THE IMPACT OF HURRICANE KATRINA ON GOVERNMENT & THE INSURANCE INDUSTRY

THE IMPACT OF HURRICANE KATRINA ON GOVERNMENT & THE INSURANCE INDUSTRY ALEX GLASIER FIN 619 DR. XIANGWANG QIAN MAY 14, 2020 ABSTRACT Hurricane Katrina struck New Orleans in August 2005, driving hundreds of thousands of residents out of the city and causing upwards of $55 billion in damage. Between August 2005 and New Year's Day 2006, New Orleans lost over half its population because Katrina forced people out of their homes and businesses were relocated temporarily, if not permanently. This natural event played a crucial role in the development of the insurance industry with regards to how it reacted to these "black swan" events. Journalists and reporters were quick to criticize the response time of government organizations such as FEMA, but insurance companies were also to blame for the disastrous aftermath. The mathematical models used at the time failed to properly prepare companies for the payouts needed after the storm subsided, meaning hundreds of thousands of New Orleans residents were left unsubsidized for the damage done and were forced to move out of the city altogether. This paper analyzes how models were used by the insurance industry prior to Hurricane Katrina, followed by an analysis on how those models changed to accommodate for future events that may cause similar damage. I also discuss the role of government in natural catastrophes and the regulation of insurance before vs. after Hurricane Katrina. Why did insurance fail? An insurance company is able to function and prosper if it can properly measure the overall risk of an event as well as the average cost of an event. Insurance can be all the more profitable if it can do this on a policy-by-policy basis. Because of market competition from other insurance companies, the industry as a whole has an incentive to provide fair premium rates and deductibles to their policyholders which don't overcharge them. However, if an insurance company undercharges their policyholders as a whole, or an unexpected but catastrophic event leads to an overwhelming number of claims, they likely won't be able to survive on the market. This makes risk management a fundamental role in the insurance industry. However, in the case of Katrina, there were countless cases in which insurance companies intentionally withheld reimbursement funds due to a lack of reserves. This forced the federal government to step in with agencies such as the Federal Emergency Management Agency (FEMA) dispersing roughly $20 billion to victims. Black swan events It was well publicized after Hurricane Katrina that insurance companies failed to provide adequate insurance to their constituents. Insurance companies were not prepared for the financial devastation that this catastrophe would bring, and thus took measures to strictly limit their claim disbursements. Perhaps the most notable reason insurance companies failed to prepare for a catastrophe of this size is because Hurricane Katrina is what we would describe as a "black swan" event. Black swans are occurrences that very rarely happen, but have an enormous impact on the way people organize their lives if they do happen. Because of these events, insurance models typically are formed via a normal distribution with fat tails at the end. These fat tails should, theoretically speaking, overpredict the likelihood of black swan events to occur, so that the insurance company will have reserves in the case of a natural event similar to Hurricane Katrina. Image from https://www.clubstreetpost.com/2018/07/fat-tail-distributions-what-are-they-and-why-do-they-matter/ Moral hazard In economic terms, a moral hazard is a situation where a person or party intentionally puts themselves at risk of damage in the belief that they will be either fully or partially reimbursed for that risk. Although businesses and residents along the southern coast are at risk of hurricane weather during the summer, they (theoretically) are well-insured for floods, high winds, debris, and other types of coverage. However, in the case of Katrina, since many insurance companies were running low on payout reserves, they would label certain kinds of damage as wind damage instead of flood damage. Because many people and businesses had flood insurance but not wind insurance, the insurance companies could avoid sending out reimbursement checks. This is a situation where a moral hazard has backfired against those who took out the insurance policies. Claims costs are increasing Although Hurricane Katrina has been the most costly catastrophe to the insurance industry in recorded history, it is an event which epitomizes the trend occurring in property insurance over the past several decades: property insurance has become increasingly more expensive, and the reimbursements sent out continue to get larger over time. The average cost of a claim to the insurance industry has increased significantly over the past 40 years. The primary reason driving this trend is the increased use of machines and other capital over the past few decades. Machines are damaged or destroyed as a result of flooding and other natural disasters, and it can be very costly to repair or replace these machines. In the meantime, it will also cost the company money as the capital will not be in use as it is being fixed. On the other hand, with human labor, even after a natural disaster, workers can still show up to work the next day, clean the site, and maintain productivity after a storm. Because of the increased dependence on capital in comparison to human labor, natural disasters are becoming much more costly to companies, which are increasing premium rates for their casualty insurance policies. Attrition risk Attrition risk within a business refers to the risk associated with employee turnover. Many jobs require several hours of on-the-job training, and the risk is measured to see if an employee will stay long enough and contribute enough to be worth the training. Jobs within the government, including public school faculty and staff, are typically offered pensions to assist them with retirement. In the case of Hurricane Katrina, many of these pension plans were cancelled and the funds withdrawn altogether. These pension plans grow exponentially, so that those workers with little seniority show little growth in their pension contributions, but for the most senior workers, their pension plans grow significantly year after year. These workers near the end of their careers in 2005 were negatively impacted by Katrina. According to the graph below, a teacher who started his/her career at age 25 would see their pension amount triple between the ages of 50 and 60. Image from https://www.teacherpensions.org/blog/nola-hurricane-katrina-and-teacher-pensions The aftermath of Katrina caused the Orleans Parish School Board to release 7,500 teachers and other governmental staff. Those with the most seniority, and thus the most to lose with regard to their pension plan, took their cases to the Supreme Court in an attempt to gain back wages. Corrections after Hurricane Katrina Several actions were taken by individuals, corporations, and insurance companies to improve on how these three entities interact with one another to facilitate as smooth a transition as possible in the midst of a crisis. Both the public and private sector have played a role over the past several years to improve business continuity and "smooth out the curve" to avoid short-term fluctuations as best as possible. Fixing mathematical models As stated earlier, one of the largest failures on behalf of the insurance industry was the inability to prepare for Hurricane Katrina as a black swan event. Insurance companies can function easily as long as events occur according to their models, but it's the one-time catastrophic events that can drive them deep into the red. Without proper modeling to accurately predict the probability of black swan events, the insurance industry will find itself under-charging premiums and running out of funds when disaster strikes sooner or later. According to capitalpremium.net: "Before Katrina, the modeling of catastrophe exposures was typically done on aggregate portfolios for reinsurance purchasing. Modeling was a 'nice to have' item and it was not considered from a per-risk standpoint. Since Katrina, CAT modeling has generally been used on a per-risk basis." There are currently 3 main CAT models used by mainstream insurance companies: AIR Worldwide, Risk Management Solutions (RMS), and EQECAT. Each of these models is being regularly updated due to changes in a variety of variables year-to-year, as well as due to a consideration of new variables. While mathematical modeling may have been in its infancy (relatively speaking) prior to Katrina, it is now common practice for insurance companies to heavily invest in creating complex and accurate catastrophic models to charge proper rates to customers without dipping into debt. Reinsurance industry Reinsurance is when insurance companies buy insurance from each other to insulate themselves from major losses. Reinsurance is also helpful because it can mutually benefit the insurance companies involved with regards to the number of policyholders they can hold. Hurricane Katrina sparked the passage of the Reinsurance Reform Act. Prior to its passage, the details were hazy with regards to reinsurance regulation in the United States. With each state having different laws on the books, or similar laws worded differently, the Reinsurance Reform Act streamlined the process at the federal level. Dodd-Frank Act of 2010 While the Dodd-Frank Act was signed into law in 2010 as a response to the financial meltdown of 2008, the law made notable changes to the regulations involved in the insurance industry, which will certainly change how they will respond to future catastrophes like Katrina. The Act created a new office in Washington, the Federal Insurance Office, which broadly oversees all aspects of the insurance industry, including assisting to provide insurance to "undeserved communities." More division in the private sector Hurricane Katrina created an influx of regional insurance companies that specified in a certain state or region. Beforehand, a few large insurance companies such as State Farm held a tremendous amount of the insurance market share. The occurrence of Hurricane Katrina, along with several other disasters that affected a specific region, has started a trend of smaller insurance companies popping up, specializing in one area of the United States. Because of their smaller focus, they are more accurate in their assessments of risk and hazards and also create a more personal experience for their customers. In addition to a division of the insurance industry to include smaller, more personal insurance companies, the variety of insurance packages increased for consumers as well, and the purchase of these new packages also increased. For example, surplus line insurance became a more recognized and accepted form of insurance. This type of insurance is purchased by an individual or a firm as extra coverage to whatever their current insurance policy is. Typically, this can't be bought directly with an insurance company itself, so it must be purchased through an agent or broker. Business continuity expertise While Hurricane Katrina was clearly damaging in terms of destroyed infrastructure and residential zones, the economic impact was exacerbated when many businesses were unable to continue operations and/or unable to relocate to another area. Jobs were lost, and many were never recovered even several years later. Katrina sparked a rise in the importance of business continuity experts. These people form and revise contingency plans in the case that the physical building has to be evacuated on a long-term basis for whatever reason. With the birth and rise of the internet, business continuity has become significantly easier in the last 25 years as more employees are able to work from home with an internet connection. CONCLUSION It is fitting to compare Hurricane Katrina with the current COVID-19 crisis. While Katrina certainly prompted a significant amount of regulation and oversight at the federal level to streamline ambiguities and confusion between interstate regulatory agencies, the Trump administration appears to leave policies & activity regarding COVID-19 to the individual state governors to decide. How government stimulus affects quality of risk management The level of government assistance during catastrophic events like Katrina will make an impact on the quality of the underwriting provided by insurance companies. If the insurance industry feels as if government stimulus to their policyholders will compensate for their own lack of proper coverage, then the role of risk management will likely be downplayed far more than it should. While government assistance may be necessary in some circumstances, intervention should be carefully considered. It should not replace risk management and the underwriting aspects of insurance as a whole. 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