My Two Cents

I sent this off to the WSJ.  But  just in case they don't like it you can read my opinion here.

Letters to the Editor
The Wall Street Journal
200 Liberty Street
New York, N.Y. 10281

RE: Jay Fishman’s Opinion Piece on Catastrophe Finance

Before the Next 'Big One' Hits
By JAY S. FISHMAN
August 27, 2007; Page A10

Dear Editor:

Mr. Fishman is right on a number of dimensions. The problem he sees is the states are not in the position of allowing adequate rates for insurers to make long term commitments in a state. This is due to policies restricting insurers' ability to adjust portfolios or pricing in response to changes in risk. Further, we see a strong incentive for the states’ courts to rewrite insurance contracts after a large storm. Thus, prices are suppressed before a storm and contract terms are potentially expanded after a storm. The state policies may be rational in the sense that if the state destroys the insurance market for short term political advantages, the Federal government would be there to bail out the state.

Mr. Fishman’s solution is a federal one whereby the federal government sets windstorm prices and contract terms, but the insurance is provided by the private market. His proposal on the surface eliminates the ability of the states to suppress prices and the ability to reinterpret contracts after the fact. This solution also takes the incentive away for mis-pricing which could lead to a Federal bailout for homeowners in coastal areas. Congress would have less of an incentive to meddle in pricing if the meddling brings about significant subsidies to those living in high risk areas as constituents in Iowa or California will be reluctant to subsidize high risk homeowners.

Researchers at the Wharton School, Georgia State University and the Insurance Information Institute are undertaking a multi-year study of catastrophe markets and have come up with two principles to guide the analysis. The first is that prices are set based on risk and the second is if there is a social concern about affordability, that this concerned be remedied through general public funding rather than through the insurance industry.

Mr. Fishman’s proposal is consistent with the general principles. Prices are based on risk to allow people to make rational decisions about where they live and where builders put new homes and businesses. Further, if there is a social concern about affordability, Mr. Fishman proposes a tax credit which would help people initially with affordability issues, but would be phased out over time. Mr. Fishman’s proposal, in contrast to both the Florida situation (where the state is making a bet that no storms occur) and the Mississippi situation (where the instability of the state’s insurance law is driving insurers away from storm prone areas), is eminently superior to the status quo. My only critique of his proposal is that the tax credit would be funded by a tax on “wealthy” people in high risk areas. If affordability is truly a social concern then all should participate in the funding of the tax credits rather than just those in the high risk areas.

Martin F. Grace

James S. Kemper Professor of Risk Management
Department of Risk Management and Insurance
Georgia State University

Atlanta

The author is a researcher with the Wharton-Georgia State University-I.I.I. study but does not speak for any of the other researchers or organizations.