Many businesses along the Gulf of Mexico coast have had a difficult time obtaining wind insurance coverage since Hurricanes Katrina, Rita, and Wilma hit in 2005 and have often ended up paying more than twice as much for the insurance as they did previously, according to a RAND Corporation study issued today.
Gulf Coast businesses are also paying higher wind insurance deductibles while getting lower limits on policy coverage, the study by the nonprofit research organization found. That means businesses are spending more for less protection from hurricanes, tornadoes and other major wind storms.
Because they have been increasingly unable to purchase coverage in the regulated, insurance market (known as the "admitted" market), business have often turned to state-run "residual" insurance markets that provide limited insurance to businesses unable to find insurance elsewhere, according to the study conducted for the RAND Gulf States Policy Institute by the RAND Institute for Civil Justice. The residual markets can recover premium shortfalls from taxpayers and policyholders throughout a state.
Researchers found that as wind insurance coverage limits have declined and deductibles have increased, while the use of residual markets has risen, wind risk has shifted in part from insurers to policyholders and taxpayers - including those not living in high-risk areas along the Gulf Coast.
The report says that the scarcity and high cost of wind insurance has delayed some business investments in the Gulf States region since the 2005 hurricanes, but that the overall effect on the region is hard to assess because higher insurance premiums may have in part redirected economic activity to lower risk areas. Half the lenders interviewed for the study said they were aware of delayed or cancelled business projects in 2006 because of high insurance prices or the unavailability of insurance.
"The plight of homeowners after Hurricane Katrina has received most of the attention," said Lloyd Dixon, a RAND researcher and lead author of the study. "But business owners - especially small businesses in the hardest-hit areas - had a difficult time finding wind insurance despite steep price increases, and some couldn't get insurance at any price."
Researchers interviewed commercial insurance policyholders, insurance agents and brokers, insurers and reinsurers, commercial lenders, firms that model wind and other losses for the insurance industry, and companies that provide credit ratings for insurers and other firms. The sample included large, medium and small companies. Interviews were conducted in late August and early September 2006, with follow-up interviews continuing through April of this year.
The study found that in the first three quarters of 2006 the cost of insurance for commercial property skyrocketed, and coverage became less available in areas most exposed to substantial wind risk.
One large insurance broker said that among its business clients with catastrophic risk exposure, premiums increased 80 percent on average from the time Katrina struck in August 2005 to July 2006. And, while coverage limits for overall policies rose slightly, coverage limits for losses caused by wind fell by approximately 30 percent on average from August 2005 to July 2006.
"Many firms are bearing more of the risk than they did before the recent hurricanes, so they are less protected against the next big windstorm," Dixon said.
Researchers noted that one small business owner in Florida purchased $38 million in property coverage for $250,000 in 2005. In 2006, after his insurer refused to renew his policy, the business owner was able to buy only $5 million in coverage for $940,000 - a nearly four-fold increase in cost for about one-eighth the coverage.
Researchers found that small businesses in high-risk areas are less attractive to insurance underwriters, in part because they are typically less geographically diverse than large firms. Such companies are also more likely to be in a weaker bargaining position when negotiating insurance rates and often lack the leverage with lenders to negotiate insurance coverage requirements lower than their loan balance.
The study notes some good news: wind insurance premiums for firms with operations concentrated in hurricane-exposed areas remained flat or showed only modest increases in the first quarter of 2007. Large firms with geographically diverse operations saw price declines, in part because there were fewer storms than expected in 2006.
The study identified several reasons behind the large premium increases:
- Insurers and the modeling firms on which they rely increased estimates of the number of hurricanes expected to hit the region and the damage caused by hurricanes when they do occur.
- Financial rating agencies tightened capital adequacy requirements for insurers.
- Litigation and government actions following the 2005 hurricane season led to uncertainty about how insurance contracts will be enforced by courts in the region.
- The threat of large assessments on insurers after future hurricanes that caused deficits in residual markets.
"While some of the factors that caused price increases may be transitory, the expectation of more frequent hurricanes and higher repair costs will likely prevent wind insurance prices from returning to pre-Katrina levels," Dixon said. He also noted that greater expected risk may require increases over pre-Katrina premiums.
The study calls for an evaluation of what type of government commercial wind insurance programs - if any - might be warranted given the turmoil following the 2005 hurricane season.
Researchers also warn policymakers not to put blind faith in either the private market or government programs to create a well-functioning insurance system.
Private insurance markets work best for high-frequency events without widespread impact, such as auto insurance. But the study notes that the private markets are less effective for infrequent, catastrophic events - like hurricanes - that affect a large number of policyholders at the same time. To reduce the risk of financial collapse, insurers may charge premiums that substantially exceed the expected value of losses.
The study also says that private insurance markets are prone to volatile swings in the price of insurance. This makes it difficult for business to rebuild after a hurricane when prices are high, and can discourage loss-mitigation measures when memory of the event fades and prices are low.
Government can in theory set insurance prices closer to the long-run expected loss for hurricanes and other natural disasters because tax revenue eliminates concerns about insolvency. However, the study says government officials can face political pressure to subsidize one group over another, or set premiums too low. As a result, low insurance rates could encourage the construction of buildings in high-risk areas that are not sufficiently wind resistant. Government intervention may also compound the problem by reducing private insurers' willing to provide insurance.
The study identifies areas where further research and analysis would help identify what balance between private and government programs would be desirable.
The study, "Commercial Wind Insurance in the Gulf States: Developments Since Hurricane Katrina and Challenges Moving Forward," is available at www.rand.org. Other authors include James Macdonald of Navigant Consulting and Julie Zissimopoulos of RAND.
The study was funded by grants from the American Resort Development Association, the Commercial Mortgage Securities Association, the International Council of Shopping Centers, the Mortgage Bankers Association, the National Apartment Association, the National Association of Industrial and Office Properties, the National Association of Realtors, the National Multi-Housing Council, and the Real Estate Roundtable.
The RAND Gulf States Policy Institute works to develop a long-term vision and strategy to help build a better future for Louisiana, Mississippi and Alabama in the wake of Hurricanes Katrina and Rita. The goal of RGSPI is to assist in long-term recovery efforts by providing evidence-based policy guidance to speed regional recovery and growth.
RAND joined with seven universities to create RGSPI in late 2005. The seven are: Jackson State University and the University of Southern Mississippi in Mississippi; Tulane University, the University of New Orleans and Xavier University in Louisiana; and Tuskegee University and the University of South Alabama in Alabama.
RGSPI seeks funding from nonprofit institutions, other donors, government and the private sector to conduct a broad range of studies. It is the first organization of its kind in the region to conduct a full spectrum of policy research on pressing challenges facing the three states, including problems that existed even before the hurricanes struck.
The RAND Institute for Civil Justice helps make the civil justice system more efficient and equitable by supplying government leaders, private decision-makers and the public with the results of objective, empirically based, analytic research.
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