Five years after Hurricane Katrina devastated the Gulf Coast, neither the federal government nor the private sector is any closer to developing effective solutions to the problems facing flood and windstorm insurance, according to a new study from the RAND Corp.
The seven hurricanes that pummeled the Gulf Coast region in 2004 and 2005 did an unprecedented amount of damage, causing nearly $90 billion of insured wind losses to property, with one-half of those losses caused by Hurricane Katrina alone. As a result, insurance premiums skyrocketed, numerous private insurers retreated from coastal regions and government insurance programs were expanded.
Taxpayers and policyholders in low-risk areas have often subsidized the premiums offered by public insurance programs, raising concerns that these programs provide inadequate incentives to avoid high-risk areas or otherwise reduce risk. In addition, thousands of residents whose homes were damaged or destroyed by the storms resorted to the courts to resolve disputes over whether their insurance policies covered the losses.
“The current constellation of institutions and regulations is not adequate for achieving the basic goals for a well-functioning residential insurance market along the Gulf Coast,” said Lloyd Dixon, one of the authors of the study and senior economist with RAND, a nonprofit research organization.
“Until an improved system for mitigating and insuring hurricane risk is developed, these storms will continue to cause record-setting losses to life and property, ever-increasing federal disaster relief and major economic disruption in the Gulf Coast states,” Dixon said.
Building on previous work by RAND and others, Dixon and his colleagues reviewed the latest research and conducted more than 40 interviews and meetings with a broad range of concerned stakeholders, including coastal residents, consumer groups, insurers, regulators and legislators.
The RAND study suggests four goals to guide any reform effort:
insurance premiums should create appropriate incentives to mitigate risk;
decisions by households and residential developers should factor in wind and flood risk;
the insurance system should pay legitimate claims efficiently and expeditiously;
and the insurance market should encourage innovation and price competition. The researchers also suggest that a national commission be created to assess reforms.
The study identifies numerous obstacles to public and private efforts to achieve these goals. For example, it has always been difficult for the private sector to insure low-probability, high-consequence events like major hurricanes and earthquakes that affect a large number of policyholders simultaneously. The large variation in annual losses can mean that insurers must hold a large amount of capital in reserve to protect against insolvency, which forces rates up.
“We found that the last round of catastrophic hurricanes has shaken the confidence of some insurers in their ability to predict wind damage risk,” said James Macdonald, a study co-author and an adjunct staff member at RAND. “Several insurers we interviewed raised doubts about whether catastrophic windstorm peril can be accurately modeled.”
While public sector programs have some advantages over private sector insurers, government programs often subsidize premiums in high-risk areas by charging less than actuarially needed. By doing so, these programs may be creating disincentives for homeowners to take the risk of hurricane damage into account when they choose where to live, or discouraging them from taking mitigation measures.
The study identifies the types of reforms that could address the ongoing problems facing the Gulf Coast residential insurance marke and discusses the trade-offs of different approaches. Some of the policy approaches that the researchers say warrant consideration include:
Changes in government regulations that reduce the cost of capital that private insurers hold to protect against large losses