Washington's Beach House Bailout

It seems obvious that Americans who choose to live along the coast, near an active earthquake fault, or in a wildfire-prone area ought to pay more for homeowners’ insurance than those who live in safer places. But some in Congress want to wish this fact away.

It seems obvious that Americans who choose to live along the coast, near an active earthquake fault, or in a wildfire-prone area ought to pay more for homeowners’ insurance than those who live in safer places. Some in Congress want to wish away this fact and, next week, they’ll begin to move forward on something called The Homeowners’ Defense Act. The bill, which passed the House in 2007 but went nowhere in the Senate, is quite possibly the worst piece of legislation under serious consideration in Congress.

Through the creation of a Fannie-Mae-like “private” but government chartered “catastrophe risk consortium” as well as bond guarantees and loans to state-run programs, Homeowners’ Defense Act sponsor Rep. Ron Klein (D-FL) aims to reduce the cost of the reinsurance that pays a large percentage of insurance company bills following major catastrophes. This would reduce the costs for insurance companies and create savings for consumers. The bill, Rep. Klein points out, even has language requiring that the new federal programs break even. In theory, these guarantees could cut the amounts that individuals pay for homeowners’ insurance while costing taxpayers next-to-nothing.

But this approach has serious problems. To begin with, only two states, California and Florida, actually qualify for the guarantee programs the bill proposes. Even worse for those who favor it, the bill’s mechanisms violate the risk pooling principles at the heart of insurance and can’t possibly work as advertised. Here’s why: through international reinsurance markets, private companies already pool the risk of hurricanes in Florida with those of earthquakes in California, cyclones in Indonesia, and industrial accidents in Japan. Because these events almost never happen at the same time, insurers and reinsurers can earn a profit insuring against one type of disaster even as they pay out enormous claims on another. This pooling reduces overall insurance prices. By focusing all risk in the United States a federally run disaster insurance program would have to charge more than the private sector in order to break even. Thus, a program would need to under-price its coverage to save any money at all for insurance companies. (Nothing in the bill, it’s worth noting, promises a penny in savings for consumers.)

In fact, the existing federal program most similar to what Rep. Klein proposes, the National Flood Insurance Program, has used rate calculation methods that no competent insurance regulator would allow in the private sector. This has kept rates well below those the private market would charge and led to repeated taxpayer subsidized rebuilding of many properties with already charged supposedly “adequate” rates. To date, the program has run up more than $19 billion in debt. A broader guarantee could easily add hundreds of billions of dollars in liabilities.

The Homeowners’ Defense Act also seems certain to cause enormous environmental destruction by encouraging construction in many places where it shouldn’t take place. Insofar as human activity causes additional climate change, furthermore, some scientists believe that greater-than-expected sea level rise and more frequent and more intense hurricanes could result.  In this context, anything that encourages construction along coasts appears foolhardy at best.  Heavily subsidized insurance will also encourage additional construction near earthquake faults, on hillsides, in box canyons and in dozens of other unsafe areas. The government shouldn’t prevent people from living in these areas, but it shouldn’t subsidize them either. And, whatever happens, the federal government should simply stay out of the property insurance business.