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Life ain't FAIR

October 23, 2007 |  2:14 pm

The Malibu Schadenfreude identified by Steve Lopez and others today contains a legitimate public-policy issue within its (even more legitimate?) naked class envy/hatred. Namely, that many rich folk who build mansions in canyons -- and their less-rich compadres who build McMansions in foothills -- do so with subsidized, artificially inexpensive, actuarily unsound, government-secured insurance of last resort, called the California Fair Access to Insurance Requirements, or FAIR for short (and ironic). FAIR, as I wrote after the last truly awful fire season, came into existence as a direct response to ... horrendous inner-city rioting in 1968. Insurers were refusing to underwrite housing in places like Watts, so Congress passed the Housing and Urban Development Act,

which allowed states to obtain federal reinsurance money if they established property insurance pools of last resort to make homeowner and business policies available to those who lived and worked in areas the insurance companies considered to be too "high risk."

It started in the ghetto, but soon branched out to floodplains, hurricane country, faultline-adjacent housing, and hillside homes in Santa Ana-bedeviled Southern California. I can't tell after a quick Internet search the raw number of California FAIR plans, and the breakdown on categories for uninsurability, but here's what I came up with four years ago:

California FAIR insures around 160,000 homes, 20,000 of which are in brush-fire areas, according to a Sept. 28 Los Angeles Times article. Of those 20,000, "about 80% of the plan's policyholders live in Southern California," the Times reported, "including pockets of Malibu, Bel-Air, Topanga Canyon, Laurel Canyon, Glendale, Pasadena and Arcadia."

That number is almost certainly higher as a direct result of the 2003 fire season, to which then-state insurance commissioner John Garamendi reacted by easing eligibility requirements.

"I want to send a message to consumers that they should never go without homeowners insurance," Commissioner Garamendi said. "And I want to emphasize to agents and brokers that this plan is now more widely available to property owners that they can't otherwise insure.

"Among the saddest things I've seen during the aftermath of the fires are people who lost their homes and did not have insurance. Not only are their homes gone, but their financial future is now incredibly bleak," the Commissioner continued. "I want to make sure that everyone who wants insurance has access to it in some form."

The order, which is effective immediately, allows homeowners to "self-certify" that they have conducted a diligent search in the private market for insurance, but were unable to secure it. Previously, applicants had to provide three written denials from insurance companies to become eligible.

The order also allows those who live in areas not specifically designated as FAIR Plan regions to more easily become eligible for coverage. The FAIR plan historically has served urban and designated brush areas deemed high risk.

"Many Californians, regardless of their location, are finding it more and more difficult to find homeowners coverage," the Commissioner said. "The FAIR Plan, in its expanded form, will provide a better safety net to help those who can't find a policy elsewhere."

The flaw in this approach is not hard to spot -- if private insurers refuse to underwrite a house because it's in too dangerous an area, maybe that's because it's in ... too dangerous an area. Further, if the state steps in to guarantee reasonably priced fire insurance in a fire zone, that wipes out most of whatever market there is for insurance priced to fit the risk. Top it all off with increased population and more intense fire seasons, and you have a recipe for actuarial failure, bailed out by all taxpayers, not just the ones who build in dangerous country.

Pointing this out, naturally, feels like an inhumane and even sadistic response to a fire that has already wiped out 1,100 homes and forced 500,000 evacuations (including that of my brother's family in northeast San Diego). Still, with the forthcoming public policy debate that is as inevitable as ash from the flames, it's worth pondering the July 2007 congressional testimony of Robert Hartwig, the president and chief economist of the Insurance Information Institute. A chunky excerpt after the jump.

Since the 1960s a myriad of different government programs in place across the U.S. have provided property insurance to high risk policyholders who, for a variety of reasons, may have difficulty obtaining coverage from the standard market. The National Flood Insurance Program is perhaps the largest and best known federal program. Many states operate so-called residual, shared or involuntary market programs that make basic insurance coverage more readily available.

There is no question that government operated insurers play a vital and necessary role as insurers of last resort, servicing hard to place risks and acting as 'safety valves' following major catastrophc events. But today, many residual property market plans have evolved away from their original design as small insurers focused primarily on relatively low insured-value urban properties into major providers of insurance in high-risk, high value coastal areas. Many operate at deficits, or slim positions of capital, even in years with light catastrophe losses. A variety of factors are at play here, including the fact that government run property insurers are highly susceptible to political pressure and manipulation and frequently are not permitted to charge rates or adopt underwriting criteria that are commensurate with the risk being assumed. The tendency of regulators and/or legislatures to suppress rates in the private sector is a major contributing factor to pull-backs by private insurers in many coastal areas. This leads directly to more property owners seeking coverage through the state’s residual market facility and more pressure on politicians to keep rates down irrespective of the risk, the magnitude of losses or the deficits incurred.

While H.R. 920 requires that rates be established on an 'actuarial basis,' government operated insurers have historically had very little success in realizing that goal. The financial consequences have been nothing short of disastrous. The National Flood Insurance Program itself currently has a deficit of $17.5 billion according to the Congressional Budget Office. Of the 31 state-run Fair Access to Insurance Requirements (FAIR) plans for which data are available, 26 have incurred at least one operating deficit since 1999. Of the seven Beach and Windstorm plans for which data are available, all have sustained at least one underwriting loss since 1999.

In the course of the last decade the FAIR Plans have seen a more than 50-fold ballooning of their aggregate operating loss, from a $51.9 million loss in 1995 to a $2.8 billion deficit in 2005. Thus, not only have government run property insurers typically found operating on an actuarially sound basis elusive, the plans have generally grown in size over time as has the size of the deficits they incur. Given this real-world experience, it is unclear what practical safeguards -- beyond language in the bill itself -- could or would be implemented as part of H.R. 920 that would prevent deviation from actuarially sound pricing practices and the ensuing taxpayer-funded bailouts.

Much of the debate surrounding the failure of government run plans to charge actuarially sound rates focuses on the deficits that invariably result. But as multi-billion dollar deficits become more commonplace, the size of the policyholder assessments, and tax levies needed to close those deficits, will necessarily grow. The fact that there are frequent and large deficits at all suggests that the rates are not presently actuarially sound. But from an economic perspective, the issue of who ultimately pays for those deficient rates is at least as important as their size.

At the federal and state level, legislators and regulators have almost universally chosen to sacrifice actuarially sound rating and underwriting practices and fiscal prudence for political reasons. Though popular with voters, the decision to effectively subsidize coastal dwellers has financially grave consequences and sends perverse signals about risk to the marketplace. Specifically, the combination of artificially low rates and underwriting criteria that are too lax is financially lethal, enabling and encouraging rampant and substandard development in vulnerable coastal areas far beyond what would occur if property owners were required to internalize the true cost of risk in their decisions to build and buy property in coastal zones.

Financing the deficits that emerge poses an unpalatable dilemma for legislators. Should coastal dwellers be required to pay more to bring rates to an actuarially sound basis? Should the government refuse to insure properties that are simply too risky to underwrite at any price? These are politically unpopular and hard decisions, which is precisely the reason why they are seldom made. Consequently, legislators tend to search for ways to spread the cost of financing deficits well beyond the policyholders who actually incur the losses. Over time, state legislatures have authorized deficits to be financed by assessments on not only their own policyholders, but the policyholders of all insurers in the state. Moreover, assessments can be levied on property owners who have never filed a claim, including those who live far from the coast as well as people who have taken every precaution to mitigate against storm damage. Even auto insurance and commercial liability policies can be assessed. General tax revenues and even federal disaster aid are sometimes diverted to offset deficits in order to lessen assessments, thereby spreading the losses to all taxpayers including those who own no property and the poor. Borrowing is also common. When money is borrowed and paid back over an extended timeframe, losses are spread intertemporally (across time), forcing future residents—people who are now children and generations yet-unborn -- to shoulder part of the burden. The total cost of financing the disaster is greatly increased as well. One billion dollars borrowed at the June 2007 state and municipal bond rate of 4.6 percent for a term of 30 years would ultimately cost policyholders and/or taxpayers $1.85 billion when interest charges are factored in.

Practical experience has demonstrated repeatedly that government-run property insurers have rarely operated on an actuarially sound basis and for political reasons are unlikely to do so in the future. The effect is to enable and encourage rapid development in vulnerable areas that will inevitably drive up the size of future deficits, financed to a great extent by policyholders and taxpayers unconnected to the events that actually gave rise to the loss, perpetuating a vicious and expensive cycle.

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