The term “observer effect” in physics refers to how the act of making an observation changes the state of the system. To measure the pressure in a tire you have to let out some air. Measure the spin of an electron and it will change its state.
There is something similar about the “insurer effect” in catastrophe loss. If insurance is in place, the loss will be higher than if there is no insurer. We see this effect in many areas of insurance, but now the “insurer effect” factor is becoming an increasing contributor to disaster losses. In the U.S., trends in claiming behavior are having a bigger impact on catastrophe insurance losses than climate change.
So, the question is – if you take away insurance what would happen to the costs of the damage, from a hurricane, flood, or earthquake? The problem with answering this question is that in the absence of an insurance company writing the checks, no-one consistently adds up all these costs, so there is little relevant data.
Beware of the Shallow Flood
Since the 1980s, the Flood Hazard Research Centre at Middlesex University, based in northwest London, has focused on costing residential and commercial flood damages. In 1990, they collected information on component losses in properties for a range of flood depths and durations – but without any reference to what had been paid out by insurance. In 2005 they revisited these cost estimates, now applying the principles that had been established around compensation for insurance claims. After bringing their 1990 values up to 2005 prices, they could compare the two approaches. For short duration flooding of less than 12 hours, the property costs of a shallow 10-centimeter (cm) (4 inch) flood had increased sevenfold, reducing to 5.2 times greater at 30 cm (one foot) and 3.5 times greater for 1.2 meter (four foot) floods.
Photo by Patsy Lynch/FEMA
For longer duration floods of more than 12 hours, the comparative ratios were around 60 percent of these. For household goods, the increases were even steeper; a tenfold increase at 10 cm flood depth, 6.2 times greater at 30 cm and 4.1 times greater at 1.2 meter. The highest multiple of all was for the shallowest 5 cm “short duration” flood where the loss for contents was 15.4 times greater.
Factoring in the Insurance Factor
The study revealed the highest “inflation” was for the shallowest floods. Some of the differences reflected changes in practice, but there may also be more expensive and vulnerable materials covering floors, as well as stationed on floors. However, the “insurance factor” is also buried in these multiples. Examining and itemizing what is included in this factor shows that the replacement of “new for old” has become standard, even though the average product is half way through its depreciation path. New for old policies discourage action by the policyholder to move furniture and other contents out of reach of a flood. Salvage seems to have become out of the question along with a reduced acceptance of any spoilage however superficial. Redecoration is not just to the affected wall but for the whole room or even the whole house.
Yet many items in flood recovery might not be something that can easily be costed. What is the price of the homeowner working evenings to make repairs, borrowing power tools from a neighbor, or spending a few nights sleeping at a friend’s house while the house is being fixed? How do we find a cost for the community coming together to provide items such as toys and clothes after everything was swept away in a flood?
We know another feature of the insurance factor concerns urgency in making the repairs. In early December 1703, the most intense windstorm of the past 500 years hit London. So many roofs were stripped of their tiles that the price of tiles went up as much as 400 percent. As described by Daniel Defoe in his book “The Storm”, most people simply covered their roofs with deal boards and branches, and the roofs stayed in that state for more than a year until tiles had returned to their original prices. There was no storm insurance at the time. Today an insurer would not have had the luxury of waiting for prices to come down. They would be expected to make the repairs expeditiously.
And then there is the way in which the lightly worded insurance terms become exploited. There was the beach front hotel in Grand Cayman after Hurricane Ivan in 2004, or the New Orleans restaurant after the 2005 flooding, or the business within Christchurch’s central business district after the earthquake, all of which had no incentive to re-open because there were no tourists or customers, and therefore kept their business interruption (BI) policies spinning.
The Contractors After the Storm
And that is before we get into issues of “soft fraud”, the deliberate exaggeration of the damages and the costs of repairs. One area particularly susceptible to soft fraud is roofing damage. By all accounts, in states such as Texas or Oklahoma, freelance contractors turn up within hours of a storm, even before the insured has thought to file a claim, and ask for permission to get up on the roof. They then inform the homeowner that the whole roof will need to be replaced, and the work needs to be signed off immediately as the roof is in danger of collapse. The insurance company only hears about the claim when presented with a bill from the contactor. In surveying the cost of individual hailstorm claims from 1998 to 2012, RMS found that claims have increased by an average 9.3 percent each year over fifteen years. It seems roof repair after a hail storm has a particular attraction for loss inflation.
In the U.S., the Coalition Against Insurance Fraud estimates that fraud constitutes about 10 percent of property-casualty insurance losses, or about $32 billion annually, while one third of insurers believe that fraud constitutes at least 20 percent of their claims costs. But it is often not so simple as to designate an increased cost as “fraud”. It is the nature of the insurance product – to make generous repayments, to keep the client onside, so that they continue to pay their increased premiums for many years to come.
The challenge for catastrophe modeling is that the costs output from the model need to be as close as possible to what will be paid out by insurers. Ultimately, we must treat the world as it is, not how it might have been in some component-costed utopia. In which case, we must provide the ability to represent how claims are expected to be settled, and explore the trends in this claiming process so as to best capture current risk cost.
The way that insurance alters claims costs is not a topic studied by any university research department, or international agency as they attempt to develop their vulnerability functions. It is something you can only learn by immersing yourself in the insurance world.