How do insurance companies prepare for large-scale natural disasters like Superstorm Sandy? They mitigate risk through policies they purchase from reinsurance companies — those who insure the insurers. As a result, reinsurers have some of the greatest insight into the effect of natural disasters on insurance, and are on the front lines of driving changes in natural disaster policies.
According to Munich Re, one of the world’s leading reinsurance companies, 2013 produced $125 billion in losses from weather-related catastrophes across the world. As tragic as that sounds, that's down from the annual average of $184 billion over the last 10 years, in part because of the lack of destructive hurricanes in the U.S. By comparison, in 2012 the U.S. alone had well over $100 billion in collective damages, led by Superstorm Sandy but also exacerbated by fires in the West as well as tornadoes and drought in the Midwest and South.
A big problem for reinsurers is that standard risk models based on historical data are increasingly less accurate. Reinsurers use sophisticated computer models to assess the probability of a catastrophic event and the likely amount of damage costs that follow. When summarized, these models allow insurance and reinsurance companies to properly set rates and manage reserves appropriately. The decreased accuracy of these models is primarily attributed to climate change, which reduces the usefulness of historical data. Since insurance companies can't control climate change, what are they to do? The reasonable solution is to raise rates for the associated higher risks.
Therefore, adjustments are being made to the extent that state regulatory agencies permit. There are also certain geographic areas where one or more insurance companies have thrown up their hands and exited a particular market. However, most have tried to adopt pragmatic adjustments for risk.
For example, let's consider flood risks. The Flood Insurance Reform Act of 2012 (known as BW-12) requires FEMA to reflect more accurately the true risks of flooding and the true costs of rebuilding in a damaged area. Subsidies and grandfathering provisions enabled people to rebuild in the same areas without meeting higher standards or proportionately sharing the risk; BW-12 is closing many of these loopholes.
The main emphasis is to re-evaluate the BFE (Base Flood Elevation) and enforce minimum requirements for elevating above the BFE when building or rebuilding. This may mean owners of buildings previously considered safe will suddenly see large premium increases. However, it's not all punitive — premium discounts are available for construction at even higher elevations than the minimum safety elevation.
Fire risks are undergoing similar mitigation efforts. Recently, State Farm conducted a risk assessment in several Western states and mandated policyholders to remove all trees and shrubs within 100 feet of their home or face policy cancellation. This was poorly received — after all, if you live in a forest, you probably like trees.
However, those who resisted State Farm found few insurers willing to take the risk without incurring very high premiums. Residents in hurricane areas are seeing similar mitigation efforts with respect to wind damage, and construction and reinforcement methods to minimize damage.
The overall trend is that insurers are raising premiums due to the increased occurrence and severity of natural disasters. They are attempting to do so, however, in ways that reasonably assess current risks, while offering discounts back to those willing to take steps to mitigate those risks. That's all we can really ask of our insurers.