March 20, 2007
The Most Dangerous Animal
Posted by Seth Chandler

When I was a third year law student, my roommates and I would periodically gather at dinner in a chilly triple-decker not to discuss the subtleties of federal jurisdiction but to huddle around a small black and white television set to watch William Conrad's Wild, Wild World of Animals. The show had a regularity well suited to relieving stress. At some point during each episode, Conrad would deeply intone "But the greatest threat to the [insert species here] isn't the [insert predator here] [add dramatic pause] but man. Which brings me to the Florida insurance situation.

Florida, as my dear readers know, is subject to destructive hurricanes. The earth and its oceans, as my reasonable readers will likewise concede, at least in the short run, for whatever reason, are heating up in a way that certainly does not decrease the likelihood of destructive hurricanes. And so, one might think that Florida would be taking steps to mitigate the damage potential and to sensibly spread its risk over time. Alas.

Florida's reaction to global warming has been to deny that the near future is more likely to resemble the near past rather than the brisker averages of the past century and to thus claim that for this and perhaps other reasons the evil insurance market is mis-pricing property policies. The solution: create a state subsidized property insurer that now has over $400 billion in exposure and can't afford to pay for even moderate hurricanes without a post-event assessment and a grotesquely underfunded state reinsurance fund that cheerfully concedes dependence on enormous post-catastrophe assessments. These assessments are what it will take in order to pay claims and keep primary insurers solvent.

But it's facile just to snicker at Florida's absurd response to the situation. The real issue is how does one insure against the 100-year risk of loss against $1.9 trillion in coastal exposure in Florida or an equal amount in New York (Long Island) or $740 billion in Texas or an I haven't-found-good-data-but-I-know-it-is-large amount of volcanic risk in Seattle? And this is where it gets tricky. The private market has a difficult time estimating the risk of a remote mega-catastrophe and it has a difficult time diversifying that large a risk among the world's reinsurers. The result is that one has to build up an enormous reserve (read asset stockpile). Until the mega-catastrophe occurs, however, what the public sees, in part because of the limitations of accounting, are large premiums and what appear to be large profits in the insurance industry. Moreover, absent detailed premium regulation, "irresponsible" insurers win business by undercutting "responsible" insurers that accumulate the proper levels of reserves. On the other hand, if all goes well, the insurance market sends useful pricing signals to developers so that they reduce risk by building sturdier structures or focusing development efforts on regions less prone to the most destructive winds (read, not the coast, and possibly not Florida at all).

The alternative is to allocate the risk of loss on people after the catastrophe. The economic virtue of this methodology is that the size of the loss is basically known. The problems, however, are multiple. First, there's the liquidity problem. From where does the money come to rebuild while the assessments trickle in? Sophisticated financial rating agencies know this, by the way, and are beginning to have questions about Florida insurers. Second, except possibly in the unlikely event that the assessment is proportional to the ex ante risk posed by each insured, retrospective assessments will not have been sending the correct pricing signals to the property development market before the loss. The consequences will be (a) a loss that will be way larger than it would have been had the proper pricing signals been sent and (b) slowed development in regions less subject to risk who fear having to pay enormous post-disaster assessments. Moreover, in the event the state ever wishes to change its mind and go to a conventional insurance system, it will be deterred by the prospects of coping with its brewed population of property owners now hopelessly addicted to subsidized insurance.

Of course, one way to dilute the effect of post-disaster assessments is to spread the loss not over just the affected state but over a larger group, say the nation. This is basically what we did in an ad hoc way following Katrina. And we thus see a flurry of legislative activity to establish national catastrophe funds. (Three guesses, by the way, as to which state's legislators introduced the most prominent bill.) Unfortunately, however, absent enormous political discipline, the creation of this fund may simply exacerbate the perverse incentive effects of the Florida fund.

Which brings me back to William Conrad and his Wild, Wild World. It appears his wisdom extends further than that group of young legal minds suspected at the time. The greatest threat to Florida isn't hurricanes, but man.

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