Insurance Industry Relies on Flawed Models to Set Rates
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In theory, premium rates for all kinds of insurance - auto
coverage, life insurance, health insurance, and homeowners
insurance - are set by a sophisticated examination of the
actuarial risk involved in the value of the property being
insured, and the nature of the behavior or activity that
creates a hazard to that value.
In the case of insurance against hurricane damage, however,
the Sarasota Herald-Tribune is reporting this month that
insurance company risk-modeling programs are fraught with
error, misinformation, and wild guess-work
("
Insurers' computer models deeply flawed," by Paige St.
John).
Complex computer models used by insurance companies,
according to the paper, are a "black box" whose contents are
kept secret from all prying eyes - with the exception of one
obscure Florida agency, the Florida Commission on Hurricane
Loss Projection Methodology. That agency knows something about
how the models work, but is bound to keep those details
confidential as trade secrets, in spite of Florida's
open-government "Sunshine" laws.
Developed decades ago as advisory tools, the paper says,
these top-secret computer models are now relied on as a source
of hard, precise numbers used to set premiums, and to purchase
reinsurance in case the insurance companies bite off more than
they can chew - even though the programs' output is at best a
range of possibilities, similar to the cone of probabilities
generated by weather forecasters to approximate the predicted
landfall of a hurricane.
Inaccuracies in the models may come out in the wash over
time, as a large number of storms and a large number of
insurance companies and homeowner policies are factored in, the
paper says. But for a given company handling a given storm,
“the final number chosen from the range of estimates
... is almost always wrong.”
Worse, according to the report, insurance companies working
to set premiums or to influence state officials, given multiple
computer models to choose from, have gotten into the habit of
choosing the model whose answer they like the best in any given
case. "The Herald-Tribune found insurers choosing models or
using them in ways that boosted their bottom line, including to
argue for rate hikes," said the report. "Filings with Florida
regulators show several insurers sought rate increases this
year after using catastrophe models that left out loss-reducing
details such as roof shape or storm shutters... State Farm this
year openly switched to a model that better supported its
rate-hike request. After years of presenting other models,
State Farm swapped to a seldom-used engineering-based
catastrophe model to argue for a 21 percent rate increase on
homes fortified against hurricanes."
With complexity in the risk analysis has come increasing
cost for individuals and for states - along with reduction in
coverage and a confusing gauntlet homeowners must run in the
event of a catastrophic storm. The RAND Corporation think-tank
released a study of the troubled insurance market in October,
pointing to, among other vexing policy issues, a pattern of
rising premiums and reduced coverage
("
Residential Insurance on the U.S. Gulf Coast in the Aftermath
of Hurricane Katrina," by James W. Macdonald, Lloyd Dixon,
and Laura Zakaras).
Says the report, "In areas exposed to the most risk of wind
and flood damage, prices for private residential wind insurance
have increased dramatically at the same time that access to
coverage has declined." And as private insurers have pulled out
of the riskiest markets, state wind pools have stepped in to
pick up the slack - making the situation, if anything, more
complicated for homeowners. "Because homeowners insurers often
exclude wind coverage (along with flood coverage)," the report
notes, "many homeowners in coastal regions must now purchase
three insurance policies to insure the same dwelling: one,
underwritten by a traditional insurer, to cover perils such as
fire and theft (but not wind and flood); a second, from the
state windstorm residual market, to cover damages from wind or
hail; and a third, from the NFIP, to cover flooding."
Typically, the policies have different deductibles and other
key details - and they also require homeowners who suffer a
loss to somehow establish whether wind, flood, fire, or some
combination of those forces caused their damage.
Meanwhile, insurance companies continue to try to predict
the future - and, according to the Herald Tribune, to fudge the
results in their own financial interest. According to the
paper, Florida insurance companies are still relying on storm
predictions based on the work of a handful of scientists, some
of whom no longer support the conclusions of their
collaboration
("
Florida insurers rely on dubious storm model," by Paige St.
John). After Hurricane Katrina, the paper reports, an insurance
industry consulting firm gathered four weather scientists
together in Bermuda to ask how many storms would hit the U.S. -
and, in particular, Florida - in the next five years.
The firm, RMS, used the results to help persuade Florida
regulators to allow a sharp escalation of insurance premiums in
the state — saying that the data represented
“scientific consensus,” reports the
Herald-Tribune. “The reality was quite
different,” the paper asserts: “Today, two of
the four scientists present that day no longer support the
hurricane estimates they helped generate. Neither do two other
scientists involved in later revisions. One says that monkeys
could do as well.”
That scientist — University of Colorado professor
Roger Pielke — posts about the continuing scientific
controversy on his blog
(“
RMS Responds to the Sarasota Herald-Tribune”).
Comments Pielke, “Along with its peers, RMS is an
important company. They do work that potentially helps make the
global reinsurance and insurance industry do its work with a
closer connection to empirical science. It is precisely because
RMS is so important that it merits close attention. Like
ratings agencies, RMS and other catastrophe modelers are too
important to a range of public outcomes to be left to govern
themselves.”
After Katrina, the Herald-Tribune says, "The new RMS model
called for at least 11 hurricanes to come ashore in the United
States by the end of 2010, most of them aimed at Florida." And
what happened in reality? "Four hurricanes struck the U.S. None
hit the Sunshine State."