What Does it Mean to Say our Prices Are "Actuarial"?

Let’s think about this question “What is an actuarial price?”  On first blush, an economist (or an actuary) would likely say that it is the price that reflects the probability of a loss.  This assumes that there is no bankruptcy probability and that we do not compensate the insurer for any transactions or opportunity costs.  However, both an economist and an actuary must account for market realities in pricing.  Thus, one needs to consider transaction costs and bankruptcy costs.

The national flood insurance plan is supposed to have prices that are actuarially sound-yet it has a large deficit.  If there was truly actuarial pricing there would be little or no deficit. In addition, a number of state plans are operating at a significant deficit.  In fact, according to some figures I just saw but can’t quote, a major insurer is claiming that there is about $5.5 billion of losses in excess of premiums in state wind pools. This is a massive subsidy to homeowners on the coasts.  (Now, to provide some perspective I found a Heritage Foundation white paper on the Chrysler bail out.  The paper claims that the value of the federal guarantees that were given to Chrysler were in the order of  $300 million in the mid 1980s (now worth about $575 million). I cite these figures not for their absolute accuracy, but to provide an order of magnitude figure about the potential size of the coastal resident bail out).

Obviously there is a disconnect between how the government thinks about actuarial principles and subsidies and how economists and actuaries think about these same notions.

This brings me to my real point.  Representative Gene Taylor of Mississippi has been instrumental in putting a bill together (HR 920) that would expand the national flood program to include an all multi perils policy which would cover wind and flood. (One would still have to buy a separate policy that covered fire and liability).  At one level this is a good idea as it would undo the divorce between wind and water that is causing so many lawsuits on the Gulf Coast.  However, if the federal government can’t price flood insurance without a subsidy, why would one think it will do so with the new multiple peril coverage.  Here is what HR 920 Section 2(5) says

(5) ACTUARIAL RATES- Multi peril coverage pursuant to this subsection shall be made available for purchase for a property only at chargeable risk premium rates that, based on consideration of the risks involved and accepted actuarial principles, and including operating costs and allowance and administrative expenses, are required in order to make such coverage available on an actuarial basis for the type and class of properties covered.

OK, if this is what the government means, then why can’t the private market do it?    Well, the private market needs ex ante reserves which come at some holding costs and the government does not. The government can just raise taxes if a deficit occurs.  What is missing from Section 2(5) is the loading for the risk the firm takes by committing capital to the market.  However, shouldn’t the government account for the risk in some way to recognize the fact it is creating a potential tax payer liability?  That would be actuarial pricing.

Actuarial pricing the way the government means it still implies a bail out program for coastal residents to be paid for by the US taxpayer. The Federal government and the states haven’t a clue what it means to price a product actuarially.  Instead, they will price the product socially for political goals.  Hence, the large deficits in the current catastrophe programs.

Comments

[RiskProf]

This comment came from Brian.
I couldn't get the comment block to work. I lost a long comment.

I don't buy that limits on reserves have anything to do with insurers dumping disaster risk on the government. Their risks are all shifted to unregulated reinsurers in off-shore tax havens who do not have those limits. Insurers are forcing the highest risks onto the taxpayers, the taxpayers are not asking for them. Insurers do not cover flood, earthquake, volcano, tsunami, or disaster peril except wind, and they do not want to cover hurricane wind. After every major hurricane the industry has coordinated coercive actions to force states to take on risk or at least allow insurers to shed risk. In the 1980s they threatened to leave Gulf areas unless states formed wind pools. The Mississippi wind pool is controlled by the insurers in the association. It did not build up reserves in the non-hurricane years because the insurers would not let it. They divvied up every penny that was left at the end of each year. The wind pool bought reinsurance rather than build up reserves. The companies were hit with high assessments after Katrina because it far surpassed the reinsurance coverage. They immediately made the wind pool buy much more reinsurance at uncompetitive post-disaster profiteering rates charged by the off-shore looters of the reinsurance industry. I challenge you to provide any credible risk assessment that justifies a one-year premium of $42 million for $350 million in reinsurance for $1.8 billion in risk in coastal Mississippi. You cannot possibly defend the rates in the primary market and the excess coverage and reinsurance are much, much worse. We have examples of up to 2500% increases in commercial windstorm premiums, and they are not based on any risk or historical data, but can only be a deliberate plan to force the state to expand the wind pool to that companies can shed risk, permit higher hurricane deductibles and higher premiums in order to get them to stay, and to try to build a business backlash against the lawsuits that demanded that insurers honor their insurance contracts by paying for wind damages in the surge area. The Taylor bill is not taking any market away from the private sector. They want no part of flood and are forcing hurricane wind coverage on states. The question is whether there should be one federal pool of flood and wind together or a federal flood pool and a dozen or more state wind pools all with different rules and standards. The insurers prefer the latter because they can bully states to give them better terms and many insurance commissioners are owned. The government can figure out the risks just as well, if not better than the industry, without the hard market manipulation and profiteering after every disaster. The Mississippi evacuation maps based on NOAA surge models predicted Katrina's surge almost exactly. If the flood insurance maps had been based on those maps, almost everyone in the surge zone would have had flood insurance and would have paid more appropriate rates. The National Research Council has a recent report recommending use of quicker and more accurate methods to update the flood maps. The Taylor bill is a responsible proposal to prefund through the premiums mucho of the money that the federal government ends up spending on uninsured and underinsured losses. We are spending billions on assistance to may people who bought all the insurance they were advised to buy. FEMA is a concern, so maybe we should take the program out of FEMA and make it a GSE. The Taylor bill cannot possibly be worse than what happened after Katrina.

Do a little googling. There is a shakedown on a massive scale going down right now, by an industry that had $44 billion and $60 billion profits in the last two years. This is completely manufactured crisis to coerce weak state regulators to surrender on regulation and rate-setting. The industry, via ProtectingAmerica.com, is pushing for a federal catastrophe reinsurance backstop. If you question the ability of the government to set primary insurance rates, how well do you think it could set reinsurance rates of an industry that operates as a cartel and is very weakly regulated by the states?

A small sampling of the hundreds of recent headlines about the coastal insurance crisis:

State Farm announces big coastal cutbacks
- Mobile Press Register

Allstate to Halt New Property Business in Conn., N.J. and Del.

- Insurance Journal

Oxendine to insurer: Cover the Ga. Coast

- Savannah Morning News

Insurance reform called key to future

- New Orleans Times-Picayune

Many find storm insurance gone

- Baton Rouge Advocate

Insurer to limit policies in state

- Baltimore Sun

Insurance Policies Pulled On Cape Cod

- WCBV-TV Boston

Homeowner's insurance costlier: Just getting a policy in N.J. can be a problem

- Asbury Park Press

Travelers halts policies for Long Island homeowners

- Newsday

St. Paul keeps Ga. exposure, cuts back in New York

- Reuters

Insurance cost will leap along the coast

- Raleigh News and Observer

State Farm drops coastal policies

- Myrtle Beach Sun News

Nationwide to limit exposure along coast

- Galveston Daily News

Allstate scales back coverage of coastal areas

- Hampton Roads Virginian-Pilot

[RiskProf]

First, if you want to make insurers cover risk they don't want to take, the government must make them public utilities. This means that one has to guarantee them profits in exchange for taking all risks. Otherwise the insurers should be free to pick and choose the risks they cover. Second, while MS probably does not have its own antitrust law, is there not another state that does so that if the industry was truly a cartel, one could sue it under the state antitrust provisions? I have been trying to see which states have a law authorizing the antitrust law against the industry. I know that a number (including California) have provisions regulating the anticompetitive behavior that you complain of, yet we don't see the AG's or injured parties doing anything. I admit it could be that no state on the coast has such a state antitrust provision, but these same things are happening in New York, New Jersey, and Massachusetts's (to a lesser degree, of course). If there is a cartel (rather than each company operating in its own self interest), then there shouldn't be antitrust lawsuits. Third, in the case of State Farm (which did make profits), who benefits from those profits? Policy holders do. There are no shareholders. State Farm is a mutual. So do you think they try to stick it to the policy holders? Even if the total dollar profits were record in the sense of bigger than in the past, what is the rate of return? That is really the question, not the total dollar of profits. If the rate of return is in accord with the risk of the industry, then we don't have a problem. I have not heard anyone say that the industry was making above normal profits in terms of rate of return. Further, just because they made money this year does not mean anything. If you look at Florida, Andrew wiped out something like 40 years of profits for the insurers writing in Florida. Since that time, I think last year was the first year since 1992 that the Florida industry had a cumulative profit (looking at the present value of premiums from 92-2006 minus the present value of losses since 1992-2006). Finally, the industry was profitable in part because there was no major disaster. If there was, it would have been an unprofitable year. The insurance industry sets rates prospectively--if the perception of risk has increased then prices have to go up. That is how it works. I do think it is possible that insurers can over react, but this is due to uncertainty about the future. Some are very pessimistic and that they view risk as having really gone up. I think Allstate is in that boat. They feel like they can't even cover those risk and get shareholders to contribute capital. Others want to sell, but are concerned that (1) consumers can't pay the premiums and (2) even if consumers can pay the premiums, regulators won't let them charge what the insurers believe the premium to be. Since we have putatively competitive markets can we force companies to take a loss? Further, firms will charge high prices when they can not predict the future well enough. This will change over time as modeling science gets better and/or losses become more predictable. However, it is a fact of life that when a good is scarce its price is higher. Reinsurance markets are international markets and the price is high because a lot of reinsurance capital is going to cover risks in the Gulf Coast.

Your comment about the flood maps is correct. The federal government has no incentive (when there are no floods) to spend money on these maps. Thus, they get out of date and no one seems to care until there is a disaster. I am in favor of prefunding disaster payments. I think if insurance prices were lower more people would have insurance and the need for post disaster assistance would be reduced. A pre event cat reserve helps with this too. The major benefit of doing a pre event reserve is that it keeps the decision whether to ensure in the private market rather than in the government's hands.

The major problem is that there is likely (this is a value judgment on my part) too much coastal development. Ensuring this risk is extremely expensive. And recently, the risk of disaster appears to have increased. Markets create price signals to get people to change behavior when market conditions change. By subsidizing these types of risks through flood or other mulit peril policies, we do not encourage people to change their risky behavior. In fact, by subsidizing their risk we put them back in, or reduce the cost of them staying in, harms' way. I know Mr. Taylor has the best interests of his constituents at heart, but the major question is whether we want to subsidize people living in high risk areas or pay them to move to lower risk areas. I am in favor of paying them to move. They wouldn't have to go, and they could use their money to rebuild in the risky areas, but there would be no expectation of disaster assistance if they stayed. I realize that this is not an ideal policy and there are social concerns with something like this, It is better for everyone coastal residents and the nation's taxpayers.

Again, thanks for your comment.

[RiskProf]

This comment came from Brian

Should we move everyone out of California because insurers do not offer earthquake coverage? 53% of America lives in a coastal area. Should we move all of them to Iowa? No, wait, the government has to provide all-perils crop insurance there, so I guess we should move all those farmers somewhere less risky.

I'm sure that the taxes and economic output of coastal areas more than pay for the additional costs to the government.

As for the poor insurers being regulated by the states, give me a break. Most of the commissioners in Gulf and South Atlantic states have been owned by the insurers. Our insurance commissioners are begging them to stay, allowing higher hurricane deductibles and higher premiums even as they dump more and more coastal customers into state-sponsored pools. I don't have a problem with insurers earning profits. I have a problem with them conducting a coordinated shakedown of coastal states while they have record profits. You talk as if Katrina was a common event. It was not. We suffered a massive disaster that was made much, much worse by insurance fraud. I have copies of company claims guidance that say pay flood but not wind for damage caused by both wind and flood. Whatever foolish policy language Mississippi allowed them to stick on consumers, that is most certainly not the contract they have with the flood insurance program. We have documents from cases where engineering reports that concluded that damage was caused by wind were revised in the office to blame flooding without the knowledge or consent of the engineer who visited the home site, and cases where duplicate engineering reports were ordered to overturn the original. Do you thinks State Farm's mutual status justifies saving money for some policy holders by cheating those who lost their homes and dared to file claims?

As for cartel behavior, call it what you want, but this is not a competitive market at all. In any other market, when demand exceeds supply and prices go up, companies enter the market or expand their offerings to cash in on that demand. Even OPEC countries increase production and marginally compete when the prices are high. With property insurance, in hurricane risk areas, increased demand does not entice new supply. Instead, it results in industry-wide efforts to seek regulatory and pricing concessions from state insurance commissioners and state legislators. Put the riskiest areas in a state wind pool or we will leave. Allow us a higher hurricane deductible or we will leave. Approve our restrictive policy language or we will leave. Approve higher premiums for less risk or we will leave. Implement a dispute resolution process favorable to insurers or we will leave. That is what happened and is still happening in the Gulf and South Atlantic. See South Carolina.

[RiskProf]

I'd say that we do not provide disaster assistance if people choose not to buy earthquake coverage. It is available in California and people choose not to buy it. There is not one person in the state who is unaware of the risk. However, there are many people who do not want to pay for it because they know the federal government will help them in case of a disaster. Why should tax payers pay for this when people had the opportunity to reduce their own risk?

Second, the government does not have to provide all perils crop insurance. It chose to do so as a social program and it benefits large businesses. I don't see why we should be doing this either as business have access to sophisticated risk management products. The small family farmer is a vanishing demographic. It would be cheaper just to buy out the small family farmer than to insure all farmers against crop risk.

The problem is we should not be subsidizing risky activity.

I am not sure the assertion that taxes would pay for this in the long run is correct. I am not sure this is true in the long run--subsidization allow extra risk taking, extra risk taking causes extra losses. We might be able to pay off one or two disasters, but how many and why do we want to encourage risk taking?

I believe you have good intentions about not wanting a subsidy, but what you are suggesting does not work and has never worked. Just look at the crop insurance program and the states wind pools and automobile pools. I agree the government can better withstand the timing risk. However, as I pointed out in my discussion of actuarial pricing on the blog, the government will not account for all other risks. Just look at the deficits in all of the plans. These are non-trivial deficits and is there an incentive in government to make sure that over a 20 year or 30 year period there is no deficit or no subsidy? If I believed that the government had the ability to bear this timing risk responsibly, I'd say go ahead. However, can we can point to any example of where Congress or a state has never intervened to keep rates lower for political reasons? it just doesn't happen.

Profits--

Again, what do you mean by record profits. The rate of return is not out of line with other companies. I just looked up what the PC industry earned last year in terms of rate of return ( 16.57%) compared to the DJIA return of 14.71%. The DJIA represents a portfolio and has a lower risk compared to a portfolio of PC insurers. I obtained the data from SNL Financial and Yahoo Finance. This is not record profits. It is not even a "high rate" of return. AT&T earned a return in the 50%s last year and what about Exxon_Mobil? I am not arguing that even Exxon's_profits are too high, it is just there is so much being made about record profits which doesn't make economic sense.

Fraud--

If you believe that the insurers have committed fraud, then the courts are the place to decide this.

Cartel--
If you alleged a cartel, you should have proof and you should bring it to the attention of an AG. I suspect that if there was any kind of proof that many state AGs would be after the industry. Just because one objects to behavior does not make it a cartel.

Demand Exceeds supply--

Companies will enter only if they think they can make money on it will they enter a market. If they do not enter, it means that they can't make an expected return commensurate with the risk. In fact Florida had to pay bounties to get people to enter the market during the mid 90s. This company (Poe) just went bankrupt. If the state wants to throw away tax money for bounties ..... then I guess it can. However, it is not good policy in the long run.

Further, demand does not cause supply. This is economics 101. I am sure we'd all like a cure for cancer. There is a big demand for that. Where is the cure?

What causes supply to enter a market is the ability to make money. Demand does not guarantee that at all. If there is no entry to a market, that is a great signal that while demand may be high, the entrant can not make a decent rate of return.

Industry-wide efforts to seek regulatory and pricing concessions ...

I agree with the effect of what you say in this paragraph. I just have to remind you that insurance is voluntary. If one makes restrictions that the industry does not want to comply with, firms will leave. There are plenty of examples of this. One need to look at South Carolina's auto market in the 1990s, New Jerseys' in the 1980s to recent times, and the Massachusetts's auto market. Ultra restrictive rules cause insurers to leave. If you want them to cover risks they don't want to cover you must come up with a different system.

Much of what you say appears to be based on the fact that you believe the insurance industry has a duty to serve everyone. That is just not the case. There is no duty and it has a First Amendment right to tell the government it won't operate under a given set of rules.