Perspective

Do the math of risk

By JIM VERHULST, Prospective Editor
Published September 9, 2007

John Seo, co-founder of Fermat Capital Management and the main character in today's cover story, agreed to answer some Florida questions by e-mail from Perspective editor Jim Verhulst.

The government-run Citizens Property Insurance here is now the major private property insurer in the state. Citizens is big and getting bigger. Given your research in spreading risk across world financial markets, is this a good development, a bad one or something in between?

John Seo: This is a terrible development. The risk is getting trapped in a corner, not distributed worldwide. Citizens Insurance lowers rates, but any homeowner, completely on their own, can lower their insurance premiums to as low as a dollar a month by mailing a dollar bill in an envelope to themselves every month and agreeing to pay their own household losses. Citizens is self-insurance for the state of Florida, and self-insurance is the antithesis of spreading risk across the world financial markets.

Governments have more resources than private insurers. Does it make any sense to have the state or even the federal government take on the broad risk of hurricane coverage (perhaps modeled on the federal flood insurance program), leaving the rest of property insurance in the hands of private insurance companies?

It does not make sense. True, governments have plenty of resources, but what is at issue here is the improper application of them.

I must first establish some generalizations. Flood-prone areas tend to have affordable housing. Affordable housing tends be occupied by lower-income households. Hurricane-prone areas in the United States tend to have expensive housing because these regions are near the ocean, desirable to many people. Expensive housing in desirable areas tends to be occupied by higher-income households. All of this, of course, is just generalization.

Now here is a little-known fact: As income doubles, spending on insurance tends to quadruple. At least, this is what we can see from financial data on over 70 different countries around the world, including, of course, the United States. I will use this nearly universal tendency about insurance spending to put flood and hurricane insurance in perspective.

In severely flood-prone zones, let's say that average household income is about half the national average. That would mean that household budgets for insurance are around one-fourth the national average in these areas, so a market rate for flood insurance will tend to be beyond the reach of these severely flood-exposed households. When personal income and market price do not match up like this on such a broad, fundamental basis, it does not strike me as surprising that the government must get involved.

In hurricane-prone zones where insurance costs are going up (because insurers are concerned with mounting property exposure in the zone), let's say that average household income is about double the national average.

That would mean that household budgets for insurance are around four times the national average, so a so-called market rate for hurricane insurance (even at elevated levels) will tend to be within the reach of most of these hurricane exposed households. In this case, we have a broad, fundamental alignment between income and insurance cost in hurricane-prone areas, so it is not obvious the government needs to step in with long-term assistance for all households.

Of course, the scenarios used above are crude, but extending the National Flood Insurance Plan (NFIP) to wind losses might be as bad as extending a federal student aid program to include vouchers for luxury automobile leases. Just because flood losses accompany wind losses, it does not mean we should fold the two risks together in the NFIP. On the surface it may seem logical, but under the surface this would be a travesty of good public policy.

Do governments bear culpability because they allow building on barrier islands and coastal development that puts thousands, perhaps millions, of people in harm's way? Or do they ameliorate things by requiring writing tougher building codes such as requiring hardened homes on higher foundations? And do - or should - the financial markets care?

I believe governments bear some responsibility for the mounting threat to human life along the coastlines, but I would think that government responsibility extends only to the provision of adequate evacuation routes and evacuation plans and to enforcing special building codes to save lives and property.

Financial markets, which are emotionless in the personal sense, care about these issues for a host of monied reasons. In particular, the more lives that are lost in an event, the greater the pressure from society as a whole for insurers to pay on claims that would not otherwise be paid in a normal situation. No one wants to be the bad guy in a human tragedy, but insurers are not handling their personal money; insurers are handling the money of a million other hardworking families who live in other parts of the country.

Knowing that world financial markets have more resources than governments (which, in turn, have more than private insurers), should government get out of the way altogether and let financial markets price the risk at whatever the cost is, forcing homeowners to absorb it? Would governments somehow have to encourage markets to price that risk appropriately?

Absolutely, governments should get out of the way of the distribution of natural catastrophe risk in the private market, but I would not say governments should get completely out of the way. Governments have some important work left to do. In those areas of the country where state government, even with the best original intentions, have already interfered with market-pricing mechanisms, the government needs to ease the transition to a market price for risk. Price shocks are traumatic to households, cruel to businesses, and totally unnecessary for the long-term functioning of our markets.

As for encouragement to price risk appropriately, I do not believe that financial markets will need (nor respond) to encouragement from the government: Risk gets priced appropriately (of course, what we really mean here is cheaply) through intense competition among investors, which only grows more fierce as global investment assets swell past the $50-trillion mark.

As a finance professional, I can say this with confidence: The 21st century is shaping up to be a time where a big problem will be that global financial markets price risks too cheaply, which can actually cause a whole set of different problems like mass stupidity. Nonetheless, plug yourself into the global financial markets, and you can expect cheap and plentiful risk capital so long as you play fair and perform on your contractual obligations in good faith.

Are the world financial markets truly an efficient way to price hurricane risk? And, if so, what will it take for that to happen? Would Florida homeowners be shocked or pleasantly surprised at the true cost of market-based risk?

Global financial markets, in partnership with insurers and reinsurers, who are vital to the proper functioning of an insurance market, will be the most efficient possible way to price hurricane risk. In the long term, Florida will probably be wondering what all the fuss was about, as overall insurance rates will be no less affordable than all the other things in a household's budget, while coverage will be widely available and stable, even after a major storm.

What is required for all this to happen is time. Fortunately, the catastrophe bond market has turned an important corner this year: It had its 10-year anniversary (since the first, large, credit-rated catastrophe bond was issued in June 1997), and the catastrophe bond market has finally passed the $10-billion mark for bonds outstanding.

When milestones like these are finally passed, institutions start pouring their money into an asset class, and the inflows of money can really snowball quickly. Many market observers are forecasting, quite reasonably, that the catastrophe bond market will grow to $50-billion over the next five years. A little over half of that $50-billion would likely be dedicated to U.S. hurricane risk. That may not meet all of Florida's insurance needs, but it is nothing to sneeze at, either, and it is just the beginning. Help is on the way.

[Last modified September 9, 2007, 01:20:30]