The
property and casualty insurance
industry is, just as any industry, in
business to make a profit. This
means that for any individual insurance
company, the premium dollars
received must equal the losses paid
out (including court awards, legal
costs, and settlements), plus a margin
for the cost of doing business and
profit. It may not be economically
feasible for a company to provide
coverage which does not at least pay
for itself. Nevertheless, consumers
demand that property and casualty
insurance companies provide coverage
at rates "acceptable" to the consumer
when doing so places these
companies at financial risk.
The following news story excerpts
illustrate the magnitude of the problem
faced by the property and casualty
insurance companies.
"Texas insurers have paid out $4 billion
in mold claims over the past three
years, according to a new study
released by the Insurance Council of
Texas." ("Texas Mold Claims Pass $4
Billion," A.M. Best via Comtex,
May 21, 2003.)
"According to Industry Outlook 2003,
a survey by National Marketing Services
Inc. of more than 200 North American
insurance executives, more than 80%
expected insurers to either limit coverage
or cancel coverage altogether as a result
of mold claims." (BestWire,
April 30,
2003 By R.J. Lehmann, associate editor:
raymond.lehmann@ambest.com,
www.globalreinsurance.com/default.asp?menuid=1126.)
"State Farm, which in September 2001
stopped writing homeowners insurance
policies for new customers in Texas,
said...it would no longer offer coverage
to its existing policyholders who move
into a different home in the state."
("State Farm to stop covering current
customers who move." abclocal.go.com/
ktrk/news/40403_state_insurance.html)
"As at least 18 states recover from
more than 400 tornadoes, insurers are
facing what could be the largest loss
ever from such a storm system with one
catastrophe-modeling company estimating
the insured loss could exceed
$2.2 billion." (Twister Damage May
Surpass $2.2 Billion in Insured Loss,"
www.globalreinsurance.com/default.
asp?menuid=1126)
Clearly, the costs of covering perils
have increased dramatically. Insurance
company revenues must be increased,
expenses decreased or both.
Failure of a property and casualty
(P&C) company is not necessarily
to the benefit of either the company,
company shareholders, or the consumer.
In the example of State
Farm, the down rating of the company
financials by A.M. Best and
Standard and Poors increases its cost
of debt which translates into an
increased cost of doing business.
One of the decisions that the company
has made is to reduce potential
losses by reducing its exposure in the
state by reducing the number of
homes insured. State Farm succeeded
in obtaining approximately a one third
market share but now finds its
success a burden rather than an
asset. For the company, this is a
rational reaction to what could very
well be an unsustainable loss situation.
For consumers, home buyers,
and real estate licensees, this is a
very difficult situation.
DEALING WITH RISK
Insurance firms have five methods
of dealing with risk: acceptance,
avoidance, reduction, pooling and
transfer.
With acceptance, the insurance
companies determine that the risk
or severity of loss from a peril is
either not worth the costs, or the
cost to transfer the risk to an insurance
company is too high.
With avoidance, the insurance
firm avoids the risk of loss by hurricane
by moving to Montana or
avoiding snow-related losses by
moving to Florida or Southern
California.
As an example of reduction, a
firm can reduce the risk of mold, for
example, by doing its best to assure
that property owners have no interior
water or condensation problems.
This may require that in mold
prevalent areas, property owners
vent with fans, or have bathrooms
with windows even though the local
building codes may not require such ventilation. As another example,
firms can reduce risk by providing
incentives for property homeowners
to avoid catastrophic loss by house
fire by installing fire detector/alarm
systems. Property owners can further
reduce the risk by installing a home
sprinkler system. Home owners living
in high fire risk areas could
reduce the risk of loss by fire by not
building homes with cedar siding
and cedar shake roofs. Poured concrete
insulated exterior walls with a
fire "proof"— not fire "resistant" roof
treatment— a substantial higher
survival rate in a high fire area
and may very well merit lower insurance
premiums.
Pooling of risk on the part of the
insurance company is sharing the risk
of loss where the companies purchase
reinsurance coverage from reinsurance
companies or from groups which
share the risk of loss in some proportion
and also share the premiums.
Transfer of loss to shareholders
and to some policy holders is another
method of avoiding risk. Transfer is
what happened when eleven companies
went bankrupt following
hurricane Andrew.
INSURANCE
COMPANIES'
GUIDING PRINCIPLES
There are a number of guiding principles
which govern the actions that
are taken by insurance companies.
The following list will help the reader
to understand what underlies the
decision making process (underwriting)
of the P&C industry.
1. Probability and the law of large
numbers. This "law" is based on the
statistical concept that the more
similar events you have to deal with,
the more accurate will be your forecast
of the future occurrence of any
one event. Example: At best, we can
make only the most general guess as
to whether a particular house will be
destroyed by perils of fire, flood,
earthquake, or tornado. However, if
we were to look at a group of houses,
the larger the group the better, we
can make some reasonably accurate
estimates of the number of houses in
the group that would be affected by
the perils listed. Within some limits,
the larger the group sample, the more
accurate the estimate. Life insurance
is the ultimate accuracy as the sample
is almost the entire universe of
deaths. Even there, the life insurance
industry was surprised by the
AIDs epidemic as such sudden onset
epidemics cannot be anticipated.
2. Risk pooling. This principle is
related to the law of large numbers.
The insurer collects relatively modest
premiums from a large number
of insureds to create a financial
resource pool from which the
insureds who have an insured loss
may be reimbursed (indemnified).
3. Principle of indemnity. This principle
means that the
insurance company is willing to compensate an insured loss to a maximum
of its financial
value. In other words, no matter how much insurance you purchase, the
insurance
company will not knowingly pay you more for a loss than its current
value
(either depreciated [actual cash value] or replacement value if that is
the
coverage purchased).
4. Insurable risk. This risk subjects
an individual to the possibility of
economic or financial loss.
5. Fortuitous loss. This principle
means that the loss is typically
unexpected, unplanned, and generally
sudden. A tornado is an example
of fortuitous loss.
6. Reasonable costs. These are the
costs to the consumer as to the
amount of premiums. The more persons
purchasing a particular coverage
may very well reduce the
individual purchasers costs if the
overall amount of loss is not expected
to change.
7. Catastrophic/Non-catastrophic
loss. An individual desires to protect
against the catastrophic loss
while the insurance company desires
to avoid a catastrophic loss.
REGULATION
The history of the development of
property and casualty insurance differs
from many other businesses in
that there is relatively little regulation
of the industry at the national
level. The McCarran-Ferguson Act
(passed by Congress some 58 years
ago), reads, “No act of Congress
shall be construed to invalidate,
impair or supersede any law enacted
by any state for the purpose of regulating
the business of insurance...
unless such act specifically relates to
the business of insurance.”
The effect of this act is the
diverse regulation seen in the various
coverages and state requirements for
insurance companies in the various
states. The major differences are
generally found in automobile and
health insurance coverages where
states have mandated that the companies
doing business in that state
provide various coverages usually
defined by the state legislature. The
only way that companies could
avoid providing the coverages was
to cease doing business in the state
in question.
The various states have also mandated
some coverages in homeowners
insurance. For example, Texas does not
use the traditional HO-1 and HO-2
homeowners policies but has created
HO-A, HO-B, and HO-C. It appears,
on a brief review, that the HO-B
and HO-C coverage has allowed the
filing of the very costly mold claims
in Texas which would not necessarily
occur in states that basically use the
traditional Home Owners policies.
The exceptions to this primarily
hands-off policy at the federal level
are the federally-backed Flood and
Fair Access to Insurance Requirements
coverage (commonly called a FAIR
Plan).
Flood insurance (1968) is offered
now because the Federal Insurance
Administration manages and subsidizes
the cost for any community that
meets the established requirements.
The FAIR plan coverage was also created in 1968 as a riot reinsurance
plan. This was after riots in major
cities made property insurance difficult
or impossible to obtain in certain
urban areas.
Even these coverages are not
mandated by the federal government
in a direct manner. Both plans
typically require that either the
community and/or the state create a
set of regulations complying with
the federal requirements before the
plans can be implemented. The federal
government has also provided
some incentives such as not providing
federal flood disaster assistance
unless adequate flood insurance had
been purchased.
A FAIR plan requires that insurance
companies who write property
insurance doing business in the state
must offer property insurance coverage
in economically depressed areas
in the same proportion as their participation
in the total state property
insurance market. Reinsurance is a
requirement and the federal government
(HUD) stands ready to provide
additional reinsurance against
exceptional losses. The concept of
the coverage has been expanded to
basically allow participation of any
property owner who either could
not obtain coverage or that the state
determined that rates were too high.
All states do not have a FAIR
plan and others have only limited
plans. For example: The Texas legislature
has just recently (2002) created
a FAIR plan in response to the
major mold losses and loss of coverage
by homeowners.
The reason for the federal backing
was a little-realized concept of adverse selection,
a concept
well
known in the insurance industry.
Adverse selection means that the
primary purchasers of insurance coverage
will be the persons most at risk
from a particular peril. This situation
leaves the insurance company
in a position of very high (potentially
catastrophic) expected loses. This
translates into extremely high premiums
for the individual consumer.
This basically means that the insurance
company will not offer coverage
that is essentially not affordable
by the persons desiring coverage.
With the entry of the Federal Flood
insurance program, all properties
within defined flood risk areas are
required to obtain flood insurance
by the lenders, not just properties in
river bottoms that could expect to
be flooded every fourth or fifth year.
This means that properties which
have a relatively low risk of flooding
are grouped with properties with
higher risk of flooding. Therefore,
the total expected flood loss for all
properties is low enough that insurance
companies can offer the coverage
at reasonable rates. (In addition,
the federal government is forcing
the relocation of entire towns in frequently
flooded areas, which further
reduces the expected losses.)
Another difficulty that property
insurance companies face is a major
forecasting problem. While forecasting
home fire and automobile losses
is relatively simple and accurate, the
forecasting of losses from acts of
Mother Nature is far less dependable.
Hurricane Andrew, which
struck South Florida in 1992, was
the cause of several regional P&C
insurance companies going into
bankruptcy and ultimately out of
business. This also forced a large
number of homeowners into costly
FAIR plan coverage.
The ultimate fear of a P&C company
is a catastrophic loss to the
company. Even major national P&C
companies were hit hard financially
and frightened by the results of
Andrew' destructive path. Insurance
companies reacted by refusing to
renew homeowners' contracts and
revoked thousands of existing policies.
Eleven insurance companies filed
for bankruptcy and dozens of others
lost significant financial reserves.
The Florida legislature actually
passed legislation restricting the
number of HO policies that a company
could cancel or not renew to
protect the state-funded Insurance
of Last Resort plan. Surviving P&C
companies embarked on draconian
programs of cutting their risk exposure.
Texas insurance companies have
significant legal costs and awards by
the courts and juries in mold cases.
Money paid out is money paid out
and must be made up either from
premiums, investment earnings, or
reducing expenses in some way.
Questions have been raised concerning the losses by P&C
companies
from equity (stock market)
investments. While the market
reverses in the first part of this century
certainly haven' helped the
P&C companies, it is difficult to
determine exactly what the impact
has been as many of the companies
report consolidated earnings. A
cursory look at the financial statements
of a couple of companies indicates
that most of their investment
appears to be in fixed income securities
(bonds) rather than equities.
This is a rational move as the companies
ability to predict the need for
liquidity at any point in time is low
and fixed income investments offer
better opportunities for liquidation
as needed without taking a major
financial loss as might be experienced
if the investment was in equities.
IMPACT ON
RESIDENTIAL SALES
With the dramatic increase in
homeowners insurance premiums
and the possibility of fewer companies
making insurance available,
real estate agents, particularly in residential
real estate, now face new
questions:
• Who is responsible for ensuring
that the purchaser has a valid
homeowners insurance policy?
• How much insurance should a
homeowner purchase to provide
adequate coverage? When should
the insurance for a new home be
obtained?
• How can we be sure that the
insurance commitment issued by
an independent insurance agent
is not subject to cancellation by
the P & C company?
• What are the responsibilities of
the real estate agent, the buyer,
and the seller?
SOME SUGGESTIONS
FOR REAL ESTATE
PROFESSIONALS
The following are some actions that
a real estate agent might consider:
• All purchasers should be strongly
encouraged to have their potential
home inspected by a well
qualified house inspector.
• Purchasers should be encouraged
to line up homeowners insurances
as soon as the contract is
created is another possible action.
• Add the obtaining of reasonably
priced homeowners insurance as
a contingency just like obtaining
financing.
• Warn purchasers that if they are
obtaining their homeowners insurance
through an independent
insurance agent, that the company
actually issuing the policy has a
time period within which they
can reject the policy. This leaves
the homeowner without insurance
coverage. If this occurs before
closing then the sale will fall
through. If the agent "promises"
coverage shortly before closing,
the company may decline the
policy after closing the transaction.
This leaves the new homeowner
without hazard insurance
and in default of their loan agreement.
The lender could foreclose
on the property. In any case, the
situation will most likely lead to
considerable heart burn and brain
damage (not to mention the cost)
before resolution. Lenders may
begin to require that the hazard
insurance be locked in before
funding the loan. This will eliminate
the declining of coverage
after closing problem. However, this
could delay closing while a P&C
company makes a determination
based on the request from an independent
insurance agent.
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