Insurance specialists tend to be a gloomy lot. After all, their work demands they think of the worst-case scenario every time. But when these professional pessimists start talking about the hurricane season that kicks off Monday, even they get a little rattled. The prospect of another year like 2005, which saw Katrina, Rita, and Wilma pummel the southeastern United States, could prove exorbitant for insurers and taxpayers alike.
But ironically, the property/casualty sector of the insurance industry is in much better fiscal shape than its life-insurance counterpart. While insurers like AIG lost a bundle in 2008 due to their investments in mortgage-backed derivatives, companies who offer things like homeowner's insurance didn't dabble as much in these riskier options.
The reason for this disparity has to do with the payout schedule of each type of insurance. Life insurance companies prefer long-term investments with (theoretically) better returns, because they anticipate the need to service a policy or annuity for up to four decades into the future. Property insurers, however, know a tree can fall on your roof anytime. So they traffic in shorter-term investments, mostly in the fixed-income sector, which turned out to be better insulated during the market's fall of ‘08.
This doesn't mean Property & Casualty insurers didn't suffer any losses. According to the Insurance Information Institute, these companies had 18 percent of their collective capital invested in the stock market, including some investments like mortgage securities and Lehman Bros. debt. But while the life-insurance arms of some of the nation's largest insurers have received federal TARP money, the P/C divisions are merely bruised. For them, 2008 was more of a fall from a tree house than a high-rise.
Analysts' biggest worry is that something even larger than Katrina will come careening through the Gulf this summer. Big hurricanes have been getting costlier. A direct, Category 5 hit on an urban center like Houston could cost $100 billion. By comparison, Katrina damages rang in at around half that, and Andrew, which blasted south Florida in 1992, cost a relatively comparatively paltry $21 billion in 2005 dollars.
Could the industry afford such a mega-storm? Technically, yes. P/C companies were sitting on $456 billion at the end of 2008. So, with the possible exception of some smaller firms, they wouldn't implode if the Big One hit. The problem is what happens next.
For a glimpse into the future, take a look at Florida, which has been grappling with the hurricane issue for years. To answer the perennial threat of insurer flight in 2002, Florida set up the Citizens Property Insurance Corp., which was touted as an alternative to pricier private insurers, many of which have fled in the face of state-mandated rate caps. State Farm pulled up stakes in the Sunshine State earlier this year after a bid to hike rates by nearly 50 percent was turned down. Allstate failed to get a 42 percent rate hike on Florida homeowners, and other companies have cut the state out of their coverage areas.
The concept of a nonprofit, public insurer is an idea with huge populist appeal, but it's a crummy business model. If a big storm hits a city like Miami or Tampa, the company could be wiped out. It's happened before. Citizens ran out of money in 2004 and '05. And the state's homeowners paid the bill to keep the insurer afloat, even if they'd shelled out for private insurance. Florida also has a Hurricane Catastrophe Fund that acts as a reinsurer, but its solvency is also not assured. While the fund can theoretically sell bonds to bolster its bottom line, the bond market hasn't exactly been going gangbusters lately. Worst-case scenario: the state comes hat-in-hand to taxpayers again, or to the federal government.
Insurance companies contend they have to price for risk, but if the state-mandated caps came off, it's conceivable that rates on some properties could spike by 500 percent. The industry says high rates could be mitigated by adding shutters or roof reinforcements. But it's unlikely that most homeowners could shoulder the cost of potentially extensive renovations. And yet, the alternative of keeping rates artificially low has served only to push the state-and, by extension, taxpayers-into the role of last-ditch insurer.
Some analysts and academics are trying to get the insurers and politicians to come up with a solution before the next crisis. Howard Kunreuther, who co-authored a forthcoming book about the problem, says the key is to get the government out of the insurance business and remove rate caps, then offer subsidies to low-income homeowners in high-risk areas. He also suggests the industry develop long-term home-insurance policies, perhaps tied to the life of a homeowner's mortgage, to promote market stability.
Robert Litan, a Brookings Institution senior fellow, takes the opposite tack, saying the government needs to step in as a formal insurer. He proposes a federal reinsurance program to which all homeowners would have to contribute. Premiums would vary according to risk level, but everyone would chip in. The program would include not just hurricane-prone homeowners but also those in regions at risk for earthquakes or major wildfires, to spread out costs and coverage.
There are those who say the government shouldn't be in the insurance business. Over the past several months, though, it seems like Washington has done nothing but backstop everything, from financial institutions to automakers. While there's no way to protect homeowners from the physical devastation of a hurricane or other natural disaster, a federally funded safety net could keep financial ruin at bay.