Another Perfect Storm Brewing: Government Underwritten Contingent Liabilities

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Includes: FMCC, FNMA, SPY
by: Michael Panzner

Of all the brewing firestorms in the U.S. economy, perhaps the least known is the one stemming from the massive build-up of contingent liabilities underwritten by federal, state, and local governments -- that is, taxpayers. These include a vast array of explicit backstops, such as federal and state loan guarantees, where the public is on the hook if the insured borrowers default. They also include various implied guarantees, like those associated with government-sponsored enterprises such as Fannie Mae and Freddie Mac, which are not legally binding but which authorities will nonetheless find it difficult to renege on if and when disaster strikes.

One category of contingent obligation that has grown in size to the point where it is beginning to represent a potentially serious threat to future financial stability is comprised of government-sponsored insurance pools, or "insurers of last resort." In many cases, ILRs have been established to provide coverage for those who can't obtain insurance from the private sector, but who are nonetheless required to have it (as is the case with those who own and operate motor vehicles, for example). While overseen by the public sector, many are funded by premiums levied on most or all of the firms operating in a particular market, though large deficits often stir up controversy and legal wrangling.

Other ILRs have been set up not because the coverage in question is mandatory, but because they are seen by those in charge as economically and socially desirable initiatives and the private sector has otherwise been unwilling or unable to fill the breach. These run the gamut from the federal government's aviation war-risk insurance program, which was put in place in the aftermath of the 9/11 terrorist bombings to aid America's beleaguered airlines, to federal and state-run entities that offer flood insurance in high-risk coastal areas.

Many experts believe that most, if not all, of these programs, however well-intentioned, are generally a bad idea because they distort the marketplace and encourage various forms of moral hazard (e.g., overdevelopment in flood-prone areas). Other shortcomings include the fact that they are often heavily influenced by politics or badly mismanaged -- like most government-run programs are. Pricing also tends to be artificially low, which naturally attracts the highest-risk customers and all too frequently sows the seeds of the programs' own demise.

All of which brings us to a report in today's Wall Street Journal. In "As Insurers Flee Coast, States Face New Threat," reporter Liam Pleven delves deep into the worrying prospect that "'last resort' carriers could shift liability to the broader public."

As hurricane season gets under way, a dramatic shift in the way homeowners insure against disasters could pose a big financial risk in several coastal states.

Private insurers have been fleeing the shoreline, wary of costly storms and often fed up with government regulations that prevent them from pushing rates higher. In more than a dozen states -- from Texas along the Gulf of Mexico and up the East Coast to Massachusetts -- an odd breed of carriers known as "insurers of last resort" is filling the void.

These last-resort insurers, which cover people the private sector won't, issued more than two million policies to homeowners and businesses in hurricane-prone states last year, about twice as many as in 2001. Over that same five-year period, their total liability for potential claims has increased roughly threefold, topping $650 billion. Meanwhile, a separate federal flood-insurance program has seen its liability jump by two-thirds since 2001 to just over $1 trillion.

The sum effect: Much of the risk associated with hurricane coverage is shifting to the broader public and away from private companies and coastal homeowners.

It's unusual for several reasons. At a time when financial markets are becoming increasingly adept at spreading risk, states and the federal government are concentrating it on a massive scale. The shift contrasts starkly with the federal government's effort to make individuals assume more risk and costs in other areas, such as retirement and health-care plans.

Last-resort insurers are created by state governments, although they operate much like other insurance companies. Many of them are set up as associations, which actually write policies that cover hurricane damage from wind, among other standard threats. Any insurer that sells property insurance in the state must also be a member of the association.

But these insurers also differ in significant ways. They often don't have deep financial reserves, leaving other private insurers, and sometimes taxpayers, to help foot the bill for huge claims.

In a catastrophic situation, for instance, the associations are often authorized to impose assessments on all their member insurers. That can translate to rate increases or surcharges for policyholders throughout the state -- not just in places hit by a storm. And after recent hurricanes in Florida and Louisiana, lawmakers tapped state coffers -- and hence taxpayers -- to help defray losses incurred by last-resort insurers.

The system "shifts the risk literally from those who are most at risk...to individuals who are at less risk or even at no risk," says Robert Hartwig, president of the Insurance Information Institute, an industry trade group that plans to release a report detailing the growth of last-resort insurers.

States have a strong economic incentive to make coverage available, since most banks require insurance before they write a mortgage. If policies are tough to obtain, states could miss out on the revenue that comes with development -- particularly on choice coastal property. Moreover, the states face political pressures from homeowners who want to be sure they have affordable insurance. (See related story1.)

The government's role in homeowners insurance has long been a hodgepodge. Each state has its own regulator which typically sets or approves the rates insurers can charge.

Many insurers of last resort were established starting in the late 1960s, when urban riots led private insurers to shun some inner-city properties. Today, they cover a broad spectrum of homes. Generally, they aren't backed by state budgets.

While the rates charged by last-resort insurers can be high, they're generally not steep enough to invite competition from private insurers.

"There's no competition anymore," says Melanie Tringali, whose second home about half-a-mile from the water on Cape Cod is covered by Massachusetts' insurer of last resort, the Massachusetts Property Insurance Underwriting Association. Ms. Tringali switched in 2005, after her insurer told her agent it was no longer writing policies on the Cape. Ms. Tringali says the 1,000-square-foot house costs about $1,300 a year to insure.

Massachusetts hasn't been hit by a major hurricane since 1954. But in the wake of severe storms elsewhere, some forecasters believe that could change. Companies that build computer disaster models say the losses could be enormous, which has frightened many private insurers all along the Eastern seaboard. On the Massachusetts coast, private firms such as Hingham Group and Quincy Mutual Fire Insurance Co. are cutting back.

As a result, some 43% of homeowners on Cape Cod and nearby islands are now covered by the Massachusetts association. It issued more than twice as many policies last year as five years prior, and its liability more than quadrupled, to $92 billion.

Insurers of last resort in other states have seen similar growth. In Texas, liability almost tripled. In North Carolina, it quadrupled. In Rhode Island, it was up sixfold.

A severe storm in Galveston, Texas, site of a deadly 1900 hurricane, could cost the Texas Windstorm Insurance Association, the state's insurer of last resort, as much as $8 billion, officials there say. The association and its member insurers would be able to cover about $700 million in losses. Beyond that, it would need to ask all its member insurers -- even those who don't write coastal coverage -- to make up the huge shortfall. If insurers did have to chip in at that point, they would be permitted to recoup the funds through years of tax credits -- a potentially big hit on the state budget.

"It's scary as hell," says James Elbert, an independent insurance agent who recently retired as chairman of the association's board.

The current situation represents a reckoning for years when states saw extensive waterfront growth, due in part to low insurance premiums. For a three-decade stretch starting in the early 1970s, private insurers were writing policies more or less freely along the water and relatively few major storms hit. Coastal development boomed.

Florida offers a glimpse into what could happen down the road. In the wake of recent storms that prompted many insurers to limit their exposure, the state's last-resort insurer is growing -- and assuming more risk.

When the 2004 and 2005 hurricanes slammed its coast, the state's insurer of last resort, Citizens Property Insurance Corp., suffered heavy losses. It hit its own policyholders -- and eventually even those insured by other companies in the state -- with $2.7 billion in premium surcharges. Florida legislators also allocated $715 million to hold down fees.

Since last year, Citizens has continued its massive expansion, writing roughly 15,000 to 20,000 new policies a week. As a result, it could be on the hook for significant losses if major storms roll in. A direct hit on Miami could cost tens of billions of dollars, much of which would be borne by Citizens -- now the largest property insurer in the state.

Some believe the federal government might be called upon in the event of severe losses. Washington is already taking on additional risk through the National Flood Insurance Program. Under that program, insurance agents sell special government-backed policies that cover water damage from floods, including from hurricanes. (Flood damage is generally excluded from policies issued by private insurers, which typically only cover wind damage from storms.)

Last year, the number of federal flood-insurance policies rose by 12% from 2005, when Katrina hit, mostly due to double-digit growth in hurricane-prone states such as Mississippi, New York, Louisiana and Texas.

Tom Lasater, a retired high-school principal in Galveston, has separate insurance policies to cover both flood and wind damage. He's got reason for caution. In 1900, a storm drove tides 8 to 15 feet high and inundated Galveston.

Today, Mr. Lasater pays about $1,000 a year for $225,000 worth of wind coverage from the Texas Windstorm Insurance Association on his two-story brick house, which he says is 13 feet above sea level and sits behind a 14-foot-high seawall. His former insurer said it would not renew his policy after Hurricane Rita ravaged the area in 2005. With the windstorm association, he says his premium is lower, though he'll have to pay more out of pocket through his deductible before coverage kicks in.

As for flood insurance, Mr. Lasater says he pays roughly $200 a year for his policy from the federal program. He says he only decided to buy it after Hurricane Katrina, when he saw insurers trying to deny claims by arguing that damage was caused by water, not wind. "It was affordable, and I figured, 'Why take a chance?' " he says.

A number of states, including Texas, are concerned about what could happen if their last-resort insurers face a significant deficit. Like officials in Florida, lawmakers in some states are also facing deep public anger about the rising cost of insurance on the coast.

"There's a catastrophe playing out with my constituents," says Robert O'Leary, who represents much of coastal Massachusetts in the state Senate. The private market, he says, "is sort of shriveling."

In South Carolina, the state's insurer of last resort has seen its liability nearly triple since 2001. The insurance commissioner, Scott Richardson, backed a plan to eventually lure more private insurers to the coast. A former insurance agent in Hilton Head, S.C., Mr. Richardson argued that premiums charged by the last-resort insurer were typically too low. Yesterday, state lawmakers approved legislation that will require the insurer to charge "adequate" rates.

The legislation also gives tax credits to insurers that offer wind coverage on the coast. That could cost the state budget $6 million to $10 million, and possibly more, Mr. Richardson says. "If it makes a company go in and write 100 policies in Charleston, it's worth it," he says.