Disaster insuranceThe benefits of multi-state catastrophic risk pool

In the wake of the multi-state destruction wrought by the one-two punch of Superstorm Sandy and the nor’easter that followed, a new study suggests that geographically diverse, multi-state catastrophic risk pools provide clear financial benefits without creating subsidies between low and high risk areas. Sponsored by the Florida Catastrophic Storm Risk Management Center at Florida State University (FSU), the study was conducted utilizing the science-based risk modeling platform from Kinetic Analysis Corp., a specialist in multi-model impact forecasting and risk assessment for catastrophic events.

Kinetic Analysis Corporation of Silver Spring, Maryland, notes that the study was conducted by Charles C. Watson Jr., director of R&D at Kinetic Analysis Corporation and developer of the modeling system used in the study; Mark E. Johnson, professor of statistics with the University of Central Florida; and Randy E. Dumm, William T. Hold professor of risk management and insurance with FSU. It sought to determine whether geographic diversification reduces the amount of reserve funds required to cover catastrophic losses. This was accomplished by analyzing performance of insurance portfolios drawn from various combinations of nine coastal states in the Southeastern United States based on tropical cyclone losses.

“Single state portfolios, on which the current property insurance system is based, are far from optimal. They are large enough to encompass the risk from single events, but not large enough to diversify that risk sufficiently to take advantage of different climate zones or areas not hit by a single major storm.” said Watson.

Added Johnson: “Creating portfolios covering diverse climate zones, such as combining properties from both the Gulf of Mexico and Atlantic Coasts, is highly advantageous over portfolios in a single region. Covering all exposures in the entire study area, Texas to Virginia, was the most efficient and sustainable grouping examined.”

In addition, the study found that a system covering all storm hazards (wind, wave, flooding) would be more efficient and much easier for consumers to navigate than the current system where private insurance covers wind damage, but flood damage is covered through a separate government backed insurance through FEMA, each with different rules and deductibles.

The study’s findings are particularly relevant in the wake of Sandy, which pelted coastal and inland regions with high winds, driving rains, heavy snow and flooding along the Eastern Seaboard. Kinetic Analysis projects that that storm’s direct impacts could run as high as $25 billion, excluding the New York City underground infrastructure.

Sandy has renewed calls for a federal catastrophe plan that creates risk pools across larger geographic areas — along with objections that doing so will force low-risk areas to subsidize high-risk states.

The study found, however, that the opposite to be true. As geographic diversity increased, funding levels for sustainable catastrophic risk pools decreased relative to premiums, actually resulting in savings for both low and high risk areas.

“If subsidies are created in this setting, it is due to incorrect risk pricing rather than the risk itself,” said FSU’s Dumm. “Our analysis found that each state derives benefits from geographic diversification regardless of risk ranking. In fact, failure to diversify catastrophic wind risk may impose its own set of costs in the form of lost diversification benefits that exist precisely where they are needed, for less frequent and more severe catastrophic events.”

Specifically for the portfolios analyzed, reserves totaling just over $130 billion would be required for each of the nine states to individually cover 100-year losses. However, for a portfolio covering the entire region, required reserves total just $71.1 billion. The difference is due to the extreme unlikelihood that all states would suffer a 100-year event in any given year.

Using Kinetic Analysis’ modeling platform, numerical calculations for the risk diversification study were generated by:

• Simulating all Atlantic storms (1871-2011), with a complex high resolution storm hazard model consisting of wind, wave, storm surge, and rain components
• Determining damage to the target portfolio using a composite damage function derived from six different public domain damage function families
• Analyzing the output statistically and conducting a financial analysis on various portfolios and policy provisions

“This study is a significant addition to the body of scientific knowledge upon which critical decisions governing risk pooling and geographic diversity of insurance portfolios are made,” said Steven Stichter, CEO, Kinetic Analysis. “As a company, we are particularly gratified to see our modeling tools successfully utilized in a meaningful way that addresses real-world issues confronting federal and state governments in protecting their populations and infrastructures.”

—   Read more in Charles C. Watson et al., The Impact of Geographic Diversity on the Viability of Hurricane Catastrophe Insurance (Florida State University, November 2012)