Luckily, the damage from Hurricane Irene was much less than the dire pre-storm predictions. Still, some homeowners along the Eastern Seaboard have sustained wind and flood damage. In certain states, the homeowners may rely on state-mandated catastrophe insurance programs to insure their homes. Often called "wind pools," or "beach plans," these programs offer wind-only insurance coverage to homeowners in high-risk areas (although some are hybrid programs that offer broader coverage). These programs exist in Georgia, South Carolina, North Carolina and the Gulf Coast states; Maryland does not have a beach plan.
Were the state programs geared toward wind damage ready to handle the potential losses that Irene could have imposed?
Most such programs were established following a disaster that raised concerns about the ability and willingness of private insurance companies to cover catastrophes — and the cost of policies when they do. They are designed to provide insurance coverage to property owners and businesses unable to find a policy in the voluntary market.
Why couldn't many homeowners find policies? Two aspects of hurricanes make insuring them very expensive: "fat tails" and correlated losses. Hurricane damage is fat-tailed, meaning extremely large losses are possible. They are also correlated in space; that is, a large number of buildings in close proximity are affected simultaneously. Both features imply a high risk of insolvency for an insurer trying to match annual premium payments — insufficient in any given year to cover a large loss — with the need for enormous sums in a catastrophic year. To cover these risks, therefore, insurers charge a lot for policies.
Yet state insurance commissioners, concerned about high prices for homeowners, may cap the amount insurance companies can charge. If companies can't charge enough to cover the risk, they will leave the market. Additionally, some insurance companies may find that homeowners are unable or unwilling to pay the necessary rates even with a cap, or they simply may want to reduce their coastal exposure.
To prevent a widespread dearth of insurance in coastal areas, state programs have stepped in. And these programs have been growing. Total exposure in wind pools grew 100 percent between 1990 and 2005 and is up more than 80 percent again in the last six years.
So, are they prepared for a major hurricane? All state programs cover losses through some combination of premium revenue, surplus and investment income, reinsurance (insurance for insurers), the issuance of bonds, and ex-post assessments (surcharges assessed after the fact to recoup costs). If some of the worst projections for Irene had materialized, state programs — such as the one in North Carolina, which was in Irene's cross-hairs early on — could have quickly used up their surplus.
What happens then? Programs that have purchased reinsurance, as North Carolina has done, will also have those funds available for claims. After that, the programs largely issue bonds, most of which are paid back with post-event assessments. In North Carolina, if losses exceed the claims-paying capacity of the program, all property insurance premiums in the state can be assessed up to 10 percent per year. Property insurers in the state can be assessed no more than $1 billion. The layered funding of North Carolina's program, combined with a decision in 2009 to lower coverage levels and raise prices, has led the state to estimate it could handle claims of up to $4 billion.
But there is little agreement on who should pay for disaster losses. Most states allow for assessments on all property companies or property insurance policies in a state, meaning policyholders outside the program are subsidizing those within it. Lower-risk policyholders are thus underwriting some of the costs of higher-risk policyholders. If the programs require taxpayer funds, as has happened in other Gulf Coast states, another cross-subsidy is created from all residents to those on the coasts.
When designed as true insurers of last resort, state programs fill an important gap in the insurance market. Many, however, are under-pricing policies and taking on excessive exposure such that costs will ultimately be passed to policyholders or taxpayers outside high-risk areas. Is this equitable?
Hurricanes are not simply acts of God but also acts of man; their effects depend on where and how we build. Should all taxpayers help homeowners rebuild? Or should those who run the risk of locating in a high-risk area bear all the costs of that choice?
One thing is certain: Hurricane-prone areas are beautiful, but they are also risky — and insuring those risks is not cheap. Recognizing this, governmental policies should promote cost-effective risk reduction and building in responsible locations.