Some insurers supporting federal multi-peril insurance

Here a story from Arthur Postal of National Underwriter about Allstate and Nationwide bucking an industry trend and supporting some form of Rep. Gene Taylor’s proposed Multiple Peril Insurance Act.  The bill, as I wrote about last week, has come under fire from the American Insurance Association, which raised concerns that it would be too costly and wouldn’t accomplish what it is intended to do.    

The story says Michael McCabe, Allstate senior vice president and chief legal officer, sent a letter to Taylor saying "We support the concepts contained in [the proposed bill], if properly constructed and implemented  . . . ."

Here’s more from the story about McCabe’s letter:

He wrote that the “private insurance mechanism is not well suited to low-frequency, high-severity events.”

He explained, “We need a better system in our country to deal with major events, one that would leverage a stronger public-private partnership as part of an integrated and comprehensive solution.

This concept of low-frequency, high-severity losses is central to why insurers exclude certain perils like flood and earthquake, and deserves a thorough explanation.  Fortunately, J. David Cummins and Neil A. Doherty of the Wharton School, University of Pennsylvania, explained this stuff a while back in a scholarly paper much better than I could, so I’ll let them do the talking.  Here’s their explanation, to which I’ve added some emphasis to make it easier to read:    

1) High-frequency, low-severity losses. These are losses that are numerous and small relative to industry resources. A good example is automobile collision losses. Although such losses may be considered a serious financial hardship to the individual insured, they are very small relative to the resources of the industry. Moreover, there are large numbers of such losses, most of which are statistically independent, meaning that the occurrence of any one accident is not usually associated with other, related accidents. For types of insurance where there are many statistically independent losses, insurers can exploit the statistical property known as the "law of large numbers.” The law of large numbers essentially says that when large numbers of statistically independent events are observed, the average loss becomes highly predictable. Or, in other words, the chances become small that the actual observed losses will deviate from expected losses by an amount which is large relative to the overall expected value of loss. This is the type of loss the insurance industry handles most effectively. By pooling together the losses of many individuals with statistically independent risk exposures, the industry is able to charge premiums which reflect the expected or average loss plus expenses and a relatively modest charge for risk bearing. The industry’s equity capital is more than adequate to absorb any adverse fluctuations in losses of this type.

(2) Low-frequency, high-severity losses. The second major type of loss is the type represented by large catastrophes, i.e., events that occur infrequently and are large relative to the resources of the insurance industry. This type of loss is much more difficult for the insurance industry to handle because the usual pooling mechanisms do not apply. The events are simply not sufficiently frequent for the law of large numbers to operate. For this type of loss, the insurer is essentially in the same position as the policyholder in the usual insurance transaction, i.e., the insurer faces a loss that amounts to a high proportion of its resources and that is highly uncertain or unpredictable. Low-frequency, high-severity losses cannot be handled effectively by the insurance industry acting alone. However, these losses can be diversified by pooling them with other economic events that are not usually the subject of insurance . . . .

 

 

 

4 Comments

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4 Responses to Some insurers supporting federal multi-peril insurance

  1. Paul Dzielinski

    Why are possible solutions to catastrophe losses always centered on government backstops? Why don’t we look at amending the tax code to allow insurers to establish catastrophe reserves? European and Japanese companies are allowed to pre-fund cat losses, and it has made it much easier for these companies to absorb cat losses when they occur.

  2. Good point. One can also wonder whether, simply because federal disaster relief acts as a de facto subsidy of development in high risk areas, that means the principle of subsidy should be extended in a national catastrophe fund or if instead there should be fewer incentives to develop and live in high risk areas, such as allowing the market price for insurance in those areas.

  3. Simon Smith

    Why the oppositon to a national catastrophe fund? I dont live on stilts, I am 30 minutes drive from the ocean. Making the entire State of Florida a “high risk area” is significantly harming the economy. $5k-$10k *home* windstorm policies are unconsciounable. Property owners cannot afford coverage. Every commercial property that can has dropped windstorm coverage completely because six figure premiums are economically not viable. The private insurance business has failed to provide a reasonable product. The govt provides reinsurance, flood insurance, crop insurance, ag subsidies, why not a low frequency high severity disaster policy? Split fire and property from windstorm please!

  4. Simon, I don’t think the issue is whether someone is “making” parts of Florida high-risk, but the fact that much of Florida IS high risk. Part of the opposition is that this would be a subsidy of people in hurricane areas — objectively, what is wrong with people in more dangerous areas paying more for insurance? Another part is that the NFIP is an incompetently run program as it is, a welfare program as much as an insurance program, and why would anyone suppose the government is capable of either accomplishing an objective or, if they do, do it at an acceptable cost?