Risk Matters

By Clifford Rossi

Hurricane Helene was a wake-up call to millions of homeowners that the risk from natural disasters may be much higher than perceived, even in areas where such events have been historically negligible. Now with Hurricane Milton bearing down on the Florida coast, these nearly back-to-back storms once again underscore the dire need for a major overhaul of how homeowners insurance is structured and delivered between Main Street and Wall Street.

The market for homeowners insurance is quickly unraveling with homeowners left facing significant financial burdens in the future and uncertain access to coverage for increasingly severe natural hazard events. That severity is also spreading to areas once thought to be immune from hurricanes, tornadoes and other seemingly unusual hazards, and yet the mechanisms for providing homeowners insurance remain largely unchanged over the years and unable to accommodate greater uncertainty from natural disasters.

Have Extreme Weather Events Outstripped Risk Absorption Insurer Capacity?

The market for homeowners insurance still remains largely viable for the majority of homeowners in terms of availability and cost, however, that stability is eroding quickly in many parts of the country hit hardest by natural hazards. Two major forces at work though threaten to upend what otherwise has been a fairly mundane segment of the housing market; market structure for the delivery of homeowners insurance and uncertainty in measuring natural disaster risk.

Today’s homeowners insurance market is characterized by a number of private insurance companies regulated at the state level. Companies must obtain approval from state insurance commissions for rates and products offered to their customers. As observed in recent years in states such as California or Florida following major natural disasters, insurance companies have experienced significant losses from both the severity of disasters as well as from accelerating rebuilding costs. Separate from a standard homeowners policy are flood insurance policies offered through FEMA’s National Flood Insurance Program (NFIP). Established in 1968, NFIP has provided millions of homeowners with flood insurance coverage, however, NFIP has faced a number of critical challenges, including a $20 billion shortfall due to mispriced premiums over time. Likewise, state-run insurance programs of last resort are financially unstable mechanisms ill-equipped to handle any acceleration of natural disaster risk.

Reinsurance, a major type of risk transfer for insurers, has become very costly and another alternative, catastrophe bonds, despite significant issuance growth, for a number of reasons is unlikely to provide sufficient risk capacity over time in its current form.

Limiting or denying rate approvals for homeowners policies by state insurance commissions leads naturally to insurers dropping coverage in high-risk areas as has been the case in several markets. And when rates can be passed along, annual premiums have surged. In Florida, for example, the average cost of a homeowners policy is $6,000 compared to the US average of $1,700.

Event uncertainty and model risk have left insurers, reinsurers and cat bond investors scrambling for better tools to more accurately assess their risk from natural disasters. Even with major advances in physical climate models, they remain handicapped by their reliance on historical data that may not be representative of future outcomes. This becomes even more problematic when attempting to understand extreme (tail) risks. As a result, such outcomes and model uncertainty introduce significant volatility into insurer, reinsurer and cat bond investor pricing and financial performance. This volatility in turn is passed along to homeowners who cringe when they open their annual renewal letters from their insurer.

Without major changes, large segments of the housing sector will come under severe pressure from the market’s inability to respond to an impending crisis in homeowners insurance. Property devaluations will leave many homeowners unable to sell their homes and hence leave them stranded indefinitely, others financially strapped due to exorbitant premiums and others completely left with no alternative but to self-insure.

A Private-Public Capital Market Solution

With fragmentation in the delivery of homeowners insurance among private insurers, 50 state insurance commissions and private risk transfer markets are unable to meet the needs of a changing environment. Instead, a strong argument can be made for a central provider of natural hazard insurance policies. Establishing a federally chartered entity that issues hazard policies to homeowners through an insurance broker network comparable to that of NFIP would ensure consistent underwriting of natural hazard risk policies.

To be clear it would not be a federal agency, but rather a government-sponsored enterprise that is privately funded. It would also alleviate the need for 50 different state insurance commission gatekeepers to approve rates on these policies considering the federal charter.

And there would no longer be a need for state homeowners insurance programs.

Once established, the first order of business would be to absorb the NFIP, taking it out of FEMA and placing it on a path to financial stability based on sound underwriting and actuarially fair pricing. Over time, this new organization would provide a comprehensive natural disaster policy to every homeowner in America.

Having one provider of natural hazard policies would allow for the creation of multi-year insurance-linked securities similar in structure to credit risk transfer (CRT) securities issued by Fannie Mae and Freddie Mac today. Similar to what GSE mortgage-backed securities did for the mortgage market relative to private-label securities, these new climate risk transfer securities (CLRT) would do for homeowners insurance.

The benefit of having this new hazard insurance GSE issue ILS are several; first, it would provide regularity and consistency in the issuance of securities than what is currently provided today in the market for cat bonds and as a result of the scale would wind up being less costly which would help keep a lid on homeowners natural hazard insurance premiums. A second benefit is that the hazard insurance GSE would distribute this risk across private investors rather than retain it completely. This would significantly reduce the potential for moral hazard and taxpayer exposure in conjunction with requirements to take some small side-by-side risk by the GSE in each tranche. A market for such securities would be more liquid, broadening the appeal to a larger segment of investors including insurers and reinsurers that could buy tranches of these new securities that align to their risk appetite. Insurers and reinsurers would then be able to make up the lost business from natural hazard riders on current homeowners policies while continuing to offer standard policies for hazards other than from natural disasters.

Risk Takeaways

Creating a new hazard insurance GSE is not without its risks. Chief among these is the political will to stand up a brand new GSE at a time of intense legislative discord and where the national debt is near crisis levels. Time in this case to set this new entity up is also a risk as the risk of continuing to do nothing to reform homeowners insurance is acute. The numerous benefits such a private-public arrangement brings to the housing sector and homeowners more than outweigh the risks in bringing it to fruition.

Clifford Rossi (PhD) is the Academic Director of the Smith Enterprise Risk Consortium at the University of Maryland and a Professor of the Practice and Executive-in-Residence at UMD’s Robert H. Smith School of Business. Before joining academia, he spent 25-plus years in the financial sector, as both a C-level risk executive at several top financial institutions and a federal banking regulator. He is the former managing director and CRO of Citigroup’s Consumer Lending Group.