
The HO-3/DF frequency of water claims per 1,000 policies has increased by 46% since 2010. This represents an average annual increase in frequency of water claims of 8.3% each year.
The average severity of HO-3/DF water claims increased by 28% since 2010. This represents an average annual increase in the severity of water claims of 5.4% each year.
Southeast Florida has the highest frequency and severity of HO-3/DF water losses; however, the highest combined change in frequency and severity actually occurred in Central Florida. All regions are seeing significant increases in water losses.
The report does not mention taking into account changes for inflation and or development but... at least these people say that construction costs have increased on average over 4% per year over the same time period of the FLOIR analysis (2010-2015). Elsewhere, though I don't recall where, I've read that the rising cost of construction is higher in denser urban areas such as, say, Miami-Ft. Lauderdale. Provided that changes in construction costs were not accounted for in the report then this could explain most of the rise in the cost of severity.
In any case, if we follow McCarty's reasoning above, then another potential reason rates continue to increase is that Citizens off loads its risk onto reinsurance and capital markets through catastrophe bonds and needs the premium money to pay for this (either in reinsurance premiums or interest on catastrophe bonds). And sure, the ratemaking is different for fire, theft, hurricane, other wind, and All other perils, but if 'the big one' can wipe out all that is there, I would also assume that pots of money mingle at other times as well. I imagine. I don't have any first hand knowledge of CPIC bookkeeping.
Since reinsurance costs have decreased, the economy has come back from it's pitiful 2008 condition, and no major hurricane landfalls, CPIC has been able to 'depopulate.' That is, it transfers it's lower risk policies to the private industry who has been able to soak up a bunch of risk at somewhat publicly palatable rates by taking advantage of low reinsurance costs. CPIC raises rates so as to not 'compete with the private market.'
“The remaining policies are the more difficult policies. The good policies as perceived by the insurance companies and private carriers are gone so what we are left with is a ‘residual’ book of business and frankly that’s our charge – to act as a residual mechanism.”
That is to say, everyone not in Citizens is "normal" everyone in Citizens is in the tail. (Insurance politics is often a fight about the size and shape of the tail.)
Great, for those that believe in the sacrosanctity of such things, but it also means that it needs to come up with reasons for always upping the bar.
What if we create new residuals... say, the water loss distribution or as before, the sink hole distribution? Then there are a bunch of new risk pools to manage and share and negotiate over.
Other things to ponder...
CPIC has become a major player in the catastrophe bond industry through its special purpose vehicle, Everglades Re, which offloads Florida coastal account hurricane risk onto the insurance linked securities market. Everglades Re offers the largest cat bonds available. Artemis provides a good discussion of all the cat bonds and a nice illustration of CPIC's management of its Coastal Account. Paying interest on cat bonds is one reason why CPIC (or insurers generally) don't have all the premiums that people pay laying around waiting for a rainy day.
A final thought, there is one theory that severe competition on the insurance market is bad because it encourages insurers to take risks at costs that have no promise of covering potential losses. Severe competition is considered bad faith and immoral because society enables insurers to run their business and take on societal risks in exchange for covering losses. But if they go out of business trying then, it doesn't do anyone any good particularly the public as it destabilizes society. (Note that this is different from the public taking risks it has no hope of being able to pay for. That, is retention... and debt.)
According to many, this was the state of the insurance market in Florida prior to Andrew. Insurers, under market competition, depressed insurance rates. Then according to some, they routinely took losses on the insurance side of their business because premium dollars were turing a hefty profit on the investment side. In short, savvy insurance market regulators have an interest in keeping insurance rates from plummeting much to the chagrin of the public.
Ha! So why have rates in Florida stayed the same or increased despite a dearth or drought of hurricane landfalls? Well, as many scientists have pondered: is there really a drought in activity? was their ever a jump in activity? Given time scales involved how would you know? And if the science is uncertain then should rates change in response to what some feel is a decline in the risk? This is what they did when some felt the risk had increased....
Better: Are market interests using information and theory as needed to meet market needs and select ideals of how insurance ought to work in society?
Personally, I'd go with that last one but clearly the story one could tell is as rich and varied as any account of decision making where a lot of money and heated politics is involved. The only one's that really know are probably Barry Gilway and Kevin McCarty and McCarty just washed his hands of the whole thing.