Question

What are some of the more important risk factors against which a corporation may purchase "fairly
priced" insurance, including derivatives and options? What are some of the more important risk factors a
corporation cannot buy insurance against? Why are these markets missing? 20 marks.

Answer 1

Your gender, age, marital status, geographical location, and credit score all affect your insurance rates in different ways.

1. Gender and Age
Young men usually incur higher rates than young women as statistically, more male teenagers have accidents than female teenagers. However, older men generally have better rates than older women. Some evidence suggests that older women are in more minor accidents than older men – though the difference in premium costs usually isn’t drastic.

2. Marital Status
Married people tend to have fewer accidents than single people; therefore, getting married (especially for men) can significantly lower your rate. How much your rate decreases depends on your previous driving history – if you are a man who has never been in an accident and has a clean driving record, you could see your rates nearly halved.

3. Where You Live
Because most traffic accidents occur close to home, the area you live in greatly affects your rates. More densely populated neighborhoods with more cars mean you are at a higher risk of accidents, theft, and collisions with injuries.

Repairing your car also costs more in some areas, and some areas have higher rates of theft. Plus, in this economy, many urban areas with high unemployment rates have a lot of uninsured drivers, as many people can’t afford to insure their cars. Detroit and Philadelphia are two of the most expensive cities in which to insure a car, as they both have high traffic density and high rates of uninsured drivers.

4. Credit Score
Many insurance companies take your credit score into account when determining your rate. There is no specific point at which your credit score begins to affect your rate, but in general, lower scores mean higher insurance premiums.

5. Profession
Auto insurance companies may also make correlations between a person’s risk of accident and their profession, and they can adjust your premium accordingly if they think you’re more likely to get in an accident. For example, delivery drivers and journalists are on the road constantly, and thus are more likely to be in an accident, whereas airline pilots often just drive between the airport and home, and don’t spend much time on the road. Others, such as police officers, paramedics, nuns, and insurance underwriters, often receive a good rate, as they are seen to be more careful than the average driver.

Car-Related Factors

The car you drive significantly affects your rate, since some cars are more likely to be stolen, lack safety features that prevent accidents, or cost more to repair.

6. Safety Rating
Owning a vehicle with a high safety rating means there is a lower chance of needing to pay for your or your passengers’ medical bills – therefore, your rate will be lower. Owning a car with a lower safety rating, however, will usually result in a higher cost.

The safety rating is based on several factors, including the likelihood of the car’s owner getting into an accident, and also how likely a passenger is to be injured in an accident. Safety features such as airbags, automatic seat belts, and traction control help make your car safer, which makes you less likely to get in an accident, as well as making it less dangerous.

7. Vehicle Size
Larger cars are generally safer than smaller cars in an accident. Therefore, many larger cars with good safety ratings have lower premiums than smaller cars with otherwise similar ratings. However, cars with larger engines relative to body size tend to have higher rates – for instance, insurance for a sports car with a V8 engine costs much more than a small car with a V4 engine.

8. Age of the Car
Though the repair costs of an older vehicle are similar to the costs of a newer vehicle, an older car is more likely to be “totaled” in an accident. This is because the cost of significant repairs needed for an older car can often be higher than the vehicle’s entire worth. Therefore, it is likely that the owner would simply discard the vehicle and replace it, rather than paying for repairs.

Since the cost to replace a new car is much higher than to replace an old car, newer cars are not considered to be totaled as often, and generally have much higher collision coverage rates than older autos. The higher coverage translates to a higher premium for a newer car.

However, if your car is quite old, you could probably drop the collision coverage altogether and simply save the money to buy a replacement jalopy if you get in an accident.

9. Likelihood of Theft
Some cars are more attractive to thieves than others, and a car model that hits the top 10 most stolen list is likely to have higher rates than one that’s not a likely target. But if you have a car alarm or other anti-theft features, this can lower the premium.

Personal Driving Habits

While the above items do influence your overall rate, the most important factor in determining your insurance costs is your personal driving record.

10. Driving History
If you have been in accidents, received any tickets, or made previous auto insurance claims, the insurance company has learned that you’re more likely to make another claim than a similar driver who doesn’t have any blemishes on their record. If your driving record is bad enough, some insurance companies will refuse to give you insurance at all.

Fortunately, these blemishes tend to become less important over time. So if you had some wild years with a few tickets or accidents in your past, making an effort to drive more slowly and carefully in order to avoid future problems can pay off in time. Most tickets and non-injury accidents stop affecting your rate after three years, and injury accidents generally do not affect your rate after five years. A DUI ticket can affect your premium for up to 10 years, however, and many companies won’t insure someone with one.

11. Driving Activity
Some companies can alter your rate based on what you use your car for, the distance you drive, and where and when you drive. Business commuters usually put more miles on their car, and the more you’re on the road, the more likely you are to get in an accident. You may be able to get a discount on your insurance if you don’t drive the car much, or don’t use it to commute to work. Plus, if you can keep your car in a secure location, such as a garage, it’s less likely to incur damage, which lowers your rate further.

Almost all of us have insurance. When your insurer gives you the policy document, generally, all you do is glance over the decorated words in the policy and pile it up with the other bunch of financial papers on your desk, right? If you spend thousands of dollars each year on insurance, don't you think that you should know all about it? Your insurance advisor is always there for you to help you understand the tricky terms in the insurance forms, but you should also know for yourself what your contract says. In this article, we'll make reading your insurance contract easy, so you understand their basic principles and how they are put to use in daily life.

Insurance Contract Essentials

• Offer and Acceptance. When applying for insurance, the first thing you do is get the proposal form of a particular insurance company. After filling in the requested details, you send the form to the company (sometimes with a premium check). This is your offer. If the insurance company agrees to insure you, this is called acceptance. In some cases, your insurer may agree to accept your offer after making some changes to your proposed terms.
• Consideration. This is the premium or the future premiums that you have pay to your insurance company. For insurers, consideration also refers to the money paid out to you should you file an insurance claim. This means that each party to the contract must provide some value to the relationship.
• Legal Capacity. You need to be legally competent to enter into an agreement with your insurer. If you are a minor or are mentally ill, for example, then you may not be qualified to make contracts. Similarly, insurers are considered to be competent if they are licensed under the prevailing regulations that govern them.

• Legal Purpose. If the purpose of your contract is to encourage illegal activities, it is invalid.

Contract Values

Most insurance contracts are indemnity contracts. Indemnity contracts apply to insurances where the loss suffered can be measured in terms of money.

• Principle of Indemnity. This states that insurers pay no more than the actual loss suffered. The purpose of an insurance contract is to leave you in the same financial position you were in immediately prior to the incident leading to an insurance claim. When your old Chevy Cavalier is stolen, you can't expect your insurer to replace it with a brand new Mercedes-Benz. In other words, you will be remunerated according to the total sum you have assured for the car.

(To read more on indemnity contracts, see "Shopping for Car Insurance" and "How Does the 80% Rule for Home Insurance Work?")

There are some additional factors of your insurance contract that create situations in which the full value of an insured asset is not remunerated.

• Under-Insurance. Often, in order to save on premiums, you may insure your house at $80,000 when the total value of the house actually comes to $100,000. At the time of partial loss, your insurer will pay only a proportion of $80,000 while you have to dig into your savings to cover the remaining portion of the loss. This is called under-insurance, and you should try to avoid it as much as possible.
• Excess. To avoid trivial claims, the insurers have introduced provisions like excess. For example, you have auto insurance with the applicable excess of $5,000. Unfortunately, your car had an accident with the loss amounting to $7,000. Your insurer will pay you the $7,000 because the loss has exceeded the specified limit of $5,000. But, if the loss comes to $3,000 then the insurance company will not pay a single penny and you have to bear the loss expenses yourself. In short, the insurers will not entertain claims unless and until your losses exceed a minimum amount set by the insurer.
• Deductible. This is the amount you pay in out-of-pocket expenses before your insurer covers the remaining expense. Therefore, if the deductible is $5,000 and the total insured loss comes to $15,000, your insurance company will only pay $10,000. The higher the deductible, the lower the premium and vice versa.

Not all insurance contracts are indemnity contracts. Life insurance contracts and most personal accident insurance contracts are non-indemnity contracts. You may purchase a life insurance policy of $1 million, but that does not imply that your life's value is equal to this dollar amount. Because you can't calculate your life's net worth and fix a price on it, an indemnity contract does not apply.

(For more information on non-indemnity contracts, read "Buying Life Insurance: Term Versus Permanent" and "Shifting Life Insurance Ownership.")

Insurable Interest

It is your legal right to insure any type of property or any event that may cause financial loss or create legal liability for you. This is called insurable interest.

Suppose you are living in your uncle's house, and you apply for homeowners' insurance because you believe that you may inherit the house later. Insurers will decline your offer because you are not the owner of the house and, therefore, you do not stand to suffer financially in the event of a loss. When it comes to insurance, it is not the house, car or machinery that is insured. Rather, it is the monetary interest in that house, car or machinery to which your policy applies.

It is also the principle of insurable interest that allows married couples to take out insurance policies on each other's lives, on the principle that one may suffer financially if the spouse dies. Insurable interest also exists in some business arrangements, as seen between a creditor and debtor, between business partners or between employers and employees.

Principle of Subrogation

Subrogation allows an insurer to sue a third party that has caused a loss to the insured and pursues all methods of getting back some of the money that it has paid to the insured as a result of the loss.

For example, if you are injured in a road accident that is caused by the reckless driving of another party, you will be compensated by your insurer. However, your insurance company may also sue the reckless driver in an attempt to recover that money.

The Doctrine of Good Faith

All insurance contracts are based on the concept of uberrima fidei, or the doctrine of utmost good faith. This doctrine emphasizes the presence of mutual faith between the insured and the insurer. In simple terms, while applying for insurance, it becomes your duty to disclose your relevant facts and information truthfully to the insurer. Likewise, the insurer cannot hide information about the insurance coverage that is being sold.

• Duty of Disclosure. You are legally obliged to reveal all information that would influence the insurer's decision to enter into the insurance contract. Factors that increase the risks – previous losses and claims under other policies, insurance coverage that has been declined to you in the past, the existence of other insurance contracts, full facts and descriptions regarding the property or the event to be insured – must be disclosed. These facts are called material facts. Depending on these material facts, your insurer will decide whether to insure you as well as what premium to charge. For instance, in life insurance, your smoking habit is an important material fact for the insurer. As a result, your insurance company may decide to charge a significantly higher premium as a result of your smoking habits.
• Representations and Warranty. In most kinds of insurances, you have to sign a declaration at the end of the application form, which states that the given answers to the questions in the application form and other personal statements and questionnaires are true and complete. Therefore, when applying for fire insurance, for example, you should make sure that the information that you provide regarding the type of construction of your building or the nature of its use is technically correct.

Depending on their nature, these statements may either be representations or warranties.A) Representations: These are the written statements made by you on your application form, which represent the proposed risk to the insurance company. For instance, on a life insurance application form, information about your age, details of family history, occupation, etc. are the representations that should be true in every respect. Breach of representations occurs only when you give false information (for example, your age) in important statements. However, the contract may or may not be void depending on the type of the misrepresentation that occurs. (For more information on life insurance, read "Buying Life Insurance: Term Versus Permanent, Long-Term Care Insurance: Who Needs It?" and "Shifting Life Insurance Ownership.")B) Warranties: Warranties in insurance contracts are different from those of ordinary commercial contracts. They are imposed by the insurer to ensure that the risk remains the same throughout the policy and does not increase. For example, in auto insurance, if you lend your car to a friend who doesn't have a license and that friend is involved in an accident, your insurer may consider it a breach of warranty because it wasn't informed about this alteration. As a result, your claim could be rejected.

As we've already mentioned, insurance works on the principle of mutual trust. It is your responsibility to disclose all the relevant facts to your insurer. Normally, a breach of the principle of utmost good faith arises when you, whether deliberately or accidentally, fail to divulge these important facts. There are two kinds of non-disclosure:

• Innocent non-disclosure relates to failing to supply the information you didn't know about
• Deliberate non-disclosure means providing incorrect material information intentionally

For example, suppose that you are unaware that your grandfather died from cancer and, therefore, you did not disclose this material fact in the family history questionnaire when applying for life insurance; this is innocent non-disclosure. However, if you knew about this material fact and purposely held it back from the insurer, you are guilty of fraudulent non-disclosure.

When you supply inaccurate information with the intention to deceive, your insurance contract becomes void.

• If this deliberate breach was discovered at the time of the claim, your insurance company will not pay the claim.
• If the insurer considers the breach as innocent but significant to the risk, it may choose to punish you by collecting additional premiums.
• In case of an innocent breach that is irrelevant to the risk, the insurer may decide to ignore the breach as if it had never occurred.

Other Policy Aspects

The Doctrine of Adhesion. The doctrine of adhesion states that you must accept the entire insurance contract and all of its terms and conditions without bargaining. Because the insured has no opportunity to change the terms, any ambiguities in the contract will be interpreted in his or her favor.

Principle of Waiver and Estoppel. A waiver is a voluntary surrender of a known right. Estoppel prevents a person from asserting those rights because he or she has acted in such a way as to deny interest in preserving those rights. Presume that you fail to disclose some information in the insurance proposal form. Your insurer doesn't request that information and issues the insurance policy. This is a waiver. In the future, when a claim arises, your insurer cannot question the contract on the basis of non-disclosure. This is estoppel. For this reason, your insurer will have to pay the claim.

Endorsements are normally used when the terms of insurance contracts are to be altered. They could also be issued to add specific conditions to the policy.

Co-insurance refers to the sharing of insurance by two or more insurance companies in an agreed proportion. For the insurance of a large shopping mall, for example, the risk is very high. Therefore, the insurance company may choose to involve two or more insurers to share the risk. Coinsurance can also exist between you and your insurance company. This provision is quite popular in medical insurance, in which you and the insurance company decide to share the covered costs in the ratio of 20:80. Therefore, during the claim, your insurer will pay 80% of the covered loss while you shell out the remaining 20%.

Reinsurance occurs when your insurer "sells" some of your coverage to another insurance company. Suppose you are a famous rock star and you want your voice to be insured for $50 million. Your offer is accepted by the Insurance Company A. However, Insurance Company A is unable to retain the entire risk, so it passes part of this risk – let's say $40 million – to Insurance Company B. Should you lose your singing voice, you will receive $50 million from insurer A ($10 million + $40 million) with insurer B contributing the reinsured amount ($40 million) to insurer A. This practice is known as reinsurance. Generally, reinsurance is practiced to a much greater extent by general insurers than life insurers.

The Bottom Line

When applying for insurance, you will find a huge range of insurance products available in the market. If you have an insurance advisor, he or she can shop around and make sure that you are getting adequate insurance coverage for your money. Even so, a little understanding of insurance contracts can go a long way in making sure that your advisor's recommendations are on track.

Furthermore, there may be times when your claim is canceled because you didn't pay attention to certain information requested by your insurance company. In this case, a lack of knowledge and carelessness can cost you a lot. Go through your insurer's policy features instead of signing them without delving into the fine print. If you understand what you're reading, you'll be able to ensure that the insurance product that you are signing up for will cover you when you need it most.

D&O insurance pricing has flown under the radar for several years, with decreasing premiums and increasing market capacity. But if industry expert projections hold, those days may be coming to an end. In the past, D&O insurance may have been purchased as an afterthought for some companies.

Seemingly low risk coupled with affordable premiums, made purchasing a D&O policy, a “why not” kind of decision. Now increasing claims cost, new risk factors, and a soft market have begun to affect the D&O industry, and all players must prepare for some changes.

Here we will look at where the D&O market has been as well as what to expect for pricing in 2019.

What Affects D&O Premium?

Historically, D&O insurance is rated based on several factors:

• The size of a company
• The number of employees
• The operating costs
• The scope of the business
• Financial stability of the business
• Ownership structure – i.e. “insider” vs outside investment ownership

In short, D&O policies were underwritten based on accounting and financial statements. However, today’s D&O market calls for a different approach. The new D&O claim involves data breaches, privacy concerns, social media usage and other events that are often unpredictable by standard underwriting practices. These events have nothing to do with a company’s financial situation, making them almost impossible to quantify.

Once believed to be necessary for only large, publicly traded companies, even small-cap companies now seek the coverage a D&O policy provides. Corporate executives, business owners, and company directors and officers are held to exceedingly high standards. Proper D&O insurance helps protect the leadership in cases where a breach is perceived.

In exchange for an annual premium D&O coverage protects the executive board from claims arising from wrongful acts, discrimination, and fines from the Securities and Exchange Commission (SEC) among others. Although the nature of D&O claims is changing, as is the market, the main players remain the same. The largest D&O carriers include:

• American International Group (AIG)
• Chubb
• CNA
• Tokio Marine
• Travelers
• XL Catlin
• Zurich

How has D&O Pricing Changed?

2018 was an interesting year as far as the D&O market is concerned. SEC lawsuits remained near record levels, nearly matching 2017. The U.S. Supreme Court ruled section 11 claims cannot be removed to federal court, and event litigation soared.

Still, premiums remained relatively flat for most of the year, with a slight increase in the last quarter of 2018. Although premiums have remained mostly unchanged, loss ratios and costs to defend claims have risen. In short, the D&O sector faces new and growing risks with little to no new premium growth.

Event Driven Lawsuits a Growing Problem in 2018

Traditionally, D&O insurance protected executives from claims of misrepresentation in fiduciary duties. However, the risks for today’s executives are more complicated. Event-driven claims, named so because the source of the litigation is a disruptive event in a company’s operations, are on the rise.

The 2018 California wildfires are illustrative. After the fires, shareholders filed a securities lawsuit against utility companies Edison International and PG&E after reports surfaced the utilities were at least partially responsible for the fires.

Similarly, shareholders brought a suit against Boeing after it was reported one of their airliners was involved in the Lion Air 610 crash.

These event-driven lawsuits are a departure from typical D&O litigation and may not always hold up. The claims may lay more along the lines of mismanagement of operations rather than misrepresentation. Still, the suits present considerable challenges for D&O carriers because they must be defended.

Event-driven suits also complicate underwriting. Because the lawsuits are based on significant, but unpredictable events, there is a lack of underwriting tools in which to quantify such events. Insurers are left with very little on which to base price for this emerging risk.

Data Breach Litigation Climbs

The most significant data breach litigation in 2018 is the settlement of the Yahoo securities lawsuit. While securities suits over data breaches have cropped up over recent years, Yahoo represents the first such suit to earn a large payout to plaintiffs. In all, the company has agreed to pay a total nearing $145 million to settle the management liability claims and regulatory fines and actions.

Granted, the allegations leveled against Yahoo in the suit are particularly damaging. The company accused of mishandling users’ private information, and also charged with covering up the breach.

Although forthcoming data breach litigation claims may not contain the same level of indiscretion and so not win such large settlements, the Yahoo settlement may have succeeded in at least opening the door to higher plaintiff settlements involving data breaches.

MeToo Litigation

MeToo litigation evolved in 2018 to include not only the perpetrators of wrongful acts involving sexual harassment or discrimination but also company board members. For example, a shareholder derivative lawsuit brought against sports giant Nike alleges the board allowed a “boys club” atmosphere in which men received pay raises and promotions more often than women.

The suit turns on allegations of a hostile atmosphere, unfair treatment and pay inequality based on gender.

Cost of D&O by Company Size

D&O pricing trends for the past few years differ according to company size. A study by property and casualty reinsurance company, TransRe, shows the price deterioration of D&O insurance is most significant among large-cap companies.

The October 2018 study shows the prices for all layers of D&O insurance for large-cap companies are down 18 percent. The highest excess layers decreased by 30 percent between 2013 and 2018.

Mid-cap companies showed a 3 percent decline in the working layer D&O premiums with an overall reduction of 17 percent across all layers and a 28 percent dip in the highest excess layers.

Small cap companies are the outlier, showing slight increases in pricing between 2017 and 2018:

D&O Market Outlook

As the TransRe report illustrates, the D&O outlook for 2019 is difficult for carriers. Although the market for small-cap companies, as well as a few specialized classes such as life sciences and IPOs, may be hardening a bit, the industry is handicapped by increasing claims costs and a history of decreasing premium. Large market capacity only adds to the challenge.

So, what can we expect for the 2019 D&O market? Here are a few key takeaways.

1. The market will continue to be challenged by claims: The 2018 trend of increasing securities suits spurned by catastrophic events will have D&O carriers wrestling with setting proper reserves for claims handling well into 2019.
2. Insurers will push for rate increases: Even with the slight hardening of the D&O market for the smaller cap companies, D&O insurers are dealing with years of price decreases coupled with increasing claims costs. Carriers will likely make the difficult decision to raise rates even while the market offers high capacity.
3. Flat or slightly increased premiums ahead: Insureds can expect a departure from years of decreasing D&O premiums. Instead, companies are likely to see flat premiums or an increase over the expiring.

Rising claims costs, years of decreasing premiums, and the rise of event-driven claims are taking a toll on the D&O market. Changes in the market are on tap for 2019, and every player in the D&O game must be prepared.

3. Can the company take any measures to reduce the probability of a bad outcome or to limit

its impact? For example, most businesses install alarm and sprinkler systems to prevent

damage from fire and invest in backup facilities in case damage does occur.

4. Can the company purchase fairly priced insurance to offset any losses? Insurance

companies have some advantages in bearing risk. In particular, they may be able to spread

the risk across a portfolio of different insurers.

5. Can the company use derivatives, such as options or futures, to hedge the risk? In the

remainder of this chapter we explain when and how derivatives may be used.

THE EVIDENCE ON RISK MANAGEMENT

There are three principal ways to manage risk.

1) First, the firm can reduce risk by building flexibility into its operations. Firms are using

real options to limit their risk.

2) A second way to reduce risk is to buy an insurance policy against such hazards as fire,

accidents, and theft.

3) Finally, the firm may enter into specialized financial contracts that fix its costs or prices.

These contracts are known collectively as derivatives, and they include options, futures, and

swaps.

Derivatives: Securities whose payoffs are determined by the values of other financial variables

such as prices, exchange rates, or interest rates

 A survey of the world’s 500 largest companies found that almost all the companies use

derivatives in some way to manage their risk. Eighty-five percent employ them to control

interest rate risk; 78 percent use them to manage currency risk; and 24 percent to manage

the risk of fluctuations in commodity prices.

 Risk policies differ. For example, some natural resource companies work hard to hedge their

exposure to price fluctuations; others shrug their corporate shoulders and let prices wander as

they may. Explaining why some hedge and others don’t is not easy. One study of oil and gas

companies found that the firms hedged most if they had high debt ratios, no debt ratings,

and low dividend payouts. It seems that for these firms, hedging programs were designed to

reduce the likelihood of financial distress and to improve the firms’ access to debt finance.

REDUCING RISK WITH OPTIONS

In the last chapter we introduced you to put and call options. Managers regularly buy options on

currencies, interest rates, and commodities to limit their downside risk. Many of these options

are traded on options exchanges, but often they are simply private deals between the corporation

and a bank.

 You don’t get something for nothing. The price Onnex pays for insurance against a fall in

price of oil is the cost of the put option. Similarly, the price Petrochemical paid for insurance

Unleashing the invisible hand that has been missing from the flood insurance market for nearly 50 years is no easy task. But private flood insurance experts say the change will be a good thing not only for private flood insurers but for consumers as well.

How much and how fast the private market for flood coverage will change depends on what Congress does to overhaul the current federal program, the National Flood Insurance Program (NFIP). The House and Senate are both working on legislation that would reauthorize the NFIP, which expires on Sept. 30, and introduce reforms that include changes to encourage private insurance. There appears to be bipartisan agreement on encouraging more of a private market, although there is some disagreement over how to go about it.

Some private insurers and brokers are enthused about the potential.

“It is inevitable that the private market will assume the dominant position of flood (insurance) in the United States,” claims Craig Poulton, CEO of Salt Lake City-based Poulton Associates, which administers one of the largest U.S. private flood insurance programs, the Natural Catastrophe Insurance Program

It is inevitable that the private market will assume the dominant position of flood in the United States.

Poulton believes that a vibrant private market will drive out waste in the NFIP. “When you look at how much of each dollar is available to pay a claim and what is paid in, you understand why there’s a $24 billion deficit,” he said.

The deficit continues to grow, he added. In January, the Federal Emergency Management Agency (FEMA) again announced that the NFIP would need to borrow another $1.6 billion from the U.S. Treasury to break even on its 2016 losses. Add that to the existing debt, largely due to Hurricanes Katrina and Rita and Superstorm Sandy, and the NFIP currently is almost $25 billion in debt.

Taxpayers in every state where flooding is not a major issue are demanding change, according to Poulton. Why? “Because enough is enough. Flood insurance is not special. Flood insurance is insurance. Flood insurance is just property insurance” and the private market should be insuring the risk, he said.

“Whatever works for homeowners [market] is going to work for flood. Let’s get it insured and let’s move forward,” he said. “Overall, both the NFIP and the private market will deliver lower rates if you unleash the invisible hand. That’s the way we see it, and we think we’ve demonstrated that.”

In the past, flood was considered an uninsurable risk for private market insurers.

“The reason that has been a generally accepted truth for many years, 50 years or so almost, is that we did not have the right information,” said Nancy Watkins, a principal consulting actuary for Milliman, an actuarial consulting firm in Seattle.

“Insurance companies for many years did not have that information, and they didn’t have any good way of measuring how risky a house was for flood peril. With catastrophe models over the last few years, and with a lot of big data sources coming available that didn’t used to be available, that problem has largely been reduced.”

The NFIP says it is not allowed by law to share its data. Data-sharing is among the issues addressed by the bills before Congress.

Another reason the private insurers have not jumped deep into flood waters is price.

“It was perceived — maybe true in some cases, maybe untrue in other cases — but it was generally perceived that the NFIPs rates were too low,” Watkins said.

“Without data to understand how risky a house was, and then having a suspicion that the NFIP’s prices were too low, there wasn’t much incentive [for carriers] to go in and try to offer coverage. Some companies did it anyway and have been doing it for many years, but most companies didn’t,” Watkins said.

Things are different now, according to Watkins and others. NFIP premiums are no longer low in all cases and insurers have new underwriting tools they can deploy.

“First of all, after the storms of 2005, Katrina especially, the NFIP built up a very big deficit and they started raising their premiums. That really made a big difference in terms of perception as to whether their premiums were too low or not,” she said. “Once the premiums got higher, more in the range of what a private insurer might be interested in charging, there became real opportunity for private market insurers.”

The second thing driving opportunity for a bigger and better private market is new and evolving catastrophe models. Carriers can now measure flood risk in much of the same way as they measure wildfire risk, earthquake risk, hurricane risk, etc. “They’re already used to these big disaster types of occurrences, but they didn’t have a model for flood. Now they have several models for flood,” Watkins said.

More Than the NFIP

While the NFIP insures about five million policyholders, the opportunity for private market spans far beyond that, experts say.

There will always be a need and a place in the market for the NFIP, according to G. Michael Sloane, executive vice president and chief marketing officer of Wright Flood, one of the largest flood providers in the nation. Wright offers federal, excess and private flood insurance, rated A- (Excellent) by A.M. Best, and claims to have written the first-ever flood policy through the NFIP.

“We are strong believers that we will continue to grow the NFIP book and that marketplace will always be there. But we also have financial partners that allow us to be able to offer flood in the private market,” Sloane said. “We are going to go full throttle to continue to grow the NFIP book and provide a private flood alternative for those that want to pursue that course.”

Sloane doesn’t know how much of the NFIP book of business will be viable for the private market but he believes there’s no doubt that some could be moved out of the federal program. However, the real opportunity will come from outside of the NFIP, he said.

“What I think is going to happen and what is incumbent upon us as an industry and those that are offering a private flood alternative program is to grow that base outside of the NFIP, not just concentrate on what’s there already,” he said. “Some 25 percent of all flood losses happen in non-required flood zones, or what we call preferred risks. And that’s just those that have insurance. There are literally thousands more [properties] that didn’t have any type of coverage or thought they had coverage or didn’t understand coverage. That’s where we really have to grow as an industry and I think competition and the private market can help stimulate that more.”

Milliman’s Watkins says that opening up the insurance market should afford homeowners insurers an opportunity to offer existing policyholders broader and more complete property coverage.

“For an insurance company, one of the major opportunities is to offer more coverage to their existing policyholders that people really need,” she said. “Flood is not just a hurricane or a river. It’s just a lot of rain sometimes, and a lot of rain can happen anywhere. Or a pipe breaking down the street, and the water flows down the hill and gets into your house.

“It’s water that gets in, rising up from the ground, and that is not as unusual as many of the other perils that are already covered under homeowners insurance.”

Flood is an opportunity for homeowners insurers to provide coverage that people really need, she added. “It’s an opportunity [for the industry] to not have a black-eye when somebody’s man cave gets flooded in a bad rainstorm, and he thinks he has coverage, and then finds out that he doesn’t.” Flooding in basements is often excluded from a typical homeowners policy.

If insurers are able to properly price flood coverage, one or two man caves getting wet, is OK. “They can pay for it, because they collected premium for 98 other man caves that didn’t get wet,” she said. “All in all, they hopefully made a profit on it. That’s the way homeowners works.”

If insurers can sell flood to more of their existing policyholders, not just the riskiest properties, and bundle flood in with other coverages, then they’ve increased their premiums, while also increasing coverage for their policyholders, Watkins said.

Matt Herr, president and lead underwriter for Superior Flood Inc., also known as Flood Insurance Services, in Brighton, Colo., agrees that insurers are not just interested in cherry-picking the best risks from the NFIP. He says insurers are interested in providing a broader coverage flood product, at the right pricing structure in order to make a profit. He believes the insurance industry can deliver on that promise by reducing some of the cost that comes along with a government-run program.

“There’s a lot of overhead that we don’t have and that’s true with any private market side versus the forced NFIP policy or government-run,” Kerr said. “There’s a lot of extra layers and layers and layers and layers [in the NFIP] and that money could be allocated on the FEMA side to pay for claims. On the Lloyd’s side, which we write the private [flood] through, we run lean and mean. We don’t have a lot of fat in the steak.”

Everybody Stands to Gain

Martin Hartley, executive vice president and chief operating officer of New York-based PURE Insurance, says everyone stands to gain by opening up the flood insurance market but adds there is huge room for improvement all around.

“The NFIP does an excellent job at what it was originally designed for, but I think there is huge room for innovation and improvement,” Hartley said.

“Unleashing the private market [in flood] while keeping some presence in federal responsibility, policyholders will gain because there will certainly be more choice. There’ll be more competition. Different insurance companies will price risks differently and have a different view of risks. People can only benefit from that.”

Will insurance companies benefit? Sure, he says, but like any competitive product line the short-term view will be tight. “Short-term, insurers may overcompete, but I think ultimately it would probably benefit private enterprise.”

Hartley sees more product innovation occurring as more competition enters the market as well.

“Right now, in the private market, there is a lot of ‘me-too-ing’ of the NFIP. It’s the same coverage the NFIP is writing. That’s just simpler, because it’s easier to get banks to approve a private market as the flood carrier to satisfy the mortgage requirements if the coverage is the same,” he said. “There isn’t a lot of creativity yet in how flood coverage is offered.”

People want to buy flood especially post-disaster.

“There is a great opportunity for the private market to come up with products that people want and to come up with service that people want,” he added.