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Tuesday, July 1, 2008

To Model or Not To Model

According to this WSJ article, insurers are boosting premiums based on models of "climate change" that predict more severe hurricanes in the future. This is in turn leading to a "glut of houses" for sale in some markets as homeowners are unable to bear the cost of the rising premiums. The basis of these increased forecasts are computer models:

Helping to drive these developments is a little-known tool of the insurance world: Computerized catastrophe modeling. Crafted by several independent firms and used by most insurers, so-called cat models rely on complex data to estimate probable losses from hurricanes.But regulators and other critics contend that the latest cat models -- which include assumptions about various climate changes -- are triggering higher insurance rates.

In other words, the same models which are causing global warming hysteria throughout the world and inducing the government to pursue economically destructive policies are being questioned and criticized by other government regulators since they are leading to increased insurance premiums! So, if based on these models, the government acts to increase energy and food costs by promoting ethanol it is considered prudent policy. But, if a private insurer uses these same models to increase insurance premiums, it triggers a regulatory backlash.

State insurance regulators and consumer groups are beginning to push back, saying that some insurers are relying too heavily on their use of cat models. Such critics note that the industry managed to realize huge profits in recent years -- despite record damages from back-to-back hurricanes in 2004 and 2005. (The Insurance Information Institute, the industry's trade group, says profitable years help offset bad spells when claims can exceed premiums. That happened in 2001, when insurers lost $7 billion.)

In May, Massachusetts officials denied a 25% rate increase that had been sought by the state-administered FAIR plan, its insurer of last resort. The request was "based in large part on a hurricane model that is not calibrated for Massachusetts weather patterns," state Attorney General Martha Coakley said in a statement. It "predicts the type of storms that have never made landfall in Massachusetts."

Last fall, Florida rejected Allstate's request for a 43% rate increase. In the process of investigating the proposed rate hike, officials learned that Allstate's cat model didn't comply with the state's rules against using a short-term model.

"They were using five-year projections [in their cat modeling] even though they had not been approved, and our concern was that it was because it generates a higher loss cost," said Kevin McCarty, the state's insurance commissioner.

So, the government is now actually regulating the types of models these companies can use and in fact, Florida objected to Allstate's "unapproved" model because it had the audacity to project out only 5 years. (I wonder what the commission's reaction would have been if the model projected a lesser "loss cost"?) Of course, aren't these the same models which are leading the United Nations-Al Gore-etc. to predict Armageddon? Does the government have an "approval" process for Al Gore's model (especially since his model is leading to a "higher loss cost")?

This is yet another example of how government intervention leads to massive market distortions. In a free market, an insurance company could offer an insurance policy at any premium they choose. If the premium they charge is too low then they would be taking the risk of having to pay out more than they take in and therefore would be risking bankruptcy. If the premium charged is too high, then a competitor (with a better model) could charge less premium and take their customers away. In other words, the market would operate in such a way to insure (pardon the pun) that companies would use the most objective models possible as possessing the best model would lead to the maximization of profits. (In fact, in the absence of government interference, I would bet all day that the insurance companies would have the best forecasting models as they have real money on the line versus government scientists whose incentives lie in alarming the public to procure more government funding.) Also, note that market-based home owner's premiums would act as a deterrent to those who wish to live in high risk areas. If it is true that a certain area is more prone to hurricanes either generally or due to "climate change" then higher premiums (or no possibility of insurance in extreme cases) would deter people from inhabiting these areas. As I noted in a previous post Can Evil Knievel Get a Free Lunch:
Furthermore, insurance premiums are one of the free market's defenses against irrational behavior. If you build your house on a volcano, it is unlikely anyone will insure you. To the extent that the government underwrites insurance policies that would not otherwise be offered, it encourages people to engage in risky behavior. In economic theory, this is known as "moral hazard." (The most notorious cases are those in which homeowners continually build on ocean frontage and receive a new home from the government every time it washes away.)

Of course, in reality, the government regulates premiums and/or sets up state (taxpayer) underwritten pools to insure people who can not get private insurance. As noted in the previously quoted post, such regulations forced many insurers out of Florida often leaving smaller, poorly rated insurance companies or no insurance companies in their place. Furthermore, when the state underwrites policies it encourages people to live in high risk areas which cause further increases in premiums or risk to the taxpayers who must underwrite the pool. In accordance with reality's law of "no free lunch", someone will pay. No company is going to underwrite policies where the premiums they receive are likely to be lost to claims (if they did that the government would prosecute them for defrauding their shareholders). And if the government takes the risk, then ultimately the taxpayers will foot the bill.

I have no doubt that many of these companies are using the uncertainty and pliability of these computer models to project results which then justify requesting the regulators to allow higher premiums to be charged. Of course, in the absence of a truly free market, we will never know and instead of the simplicity and objectivity provided by a free market, such disputes will always end up being fought over by pressure group lobbyists and opportunistic politicians with the final bill going to honest, hardworking people who least deserve it. And, finally, when the smoke clears, capitalism and the free market will be blamed thus leading to calls for more government regulation.

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