RiskProf

Slow Catastrophe Risk Management

We normally think of Cats as step function  events--everything is fine then a disaster occurs.  However, is it possible to manage the death by 1000 cuts type of Cat?  This would be one where each individual event is not that big, but at the end of the" day" a Cat has occurred.  This paper suggests that it is possible to manage these types of risks.

"Improving Humanitarian Response to Slow-Onset Disasters Using Famine Indexed Weather Derivatives"

Agricultural Finance Review, Forthcoming

SOMMARAT CHANTARAT, Cornell University - Department of Economics
Email: sc384@cornell.edu
CALUM G. TURVEY, Cornell University - Department of Applied Economics and Management
Email: cgt6@cornell.edu
ANDREW G. MUDE, Cornell University - Department of Economics
Email: agm26@cornell.edu
CHRISTOPHER B. BARRETT, Cornell University - Department of Applied Economics and Management
Email: cbb2@cornell.edu

This paper illustrates how weather derivatives indexed to forecasts of famine can be designed and used by operational agencies and donors to facilitate timely and reliable financing for effective emergency response to climate-based, slow-onset disasters such as drought. We provide a general framework for derivative contracts, especially in the context of index insurance and famine catastrophe bonds, and show how they can be used to complement existing tools and facilities in drought risk financing through a risk layering strategy. We use the case of arid lands of northern Kenya, where rainfall proves a strong predictor of widespread and severe child wasting, to provide a simple empirical illustration of the potential contract designs.

Ruminations (Part II)

Time Magazine takes a look at Florida ...

Greetings from Florida, where the winters are great!

Otherwise, there's trouble in paradise. We're facing our worst real estate meltdown since the Depression. We've got a water crisis, insurance crisis, environmental crisis and budget crisis to go with our housing crisis. We're first in the nation in mortgage fraud, second in foreclosures, last in high school graduation rates. Our consumer confidence just hit an all-time low, and our icons are in trouble--the citrus industry, battered by freezes and diseases; the Florida panther, displaced by highways and driveways; the space shuttle, approaching its final countdown. New research suggests that the Everglades is collapsing, that our barrier beaches could be under water within decades, that a major hurricane could cost us $150 billion.

I was in London two weeks ago and saw a play called Avenue Q.  The opening song is entitled "It Sucks to be Me" (YouTube version potentially NSFW).  One could easily change this song to it "Sucks to be Florida" and if you watch the video, even Gary Coleman would agree.

What is interesting about the above litany of sucks is that most are the result of choices the State of Florida made.  Water was purposefully under priced to promote development; insurance is under priced and the industry is being driven from the state; pro growth policies are encouraging water use and increasing property risk and inappropriate land use (in the sense that not all costs are being considered in land use decisions); the tax system is designed that non-Floridians pay for general governmental services; and elderly wealthy retirees who were courted by low taxes directed at them do not have interest in paying for schools; and  finally constitutional homestead exemptions make school tax revenues too insufficient for  current needs.  These are all policies made by the people of Florida.  The big problem, as a non-Floridian, is that the rest of the country may be asked to bail the state out from its predicament.  That potential bail-out would be a mistake of epic proportions as then the state will never have an incentive to get its fiscal house in order.

Update:  Lynn Kiesling links to this Forbes article on the under pricing of water by David Zetland.  Under pricing is not just a problem in Florida's insurance market, but in many markets nationwide.

Ruminations on Florida (Part I)

By now everyone is aware of State Farm's recent 47.1 percent rate increase for Florida Homeowners insurance.  I received a number of e-mails about it including one from State Farm which pointed me to two items.  The first is their background information about the rate increase (here).  The second is a link to a Time Magazine article on Florida which I will discuss in a separate post. 

First things first.... Florida requires insurers to offer mitigation discounts.  The idea was provide incentives to make one's home more wind resistant.  These include shutters and roof straps which are supposed to reduce the loss to a home from wind.  One of the rationales for the increase in SF's premiums was because the mitigation rebate program has become too successful in the sense that many people are now qualifying for it.  According to the SF backgrounder..

A vastly larger number of properties are receiving the discount than could have been anticipated when the "My Safe Florida Home" program began. To date, more than 260,000 properties have qualified for the discount and we expect the number to grow to more than 300,000. In some cases, the discount exceeds 90 percent of the windstorm portion of the premium. These developments have triggered a significant and unanticipated decrease in State Farm Florida's projected revenue for 2008, 2009, and beyond. (my emphasis added).

I wonder if anyone is able to accurately price the mitigation credit?  Probably not as the sum of the credits seem to haven eaten into the total wind premium.  This would not be a problem if the remaining wind premium was able to cover the actuarial costs of a storm.  This 90 percent ratio is an amazing fact and I wonder how much of it has to do with the (in)ability of SF to price these mitigation credits properly or whether state regulatory mandates exist which reduce the ability of pricing them effectively.  Are other companies are having the same problem?

People tend to forget that the national State Farm company is a mutual (which means that the policyholders are the owners of the company)*.  So, if SF asks for an ordinary rate increase, it is not "raking profits" off its customers as the owners are the customers.  In addition, when it asks for an extraordinary increase (in terms of percentage), it is still not ripping off its customers as any residual profit is returned as a premium rebate.  No one really seems to understand this as people are saying that the rate request is outrageous.  However, it will be interesting to see how this is played out. 

SF also puts in a nice dig at the state's expense by saying it (SF) has to be the responsible company since it does not have the ability to coerce people to pay later...

Unlike a state-run insurer (Citizens) or re-insurer (Florida Hurricane Catastrophe Fund) that can issue bonds, levy assessments, and impose taxes to fund losses after an event, State Farm Florida cannot charge customers after the fact. It needs adequate capital up front to have the resources necessary to pay claims in a timely manner.

*NB.  I have an insurance policy with SF.

Florida is Full of Good Ideas

According to the Miami Herald a law maker is thinking of taking reserves away from Citizens (the state owned insurer of last resort) to capitalize new insurers. 

Two things to note here.  First, Citizens is still under capitalized in a big way. So taking away some of its reserves to put into the private market seems crazy. Essentially, the state would be taking money from an under-capitalized company to subsidize a private market company. This isn't any different than subsidizing Citizen's customers by keeping prices artificially low. Second, Florida is terrible about picking companies to give money to.  A major Florida player, POE, was essentially  started by the state through the institution of Citizen's previous take out program.  POE is, ironically, never more......

All that You wanted to Know About Cat Markets but were Afraid to Ask

Wharton, III and GSU have just released a study of CAT risks.  It is an amazing 400+ pages, so download it if you are a speed reader.  The executive summary is only 23 pages long.   

Insurance Regulation

I just finished grading a bunch of exams and Ted Frank sent me a blog post from the Orlando Sentinel.  It made me think of a test question I didn't ask.......

Ok, suppose you are the governor of a big state.  (Yes, it can have palm trees if you want.  Yes, you can have a governor's mansion.) You are the former state attorney general and have at your disposal over 1,000 employees working in the state's Attorney General's office.  In addition, you have a whole state insurance department whose sole job is to make sure the insurance industry is following the law.

You believe that the insurance industry is not playing fair.  You have no proof, but deep down in your bones you know something is going on and you even got the legislature to go along with you and it passed a law to fix all the insurance problems. You still have lingering feelings of unease about the nefarious insurers hitting your state with unconscionable, illegal, immoral, un-American, pigheaded, unreasonable, self serving, profiteering etc. and etc. price increases.  In fact, you still believe they are not abiding by the letter of the law even after all of your legislating and posturing.  The insurers are supposed to lower prices, dang it.  The law says so.

So who are you going' to call? Would you go looking to the yellow pages for a lawyer to sue the insurance industry because it was not following the law?  Or, would you ask the AG or your own insurance department to investigate?

If you thought there was merit to a case against the industry you might ask your own lawyers to look into this because that would help people who vote and it would be a good way to spend scarce state resources.  However, if you thought there was not much merit in the case, you might try to get some private law firms involved because everyone knows trial justice seeking lawyers will do just about anything for money (and it won't cost the state anything), and who knows -- one of them might strike it rich against the insurance industry.  In the mean time the nefarious insurers will have to spend tons of money defending themselves against the inevitable avalanche of lawsuits.

The first strategy makes sense if the state has a case.  The second strategy makes sense if there is no case or, merely, a superficial case.  Just ask Mr. Hood.  He probably knows just the guys who can help out the governor too!

Question:  Which governor is it?
(answer after the break)

Sink Sees the Red Ink

If a hurricane did $28 billion in damage to Florida, the state might have to issue $20 billion in bonds. That would mean putting a special assessment on homeowners and business to the tune of $1.7 billion a year for 30 years, [State CFO Alex] Sink said.

The state must spread some of that risk to private insurers, she said.

There are a number of ways to do this.  The number one way would be let the market set the price.  It will attract capital.  A second way would be to get Citizens out of the business of competing with the private market. 

Link: www2.tbo.com.

In addition, that assessment would not just go to homeowners it would go to all other purchasers of insurance (except maybe medical malpractice).

How Not to Invest

Future insurance payouts are funded, in part, by investment returns.  An insurer receives a premium, pays its initial expenses, puts part of the premium into reserves and the rest goes into the bond and equity markets.  In theory, good insurers put their investments into a broad array of high quality bonds and to a lesser extent into high quality equities.  They generally can't count on investments in an affiliates' bonds as a high quality investment.

Florida's Citizens Property Insurance Company (the biggest home insurer in the state of Florida) invested in a state investment pool.  The problem with the investment pool is  that it is shrinking to the point that Citizens might be the biggest investor in that ever shrinking pool.  From the discussion in the St. Pete times link to below it appears that Citizens has $2 billion in this pool and $5 billion in a safer pool.  My question (and I don't know the answer) is whether a private company could invest this way without the State complaining about its investment strategy? 

In fact, it appears that all $7 billion of the companies reserves are invested with the State of Florida.  Could a for-profit insurer do this? I don't think so, but ...  as Dana Carvey used to say, "It wouldn't be prudent."   

The pool appears to be a pool for state and local government entities to stash their cash and let it earn competitive interest rates. [Why is the state competing against banks?  Why is the state competing against insurers?]

It looks like the depositors (state agencies and city and counties) are withdrawing their funds which leads to a severe cash flow problem for the fund.  The bad news is that the FDIC doesn't insure the fund and the extra bad new for the Florida tax payers is that they do.  The state appears to have concentrated its risk and lowered its hurricane claims paying prospects at the same time.  Where is the Insurance Commissioner's outrage?  Where is the concern about the policy holders?  Where the the other hyperbole that we'd be hearing if an insurer did something that potentially upset the solvency of a major market player?

Check out the fund's homepage with an undated statement in red:

Day Two Update

As expected, we continued to experience outflows in our second day open. These outflows were half the amount of the first day. The size of the total outflows over our first two days is both within our expectations and well within LGIP's available capacity. Another positive development is that no one chose to redeem beyond their allowable liquidity balance.

Based on questions we have received and some stories in the media, we have published a memo to address a number of misconceptions that appear to be out there. See below for that memo.

The big misconception which appears to be true is that "more than half of the securities [backing the fund] are expected to pay  in full."  Ouch.

via  www.sptimes.com.

Change a Few Words ....

If one changes a few words from this Houston Chronicle piece, one sees almost the same charges Scruggs made against State Farm:  Lowballing claims and producing fake documents in support of the claims.

Scruggs created a legal team called the Scruggs Katrina Group to represent policyholders who sued their insurers after the hurricane.

In January, Scruggs' legal team reached a mass settlement of suits with State Farm Insurance Cos. that involved more than $26 million in lawyers' fees.

The lawsuit accuses Scruggs of trying to "freeze out" lawyers from the Jackson law firm, including senior partner John G. Jones, and pay it a "ridiculously low figure" for its "substantial" work.

After the suit was filed, Balducci is accused of having several meetings and conversations with Lackey in which Balducci agreed to pay the judge for ruling in favor of Scruggs in the case, according to the indictment.

Scruggs allegedly tried to cover up the scheme by falsely creating documents that showed he hired Balducci to work on an unrelated case, when he was actually reimbursing him for the cash bribes, the indictment said.

See also David Rosmiller's excellent posts on the matter.  Start with this one and just scroll down.

One thing that I thought of, and it is echoed in David's piece, is what about the real contract disputes.  I know the III claims that 99.99% of the claims have been settled.  However, there were many claims and some non-trivial number of them must have legitimate disputes between the insurer and the homeowner.  Does the misbehavior (this alleged bribe and the real possibility of a contempt of court citation) of the most aggressive Katrina plaintiffs lawyer poison the jury pool against claimants?  The trial bar's (oops ... the justice bar's) self-administered black eyes may be a bar to justice.

               

A New Acronym: KTFBOs or CATFEEBOWS

People aren't buying earthquake insurance in Missouri.

Figures from the state Department of Insurance show that earthquake coverage was carried on fewer than 38 percent of the insurance policies for homes, mobile homes and farms last year. 

That was down more than 5 percentage points from 2001. During that same time, the average cost of residential earthquake coverage in Missouri rose by 15 percent, according to the department's figures. (via IJ)

The Governor is worried and has appointed a task force. 

From the article it is not possible to find out what is really happening. The rate of inflation from 2001-2007 (nationally) was 17 percent, so earthquake insurance is about as expensive as it was in 2001.  So price gouging, a usual culprit, is not really on the table.   One possible reason for the drop in coverage is the expectation of a Katrina-type-federal-bail-out (KTFBO).

The effect of potential KTFBOs (cat-fee-bows) on insurance markets will be difficult to measure and I am not suggesting that this is the only reason for the drop in Missouri earthquake coverage, but it should not go unexamined as a possible reason.  If KTFBOs are real, there is nothing the state government can do short of mandatory coverage and we know how popular that option would be.

update: Mike the Actuary weighs in with other factors affecting EQ demand in Missourri