Catastrophes: Insurance Issues
The term “catastrophe” in the property insurance industry denotes a natural or man-made disaster that is unusually severe. An event is designated a catastrophe by the industry when claims are expected to reach a certain dollar threshold, currently set at $25 million, and more than a certain number of policyholders and insurance companies are affected.
Disaster losses along the coast are likely to escalate in the coming years, in part because of huge increases in development. One catastrophe modeling company predicts that catastrophe losses will double every decade or so due to growing residential and commercial density and more expensive buildings.
Man-made catastrophes such as the attacks on the World Trade Center can also cause huge losses. The attacks led Congress to pass the Terrorism Risk Insurance Act (TRIA) in November 2002. Since then, TRIA has been reauthorized twice. The latest reauthorization, passed at the end of 2007, extends the law to the end of 2014, at which time it will expire if it is not reauthorized. The U.S. Senate in a bipartisan vote passed an extension of TRIA in July 2014. Congress recessed for the August break without a bill from the House. TRIA provides a federal backstop for commercial insurance losses from terrorist acts, making it easier for insurers to calculate their maximum losses for such a catastrophe and thus to underwrite the coverage, see report on Terrorism Risk and Insurance.
The typical homeowners insurance policy covers damage from a fire, windstorms, hail, riots and explosions—as well as other types of loss such as theft and the cost of living elsewhere while the structure is being repaired or rebuilt after being damaged. Commercial property insurance policies generally cover the same causes of loss with some variation, depending on the coverages selected. Flood and earthquake damage are excluded under homeowners policies—separate policies are available—but are covered under the comprehensive portion of the standard auto policy, which more than 75 percent of drivers who buy auto liability insurance purchase.
Over the 20-year period, 1993 to 2012, hurricanes and tropical storms made up 40.4 percent of total catastrophe losses, followed by tornado losses (36.0 percent), winter storms (7.1 percent), terrorism (6.3 percent), earthquakes and other geologic events (4.7 percent), wind/hail/flood (3.8 percent) and fire (1.7 percent). Civil disorders, water damage and utility services disruption combined represented less than 1 percent. Each year about 6 percent of homeowners file claims.
- A strong earthquake registering 6.1 on the Richter scale hit California’s Napa valley, a wine producing area, early in the morning on August 24. Catastrophe modeler Eqecat estimated insured losses would be close to $1 billion, but other analysts put the number higher. Only about 6 percent of Napa Valley residents are covered by earthquake insurance. The highest losses are expected to come from the region’s wineries. The quake was the most powerful in the San Francisco Bay area in 25 years.
- Forecast for Atlantic Hurricane Season: In May 2014 the National Oceanic and Atmospheric Administration (NOAA) predicted a near-normal or below-normal 2014 Atlantic hurricane season. NOAA’s Climate Prediction Center projected eight to 13 named storms (winds of 39 mph or more), with three to six becoming hurricanes (winds of 74 mph or higher) and of them, one or two becoming major hurricanes (winds of 111 mph or higher).
- Researchers at Colorado State University are also predicting a below average hurricane season due to the probable formation of El Nino, a large-scale weather pattern that tends to suppress the development of hurricanes. Nine named storms are expected, of which three are likely to become hurricanes, one of them a major storm. Other forecasters have issued similar reports. The last time there were only nine storms in the Atlantic Ocean was 2009.
- 2014 Atlantic Hurricane Season: So far the hurricane season has been as inactive as forecasters anticipated but September and October are peak months. Hurricane Cristobal strengthened on August 25, becoming the third hurricane of the season. The storm brought torrential rain to the Caribbean and Bermuda as it headed north. It is not expected to make landfall in the United States.
- Hurricane Arthur, the first hurricane of the 2014 Atlantic hurricane season, was also the first hurricane to make landfall on the U.S. mainland since Isaac in August, 2012, and the first Category 2 hurricane in the U.S. since Ike in 2008, according to the National Weather Service. Arthur became a hurricane on July 3 and made landfall over Shackleford Banks, between Cape Lookout and Beaufort, North Carolina. Hurricane Bertha became the season’s second hurricane on August 4.
- Although insured losses from the extreme cold and winter storms of 2014 did not break records set in the mid-1990s, 2014 will likely rank among the five costliest for winter damage claims. Industry sources estimate that insured catastrophe losses in the United States were $3.0 billion, up 7.1 percent from the first quarter in 2013. Peter Hoppe of Munich Re, a major international reinsurer, says the extreme cold in North America and Asia and the unusually mild winter in many parts of Europe were due to changes in jet stream patterns.
- Worldwide, economic losses in the first half of the year from severe weather totaled $42 billion and insured losses $17 billion, according to Munich Re. Both figures were below average for the past 10 years, which were $95 billion and $25 billion, respectively. Deaths due to weather-related catastrophes were also lower than the 10-year average, 2,700 compared with the much higher 53,000.
- Reducing Catastrophe Losses: In March 2014, overcoming earlier efforts by the construction industry to oppose stronger standards, Mississippi passed legislation to upgrade its building codes. Mississippi was one of 18 hurricane-prone states evaluated by the Insurance Institute for Business and Home Safety (http://www.disastersafety.org) for the effectiveness of its building codes.
- The institute is also partnering with the Department of Homeland Security in pilot projects to develop buildings that can better withstand strong winds. Some insurers offer discounts for homes built to the stronger standards.
- Residual Markets: In Florida, concentrated efforts to reduce the policy count of Citizens Property Insurance Company is paying off. The insurer of last resort’s policy count is now below one million for the first time since 2006.
- Florida Hurricane Catastrophe Fund: The catastrophe fund offers the state’s property insurers reduced-cost reinsurance. Currently the fund has the capacity to provide $17 billion in coverage. Although a reinsurance deal could raise premiums for property owners slightly, it would also reduce the risk of the state having to assess taxpayers if the fund ran out of money to pay insurers’ claims in the event of a major hurricane.
THE TEN MOST COSTLY CATASTROPHES, UNITED STATES (1)
ESTIMATED INSURED PROPERTY LOSSES, U.S. CATASTROPHES, 2004-2013 (1)
CATASTROPHES BY QUARTER, 2013 (1)
THE TEN MOST COSTLY HURRICANES IN THE UNITED STATES (1)
THE TEN MOST COSTLY WILDLAND FIRES IN THE UNITED STATES (1)
TOP TEN STATES FOR WILDFIRES RANKED BY NUMBER OF FIRES AND BY NUMBER OF ACRES BURNED, 2013
Megacatastrophes: The insurance industry tracks catastrophes to monitor claim costs, assigning a number to each catastrophe. Each claim arising from the event is tagged so that total industrywide losses can be tabulated. The term catastrophe is often used in the property insurance industry in a narrow way to mean a catastrophic event that exceeds a dollar threshold in claims payouts. This figure has changed over the years with inflation and the increase in development of areas subject to natural disasters. Starting in 1997 the catastrophe definition was raised from $5 million to $25 million in insured damage.
While $25 million is a large figure to most people, there have been five catastrophes that fall into the megacatastrophe category, greatly exceeding that amount.
The first two, Hurricane Andrew (1992) and the Northridge earthquake (1994), were both watershed events in that they were far more destructive than most experts had predicted a disaster of this type would be. The third, the terrorist attack on the World Trade Center in 2001, altered insurers’ attitudes about man-made risks worldwide.
Hurricane Katrina (2005), the fourth catastrophe, is not only the most expensive natural disaster on record but also an event that intensified discussion nationwide about the way disasters, natural and man-made, are managed. It also focused attention on the federal flood insurance program, see report on Flood Insurance, as did Hurricane Sandy, the fifth catastrophe, which hit the New York metropolitan area in 2012. While Hurricane Katrina was a stronger storm and caused more damage ($41,100 billion when it occurred compared with $18.750 billion) Hurricane Sandy hit a more populous area so more people, as many as 15 percent of the total U.S. population, experienced the impact of the storm.
Hurricane Andrew: Hurricane Andrew, which hit the Bahamas and Southern Florida August 23-24, 1992, and then moved across the Gulf of Mexico to strike portions of Louisiana and other southeastern states on August 25-26, was the costliest natural disaster in U.S. history before Hurricane Katrina. With peak wind gusts of almost 200 mph, the hurricane flattened whole communities, leaving in its wake a wasteland of debris. Eleven property/casualty insurers became insolvent due to Hurricane Andrew (10 in Florida and one in Louisiana) and others were financially impaired. Some of the state’s largest homeowners insurance companies had to be rescued by their parent companies and others had to dig deep into their surplus to pay Hurricane Andrew claims. Allstate, for example, paid out $1.9 billion, $500 million more than it had made in profits from its Florida operations from all types of insurance and investment income on those funds over the 53 years it had been in business. In total there were 680,239 claims, including 161,400 for damage to automobiles.
The Northridge Earthquake: The Northridge earthquake measured 6.8 on the Richter scale. It jolted the San Fernando Valley, 20 miles northwest of downtown Los Angeles, on January 17, 1994, causing more than 60 deaths and 12,000 injuries and destroying some 8,000 homes. More than 114,000 buildings were damaged and some 430,000 claims were filed. In both natural disasters, Hurricane Andrew and the Northridge earthquake, homeowners accounted for the bulk of claims and claim dollars.
The Destruction of the World Trade Center: The World Trade Center disaster impacted many kinds of insurance companies, particularly commercial lines companies. Claims were also filed with life insurance companies as well as personal lines insurers. The number of people known to have died as a result of the attacks on the World Trade Center complex has been officially set at 2,976. More than 35,000 claims were filed in New York State alone, according to the New York Department of Insurance. Broken down by type, two-thirds were commercial claims and one third personal, mostly property claims. Lost income and extra expense claims for the cost of getting the business back on track, part of property insurance, represented more than one quarter of the dollars paid out. More than 5,600 workers compensation claims were filed. Other claims were paid by insurance companies to businesses that suffered indirect losses in other parts of the country. These were not reported to the New York Insurance Department.
Other large U.S. man-made disaster losses in the last two decades include those stemming from the Los Angeles riots in 1992, at $775 million, and the World Trade Center bombing in 1993, at $510 million, see charts above.
Hurricane Katrina: Katrina, the storm that most affected attitudes about managing natural disaster risk, made landfall first in Florida on August 25, 2005 as a Category 1 storm, then gathered strength as it crossed the warm waters of the Gulf of Mexico, ultimately hitting Louisiana on August 29 as a strong Category 3 storm. The hurricane generated more than 1.7 million claims, more than half of the total in Louisiana. The bulk of the claims, 1.2 million, were for personal property. There were 346,000 claims for damaged vehicles and some 156,000 commercial claims. Claims payments to businesses accounted for half of the $41.1 billion bill for insured losses when the hurricane occurred.
Katrina left more devastation and a higher reconstruction bill in its wake than any previous storm, in part because of extensive commercial and residential development along the Gulf Coast; the record breaking storm surge, reported to be as high as 29 feet in some areas; and the concentration of energy related and other high value businesses in its path. Katrina’s hurricane force winds at landfall covered a wide area, extending for 250 miles, twice as far as Hurricane Andrew. Because the damage was so severe and widespread, the demand for materials and skilled labor quickly exceeded the readily available supply, pushing up construction prices and hence the cost of property insurance claims.
The 2005 hurricane season exposed many weaknesses in the nation’s preparedness for megadisasters. For example, many people in flood zones had failed to buy flood insurance, see report on flood insurance, and many communities in harm’s way did not have or had not enforced strong building codes, which would have reduced the amount of wind damage. In addition, the disasters drew attention to the need to reconsider land use patterns in areas most vulnerable to storm damage. And as has happened after other major disasters, many small businesses that suffered damage from the storms failed to reopen, in part because they hadn’t bought business income (also known as business interruption) and extra expense insurance which would have helped cover income lost when the business was shut down and the expense of getting back on track after the reconstruction period.
Hurricane Sandy: Hurricane Sandy made landfall near Atlantic City along the New Jersey shore on October 29, 2012. Although the storm inflicted heavy damage over a wide area, in part because it collided with another storm, when it hit land it was no longer officially categorized as a hurricane but as a post-tropical cyclone. Hurricane deductibles, which require homeowners to pay a percentage share of the storm damage, therefore, did not apply. Hurricane Sandy prompted a reevaluation of how the New York metropolitan area prepares for and deals with major disasters.
The National Hurricane Center attributed 72 deaths directly to the storm and at least 87 more deaths indirectly due to conditions and accidents caused by the storm. The highest storm surge measured by tide gauges in New Jersey was 8.5 feet over normal levels at Sandy Hook and the highest in New York was more than 12.5 feet at Kings Point on the western edge of the Long Island Sound. Sandy was an extraordinarily large hurricane, according to the agency, with wind gusts felt as far west as Wisconsin and as far north as Canada. Sandy damaged or destroyed about 650,000 homes and knocked out power to 8.5 million customers, the report notes. As with Hurricane Katrina, significant damage was caused by flooding.
Creating a Federal Backstop: After Hurricane Katrina several proposals were introduced to create a federal backstop but, as with bills to add wind coverage to the flood insurance program, none were enacted. Environmental groups joined with a group of insurers in opposing these bills, which both saw as promoting growth in coastal areas prone to storm damage. However, some large insurers supported the concept.
The insurance industry is divided about a federal role. Some say that under the current system the federal government (and hence taxpayers) pay for rebuilding in any case through government grants and low interest loans and that the funds would be better spent in an organized and predictable fashion. Other insurers say that worldwide there is enough reinsurance capacity to protect U.S. primary insurers against catastrophe losses and that people who choose to live in disaster-prone areas should not be protected from the cost of their decisions through subsidies from people who choose to live in a less risky location. They believe the solution is for Congress and state legislatures to develop more stringent building codes and tax incentives for homeowners to prepare for hurricanes.
Hurricanes: A hurricane's winds revolve around a center of low pressure expressed in millibars, or inches of mercury, and the entire system moves slowly. Hurricanes are categorized on the Saffir/Simpson intensity scale, which ranges from 1 to 5, reflecting a hurricane's wind intensity. Below is the Saffir-Simpson Hurricane Wind Scale.
THE SAFFIR-SIMPSON HURRICANE WIND SCALE (1)
A windstorm becomes a tropical storm when average wind speeds reach 39 mph. The hurricane season runs from June 1 to November 30, but the height of the season is from mid-August to mid-October.
The number and severity of hurricanes seems to run in cycles. Experts now think these cycles are influenced by what is known as the Tropical Multi-Decadal System. Since 1995 conditions have been favorable for increased hurricane activity, as they were during another active period, 1950-1970. Three climatic factors are thought to influence the development of hurricanes. First, during an active period the amount of rainfall during the monsoon season in the Sahel region of West Africa just below the Sahara Desert is higher than average, and rainfall is lower than average over the Amazon basin, creating favorable conditions for winds associated with the development of hurricanes. Second, sea-surface temperatures in the tropical Atlantic Ocean and Caribbean Sea are very warm. Third, La Nina causes lower than average sea-surface temperatures in the equatorial Pacific. Between 1947 and 1969, a rainy period in the Sahel, 17 major hurricanes (Category 3 or greater) struck the East Coast of the United States, compared with 10 between 1970 and 1991, when the Sahel was experiencing a drought.
New research suggests that the degree of hurricane activity in the Atlantic Basin is not a proxy for the number of storms that are going to make landfall along the U.S. coastline. According to researchers at AIR Worldwide, the probability of landfall is linked most closely to a storm’s genesis, or where it forms, rather than the number of tropical storms in the Atlantic. Genesis patterns change from year to year. The key to understanding why in some years the number of storms making landfall in the United States is high and in others it is low is to compare long-term genesis and storm tracking patterns, the AIR study notes.
Florida is the state most vulnerable to hurricanes. Reliable records on hurricanes only go back to the 1870s. Sketchy accounts of earlier disasters exist in ship’s logs and journals. Now, geologists, supported in part by insurers, hope to add to the written record by examining sediments at the bottom of coastal lakes and marshes. During a hurricane, sand and shell debris get swept into these waters. Research so far suggests that between 1,000 and 2,000 years ago, there were five or six Category 4 and 5 hurricanes in the Florida panhandle.
Data compiled by the National Oceanic and Atmospheric Administration (NOAA) on the 30 most powerful storms over the period 1900 to 1996 show that more than 40 percent of the damage they caused occurred in southeast Florida. Of the 158 hurricanes that hit the United States, 47 hit Florida and 26 of those struck the Southeast Florida coast.
Recently, computer simulation models have been developed that can mesh long-term disaster information with current demographic data to produce potential claims losses for any given geographical location under various scenarios. This information allows insurers to better differentiate between high- and low-risk areas in states such as Florida, where formerly, in times of less sophisticated risk delineation, the entire state may have been considered high risk. In addition, computer programs designed to help underwriters evaluate a building's potential damage from windstorms allow insurers to price industrial property insurance coverages more accurately. The ability to generate such information has also led insurers to reassess their business strategies.
But quality and type of building construction are not the only factors that influence the extent of damage a windstorm can cause. Others include the number and type of trees in an area and the type of soil, both of which affect the potential for losses due to falling trees. Soft woods, such as pine, tend to have shallow roots so that they are more easily uprooted than hard woods like oak, particularly in places with sandy soil. Storm surges will cause more damage where the developed land is close to sea level rather than elevated.
Coastal Development: Using data from the 2010 U.S. census, in 2013, the National Oceanic and Atmospheric Administration said an additional 11 million people will be living along the coast by 2020, bringing the total to nearly 134 million. The 2010 census showed that 39 percent of the population is concentrated in less than 10 percent of the nation’s land area excluding Alaska and 52 percent of the population live in counties that drain to coastal watersheds. Projected population growth in coastal counties will increase population density at a faster rate than in the country as a whole.
Exposure to windstorms and high property values combine to make Florida the state with the highest potential for losses and New York's Long Island the second highest. A 2012 study by AIR Worldwide put the value of insured coastal property in hurricane-prone states—states bordering on the Atlantic Ocean and Gulf of Mexico—at $10.64 trillion. The value of residential and commercial coastal property in Florida alone was almost $2.86 trillion. This represented 79 percent of the state’s total insured property values. In New York it was $2.92 trillion, representing 62 percent of the total. Other states where insured coastal property values exceeded 50 percent of the state’s total are Connecticut, Maine and Massachusetts.
The growth and concentration of property values in hurricane-prone areas has pushed to the forefront of public policy debates the issue of coastal development and hidden insurance subsidies. Subsidies exist in various aspects of the property insurance transaction.
First, they exist where rates for property insurance are no longer commensurate with risk because it is politically unpalatable to raise rates to actuarially justified levels.
Second, there are subsidies in the pooling arrangements that were set up to make sure people living along the coast can obtain property insurance. When these pools have insufficient funds to pay claims, the shortfall may be picked up by insurance companies, which may then pass the cost on to all property insurance policyholders in the state through explicit policy surcharges, as in Florida, or indirectly in the form of higher property insurance rates.
Third, the federal flood insurance program has paid out millions of dollars to rebuild structures in high-risk zones known as repetitive loss properties, where the cost of claims over the years may have totaled much more than the home was worth. This has contributed to the program’s deficit and to continued building in high-risk areas.
Catastrophe Deductibles: After Hurricane Andrew, with computer-based models of storms, coastal development patterns and increasing values all indicating how vulnerable insurers were to large weather-related losses, homeowners insurers had difficulty finding the reinsurance coverage they needed to protect their own bottom line. Many homeowners insurers couldn't obtain reinsurance coverage unless they agreed to greatly reduce their potential maximum losses from such events through higher deductibles. These deductibles exist in regions prone to hail as well as hurricane damage. They are generally equal to a percentage of the structure's insured value as opposed to a straight dollar amount, such as $1,000. Eighteen states and the District of Columbia have what have become known as hurricane deductibles.
Percentage deductibles for windstorm losses, which may be mandatory in some coastal areas of a state, vary from 1 percent of the home's insured value to 15 percent, depending on many factors that differ from state to state, and sometimes from insurer to insurer, including the home's insured value and the "trigger," the nature of the event to which the deductible applies. In some states or portions of a state, policyholders have a "buy back" option — paying a higher premium in return for a traditional dollar rather than percentage deductible. The percentage deductibles may apply to the entire state or just part of it (see Hurricane and Windstorm Deductibles paper).
For hail damage, in addition to instituting percentage of limits deductibles, some insurers in some states are providing coverage for roofs on a depreciated (actual cash value) basis, rather than replacing a damaged roof with a new one. Some are offering a discount for hail- resistant roofs or imposing a surcharge for roofs that are not hail resistant to encourage people to replace old roofs with new, less damageable ones.
Earthquakes: On the West Coast, earthquakes represent the greatest threat. Statistics show that since 1900, earthquakes have occurred in 39 states and have caused damage in all 50. About 5,000 quakes can be felt each year, with some 400 capable of causing damage to the interior of buildings and 20 capable of causing structural damage. A repetition of the 1906 San Francisco (7.8 in magnitude) could cause as much as $100 billion in insured damage. However, a major earthquake on the East Coast, though more unlikely, could cause much greater damage. Because earthquakes in the eastern part of the country tend to be thrust-fault quakes, which produce an up-and-down motion rather than the horizontal side-to-side common in California, damage could be 10 times greater, according to seismic experts. The degree of damage also depends on other variables such as the structure of the building and soil conditions (see Earthquakes: Risk and Insurance Issues paper).
California insurers collected only $3.4 billion in earthquake premiums in the 25-year period prior to the Northridge earthquake and paid out more than $15.3 billion on Northridge claims alone. After the Northridge earthquake, insurers were reluctant to offer homeowners insurance because they feared additional earthquake exposure could potentially bankrupt them. In response to this crisis in the homeowners insurance market, in 1995 California lawmakers passed a two-part bill that allowed insurers to offer a new earthquake policy with a maximum deductible of 15 percent and created a privately funded, state-run earthquake pool.
Earthquake Insurance: Insurers doing business in California must offer earthquake insurance to their homeowners insurance policyholders, either a policy from the California Earthquake Authority (CEA) or, if they do not participate in the pool, a policy that they underwrite. Several dozen companies now write earthquake insurance in California in addition to the CEA. The CEA became operational in December 1996, with a $10.5 billion funding package. The CEA could now pay claims caused by a quake more than twice as destructive as Northridge since with each passing earthquake-free year, its claims paying ability increases. Passage of the CEA legislation opened up the homeowners market (see Earthquake paper). More recently, the CEA created a supplementary policy to broaden coverage. Nevertheless, only a small portion of the state’s property owners buy earthquake insurance and the percentage appears to grow smaller as the time span since the last major quake increases.
Tornadoes: Each year, about 1,200 tornadoes with gusts of wind as high as 200 mph touch down in the United States. Tornado intensity is measured by the Fujita scale, which runs from 0 through 5, the most damaging, based on the maximum speed of three-second wind gusts and the potential for damage. The scale incorporates 28 different damage indicators based on damage to a wide variety of structures from shopping malls to trees. Though generally not as costly in terms of insured values as hurricanes because they strike a more limited geographic area, tornadoes are more frequent. They can cause severe damage and, particularly before the advent of tornado warnings, many deaths. In the decade 1965-1974 they were responsible for an average of 141 deaths each year, compared with 107 in the 10 years 2002-2011. This average was pushed up by the unusually high number of deaths in 2011 (553).
The peak of the tornado season is April through June or July. Spring tornadoes tend to be more severe and strike the Southeast, which is more densely populated than the Great Plains, thus causing more deaths than those in the summer months. In addition, the South has more mobile homes than other regions. Mobile homes are vulnerable to tornado damage.
Since 1990 the number of tornadoes has generally exceeded 1,000 a year. In the three preceding decades, the only year in which there were more than 1,000 tornadoes was 1973, when 1,102 were reported. This increase may reflect greater ability to detect tornadoes.
Wildland Fires: Fire plays an important role in the life of a forest, clearing away dead wood and undergrowth to make way for younger trees. But for much of the last century, fire-suppression policies focused on extinguishing wildfires as quickly as possible to preserve timber and, increasingly, real estate. These policies have led to the accumulation of brush and other vegetation that is easily ignited and serves as fuel for wildfires. In an effort to reduce the incidence of wildfires, increasingly fire officials are promoting “prescribed burns” to eliminate the accumulated debris. In recent years, most of the large fires with significant property damage have occurred in California, where some of the fastest developing counties are in forested areas. However, wildfires are a growing threat in other states, particularly when there is a drought, as more homes are built in woodland areas that were once wild.
Over the past decade, the number of acres burned has increased as drought, record-setting heat and the build-up of dead trees and undergrowth together with residential development have combined to heighten the risk of fire. According to a University of Wisconsin study, in the West more than 8.6 million new homes have been built within 30 miles of a national forest since 1982.
A scientific study published in the September 4, 2007 issue of the Proceedings of the National Academy of Sciences examined the role houses play in the spread of wildfires. It found that making entire neighborhoods of homes fire resistant slows down the spread of fire. The likelihood of fires spreading from one site to another is dictated in large part by the amount and proximity of fuel—flammable materials such as dry undergrowth, trees that burn easily and unprotected wooden structures. When houses are not fire resistant, they add greatly to the fuel load and potential for the fire spreading because they quickly burn down to the ground. When homes are fire resistant, not only are they less likely to burn but they also act as a fire break, reducing the ultimate size of the fire and enabling it to be brought under control more easily. The Institute for Business & Home Safety (IBHS), (www.DisasterSafety.org) a group supported by the insurance industry, is conducting research into how construction, building components, landscaping practices and homeowner behavior play a role in the spread of wildfires, using data from insurance companies that insured structures in the “burn zone,” regardless of whether or not they sustained damage.
Fire damage is covered under a homeowners insurance policy whatever the cause of the fire, unless the person insured under the policy commits arson by intentionally setting fire to the structure. As a result of the greater potential for fire losses where homes are built on mountainous and forested sites, insurers are increasingly requiring homeowners whose property is at risk to take precautions to slow the spread of fire. Such measures include installing fire-resistant roofs and creating a “defensible zone” around the home by removing debris, overhanging tree branches and other items located close to the building that can become fuel for a fire.
Building Code Enforcement and Other Damage Mitigation Measures: In the mid-1980s, a study of the damage caused by Hurricanes Alicia (1983) and Diana (1984), two storms of roughly equal size and intensity, found that the level of building code enforcement affected the cost of claims. Hurricane Alicia hit Texas, causing $675 million in insured damage, of which close to 70 percent was attributed to poor code enforcement. By contrast, Hurricane Diana hit North Carolina, where codes were effectively enforced. Researchers found that only 3 percent of homes in that state suffered major structural damage as result of the hurricane. (Insured losses for North and South Carolina totaled $36 million.) This research and a similar assessment of losses in South Carolina after Hurricane Hugo prompted the National Committee on Property Insurance, now the Tampa-based Institute for Business & Home Safety (www.DiasterSafety.org) to study coastal municipal building code departments in southern states. Researchers found that building officials and inspectors in about half of the communities surveyed were not enforcing the building code wind-resistance standards on their books.
In South Florida, which has one of the strongest building codes in the country, experts estimated that between 25 and 40 percent of Hurricane Andrew losses were avoidable. A Dade County, Florida, grand jury report issued in December 1992 confirmed that much of the damage was due to lax code enforcement, warning that it was a long-standing problem in the state and that the quality of rebuilding in the hurricane devastated area might be even lower.
As a result, the insurance industry began to develop a building code compliance rating system, similar to its fire protection rating system, which dates back to 1916. Under the fire protection classification program, each local fire department's firefighting capability is ranked according to various factors, such as water supply and whether its firefighters are fulltime paid employees or volunteers. The final ranking is incorporated into the property insurance premium rate structure. The building code enforcement ranking process takes into account such things as the size of the building code enforcement budget relative to the amount of building activity, the professional qualifications of building inspectors and past code enforcement levels, with special emphasis on mitigating losses due to natural disasters. Insurers can now offer discounts on property insurance for new construction in communities that enforce accepted building codes. Communities are regraded for building code enforcement every five years.
Through the Institute for Business and Home Safety (www.DisasterSafety.org) insurers are sponsoring building construction that better withstands natural disasters. Named "Fortified…for Safer Living," the program specifies construction, design and landscaping guidelines for homes (and eventually businesses) in areas subject to windstorms, hailstorms and earthquakes. The current program applies to homes now being built. There is also a retrofitting program for existing structures. In Florida, such houses cost from 4 to 9 percent more to build. Surveys show that on average people are prepared to pay up to 6 percent more for a disaster resistant dwelling.
The concept behind this program is twofold: to keep the structure intact and to protect those inside from outside debris, which turns into dangerous missiles in a storm. The more secure the structure, the less storm-generated debris there will be. Some states are initiating programs to help consumers “fortify” their homes themselves, sometimes requiring insurers to offer homeowners insurance discounts for improvements. Efforts to reduce catastrophe damage are not confined to hurricane-prone regions. Homes in areas vulnerable to other types of catastrophes can be protected also and even if discounts are not offered, hail and wildfire-resistant roofs and measures taken to reduce earthquake-related damage make structures in high-risk areas more readily insurable, and because there is generally less damage, lessen the frustrations involved in getting back on track after a disaster.
Reinsurance: Just as individuals and businesses buy insurance to protect their assets, primary insurers, the companies that sell insurance to consumers, buy reinsurance to protect their bottom line. Reinsurance is sold in layers, reaching up into the millions of dollars to protect insurance companies from possible, but statistically highly unlikely events, such as a $100 million court award or an extraordinary number of homeowners claims as a result of a hurricane or a fast-spreading brush fire.
Retentions and coinsurance, through which insurers share the risk at various levels with their reinsurers, as well as coverage amounts have increased dramatically over the past decade. It is now patently evident that the cost of catastrophes, both natural and man-made, can be in the tens of billions of dollars. Hurricane Katrina cost more than $40 billion but a hurricane hit to Miami or a major terrorist attack could cost much more.
Before September 11, terrorist coverage was provided to commercial policyholders essentially without charge because the risk of an attack was considered remote. Immediately following the disaster, reinsurers said they would no longer offer terrorist coverage to the insurance companies they reinsure because they could not price this unprecedented risk. Legislation that made the federal government the reinsurer of last resort for major terrorist attacks was passed by Congress in November 2002 and extended in 2005 for two more years, making it easier for insurers to calculate maximum losses and therefore to underwrite the coverage (see paper on Terrorism Risk and Insurance). The program was reauthorized by Congress at the end of 2007 for another seven years.
The shortage of catastrophe reinsurance capacity in the United States following Hurricane Andrew, particularly for large national insurance companies, also prompted insurers, reinsurers, investment banks and others to look for new ways to spread the risk of natural disasters (see Reinsurance paper). Increasingly, the capital markets are being seen as a large resource that can be tapped to cover claims at the higher levels (after reinsurance has been exhausted) where there is a low probability of loss. The advantage to investors is diversification. Catastrophe losses are unrelated to the usual speculative risks, which are generally economic. While the number of transactions involving the capital markets is still relatively small, some observers expect catastrophe risk to be securitized and made available to investors on a regular basis.
Pricing: The price of an insurance policy reflects the costs of paying claims covered by that policy, as well as an insurance company's costs for such items as reinsurance. Not surprisingly, reinsurance costs as well as direct claims costs are lower where the risk is low. For example, if a community has a good fire department and ready access to water to extinguish fires, serious fires in that community will likely be fewer than in similar communities that lack a good fire department. The same principle applies to windstorms: premiums will reflect the normal level of windstorm claims in a given community.
How does the insurance industry deal with extraordinary costs such as the $40.6 billion in insured losses for Hurricane Katrina? Prior to Hurricane Andrew, insurance companies accounted for hurricanes and other catastrophes with a special premium amount known as a "catastrophe loading" to spread the risk over a period spanning 30 to 40 years. Sometimes they used data from several states subject to the same kind of catastrophes to develop the average annual cost of catastrophes. However, since the mid-1990s more sophisticated computer modeling techniques have become available. Insurers now base their rates, in part, on sophisticated computer models that combine meteorological data with their own exposure data. The meteorological data show the probability of a natural disaster occurring in a particular geographical area and the exposure data indicate how many of the company's policyholders are likely to be affected and to what extent, i.e., what the insurer's potential losses from that event are likely to be. Models can also assess the losses a specific company or building might sustain in a terrorist attack.
Insurance for High Risks: The risk of flood, earthquake or landslide damage is not covered under the typical property damage policy. Because the nature of the risk is different, insurers have created special policies.
With auto and homeowners insurance, a very large number of people are exposed to the same risks but only a random few in any geographic area ever experience a loss. Thus the premium of each policyholder is relatively low. With the risk of landslides, floods and earthquakes the situation is reversed. For example, with landslides, few people are exposed to these events but where there is a risk, many living in the area are likely to suffer when a landslide occurs. And only the people in an area vulnerable to landslides are likely to purchase the coverage. So the premium needed to cover all the potential claims must be high. When the premium is high, fewer people purchase it. The same is true with flood and earthquake insurance.
Special Catastrophe Programs: Disaster Damage Coverage in Developing Countries
The Caribbean: Established in 2007, the Caribbean Catastrophe Risk Insurance Facility (CCRIF is an insurance pool that covers hurricanes and earthquakes for its 16 Caribbean member nations and their territories. In 2009 the European Union made a donation to the CCRIF joining the World Bank, the Caribbean Development Bank and a number of developed nations in contributing to the facility’s reserve pool. The reserves paid for start-up costs. Japan funded the initial feasibility study.
The CCRIF acts as a mutual insurance company, allowing member nations to combine their risks into a diversified portfolio and purchase reinsurance or other risk transfer products on the international financial markets at a saving of up to 50 percent over what it would cost each country if they purchased catastrophe protection individually. In addition, since a hurricane or earthquake only affects one to three countries in the Caribbean on average in any given year, each country contributes less to the reserve pool than would be required if each had its own reserves.
Members pay premiums based on their probable use of the pool’s funds. As countries raise building standards to provide better protection against disasters, premiums will decrease.
Parametric Claim Paying Systems: Because the CCRIF uses what has become known as parametric insurance to calculate claim payments, claims are paid quickly. Under a parametric system, claim payments are triggered by the occurrence of a specific event that can be objectively verified, such as a hurricane reaching a certain wind speed or an earthquake reaching a certain ground shaking threshold, rather than by actual losses measured by an adjuster, a process that can take months to complete. Payout amounts are derived from models that estimate the financial impact of the disaster. As a form of deductible that encourages risk mitigation, participating governments are only allowed to purchase coverage for up to 20 percent of their estimated losses, an amount believed to be sufficient to cover initial needs. In the United States, the first parametric model was sold to the Alabama Insurance Underwriting Association, the state’s wind pool, in 2010.
Mexico and MultiCat: In October 2009 the Mexican government became the first to use the World Bank’s MultiCat bond program, when it sold $290 million in catastrophe bonds to cover potential damage from earthquakes and Pacific and Atlantic hurricanes. MultiCat provides a common documentation, legal and operational framework for issuing catastrophe bonds, the World Bank says, offering developing countries a cost-effective way to transfer disaster risk to the private sector and lessen the financial and economic impact of natural disasters. A growing number of entities in the public sector have purchased catastrophe bonds recently.
This type of catastrophe bond is known as a disaster recovery bond, see Reinsurance. Disaster recovery bonds are a new type of risk financing tool for the public sector, similar to business income insurance for businesses. They provide short-term liquidity after a catastrophic event, allowing government entities to function and begin recovery efforts at a time when the disaster has shut down much of the economy and its main source of revenue. The bonds are purchased by investors, who receive a good return except when payments to the issuer of the bond are triggered by the occurrence of the event insured against.
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