The Insurance Problem - Causes, Impact, and NAR Concerns

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 The Problem

Property casualty insurance has become increasingly difficult and more expensive to obtain. This is the case for residential ownership and leasing markets as well as commercial markets.

Hit by a number of forces over the course of the past few years, insurers have experience a surge in the number and size of property casualty claims. Wildfire, flood, storm-related damage, lead paint, mold and terrorism claims have all contributed to generate a negative net income after taxes for property casualty companies.

According to the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII), the property/casualty insurance industry posted a $7.9 billion net loss in 2001, its first-ever net loss. Its statutory rate of return was a negative 2.7, down 6.5 percent from the year 2000. In the first quarter of 2002, the rate of return was 6.9, down from 7.4 during the first quarter of 2001, but a significant improvement over the full year results. Net written premium rose 10.3 percent. Net income after taxes dropped 7.3 percent to $5.1 billion in the first quarter from $5.5 billion in the first quarter 2001.

In addition to casualty claims, profitability is jeopardized by recent large court judgments against insurers. The trial bar recognizes the opportunity that the latest household hazard - invasive mold - offers for lucrative lawsuits; one trial lawyer publication headlined one of its issues with the title, "Mold is Gold". One well-publicized Texas lawsuit, for example, resulted in a $32.1 million judgment. Most legal experts expect large mold judgments to continue as mold cases are introduced in more states.

The events of September 11th also impacted the financial state of the insurance industry. The Insurance Information Institute estimates September 11-related claims will total $40.2 billion. Other analysts' estimates range as high as $70 billion. These claims obviously have the ability to tax insurance company reserves and the level of demand for future reinsurance coverage.

Finally, the impact of the decline in the stock market cannot be ignored. Historically low interest rates took their toll on investment income, which fell 5.5 percent. On an annualized basis, investment income is estimated at $35.8 billion, down $1.3 billion from $37.1 billion in 2001.

For much of the 1990's, insurance companies have competed for market share as a way to grow more profitable. The primary means of competition used was price. Consequently, homeowner premiums have not kept pace with the risk companies assumed along with this growth. Record stock gains on investment portfolios made up any losses with investment income. Now that this source of revenue no longer exists, premiums must increase.

Putting all of these factors together - increasing claims, large judgments, terrorism and the meltdown in the stock - you have what USAA Insurance calls the insurance industry equivalent of the "perfect storm".

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 What Is Different This Time?

While the magnitude of the phenomenon is much greater, this situation is not all that unusual in the sense that the insurance business is cyclical. If you look back through history, you will find previous periods when claims have gone up and/or the companies have become overextended in terms of their ability to absorb risk. This was the case, for example, in California following the earthquakes and in Florida following the hurricanes.

What is different this time is that large portions of the country are getting hit with the pullback and increased premiums - all at the same time. In the past, these market disruptions were typically localized and limited to a specific market place. This time around that is not the case and the situation is attracting greater attention.

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 Insurance Industry Reactions

In reaction to rising claims and losses, insurers have taken somewhat predictable steps to limit their risk. These steps include limiting the number of new policies written, increasing premiums, instituting new policy exclusions for some hazard claims and tightening their underwriting criteria for both borrowers and properties.

 Limitations on new policies. The most common reaction is to limit the number of new policies written. One of the largest property casualty companies, State Farm, has decided not to write new policies in 30 states nationwide. Additionally they have decided not to insure condominium associations in Florida. Consequently, approximately 5,000 condominium associations will have to obtain insurance elsewhere.

In 2001, Farmers Insurance announced that the company would not renew any homeowners' policies in the state of Texas once coverages now in effect expire. This action could have forced approximately 700,000 homeowners to find a new insurance company to provide their insurance coverages. Luckily, this possibility was adverted as the result of discussions between the Texas insurance commissioner and Farmers.

 Premium increases. Spikes in rates have done more than raise consumers' ire. The National Association of Insurance Commissioners is set to review recommendations made by a coalition of consumer groups—dubbed Americans for Insurance Reform—that is lobbying for stronger state regulations to protect citizens from unjustified insurance rate increases. The state regulator association plans to focus on whether September 11 caused insurers to implement unwarranted increases in their rates.

 Tighter underwriting. In addition to raising premiums, insurers are also tightening their underwriting criteria for both potential policyholders and the homes themselves. A homeowner who files "too many" claims can find himself or herself notified that their insurer will not renew their coverage for the coming year. What constitutes "too many" claims is obviously subjective but some have reported that homeowners who filed as few as two claims in the recent past are denied renewal. In one reported case, the homeowner had coverage through the same insurer for 10 years and had never filed a claim prior to the two claims that lead to the non-renewal of their policy.

Potential policyholders are now underwritten for risk through the use of insurance risk scores - a hybrid of the credit scoring methodology used by lenders to evaluate credit risk. According to the developers of the methodology - Fair, Issac and Company - while they have not shown a causal relationship between insurance claims and an insurance score based on credit history, there is a correlation between the two. One common industry explanation is that individuals who are not careful about paying their bills on time and managing their credit are likely to be similarly careless when it comes to dealing with routine maintenance or how they use their property and, therefore, will generate excessive claims.

The validity of insurance scores is a subject of much discussion and disagreement. Insurance commissioners have approved the use of insurance scores in many states; others have rejected them as unfounded and discriminatory; others are still debating the issue. The National Association of Insurance Commissioners had a working group charged with developing a set of "best practices" for the use of insurance scores. That working group reported at the association's fall meeting that it was unable to reach agreement on what constitutes best practice. The working group will reportedly publish as set of considerations that should be taken into account when reviewing the use of insurance scores for evaluating risk.

When it comes to underwriting the physical structures themselves, insurers have slowly tightened their underwriting requirements for structures. Some of the changes that our members report as 'new' policies have been in effect in some parts of the country for some time. Bans on wood shake roofs and requirements for circuit breakers rather than fuses are two ready examples. Whether these tighter structural requirements are evolving naturally from changes in available safer alternative technologies or a reaction to increased losses can be disputed. In either case, requirements for minimal structural elements have tightened.

What is new, however, is the increased use and sharing of databases, like the Comprehensive Loss Underwriting Exchange (CLUE) database, that record 90 percent of all insurance claims made in the U.S. The CLUE database is a service of the Choice Point. ChoicePoint is part of the Equifax credit-reporting agency. The database contains your name, address, telephone number, credit report, claims history and motor vehicle report. The company uses the information for credit scoring, claims history reporting and driving-record reporting.

The wider availability of data on prior claims is especially important in light of the relationship between water damage and mold problems. Insurers are refusing to insure a property that has a record of past water damage claims as reported by these databases.

 Increased exclusions. Mold claims and judgments have lead many insurers to seek exclusions for mold coverage from the basic homeowners policy terms mandated by state insurance commissioners. To date, 20 state legislatures have authorized policy exclusions for mold problems, according to representatives from the National Conference of State Legislatures.

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 Impact on Real Estate

The availability and affordability of property casualty insurance is critical to well being of homeownership efforts in this country and the real estate industry – the one sector of the economy that has continued to perform well in recent weeks and which is commonly cited as keeping the economy afloat.

Insurance is a necessary component in securing a mortgage. Ongoing insurance coverage is a necessary condition for meeting the terms of most mortgages. Increases in premiums can prohibit the marginal homebuyer from being able to afford homeownership and can severely strain the ability of existing homeowners on fixed incomes to continue to meet the ongoing costs of homeownership. Housing affordability is already a problem in many parts of the nation – escalating insurance premium costs only exacerbate the problem.

Insurance affects affordability in more ways, though, than just increased premium costs. Our multifamily practitioners report that their insurance costs are increasing also due to lender demands for additional insurance coverages over and above what has traditionally been required for mortgage underwriting purposes. Liability insurance is one such additional rider that is unrelated to the nature of the building structure itself.

The increased use of the CLUE database creates an interesting dilemma. One cannot argue that insurers' concerns with prior water damage claims resulting in undetected mold claims may be justified. However, this practice could be very troubling for many communities. The term "redlining" may take on a whole new meaning.

One of the major causes of water damage is flooding. Floods typically affect whole neighborhoods rather than a single property, as is the case in a broken pipe or leak. We are looking into whether or not federal flood insurance claims are included in CLUE but if they are, we are asking whether or not this practice could result in whole sections of communities being stigmatized and uninsurable. Even if we ignore the flood-induced stigmata, what happens if a number of homes in a subdivision have problems due to faulty construction, age or perhaps just bad luck? Will this result in neighborhoods with uninsurable and, therefore, un-saleable properties?

On a more micro-level, NAR has done some survey work to gauge the impact that these events are having on transactions. In general, the reports received indicate that transactions are sometimes delayed and small numbers are falling through. Limits on new policies that can be issued by any given agent are impacting transactions especially in those rural communities where a major player like State Farm may have dominated the market or if the buyer leaves the task of finding insurance to the end of the escrow period. Prior water damage claims have stigmatized properties resulted in some refusals to write coverage.

Typically, though, buyers are able to get coverage, albeit at higher rates. In some cases, they are turning to surplus line carriers like a Lloyd's of London who are not regulated by the insurance commissioner rate-setting process and are able to offer coverage at rates that are higher and, therefore, acceptable to the insurer.

Additionally, some mortgage lenders like Countrywide and Citi Mortgage have affiliated insurance companies that can write the coverage. Other buyers and owners are taking the route of increasing deductibles from the $100-$500 range that has been most commonly used to $1000 or more as higher deductibles can lower premiums.

Perhaps the most troubling reports are those that indicate that new homeowners are being informed after the close of escrow but prior to the end of the time period for which a binder is effective that the insurer will not offer the coverage indicated in the binder. This obviously is troublesome.

One additional report received by NAR, but not confirmed, indicates that some existing homeowners have been pushed into foreclosure by their lenders when affordable insurance coverage couldn't be found. In this case, reportedly, water claims made by the former owner stigmatized the property. However, if this report were true, this is the first time that foreclosure has resulted from increased premium costs.

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 What NAR is Doing

Recognizing the importance of this problem for the industry and consumers, NAR appointed a NAR Insurance Task Force. The Task Force has reviewed the evidence of the extent of the problems encountered and worked with outside experts from other entities involved in the issue to develop range of possible courses of action for remedying the situation.

Among the range of topics that the group considered were what factors have had the biggest impact on creating the current situation, can alternative insurance products and/or policies be developed that would limit the likelihood of this happening again, what state legislative/regulatory approaches are being taken at the state level and which are proving to be effective; is there a role for the federal government in solving this problem; what impact does/can tort reform play in this issue and how must it be framed to be effective; etc.

Since insurance is regulated at the state level, the state REALTOR® associations will be the first to address the problem. For this reason, NAR will focus on serving as an informational and strategy clearing house for its state and local associations. Coalition-building efforts currently underway at the national level among the housing and consumer groups aimed at finding private sector solutions continue. However, if state-level initiatives and coalition solutions prove futile or ineffective, NAR may need to address the problem at the federal level. The Task Force will report to a REALTOR® PAG that will make the final recommendations to the leadership team as to what NAR's policy and role will be.

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