Future Storms Like Superstorm Sandy Could Bankrupt States

Some state governments are so far into the insurance business that they could be bankrupted by storm claims

Superstorm Sandy killed over 70 people in the U.S., knocked out power for millions up and down the East Coast, flooded the New York Subway, and damaged thousands of homes. The final price tag for the storm's damage could exceed $40 billion, which would make it the most expensive storm to hit the U.S. since Hurricane Katrina.

Coming as it did, only a year after Hurricane Irene and eight years after Hurricane Ivan, some are asking whether it is part of a trend towards more damaging storms. The answer is yes—we humans are to blame for more damaging storms, but not for the reasons you might think. One of the main culprits is government intervention in insurance markets, which creates perverse incentives to build in danger zones, thereby increasing the threat posed by storms both to property owners and to taxpayers. If Sandy had hit Florida the way it hit New York and New Jersey, it might have bankrupted the state. To reduce the scale of future damage from storms like Sandy, and the threat of fiscal implosion, federal and state governments should get out of the insurance business.

There have been superstorms similar to Sandy in the past, including the blizzard of 1978, the Perfect Storm of 1991, and the Eastcoaster of 1996. But there doesn't seem to be a trend in the number or intensity of either hurricanes or Sandy-like superstorms. Martin Hoerling, a meteorologist at the National Oceanic and Atmospheric Administration, says there is no trend in the number of hurricanes or extratropical cyclones. Nor is there any evidence of a relationship between the numbers of either type of cyclone and climate change. However, there has been a significant increase in the amount of damage caused by hurricanes and similar extreme weather events over the past 50 years. There are two main reasons for this. First, we have become much wealthier: inflation adjusted average per capita income in the U.S. rose threefold, from $13,250 in 1960 to $39,800 in 2008. Second, the number of people living along the coast has increased dramatically: from 1960 to 2008 coastal population rose by 84 percent, whereas the non-coastal population rose by 64 percent. As a result, there is simply more valuable property in coastal areas that is likely to be affected when a big storm hits.

One reason coastal population rose more than non-coastal population is that government disaster insurance programs have actively encouraged people to locate close to the coast. In addition to the National Flood Insurance Program, the federal government's second largest fiscal liability next to Social Security, many states run property insurance plans out of the residual market intended to provide a lower cost of insurance for owners of homes and businesses in more risky areas, which would normally be difficult or impossible to obtain in the private market. Such state-run insurance plans are offered through Fair Access to Insurance Requirements (FAIR) plans, Beach and Windstorm plans, or in Florida and Louisiana, state-run insurers of "last resort."

FAIR was established by the federal government as part of an urban redevelopment program following the riots of 1968, with the express intention of encouraging people to buy property in depressed areas. The plans do that, but by reducing the cost of insuring against risks such as flooding and storm damage, they also encourage people to build properties in storm and flood-prone areas. That increases the damage done when a storm hits.

These insurance plans also suffer from risk concentration—in direct violation of one of the basic principles of insurance: risk diversification. When a state provides disaster insurance coverage to a group of people within its borders all of whom face similar risks, it is concentrating risk. When disaster strikes and a significant proportion of those insured suffer major losses, the state's insurance fund may suffer a catastrophic shortfall—with dire consequences for the state's fiscal position. According to the Insurance Research Council, U.S. residual market exposure has grown an average of 18 percent per year since 1990 in large part because of the artificially low cost of such state-backed insurance. In other words, the FAIR Plans developed in the 1960s have exacerbated the problem of risk concentration by encouraging development and population growth on the coast.

This has been especially problematic in Florida, where the state-run Citizens Property Insurance Company (CPIC) has grown to cover at least 25 percent of homeowners in the state, mostly in extremely high-risk areas prone to hurricane damage. Because they are covered by CPIC, policyholders pay rates that are not actuarially sound, underfunding the potential claims payouts. To make matters worse, the Florida Hurricane Catastrophe Fund (FHCF)—a state-run reinsurance fund which provides reinsurance to both private insurers in Florida and CPIC—has been estimated to underfund its $17 billion in obligations by at least $3.2 billion. If CPIC and FHCF fail to make ends meet to pay out claims in the event of a large storm or series of storms, Florida taxpayers will be on the hook for the bills.

Rather than sending a market signal warning of the cost of coastal living, subsidized insurance has compounded the problem, with demand for FAIR and Beach Plans more than tripling. In the wake of major storms such as Andrew and Katrina, the total number of FAIR and Beach Plan policies has increased from 931,550 in 1990 to 3.3 million in 2011. Over the same period, the total exposure to loss covered under the nation's FAIR and Beach Plans increased 1,517 percent, from $54.7 billion in 1990 to $884.7 billion in 2011. The combination of more policies and greater coverage has pushed state-run plans to record deficits, after facing high volumes of claims from bad storm seasons. According to the Insurance Information Institute, of the 31 FAIR plans for which data are available, 28 have incurred at least one operating deficit since 1999. Of the six Beach and Windstorm Plans, all have sustained at least one underwriting loss since 1999.

While much of the increase in the number of state-backed policies has been driven by Louisiana, Florida, and other Southern states, Northeastern states have also seen increases in the amount of coverage provided by their FAIR plans. In particular, Massachusetts has seen a 336 percent increase in the number of its FAIR plan policies, representing an increase in coverage by $72.6 billion.  

Government subsidies to insurance may have been well intentioned but by incentivizing people to build homes in danger zones, they have created enormous fiscal risk. If states want to avoid this looming fiscal trouble, they would do well to address all the causes. In the case of insurance, they can begin right away by ceasing to issue new policies and retiring policies when the renewals come due. That would force property owners to seek insurance on the private market, or move.