Principles for Reform of Catastrophic Natural Disaster Insurance

Along with the winds, rain, and storm surges of Hurricane Katrina came a cacophony of voices urging Congress to adopt a catastrophic hurricane fund (CAT fund). A CAT fund, like the bankrupt and highly inefficient National Flood Insurance Program (NFIP), would provide government insurance to homeowners and businesses to protect against the next catastrophic hurricane. Lost in the chorus of doomsayers is the inconvenient fact that Hurricane Katrina-the most expensive natural disaster in American history-did not bankrupt the insurance industry. Unlike the cur­rent Wall Street financial crisis, the industry did not even require a federal bailout.

From 1970 to 2006, America experienced 23 insured catastrophic losses due to natural disasters or terrorism ranging from $45 billion down to $1.993 billion (in 2005 dollars). These included 15 hurri­canes, one earthquake, and the terrorist attacks on September 11, 2001. Only four caused insured losses greater than $15 billion. Over the past 18 years, only five years have seen insured catastrophic losses in excess of $15 billion: $22.9 billion in 1992 (Hurri­cane Andrew); $16.9 billion in 1994 (Northridge earthquake); $26.5 billion in 2001 (9/11 terrorist attacks); $27.5 billion in 2004 (Hurricanes Frances, Charley, Ivan, and Jeanne); and $61.9 billion in 2005 (Hurricanes Katrina, Rita, and Wilma).[1]

As one expert noted, the insurance "industry held about $400 billion in equity capital and collected pre­miums of about $440 billion" in 2004.[2] While only 12 percent of those funds represented premiums from homeowners insurance, that still amounts to $52.8 billion in yearly premiums.[3] Assuming that actuari­ally unsound state rate caps are lifted and insurance companies take a tighter approach to paying home­owners claims, insurance companies appear easily capable of dealing with all but the most catastrophic natural disasters-they have already dealt with the most catastrophic disaster to date.

Despite these inconvenient facts, proponents of a CAT fund continue to push for another federal pro­gram that would further distort the property and casualty (P&C) insurance market. As with many federal proposals, a CAT fund started small as a hurricane-centric idea, but California's congressional delegation would likely seek to add earthquakes to any proposed legislation. Yet no matter what is covered, a CAT fund would federalize even more of America's natural disaster response and spread the risks willingly accepted by a minority of taxpayers to a majority of taxpayers who live far away from routine hurricane and earthquake activity. Common sense demands a different approach.

In 2007, one CAT fund proposal, The Home­owners Defense Act (H.R. 3355), embodied many of the worst characteristics of CAT funds. It would have made it easier to create a federal government subsidy of P&C coverage for natural disasters. The bill would also have made it easier for individual states to create unrealistic disaster insurance pro­grams, with underpriced policies, by creating a fed­eral loan fund to cover losses suffered by those programs. Although states are already empowered to create such consortiums, H.R. 3355 would have granted this consortium a federal charter that would appear to extend a federal guarantee to the bonds issued by the group, when in fact no such guarantee would have existed. This false federal imprimatur could have increased pressure for a federal bailout following the inevitable disaster.

Five Principles of Reform

Rather than trying to second-guess the collective wisdom of the private sector, this paper establishes five principles that should guide any catastrophic natural disaster insurance reform. Underpinning these principles is the belief that the private sector, state governments, and-as a last resort-the federal government could take many actions short of creating a CAT fund that would provide greater stability to the insurance market at a lower cost to most taxpayers.

Principle #1: Catastrophic should mean nationally catastrophic.

As noted in previous papers over the past 16 years,[4] the disaster response community has explic­itly and implicitly reduced the threshold of what qualifies as a natural disaster eligible for a federal declaration. This "defining disaster down" approach is largely driven by the 75 percent or more cost-share provision that Congress included in the 1988 Robert T. Stafford Disaster Relief and Emergency Assistance Act (Stafford Act).[5] This helps to explain why disaster declarations are granted months after the events when there are simply no emergencies and the events clearly had been handled without federal involvement.

In the Stafford Act, the express threshold for a declaration is a disaster "of such severity and magni­tude that effective response is beyond the capabilities of the State and the affected local governments and that Federal assistance is necessary."[6] Despite this clear requirement, the Federal Emergency Management Agency (FEMA) has approved disaster declarations for many natural disasters that historically and factually were not beyond the capabilities of states and localities. Other than hurricanes, earth­quakes, volcanic eruptions, and tsunamis, most natural disasters in America lack the potential to meet the Stafford Act definition. Even most hurricanes, earthquakes, volcanic eruptions, and tsunamis do not meet the Stafford Act requirement.

Of course, that does not mean that a particular natural disaster is not "catastrophic" for a particular community. It simply means that most natural disasters occur within confined geographic areas and that states and localities can handle them with­out federal involvement. At least, they should be and used to be before the Clinton and Bush Admin­istrations federalized more and more of America's disaster response activities, giving states and localities an incentive to reduce their own investment in disaster response capabilities. (See Chart 1.)

As noted above, most natural disasters over the past 18 years have caused insured losses of less than $15 billion. Every one of the natural disasters occurred primarily in an 11 state area. Most of the 11 states have yearly budgets well in excess of $15 billion, so they should be capable of crafting state-based programs to handle catastrophic natural disasters, including raising taxes when necessary to fund a state-based CAT fund.[7]

Fundamentally, the United States needs to return to a decentralized disaster response frame­work in which states and the people living in the states bear the cost of disasters that occur in their own jurisdictions.

Therefore, the most critical principle is that for FEMA disaster declarations "catastrophic" must actually mean nationally catastrophic. Toward this end, Congress should:

• Amend the Stafford Act to limit eligibility for FEMA disaster declarations to hurricanes, earthquakes, volcanic eruptions, and tsunamis, explicitly excluding other natural disasters;
• Insert severity and magnitude thresholds for these four types of disasters so that only those that are truly national emergencies qualify for federal involvement;
• Adopt a high economic threshold requirement for any program that is created to prevent a national catastrophic natural disaster from bank­rupting the insurance industry. For example, one insurance company suggested a $125 billion trigger for a lender-of-last-resort program.

Such a trigger is necessary given the federal tendency to spend the money by expanding eligibility downward. This tendency will increase if paid premiums piled up during years without any eligible events. Accountability needs to be returned to the governors and the people.

Principle #2: Those who assume the risk should bear the risk.

We possess at least 55 years of actuarial data on where and when natural disasters occur.[8] Roughly 11 states face a potential and predictable risk of a nationally catastrophic natural disaster. These states and the corresponding potential disasters are:

Texas hurricane
Louisiana hurricane
Alabama hurricane
Mississippi hurricane
Florida hurricane
Georgia hurricane
South Carolina hurricane
North Carolina hurricane
California earthquake
Washington volcanic eruption
Hawaii tsunami, volcanic eruption

Of course, other states could experience a nationally catastrophic natural disaster, but the frequency of such events is very low, which minimizes the assumption-of-the-risk concept. Thus, individ­uals and businesses living in those places should not face steeper insurance rates because the proba­bility of such an event is low, hard to price, and impossible to predict. For example, a catastrophic hurricane could hit New York and Connecticut, but such an event may not happen for many years, if at all. Therefore, individuals living in those states can­not be held to be placing themselves at risk of such a low-probability event.[9] If such a catastrophe occurred, a state-based program paid for by its tax­payers to deal with the economic impact should take precedence over a federal program paid for by taxpayers outside of that state.

In contrast, as the much-referenced map[10] developed by Risk Management Solutions vividly illustrates, only a handful of states are predictably at risk of a nationally catastrophic natural disaster.[11] Individuals and businesses in those states, espe­cially in jurisdictions close to the coast and along the San Andreas Fault Line, have unquestionably assumed the risk of a catastrophic natural disaster.[12]

This is especially true for the individuals and businesses that have moved to those jurisdictions over the past two decades. Six of the 11 states have experienced population growth above the national average from 1990 to 2007.[13] With the influx in population and attendant development, the cost of natural disasters has steadily increased.

To attract and keep these individuals and businesses, states have imposed rate caps to prevent insurance companies from charging actuarially sound P&C insurance rates. These state rate caps have prevented insurance companies from securing sufficient capital reserves and, more troubling, indi­rectly spread the cost of their known risks to other, less risk-prone states.[14] Hence, the rate caps in these 11 states have resulted in the other 39 states- many of which lost population, businesses, and tax revenue to the 11 states-subsidizing the cost of living in those 11 states. Such a moral hazard has disconnected the risk from those who willingly assumed the risk and enjoy the benefits of living in a warmer and more scenic place.

In nine of the 11 states, not including Florida and California, a majority of their populations and land areas are a safe distance away from the coast, thereby providing a large pool of individuals and businesses that can diversify the risk of insuring the coastal areas. At least those individuals who live in the high-risk states directly benefit from their robust and viable coastal communities. However, it is a bit harder to see how someone living in the Upper Peninsula of Michigan should bear the cost of insuring high-risk coastal or fault-line communities.

Given these realities, individuals and businesses in the 39 lower-risk states should not pay higher P&C insurance rates or pay higher federal taxes to subsidize the living costs of those individuals and business that choose to locate in the 11 high-risk states. This is especially true given the irresponsible coastal and fault line development over the past two decades in spite of the high risks.

Furthermore, Florida and Texas heavily promote their lack of a state income tax to encourage individuals and businesses to relocate into their jurisdic­tions. Low-risk states ought to be equally justified in promoting their significantly lower P&C insurance rates to retain or attract the same individuals and businesses. Since owning a home is the single largest cost-of-living expense, substantially lower P&C rates would equate to a discernable advantage. If competition is good in tax policy, then competition among the states in P&C insurance rates should also be good. Yet it is taken almost as gospel that high-risk states should not be required to charge actuarially sound P&C insurance rates. This belief should be rejected because it ignores reality.

It is axiomatic that public policy should place the full burden of risk on those who assume that risk. States need to eliminate arbitrary rate caps on P&C insurance so that the insured parties pay fully for the risk of their actions, thereby allowing insurance companies to acquire capital reserves sufficient to deal with most, if not all, natural disasters.

Principle #3: State eligibility should depend on meeting five requirements.

To be eligible for any federal catastrophic natu­ral disaster program, a state should meet five requirements:

1. No rate caps. The state must eliminate rate caps and permit insurance companies to charge actuarially sound P&C insurance rates. Before receiving federal taxpayer funds, the state must have allowed insurance companies the opportu­nity to earn capital reserves sufficient to meet any obligations. Otherwise, taxpayers in other states are forced to subsidize the high-risk state's irresponsible behavior. The decision by State Farm, the largest P&C insurer in Florida, to stop offering coverage in Florida because the state refuses to let it charge an actuarially sound rate demonstrates that this issue is not theoretical.[15]
   
2. Sound building codes. The state must enact and enforce sound building codes that minimize damage from known natural disaster risks. Due to the aggressive development in high-risk areas, the costs of natural disasters have increased sub­stantially. Therefore, it makes eminent sense to require states to enact and enforce sound build­ing codes known to mitigate the vulnerabilities and consequences of known risks.
   
3. No redevelopment of disaster-prone areas. The state must prohibit redevelopment of disaster-prone areas unless the U.S. Army Corps of Engi­neers has approved the mitigation action taken to prevent repetitive losses and the private sector insurance market has ascertained, through offering rate-cap-free P&C policies, that the mit­igation action has eliminated or minimized the repetitive loss issue. As learned from the NFIP, the only outcome that can be expected from rebuilding in a known flood zone is a flooded structure. This insanity must end.
   
4. Tort reform. As important, the state must enact tort reform to eliminate or significantly reduce the frivolous lawsuits by overzealous lawyers seeking to capitalize on sensational headlines and public sympathy following a natural disaster. In most cases, the insurance companies win such lawsuits. Nonetheless, insurance compa­nies must spend millions of dollars defending insurance contracts. In some cases, insurance companies settle to avoid negative publicity or a stacked deck in "jackpot" jurisdictions. Baseless lawsuits only drive up the cost of P&C policies for consumers.
   
5. Mandated P&C insurance. Finally, states must require individuals and businesses in known hur­ricane, earthquake, and flood zones to purchase P&C insurance, including state-based earth­quake and hurricane insurance and federal flood insurance. Such a mandate will increase the capital reserves of insurance companies and the liquidity of government insurance programs.

Principle 4: State participation should be opt-in only.

One of the greatest aspects of American democ­racy is its adherence to federalism. As U.S. Supreme Court Justice Louis Brandeis noted many years ago, America has its "laborator[ies]" of democracy[17] that constantly seek ways to meet objectives more effi­ciently and more effectively. As the Risk Manage­ment Solutions map illustrates, most states do not face a predictable catastrophic natural disaster risk. Forcing those states to join a catastrophic natural disaster program is inherently unfair and violates U.S. federalist principles. Hence, governors and state legislatures-not the federal government -- should decide whether or not their individual states will opt into any catastrophic natural disaster program and its higher P&C rates.

Principle 5: Tax and accounting policies must permit insurance and reinsurance companies to retain sufficient capital reserves.

Before launching another federal program, Congress should amend existing tax laws that prevent insurance and reinsurance companies from taking tax deductions for capital reserves. Concomitant with tax reform, the accounting industry should alter generally accepted accounting principles to permit insurance and reinsurance companies to establish reserves for potential catastrophes. These two changes would provide incentives for those companies to establish larger capital reserves for potential catastrophic natural disasters, thereby reducing the need for government assistance.

Are These Principles Enough?

These five principles are a good start, but even they may not be enough to justify passage of a CAT fund. Experience has shown that both states and insurance companies have used CAT funds and similar insurance programs to shift risk to the federal government that should be retained by insurance companies. They have used such pro­grams to obtain back-door federal subsidies for state property insurance and reinsurance systems, which are designed more to help taxpayers avoid paying insurance rates than reflect the true risk to their properties.

State governments are free to develop irresponsible property insurance programs provided that they and their citizens understand that they must bear the consequences. CAT funds that create a direct federal loan program to provide federal "bridge loans" to cover losses to state reinsurance programs when natural disaster claims exceed the state funds' assets need special scrutiny. Experience with the federal flood insurance program shows that once federal loans reach a significant level, there will be an immediate attempt to persuade the government to forgive them.[18] At that point, the "bridge loan" program becomes a back-door approach for the federal government to assume much of the risk for property losses caused by hurricanes and similar disasters.

Conclusion

Over the past six months, we have witnessed an unprecedented expansion of federal control, power, spending, and deficits. As we are quickly learning, federal expansion comes at a steep price and with the entire baggage of waste, fraud, and abuse that is expected with monolithic, opaque federal action. It is high time that America steps back from this dangerous precipice before the government structure is changed wholly beyond the one designed by the Founding Fathers in the Constitution.

Those who sound the clarion call for federaliz­ing more disasters would do well to read the Con­stitution, The Federalist Papers, and The Heritage Guide to the Constitution.[19] As President Calvin Coolidge remarked on the 150th Anniversary of the Declaration of Independence, "It is not so much then for the purpose of undertaking to proclaim new theories and principles that this annual celebration is maintained, but rather to reaffirm and reestablish those old theories and principles which time and the unerring logic of events have demon­strated to be sound."[20] History has repeatedly shown that federalization is rarely the path to a better tomorrow.

The U.S. has thrived for 223 years without a fed­eral CAT fund. Other than irresponsible govern­ment action, a lack of leadership and accountability, and a federally incented policy of ignoring risk, nothing is preventing states from freeing insurance companies to charge actuarially sound P&C insurance rates and citizens from bearing the costs of the risks they assume.

Nothing but politics, that is.

Matt A. Mayer is a Visiting Fellow at The Heritage Foundation, President and Chief Executive Officer of Provisum Strategies LLC, and an Adjunct Professor at Ohio State University. He has served as Counselor to the Deputy Secretary and Acting Executive Director for the Office of Grants and Training in the U.S. Department of Homeland Security. He is author of Homeland Security and Federalism: Protecting America from Outside the Beltway (June 2009). David C. John is Senior Research Fellow in Retirement Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. James Jay Carafano, Ph.D., is Assistant Director of the Kathryn and Shelby Cullom Davis Institute for International Studies and Senior Research Fellow for National Security and Homeland Security in the Douglas and Sarah Allison Center for Foreign Policy Studies at The Heritage Foundation.