Hurricane season officially starts Monday. In anticipation of that date, several pieces of legislation have been introduced in Congress to increase the federal role in managing the risk of natural disasters. These bills reflect a concern about the rising costs of catastrophes and the affordability and availability of insurance. If we aren't careful, however, federal intervention could make things worse, not better.
Insuring catastrophe risks is expensive. In our work, we have seen that insured losses, total damages and fatalities associated with catastrophes tend to be what economists call "fat-tailed" risks: the 1-in-20-year catastrophe may be more than twice as bad as the 1-in-10-year catastrophe. This has two implications.
First, history can be a poor guide to the future. The 2005 hurricane season, for example, sent the National Flood Insurance Program deeply into debt. The program bases its prices on historical losses. Going forward, however, they are only counting 1 percent of the 2005 losses, even though, by their own admission, this will not generate enough premiums to even cover the interest on their debt. The reason for this is stated in the 2008 Actuarial Rate Review: Fully counting Hurricane Katrina "would result in the elimination of current subsidies. While the elimination of the subsidy is a long-term goal supported by FEMA, such a significant change should be explicitly supported by Congress and not simply the result of a formula."
Second, but related: Horribly destructive hurricanes may be relatively rare, but the next one could be worse than anything we've seen. Hurricane Katrina, for instance, was only a Category 3 storm when it landed. Imagine a Category 5 storm striking Miami.
The federal government has a proper role in disaster relief efforts after a catastrophe has occurred. But how much of the catastrophe risk of specific locations should the general taxpayer bear? How much should taxpayers in Idaho contribute to covering the risk of beachfront homeowners in Florida? Conversely, what is the responsibility of a Florida homeowner to someone who lost a home to a wildfire in California?
We like to think that catastrophes are simply acts of God, but they are acts of man, too. We can choose not to build in very risky areas. If we do build in these places, we can strengthen our buildings to withstand hurricane winds, rising floodwaters and earthquakes. Individuals and businesses can insure their property so they have funds to rebuild. When state programs or private insurance companies fail to encourage responsible risk management before a disaster occurs, Congress should not simply offer them a bailout as a reward for poor management.
We believe federal legislation should do three things: (1) support mitigation efforts, particularly for low-income households; (2) price risk accurately and (3) boost the ability of private companies to insure catastrophes.
How do current bills stack up against these priorities? We consider House bills HR 308 and HR 83 and Senate bill S 505.
HR 308 offers tax breaks for mitigation to strengthen homes against hurricanes and tornados. Since up-front costs of retrofits can be expensive and mitigation offers public, as well as private, benefits we think this is a good approach. Consideration should also be given to providing federal matching funds for state-funded mitigation or, as a condition of federal support, forcing states to require property insurers to offer premium deductions for disaster-resistant buildings.
Most states facing catastrophe risk have reinsurance funds, or state-run insurance for the insurance companies. S 505 offers loans to these programs to pay claims when a catastrophe depletes their funds. HR 83 provides federal reinsurance for state insurance programs, like Citizens Property Insurance Corp. Federal support has merit in that the government can spread losses over time. Each bill, though, has a potential downside.
Since S 505 has no provisions to guarantee repayment or fair interest rates on the loans, it could introduce moral hazard — that is, encourage states to be reckless with their risk-taking, as Florida has done in the past. And if a major catastrophe bankrupts a state program, the federal government may never see any repayment.
As a condition for the loans, S 505 does require state programs to establish rates that would cover the "expected annualized cost of all claims." Encouragingly, Florida and Texas have recently begun to do this on their own. As we saw with federal flood insurance, though, the time frame over which expected cost is defined is critical with fat-tailed risks. Premiums would be very different for Florida if rates were set based on the past five years, instead of the past two years.
HR 83 would make the federal government a reinsurer. Premiums would thus be collected each year. The potential problem is that a sizable reserve could be accumulated after many good years generating political pressure to reduce rates or reallocate the funds. But we've seen that a sizable reserve will be needed when the next big one hits. To us, this problem of maintaining a reserve seems less severe than the risk of non-repayment of loans. We also stress the need for differentiated and risk-based rates for reinsurance, so that the taxpayer is not put on the hook for poor management of state insurance programs. We don't believe taxpayers should subsidize insurance, which can be quite costly. For instance, 1 percent of NFIP policies suffer repeated flooding and pay subsidized rates. That 1 percent accounts for 25 to 30 percent of all claims!
Neither bill encourages increased availability of private catastrophe insurance. One way to do this, which has been discussed previously by policymakers and scholars alike, is allowing companies to establish tax-free catastrophe reserves. This would make them better able to cover very large losses.
Catastrophes are costly — in property damage, lives lost and emotional strain. With a little bit of preparation and planning, though, we can lower these costs and distribute them more fairly. The old adage, an ounce of prevention is worth a pound of cure, clearly applies to disaster risk, especially when we know more catastrophes are coming.
Roger Cooke is a senior fellow and Carolyn Kousky is a fellow at Resources for the Future, an environmental think tank in Washington.