Florida

This year’s hurricane season, which officially ended at the beginning of this month, was the third most active season on record for the Atlantic. However, few of those hurricanes made landfall and thus the U.S. experienced little damage in the unusually active season. Despite none of the 19 named storms making landfall in the U.S., homeowners in coastal states are seeing their premiums rise. Particularly in Florida, where the government has to approve rate increases, people are asking why rates should rise when the state hasn’t had a major storm in five years. What some observers fail to understand or choose to disbelieve is that insurance companies, particularly in states with rate controls, are still playing catch-up from the years of charging rates that were far too low. In addition, many insurance companies are increasingly investing in back-up insurance, known as reinsurance.

Safety net:

The way insurance works is that a company will charge an individual a “premium” based on the perceived likelihood that this person will need to make a claim on his or her insurance. In Florida, despite the years of luck, the likelihood that someone will need to make a claim on their property insurance is much higher. If there is a good year and no hurricanes, the insurance company will retain a “profit.” But that extra money doesn’t just get dolled out to shareholders; it is reserved for future disasters or allocated to claims around the country. And based on a recent report from The Tropical Meteorology Project at Colorado State University, we may not be so lucky in the next hurricane season:

Their “extended range” forecast calls for 17 named storms in the 2011 season, of which 9 will become hurricanes, and five will reach “major” hurricane strength at 111 mph  (Cat. 3) or higher. And while no 2010 hurricanes crossed the U.S. coastline, the CSU team said, “We would expect to see more landfalling hurricanes in 2010. The average is 1 in 4 Atlantic hurricanes making a landfall in the U.S.

Insurers need to prepare for future losses. And despite several years of no significant hurricane damage, many insurers cover all types of damages around the country. Their losses are usually not limited to one state or line of insurance.

Insurance on a global stage:

While some insurers are strictly based in one state and provide limited types of coverage, many insurers operate throughout the nation providing many different kinds of insurance (property, auto, etc). This is so that a hurricane in Florida can be paid by premiums of Californians and a mudslide in California can be paid by homeowners in Minnesota. This way an insurance company can remain “solvent,” that is, it can have enough money to pay all the claims year round. The greater diversity an insurance company has among its policy holders, the less likely it is to experience a disaster that depletes all of its funds at once. However, not all insurance companies can spread the risk around the nation and even those that do can purchase extra insurance, known as reinsurance, to further protect against catastrophic claims. Reinsurers provide insurance for insurance companies around the world.

Why rates rise:

Insurance rates rise when insurance companies can get state governments to allow them to rise. The goal of most insurance companies is to estimate risk and charge a rate that brings loss and income to an almost 1 to 1 ratio. This allows them to charge the lowest amount, to be competitive with other companies, while still having enough funds to pay claims and not lose money. Basically, insurance companies would like to “break even” when it comes to insurance premiums. (A big misconception about insurance companies is that they draw the majority of their profits from unused premiums; this is not the case. Insurance companies make the majority of their profits through “holding” premiums and investing them in other products.)

The reason insurance companies in states like Florida are constantly harping for a rise in the premium rates is because the state government has forced insurance companies to operate at a loss for many years. In addition, insurers in Florida were forced to give “mitigation credits” for homeowners who took steps to prevent damage. While mitigation is a good thing and something that insurers would normally reward with lower premiums, in Florida the rates are so depressed that mitigation only reduces the amount insurers are likely to lose; forcing them to give credits puts them back at square one in terms of loss-risk.

“In the short term, it was great for consumers. Premiums on homeowners’ policies were reduced anywhere from 20 to up to 70 percent…The long-term thing was that companies like Allstate and State Farm were being forced to give back 60 to 70 percent of the earnings they made the year before because of the discounts that were made available to consumers.” This according to Brad Emmons of Vero Insurance.

Despite common belief that insurers are flush with money and reports that claim shady dealings, two-thirds of insurance companies in Florida are operating at a net loss and non-hurricane-related costs are on the rise. According to one report, non-hurricane costs accounted for 65 percent of Florida insurers losses.

In the end, Florida is a risky place to live and government interference has decimated the insurance environment in the state. The answer is to continue to let rates rise until they represent true risk. Eventually, private insurers will re-enter the state’s market (once it is profitable again), reserve money will be secure, and rates will fall to a level that reflect the actual risk of building a home on a coastline that is prone to hurricanes and other natural disasters.