Managing disaster risk has gotten so costly it may require government help

Guest:	Ben Collier
Title:	Associate professor of risk and insurance at the University of Wisconsin
Summary:	Insurance pricing plays a powerful role in signaling where disaster risk is increasing and where the federal government is increasingly exposed when coverage breaks down. We’ll examine a proposal that would bring the federal government into the reinsurance market, how that could affect those signals and what questions leaders should ask before shifting risk further upstream.

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Interview transcript

Terry Gerton There are reports of homeowner insurance companies pulling out of markets across the country. So talk to me first about the risks this industry is facing that is driving this kind of behavior.

Ben Collier There’s been a lot affecting the insurance industry in the past few years. To name a few things, there’s a broader perception that risks are increasing that insurers cover wildfires, hurricanes, severe thunderstorms, hail, and so on. There’s a number of other challenges too. The cost of rebuilding a home has gotten more expensive in the in the past is one of the others. So there’s kind of confluence of issues affecting this industry, and many people are feeling that in terms of rising premiums, and in some cases homeowners have to go find a new insurer because their existing one won’t cover them anymore.

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Terry Gerton So you and your colleagues are proposing the establishment of a new federal reinsurance entity. First question is, how does the reinsurance market work?

Ben Collier Reinsurance is insurance for insurance companies. A local insurance company operating in a high-risk area, so an area like a coastal community affected by hurricanes or a community affected by wildfire risks, for example, that local insurance can’t manage the risk of a big catastrophe there effectively because so many policyholders will be affected at the same time. So these local insurance companies buy reinsurance from these global firms that are able to spread that disaster risk across a globally diversified portfolio.

Terry Gerton What gap then would a federal reinsurer be meant to fill?

Ben Collier One of the challenges of these growing climate risks is that the size of these events seems to be increasing substantially. And so think of more severe hurricanes than in the past, record-breaking wildfires and so on. And the reinsurance industry has trouble fully smoothing out diversifying U.S. catastrophe risks. When a big event occurs, the industry needs to pay billions of dollars in claims, and that’s challenging for this industry to do. They have to set aside large amounts of capital in preparation for those events, and when one occurs, it affects the available capital in that industry. And so, as a result the prices for re-insurance coverage for these events tends to be high, and it tends to vary over time. Big spikes in prices following historical catastrophes like Hurricane Andrew, Hurricane Katrina, the 9/11 attacks. We’ve seen a run-up in reinsurance prices since around 2017 when hurricanes Harvey, Irma, and Maria occurred, the Camp Fire occurred in California. And since then, we’ve seen large price increases that have been passed on to consumers in higher risk areas as well.

Terry Gerton How would the government moving into this space be different from what it’s currently doing today? It offers flood insurance, for example.

Ben Collier So there are a number of countries around the world that have the kind of entity that we’re proposing, which is this reinsurance entity is distinct from an insurance company that you or I or other households might go to buy insurance from directly. In flood insurance, people go to buy our products directly from the National Flood Insurance Program. For this type of government reinsurance industry, it would be a backstop to the insurance and the reinsurance sector. So you and I as individuals wouldn’t be interacting with this entity. This would be something that’s covering the really severe catastrophes instead of relying exclusively on the private reinsurance to provide the funding for those.

Terry Gerton You mentioned that there are institutions like this in other countries. Isn’t the United States kind of unique in this space, just given our size, our geographic diversity, our exposure to such a variety of natural disasters?

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Ben Collier We are unique in many ways, and the U.S. Is large compared to many other countries. It’s more geographically diversified. It’s higher income than much of the world. It also has more disaster risk. This has meant that a lot of the global reinsurance risk is U.S. disaster risks that are being held by those entities. And that has limited that industry’s ability to fully smooth out those risks and is part of what’s driving to the higher and volatile costs of reinsurance in the U.S.

Terry Gerton I’m speaking with Professor Ben Collier. He’s an associate professor of risk and insurance at the University of Wisconsin. Professor Collier, I feel like I have to ask though, don’t we want those risks to be reflected in the market? I mean, there are some places you just probably shouldn’t build a house anymore. Does this idea of the government stepping in to balance that risk, mitigate the market signals that we actually wanna have people respond to?

Ben Collier That’s a great question and one of the things that we would want to make sure in creating an entity like this is that the prices that people are paying still reflect their underlying risk. Roughly think about two different types of expenses going into homeowners insurance premiums in these high risk areas. One is the risk of damage to your specific property and there’s a cost to that and insurance provides a price signal related to that risk. And there’s another piece of insurance that people are paying for, which is that when a catastrophe occurs, the insurer needs to pay potentially billions of dollars in claims at one time. And holding all of those funds in check for the next catastrophe, that part is also extremely costly. And that’s the part where a government reinsurer could help make progress in lowering those costs.

Terry Gerton When you think about federal agencies that are already managing disaster response missions or housing or infrastructure investment, what would this model change for them operationally? Not just in theory, but how risk gets assessed and managed upstream?

Ben Collier So I think there’s two real challenges for homeowners that this proposal could help address, and that would then be important in terms of mortgage markets and other markets as well. One is that the price of dealing with these catastrophic losses, being it having to pay claims, large amounts of claims at once, like this entity should reduce some of those costs and also make covering those catastrophes, the price of covering those catastrophe less volatile. And so the goal here is that this is reducing the additional costs that are added to homeowners’ insurance for individual consumers and making those additional costs less volatile, and that should be helpful in making sure consumers can pay their bills, can access a mortgage, can sell a house if they need to. The goal here is to try to provide a shock absorber that helps stabilize insurance prices.

Terry Gerton Speaking of that shock absorber function, one of your proposals specifically says that the U.S. Reinsurer should have clear authority to pay claims and political independence in setting prices. We’re seeing a lot of action around the political independence of certain kinds of organizations in our government right now. How essential is that to the effective function of a U.S. reinsurer? And would you have any concerns about that?

Ben Collier Great question. And I think part of the history that informs so many people’s views of ensuring catastrophe risks is the National Flood Insurance Program where for a very long time it was limited in its ability to price risk. It didn’t operate with independence and that this actually created challenges with encouraging people to move out of harm’s way or to improve their home and so on. I think there’s a long legacy there that we hope this entity would not fall into. The independence seems crucial for ensuring that it’s pricing risk and not creating a similar type of distortion. And we certainly have examples in the government of independent entities. The Federal Reserve is one of those examples that has some arm’s length ability to operate. And I think the concern for us would be that if this entity, U.S. RE, did not have independence, that it could create harm instead of doing good, and that if it’s underpricing risk, encouraging people to live in harm’s way, that would be a problem.

Terry Gerton Well, with that as a background then, as federal leaders would weigh ideas like this, what questions should they be asking to decide whether a new risk sharing mechanism is worth pursuing, especially in environments where we have rising disaster costs and limited public resources?

Ben Collier Our intent with this entity, or what we describe in the proposal is that this is a budget neutral entity where it would leverage the government’s ability to absorb large shocks in a way that the reinsurance industry can’t but that the users of that program would pay for it through premiums, through reinsurance premiums which are ultimately affecting people’s insurance premiums but are reducing those insurance premium overall relative to relying on the private sector alone. So the goal here would be that this would be an entity that, if priced correctly, would be budget neutral. This is something that I really do think it’s central to be thinking about the independence of this entity and the ability of it to price risk because that pricing risk is fundamental to encouraging adaptation to growing risk.

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