Kevin M. Farshchi
Risk Management
2006 Hurricane Risk: Case Analysis
Should Joe purchase wind damage coverage?
1. What is his insurance premium for this coverage?
The total premium for his homeowner’s policy is $13,000 and the wind coverage is $10,000. At the same time, the assessed value of his home decreased from $705,024 in 2005 to $648,390 in 2006. The premium comes from the fact that he currently lives in Florida, which is the highest risk region for hurricane damage in the United States. Key West has had 6 out of the 64 total hurricanes in the state of Florida, but what is more revealing of expected probability is how 7 out of 10 most ferocious hurricanes in terms of insured losses for the last 100 years affected Florida (AIR Worldwide).
The question to ask is whether or not the increase in the premium is worth the cost. The short answer is yes, and for a number of reasons. Joe is currently faced with a $5,000 increase in his homeowner’s policy due to wind damage coverage. Joe has low savings and if his home gets hit by a hurricane he will likely not have enough capital to fix it. His law practice is also in Key West so he will have a strong incentive to stay there. Given the high property and rental rates in the region, he will want to have some protection against a hurricane wiping out his home and his bank account.
2. What is his annual average expected loss?
Property loss is estimated from a number of parameters, so deductible’s attempt to capture the average expected loss. The insurance companies with then pool the losses to determine what the probabilities and expected losses will be in their model. We can make a few assumptions about total losses Joe will face and multiply that amount by a probability of hurricane occurrence. If we refer to Exhibit 2 we can see that from 1900-2004, Florida experienced 64 total hurricanes at various locations on the peninsula. The southern tip of Florida where Key West is located experienced 6 out of 64 or 9.375%.
It is also essential to note that the data set does not have enough observations to be statistically significant, so a number of subjective assumptions are needed for any hurricane prediction model. It is also safe to assume based on the severity of Florida hurricanes (from Exhibit 5 we know 70% of the most ferocious Hurricanes were in Florida) that Joe’s house will be wiped out if there is another hurricane. He will thus be able to collect the assessed value of his homeowner’s policy. If we multiple the probability of a single hurricane of 1% multiplied by the probability the hurricane hits Key West of 9.375% multiplied by the assessed value of his house $648,390, we have an annual average expected loss of $60,786.56. Because this is greater than the price of the total premium and given the fact that most insurance companies will no longer underwrite wind damage coverage in Florida, Joe should choose the insurance policy this year.
3. What should be Joe’s other considerations?
Joe should also consider the probability of default for the insurance company and the reinsurance market as a whole. To account for the industry’s losses in the past, rating agencies raised capital requirements almost twofold per each dollar of coverage. By analyzing the financials of U.S property-causality insurance companies (Exhibit 7), we can unpack some key trends. First, total assets increased from 2001 to 2005 year over year and the assets to equity ratio did not. From 2004 to 2005 for example, total assets grew 8.48% but assets/equity did not change. This indicates that equity is making up a larger and larger portion of these firms. Overall, the balance sheet is growing in line with the income statement, or simply put, the firms themselves are expanding.
