Are We Seeing the End of Hurricane Insurability?
April 14th, 2006Posted by: Roger Pielke, Jr.
Catastrophe (cat) models are computer models of expected losses that allow the insurance and reinsurance industries to have a quantitative basis for calculating the risks that they face and hence set prices in a manner that is actuarially sound (for some background see this post). At least, that is how it is supposed to work in theory. (Warning: This is a long and detailed post.)
In practice things are far more complex, not least because cat models are “black boxes” developed outside of the public view, which makes it impossible to evaluate them independently. Cat models, and their opaqueness, are the focus of an emerging debate between consumer groups and cat model companies. It is not an exaggeration to suggest that in this debate are some indications that hurricane insurance may be changing dramatically. Insurance Journal reported the following last week (Note: Risk Management Solutions (RMS) is a leading provider of “catastrophe models.”)
Risk Management Solutions has defended its hurricane risk models in the face of consumer groups’ criticisms that the models are more political than they are scientific and that they are designed to justify insurance premium increases.
RMS declined to address the specific allegations made by the Consumer Federation of America and the Center for Economic Justice but issued a statement claiming that the groups’ viewpoint “is a misrepresentation” of its role in the insurance industry.
On March 27, CFA and CEJ wrote to the National Association of Insurance Commissioners raising questions about recent upgrades in the RMS wind models that the groups maintain would lead to “unjustified increases in homeowners and other property casualty insurance rates.”
The letter, signed by CFA’s J. Robert Hunter and CEJ’s Bernie Birnbaum, called for state regulators to increase regulation of RMS and other third-party organizations, including credit-scoring firms, whose work impacts insurance rates and availability.
The groups also blasted state regulators for failing to closely monitor the activities of RMS and other third-party rating organizations.
The consumer watchdogs referred to a recent announcement buy RMS that it is changing its hurricane models. RMS said that “increases to hurricane landfall frequencies in the company’s U.S. hurricane model will increase modeled annualized insurance losses by 40 percent on average across the Gulf Coast, Florida and the Southeast, and by 25-30 percent in the Mid-Atlantic and Northeast coastal regions relative to those derived using long-term 1900-2005 historical average hurricane frequencies.”
The groups, claiming this would mean overall double-digit rate increases from Maine to Texas, contend that while RMS says that this increase is necessary for scientific reasons, “the evidence indicates that the primary reason for the change appears to be not science at all, but politics.”
The letter from the Consumer Federation of America (CFA) and the Center for Economic Justice (CEJ) can be found here in PDF. The letter states:
Consumers were told that, after the big price increases in the wake of Hurricane Andrew, they would see price stability. This was because the projections were not based on short-term weather history, as they had been in the past, but on very long-term data from 10,000 to 100,000 years of projected experience. The rate requests at the time were based upon the average of these long-range projections. Decades with no hurricane activity were assessed in the projections as were decades of severe hurricane activity, as most weather experts agree we are experiencing now. Small storms predominated, but there were projections of huge, category 5 hurricanes hitting Miami or New York as well, causing hundreds of billions of dollars in damage. Consumers were assured that, although hurricane activity was cyclical, they would not see significant price decreases during periods of little or no hurricane activity, nor price increases during periods of frequent activity. That promise has now been broken.
The CEA and CEJ are expressing frustration that the science of hurricanes has evolved since the models were first developed. For its part, RMS goes some distance towards concluding that hurricane history is now irrelevant. In a white paper (PDF) used to justify its new approach to risk, RMS writes:
Given a constant climatological state (or if annual variations from that state are short lived and unpredictable) the activity rate in a catastrophe model can best be represented as the average of long-term history. In this situation there is no need to characterize the period over which the activity is considered to apply because, with current knowledge, it is expected that rate will continue indefinitely. The assumption that activity remains consistent breaks down, however, where there are either multi-year fluctuations in activity or persistent trends. It then becomes necessary to characterize the time period over which the activity in the Cat model is intended to apply.
It does not seem to me that RMS recognizes how profoundly revolutionary this perspective is, or its potential consequences for their own business. What they are say is that the historical climatology of hurricane activity is no longer a valid basis for estimating future risks. This means that the catastrophe models that they provide are untethered from experience. Imagine if you are playing a game of poker, and the dealer tells you that the composition of the deck has been completely changed – now you don’t know whether there are 4 aces in the deck or 20. It would make gambling based on probabilities a pretty dodgy exercise. If RMS is correct, then it has planted the seed that has potential to completely transform its business and the modern insurance and reinsurance industries.
What happens if history is no longer a guide to the future? One answer is that you set your expectations about the future based on factors other than experience. One such approach is to ask the relevant experts what they expect. This is what RMS did last fall, convening Kerry Emanuel, Tom Knutson, Jim Elsner, and Mark Saunders in order to conduct an “expert elicitation”. Here is how RMS described their process and its results:
The experts were asked to address and resolve the following questions:
• What is the expected basin activity of category 1-5 and category 3-5 hurricanes in the Atlantic basin over the next five years?
• What is the expected activity for category 1-5 and category 3-5 hurricanes at U.S. landfall over the next five years?
• How much longer can we expect the recent period of high Atlantic hurricane activity to persist?
• What is the expected activity of category 1-5 and category 3-5 hurricanes in the Caribbean over the next five years?
The experts discussed each question for one hour and a consensus opinion was then established for each question. The main conclusions reached by the experts were:
1. Activity in the Atlantic basin for the next five years is expected to be close to the average of the past 11 years. The probability for the activity to return to levels corresponding to the long term baseline is small over the next five years.
2. The experts each provided perspectives on the probability of the five-year U.S. landfalling rates being above or below certain thresholds, with the probability estimates provided by each expert considered interdependent (under a Poisson assumption). Relative to the historic 1900-2005 baseline, the increases in landfalling activity rates averaged across the group convert into about a 20% increase in the rate of category 1-2 storms and a more than 30% increase for category 3-5 storms.
3. The high levels of activity observed over the last 11 years are expected to last for at least another 10-15 years.
4. The medium-term activity in the Caribbean region is expected to be consistent with the perspective of activity developed for the full basin.
RMS then used the information provided by the panel of experts to implement the five-year view of activity rates in both the U.S. and Caribbean Hurricane models.
In general, expert elicitation is a very useful method for aggregating the views of a community of specialists on focused questions. In this instance, RMS has left itself wide open to some valid criticism. For instance, although each scientist included in its elicitation is well-respected in the field, the four experts represent a small subset of the relevant and available expertise on the questions that were asked. Including more of the community in an expert elicitation would add to the legitimacy of the results, even if the conclusions themselves don’t change. Because the elicitation resulted in a forecast of persistence, I’d guess that including more experts probably wouldn’t much change the results, although it might increase the uncertainty of the conclusions.
Also, RMS conducted its elicitation October, 2005 with the intent that it will shape its risk estimates for the next 5 years. This is wholly unrealistic in such a fast moving area of science. It is unlikely that the perspectives elicited from these 4 scientists will characterize the views of the relevant community (or even their own views!) over the next five years as further research is published and hurricane seasons unfold. Because RMS has changed from a historical approach to defining risk, which changes very, very slowly, if at all over time, to an expert-focused approach, it should fully expect to see very large changes in expert views as science evolves. This is a recipe for price instability, exactly the opposite from what the consumer groups, and insurance commissioners, want.
From the perspective of the basic functioning of the insurance and reinsurance industries, the change in approach by RMS is an admission that the future is far more uncertain than has been the norm for this community. Such uncertainty may call into question the very basis of hurricane insurance and reinsurance which lies in an ability to quantify and anticipate risks. If the industry can’t anticipate risks, or simply come to a consensus on how to calculate risks (even if inaccurate), then this removes one of the key characteristics of successful insurance. Debate on this issue has only just begun.
April 14th, 2006 at 9:41 am
I don’t think the idea of a short-term risk catalogue is bad. This is saying that risk isn’t always the same, which seems to be the way other types of insurance function. Say you have lived in Miami for 30 years – and all of a sudden your rates go up because with increased hurricane frequency and intensity on the average in the next few years, you have an increased risk of damage.
Now think about auto insurance. If you’ve had the same car for 10 years and then you switch to a newer car with better brakes, etc, your rates may go down. This rate decrease basically says that the risk you bring as a person (long-term) has not changed, but the short term variation in risk (new car) has changed, so the prices adjust accordingly.
In this case, Miami is the person and the increased hurricane activity is the new car. Miami hasn’t changed its baseline, long term risk (just like the driver in the previous example hasn’t changed), but there is a change in the near term risk of increased hurricanes (just like a new car changes the risk of the driver).
The only problem in the case of hurricanes is the lack of expertise we have in modeling the increased hurricane frequency and intensity. Rather than taking years of history and millions of data points of car improvements and how this translates into lowered risk, we have four expert opinions about the change in risk for hurricanes.
The problem lies not in the idea of a near term risk catalogue but in the lack of information available to support such a catalogue. Given this, the whole thing seems like almost as much of a crap shoot as it did before CAT models. Now, though, we have a computer to point to instead of the art of pricing that took place in someone’s brain.
April 14th, 2006 at 11:20 am
As far as the breadth of opinion of the experts, I note that, originally, Chris Landsea was invited to the meeting that the elicitation followed. When he became the SOO at the Tropical Prediction Center, he had to pull out of the meeting. I was at the meeting on extreme events and climate to talk about thunderstorms. The elicitation took place after breakfast the final morning. I went for a walk and came back and shared a cab with Kerry to the airport. Based on the initial meeting agenda I got last summer, Kerry replaced Chris for the meeting. The RMS folks then met with the tropical folks who were at the meeting the morning after it ended. I don’t know why they didn’t expand the elicitation beyond the attendees (or if they tried and failed).
April 14th, 2006 at 1:51 pm
If indeed it’s the case that current rates don’t cover a potential long series of damaging seasons, then it’s inevitable that rates will go up. Even a firm expectation that the third decade out would revert to low activity wouldn’t change that at all. In effect, the consumer groups seem to be telling the insurance companies to risk their survival in order to keep rates low. I think we know what the answer will be.
April 14th, 2006 at 8:13 pm
I don’t get the point about the five year boundary. I assume that RMS will, if needed, reconvene this (or another) group of experts as the field moves. This is called formative evaluation, and is quite usual, especially if money is on the table.
April 15th, 2006 at 2:53 am
Seems like a rather hysterical headline for something as minor as a rethink of insurance rates.
April 15th, 2006 at 4:32 am
Roger
I wouldn’t be too concerned about the insurance industry. They have already adapted to the reality of increasing exposure, damage and cost due to natural disasters. In fact, the industry is doing extremely well and has just announced record profits for last year:
“The companies that provide Americans with their homeowners and auto insurance made a record $44.8-billion profit last year even after accounting for the claims of policyholders wiped out by Hurricane Katrina and the other big storms of 2005, according to the firms’ filings with state regulators….
Besides boosting profits, the industry raised its surplus by more than 7% to nearly $427 billion, according to an analysis of company filings by the National Assn. of Insurance Commissioners, which represents regulators from the 50 states. The surplus is intended to provide a financial cushion in times of high claims.
The industry covered virtually all of its claims and expenses with premiums earned during the year rather than with surplus funds, according to the organization’s analysis. The ratio of claims and expenses to premiums was among the lowest in three decades….”
How did they pull off such an amazing success in one of the worst disaster-prone years? The industry is simply using an effective free-market approach to the problem:
“The question is: How, in a year that produced an estimated $56.8 billion in disaster losses, nearly twice the previous record and more than twice what insurers paid after the Sept. 11 attacks, is this possible?
The answer, in part, is that U.S. insurers purchased disaster insurance of their own before the 2005 storms, much of it from overseas firms. Executives said that half — and by some estimates, nearly two-thirds — of the insured losses from last year’s hurricanes ultimately will be borne by so-called reinsurers, many based in Bermuda and Europe.”
http://www.latimes.com/news/nationworld/nation/la-na-insure5apr05,0,3061059.story?coll=la-home-headlines
April 15th, 2006 at 7:09 am
James, Benny- Thanks for your comments. I do think that the RMS action is a big deal. The industry really changed with the advent of cat models, we may be seeing their demise. Of course, as Joel Gratz comments hurricane insurance was available before cat models and could be again, but the transition will be very disruptive in my view. At a minimum we will see an extended period of the “excess of objectivity” in this community meaning that rate setting will be far more art than science, which means we will likely see more actions like those of the CEA/CEJ. This is far more than a rethink of rates — it is a rethink of the very foundation of catastrophe reinsurance. Thanks!
April 15th, 2006 at 8:18 am
The end of hurricane insurance?
Hunter, Scott and others have raised questions in the comments section of this blog about the future of hurricane insurability. As if on queue, Roger Pielke Jr. at Prometheus has put up a long post on the very topic that’s…
April 15th, 2006 at 12:40 pm
Gosh, Ben, you proved it: AGW is good for business, so it must be good for everybody!!!! *heart*
Best,
D
April 15th, 2006 at 6:26 pm
Roger,
Well I guess time will tell. If, in a decade (say), insurance against hurricane damage is no longer available, you will be proved correct. If not, then claims of its demise would seem rather premature. Would you care to put some money on it?
April 15th, 2006 at 8:13 pm
James-
Thanks for your comment. However, if you read my essay as a prediction of the end of hurricane insurance, that would be a misinterpretation. Perhaps it was unclear, so I’ll add a bit more.
First off, “insurability” is not the same as the provision of insurance. Have a look at this Swiss Re report which discusses criteria of insurability,
http://www.swissre.com/internet/pwsfilpr.nsf/vwFilebyIDKEYLu/ESTR-5SMHEA/$FILE/Eco_Damage_en.pdf
and most importantly: “The prerequisite for insuring evironmental liability is a clear set of criteria which would allow the underwriting risk to be calculated reliably.” (p. 27, and if you want to read further in that Swiss Re report, the issue I am raising is that because of the changes made by RMS, “asessability” and “mutuality” are likely to now be in conflict).
Just because some particular risk does not meet the criteria of insurability does not mean that insurance cannot be found to cover that risk. I’m sure, for example, that Tiger Woods has some unqiue insurance policy set up to cover a non-golf-related career ending accident or injury. But not meeting criteria of insurability sure makes it hard to set up a market. In the US flood insurance is widely available, however it is generally understood that the risks do not meet the criteria of insurability, hence it is a government subsidized program.
Have a look again at my post. I am not saying anything about the end of hurricane insurance, what I did say is “If the industry can’t anticipate risks, or simply come to a consensus on how to calculate risks (even if inaccurate), then this removes one of the key characteristics of successful insurance.”
Thanks!
April 15th, 2006 at 8:29 pm
There is a significant difference between insurance risks and reinsurance risks and underwriting which is getting lost here.
Benny, of course, did not say how much of the reinsurance loss will be carried by US reinsurers, and insurers. For him, it is enough that the swiss will have to pay, but reinsurance is a global game. For a list of the largest reinsurers see (http://tinyurl.com/gsd7s page 5)
April 15th, 2006 at 11:48 pm
Re: “insurability” is not the same as the provision of insurance.
Well, it is in every dictionary I can find (eg http://dictionary.reference.com/search?q=insurability ).
It’s quite clear in the document you cite that “reliability” of quantifying risk always involves some judgement calls anyway. Given that (as you agree) insurance will continue to be available, their “prerequisite” seem more like a wish-list than reality. Trying to extract some nuance whereby the headline of your post is defensible may get you off the hook on a technicality, but I bet that the vast majority of readers would be misled by it.
April 16th, 2006 at 7:12 am
James- I don’t see much profit in continuing to pick this nit. However, I would suggest accessing a better dictionary, the link you suggest for “insurability” actually goes to “insure”! Dictionaries aside, they are different concepts
Thanks.
http://www.wordreference.com/definition/insurability
April 16th, 2006 at 11:12 am
A good summary of the position from Warren Buffet, whose Berkshire Hathaway owns General Re:
http://www.insurancejournal.com/news/national/2006/03/06/66159.htm
Hurricane season’s effects
In addition to causing financial damage, the 2005 hurricane season has raised questions at General Re and National Indemnity. “It’s an open question whether atmospheric, oceanic or other causal factors have dramatically changed the frequency or intensity of hurricanes. Recent experience is worrisome,” Buffett acknowledges.
He maintains that the outlook is uncertain. “Was this onslaught of more frequent and more intense storms merely an anomaly? Or was it caused by changes in climate, water temperature or other variables we don’t fully understand? And could these factors be developing in a manner that will soon produce disasters dwarfing Katrina?” Buffett asks.
Buffett admits that neither he nor his reinsurers knows he answers but he advises that in the absence of answers, insurers must proceed with caution.
“What we do know is that our ignorance means we must follow the course prescribed by Pascal in his famous wager about the existence of God. As you may recall, he concluded that since he didn’t know the answer, his personal gain/loss ratio dictated an affirmative conclusion,” Buffett writes.
Following Pascal’s example means higher prices and more selective underwriting. “So guided, we’ve concluded that we should now write mega-cat policies only at prices far higher than prevailed last year – and then only with an aggregate exposure that would not cause us distress if shifts in some important variable produce far more costly storms in the near future. To a lesser degree, we felt this way after 2004 – and cut back our writings when prices didn’t move. Now our caution has intensified.
“If prices seem appropriate, however, we continue to have both the ability and the appetite to be the largest writer of mega-cat coverage in the world,” the chairman maintains.
April 16th, 2006 at 1:58 pm
I am very sorry to disappoint those people who seem to be unduly concerned about the effect of US hurricanes on the health of the global insurance industry. As a matter of fact, even the reinsurance industry has been thriving in spite of unprecedented disaster losses:
“The [global reinsurance] industry has managed the massive losses of the 2005 hurricane season and is enjoying the profits and healthy balance sheets that have resulted from a continued hard market.”
http://www.canadianunderwriter.ca/issues/ISArticle.asp?id=54500&issue=04052006
In the meantime, policy-makers in hurricane-prone US states have begun to introduce new bills that provide legal and financial incentives for adaptation and mitigation, such as -
* low interest loans to homeowners to “harden” or retrofit their homes.
* free wind certification and hurricane mitigation inspections to homeowners and potential buyers.
* introduction of a hurricane loss mitigation grading system for residential structures to be used for home inspection reports that would be available to homeowners for disclosure to purchasers.
* new requirement of storm shutters or impact-resistant glass on new construction, etc.
http://www.insurancejournal.com/news/southeast/2006/04/14/67304.htm
These and other incentives in addition to technological advances will almost certainly improve the solidity of buildings and infrastructure and, as a consequence, will bring down damage risk and insurance premiums significantly.
While there may be some short-term hiccups and teething problems in the next few years, there is absolutely no doubt in my mind that the global insurance industry will ride out future hurricanes – whatever the length of future cycles or the level of intensity.
April 16th, 2006 at 5:21 pm
Roger,
Your definition is word-for-word identical to the one I provided (you have to scroll down). Clearly, the answer to your headline question is….
No
April 16th, 2006 at 6:19 pm
James- I will simply restate that I am perfectly comfortable with the headline and the text of my post. The notion of “insurabiltiy” and “insurance” are viewed by the insurance and reinsurance industries as distinct concepts. I am sure that you might find some fault if someone were to define to you “climate sesitivity” to mean the “emotional state of the climate,” based on what they found at dictionary.com;-) Enough of this silliness for me, go ahead and have the last word if you’d like. Thanks.
April 16th, 2006 at 6:23 pm
Benny- Thanks for your comments. I have far more worries about the state of the catastrophe modeling firms than I do about their clients in insurance or reinsurance. I hope to soon post a review/comment of a recent report about the health of the reinsurance industry, and it is quite strong in many respects.
April 17th, 2006 at 8:32 am
Harold- Thanks for your comments which add a valuable perspective to this issue. (I was invited to the same extremes meeting but had a conflict.) It seems to me that this context that you share suggests some arbitrariness to the process in which the very major changes in risk estimates were developed that will certainly reverberate through this global community.
Another factor worth considering, which would certainly be raised in other contexts like energy or drug testing, is that most (if not all) of the participants in the expert elicitation have received funding from insurance/reinsurnace companies. I’ll underscore that each is a widely-respected scientists, nontheless, financial ties to industry can create a perception of too close a linkage.
April 17th, 2006 at 3:30 pm
Blonide has the final word….
http://www.blondie.com/dailies/index.asp
April 17th, 2006 at 3:32 pm
Apologies, the url is only valid for 4/17. The permanent home of the strip is http://tinyurl.com/myc3s . A
April 17th, 2006 at 3:57 pm
Roger,
Have to agree with James on this. Your headline is confusing and prone to misinterpretation. Why not just admit what you wrote was confusing. I misinterpreted it at first. I may be stupider than I think, but you writing is less clear then you think.
April 17th, 2006 at 4:27 pm
Eli:
Good link.
You’ll know when the obfuscation and mendacicization are over for good when Hi and Lois comment about AGW, HockeyStick bamboozle sites or FEMA management incompetence. Until Lois looks concerned, we can only nod our heads knowingly at Dagwood’s exclamation mark over his cowlick.
Oh, and what Mr Lewis said.
D
April 17th, 2006 at 5:06 pm
Greg- Thanks for your comments. Yes, obviously the headline is confusing for some readers! For me this is a good lesson in comunicating on issues that have some terms of art involved. However, a bit disappointing to me was James’ unwillingness to recognize that there is in fact a deeper issue involved here, initial confusion aside, rather than some bad faith on my part. For what it is worth folks I’ve heard from in the industry have expressed no such confusion. For me the lesson is to be sure to explain the notion of “insurability” and its significance when seeking to discuss this issue among a general audience. Thanks!
April 17th, 2006 at 9:00 pm
Roger,
The dictionary definition which you provided explicitly supports what I said – “the end of hurricane insurability” is hyperbole. But enough of that for now.
As I understand it, your deeper point is that an explicit acknowledgement of (poorly-understood) climate change implies that expert judgement as to future changes forms a larger part of risk analysis, and historical data on past events a lesser part, than was heretofore the case.
To which I say…sure, but what’s the big deal about that? Lots of insurance risks have always involved a certain amount of judgement – indeed it would be straightforward to argue that the existing CAT models are already a blend of expert judgement and data. There may be a shift in the balance underway, but there’s no paradigm shift here IMO.
April 17th, 2006 at 10:40 pm
The problem is not that the risks are increasing, it is that the industry cannot figure out how to evaluate the risks, e.g. they are not sure of the scientific basis, and in the absence of that they cannot price their insurance appropriately. See the comments by Buffet. The set to between the Grays and the Trenberths is a strong caution flag for them.
The insurance industry will write large policies on large risks, but only for appropriate premiums. If they have not a clue about the risks or have reasons to suspect that there is a problem with their models they will not write, or will price themselves out of the market.
In that sense an unknown risk is uninsurable (you could, of course find a bookie or go to Lloyds), and as a result the consumer will not be able to purchase insurance. There are cases where the risk is insurable, but companies will not write policies. For example if they cannot charge what they think they need for a return for regulatory or market reasons).