Sat, May 24, 2008 - Page 9 News List

Insurance industry mismatch results in fundamental problems

By Robert Shiller

Most people who save and invest do so for their entire lives. But most of the institutions upon which they rely for their investments and savings are geared to the short term. This mismatch causes fundamental problems.

An excellent example is homeowners’ insurance. Almost universally in the world today, homeowners’ insurance is short term. Typically, it is renewed annually, which means that it does not cover the risk that insurance companies will raise rates at any future renewal date.

Yet we have seen major changes recently in homeowners’ insurance rates. For example, the average homeowner premium in Florida soared from US$723 at the start of 2002 to US$1,465 in the first quarter of last year. Such rapid increases represent a risk that is on the same order of magnitude as many of the damage risks that the policies are supposed to address.

In a study presented early this month at the US’ National Bureau of Economic Research, the economists Dwight Jaffee, Howard Kunreuther, and Erwann Michel-Kerjan called for a fundamental change in policy aimed at developing true long-term insurance (LTI) that set insurance premiums for many years. Unless we do that, homeowners are unsure from year to year whether their insurance policies will be canceled or that their premiums will skyrocket unexpectedly as they have in coastal regions of Florida where there is hurricane and flood risk.

As the authors point out, for insurers to even consider a long term policy they must have the freedom to charge premiums that reflects risk.

Urbanization itself is also a source of risk, as evidenced by the recent earthquake in China, which has cost tens of thousands of lives. Moreover, global warming appears to be increasing the intensity of storms. Some scientists attribute the intensity of Cyclone Nargis, which struck Myanmar, killing more than 30,000, to global warming.

Of course, we do not know for sure that these risks will mean higher insured losses in the future. Population growth in coastal areas may not continue to imply more risk exposure, since choice lots may already be getting somewhat more scarce, and further development may favor more central areas. And urbanization, if done right, leads to better catastrophe planning and stricter construction standards, which might actually reduce risks. In fact, long term insurance may encourage homeowners to invest in risk reducing measures because the premium discounts they will obtain for taking this action will justify incurring the cost of investment.

The course of global warming, and its impact on future storms, is also the subject of considerable uncertainty. Meteorology is not an exact science, and we cannot predict the precise extent and impact of environmental initiatives, though progress in weather forecasting might also reduce the damage caused by hurricanes.

Data presented by Roger Pielke in the Natural Hazards Review in February shows that actual insured losses caused by the most important hurricanes since 1900 followed a U-shaped curve. The most damaging hurricanes (scaled for the size of the economy) to hit the US occurred both in the early 20th century and most recently — the worst being the 1926 hurricane that struck Miami, Florida.

Just as no one anticipated this U-shaped pattern of losses, so future losses must remain essentially unknown. This means that the problem is not a certain increase in homeowners’ insurance losses, but rather a risk of increase. Paradoxically, that is a good thing, because it means that risk-management technology can be used to mitigate the problem.

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