In 2005, hurricanes Katrina, Rita and Wilma resulted in a more than $200 billion economic loss. While there's no way to avoid such natural disasters, Congressman Ron Klein (D-FL) has sponsored some legislation that hopes will make it a little easier to deal with the costs they impose. Last week, on the day everyone was watching Goldman get grilled in a Senate hearing, the House Financial Services Committee quietly passed Klein's Homeowner's Defense Act (HDA). It intends to wean states off federal government assistance for natural disasters and open up the insurance market to residents in geographies more prone to natural disasters.

Catastrophe Obligation Guarantees

Often, when a state can't afford to deal with a catastrophic event, the federal government gets stuck with the bill. This legislation would seek to end that precedent. It would provide federal guarantees to debt issued by states to pay for natural disasters after they occur.

For example, think back to Katrina. Louisiana likely couldn't afford the incredible costs associated with the disaster, so it went to the federal government for assistance. Under the HDA, however, it could issue bonds to investors to help pay the costs the state incurs. Before, it might not have done so successfully, since investors might have been skeptical that Louisiana would be able to make good on its promise to pay in a timely manner. After all, its economy would be affected by the terrible event for some time. But under this new legislation, the federal government would guarantee these bonds, providing investors some assurance. Ultimately, the state would be required to pay back any shortfall that the federal government is forced to step in and cover. But unlike investors, Uncle Sam can be very, very patient in getting his money back.

Since the catastrophe obligation guarantees would seek to prevent the federal government from getting stuck paying for natural disasters, they are a pretty good idea. Now, the responsibility would fall on the states -- where it belongs. They will ultimately have to figure out a way to align disaster risk with the costs they consequently incur. This might lead to property taxes being based on geography in some locations. For example, it might be more expensive for the state of Florida if more people choose to live on or nearĀ the coast. The bill would align the price for living somewhere with the cost the state faces through natural disasters. This is one reason why insurance giant State Farm supports the legislation.

National Catastrophe Risk Consortium

Along with minimizing the cost of natural disasters to the federal government, the bill also seeks to strengthen the marketĀ for providing homeowner insurance to all Americans -- even those living in geographic locations very prone to natural disasters. It intends to do this by creating a National Catastrophe Risk Consortium (NCRC).

Basically, this new entity would seek to pool the diverse risks associated with various geographic locations and natural disaster types. It would sell reinsurance to participating insurers -- whether states or private firms -- to pay out in a catastrophe. Reinsurance is just insurance for insurers. This sounds complicated, but the following diagram might make it easier to understand:

NCRC Diagram 2010-05.PNG

For simplicity the example above just considers states even though the private market could also participate. It imagines a situation where one year there is a bad hurricane in Florida where the state is paid out more than its premiums would have covered. In this scenario, the pool easily covered the risk, as there were no other catastrophes that year.

At first, the NCRC may appear to have a problem: in the example above, wouldn't the states and private parties with little risk of costly natrual disasters essentially end up subsidizing the states with lots of risk? If they were all required to join, then this would be an issue. But they aren't. So you likely don't have to worry about a farmer in Lincoln, Nebraska paying for a hurricane hitting Miami: Nebraska just wouldn't join the NCRC. Instead, states that face high risk of natural disasters would join. For example, California, Florida and Louisiana would likely all be members. So the insurance costs incurred by those homeowners won't decrease significantly from what they were before.

Yet, that begs the question: how does this change the situation? On an actuarial basis, if a major hurricane hits Florida every 10 years and a major earthquake hits California every 10 years, then two major earthquakes or hurricanes will hit one of them every 10 years. Wouldn't the insurance costs be similar if pooled or separate? As long as the consortium only appeals to high risk locations, it's hard to see how it would bring down premiums or make the uninsurable suddenly insurable. This could only happen if areas with less risk subsidize those with more. That's not how the legislation would work. And it shouldn't: then, it would encourage people to live in locations more prone to natural disasters and discourage them from inhabiting safer regions.

So as presented, the legislation might not be perfect, but it does appear to be a good start. If it reduces the federal government's presence in funding disaster relief, then that alone would be a huge plus. Even if the proposed consortium doesn't result in cheaper or more widespread insurance coverage, it likely won't make matters worse.

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