Catastrophe risk has always presented a thorny public policy problem. Sometimes, the chosen solutions spill over and affect private insurers. Today, many U.S. states maintain catastrophe risk pools, such as “Fair Access to Insurance Requirements” (FAIR) and beach plans (wind pools), as insurers of last resort. Many are rapidly growing. In this Perspective, I discuss the increasing catastrophe exposure faced by public risk pools and the fact that private insurers can’t entirely escape it. Private insurer CEO’s should consider several specific actions to manage their share of the risk.

Macro Trends – Running to the Risk

Your intuition likely tells you that the amount of property located in areas of high risk is increasing. AIR’s Coastline at Risk report validates this intuition, documenting the growth in overall property replacement values by state and its migration toward coastal counties. People are literally “running to the risk” by building more and larger homes and businesses in harm’s way. The same phenomenon is occurring in seismically active areas of the U.S., though not as dramatically.

Why would presumably rational people make seemingly irrational decisions? There are a number of factors at play:

1. Homeowners are not getting correct price signals regarding the true cost of owning and insuring these properties. Wind pools typically offer some policies at rates that are unsound to fully fund the risk. Pools may address this shortfall by relying on debt, or by accessing other public funds after disasters. Once many voters are established in risky areas, the political resistance to higher insurance rates becomes intense.
2. As Baby Boomers retire or semi-retire, economic activity has migrated to the Sun Belt and the insured exposure has followed.
3. Public policy in the U.S. has encouraged investment in home ownership for decades, expanding government backing of mortgages over time and, more recently, holding interest rates at historically low levels. And it is the strange luck of the U.S. that the most attractive areas for home ownership, such as the Gulf and Atlantic Coasts and California, often happen to be the most risky areas.

Insurers Can Be Choosy, Public Pools Cannot

Insurance technology and economic conditions have also contributed to the trends. “Cash flow underwriting” by private insurers is long gone in the current near-zero interest rate environment, having been replaced by intense scrutiny of individual risk profitability. Insurers have made major investments in analytics and supporting computing technology—specifically, in catastrophe modeling, geocoding, automated real-time underwriting, and advanced decision engines for portfolio optimization—all with the goal of improving risk selection. What is increasingly not selected by the private sector is then often insured by a public risk pool, and so the pools have grown.

But decisions by insurers to route properties judged as “just not worth it” to the public pools does not mean the risk is fully avoided.

Insurers are Taxpayers Too

Insurer executives cannot escape from the risks associated with the expansion of public sector involvement in funding catastrophes. First, most pools have what are effectively powers of taxation against private insurers, the insurance-buying public, or both. These powers usually take the form of assessments, which are typically proportional to insurers’ market shares in a state and can take a variety of forms:

• Direct assessments against insurance companies, usually levied in years of “deficit” for the pool. These deficits are usually, but not always, due to catastrophes. Even if the assessment can be legally recouped from policyholders, accounting rules may not match the liability with an equivalent asset.
• Direct assessments against policyholders, using their insurers as collection agents. Such pass-throughs may not be accounting liabilities for the insurer, but they are administratively costly and may damage the good will between insurer and policy holder, prompting the policy holder to look elsewhere.

There is another reason why insurers should be paying attention to growing public involvement: they could actually be “crowded out” of otherwise profitable markets due to competition—intended or not—from the public pools themselves. Legal requirements that private insurers be given the opportunity to accept or decline a policy before it goes to the pool are often unenforceable and therefore disregarded. And it’s a politically attractive proposition to give the voters “something for nothing” in the form of lower rates (that is, until the bill comes due). And so the pool grows, as does the risk of increasing assessments.

One clear implication is that any insurer properly modeling its own catastrophic exposure must also consider its share of the potential deficits arising from public pools. Furthermore, “probable maximum assessments” should be considered regionally, as multiple states may be impacted by a single event. That is, a manageable pool exposure for a single state may translate to a significant enterprise risk when aggregated across all states in which an insurer operates.

When Governing Risk Pools

An equally important dimension of the relationship between private insurers and public risk pools is that of governance. Private sector insurers often help run pools by way of seats on the Board of Directors or through influence of elected officials who appoint pool managers. The staffs of these pools often have limited access to, or training in, catastrophe modeling. However, insurers that make governing decisions could be making expensive mistakes if pools are effectively discouraged—under the banner of cost-cutting—from investing in best practices for analyzing their own catastrophe risk.

A useful case study in this regard is Florida’s Citizens Property Insurance Corporation (Citizens), the largest wind pool by far in the U.S. Unlike many other pools, Citizens has a staff of trained catastrophe modeling professionals who must daily answer requests from their Board, legislators, regulators, and even the Governor and Cabinet officers in Florida regarding its exposure to catastrophic deficits. Modeling at Citizens is an essential tool for reporting.

These professionals also sponsor the largest catastrophe reinsurance program in Florida, a state that is home to over 50% of U.S. hurricane risk. Reinsurance submissions and catastrophe bond information must meet extremely granular standards, yet convey a wide spectrum of risk information in order to secure the capacity and prices needed to protect the state’s taxpayers. Robust model results generated in house are critical to these transactions.

The thought of a public pool with the authority to levy billions of dollars in assessments after an event—without the internal know-how and resources to properly analyze its risk before a costly event—should be downright scary to private insurers. The larger the pool, the greater the stakes.

Action Items for the Insurer CEO

Top insurer executives should engage their senior staffs on several questions directly relevant to managing exposure to public risk pools:

• The chief financial officer, chief risk officer, and head of catastrophe modeling should report on how the insurance company is including public risk in its “book of business” subjected to regular catastrophe modeling. Participation in pools, no matter how the assessment mechanism operates, is really no different than partial assumption of a book of exposures neither controlled nor underwritten by the insurer.
• The officers or delegates that serve on the Boards of public risk pools should report on the quality of each pool’s catastrophe modeling—who does it, how often, what models are used, whether they are fully understood, and how well the results are being applied.
• The government affairs staff should report on its knowledge of pool underwriting practices, financing structure, and other attributes relating to catastrophe risk. Insurers should devote resources to understanding the risk of each pool and to influencing pool decisions.

The catastrophe risk of public property insurance pools is material and growing, and the share borne by private insurers should not be taken lightly. Just as no major private insurer executive today would consider an operating plan without best practices in catastrophe modeling, these same executives would be well served by devoting significant resources to understanding the pools’ risk and maximizing their governance leverage to promote best practices.

AIR intends to work side by side with U.S. insurers in developing strong relationships with, and deep knowledge of, the increasing number and size of public pools handling catastrophe risk. We also recognize the challenges of assessing pool risk, particularly in light of the fact that the ultimate impact on the insurer will also depend on each pool’s evolving financial reserves and reinsurance structures.

In response, we have recently formed a new unit, named Public Risk Services, with the mission of building a center of excellence in understanding public handling of cat risk and acting as “ambassador” to public risk pools and their governing stakeholders. One goal is to assist our clients as they manage their share of publicly-administered exposures. Look for more on this topic from us.