March 31, 2011 20:32
"Catastrophic risk is different." So concludes an important opinion out of the Maryland Court of Special Appeals filed earlier this month. In the case of first impression, People's Insurance Counsel Division v. Allstate Insurance Company, the court affirmed the primacy of models and business judgment in the writing of insurance, and further recognized that there is a "gaping difference between ordinary insurance risk and catastrophe risk."
The case stems from the decision way back in 2006 by Allstate to advise the Maryland Insurance Administration (MIA) that it did not intend to write any new property policies in certain Maryland counties subject to heightened hurricane risk. As distilled by the court: "certain coastal areas bordering the Atlantic Ocean and the Chesapeake Bay presented an unusually high risk of loss in the event of a catastrophic hurricane. As a result, [Allstate] decided that it was no longer in Allstate's best economic interest to continue to write new property insurance policies in those areas."
The MIA concluded that Allstate' business decision was properly made on "an obective basis and [was] neither arbitrary nor unreasonable." However, the state's public advocate, in the guise of the People's Insurance Counsel Division, concluded differently. Following a trip to Maryland's highest court, which confirmed the Division had standing to challenge the MIA's decision, the Division argued that Allstate's determination not to write property policies in certain geographic areas was arbitrary and unreasonable in contravention of Maryland Insurance Article § 19-107. Further, the Division argued that because Allstate had not shown that a hurricane would strike Maryland and that its rates were insufficient to carry that loss, the decision violated § 27-501.
To determine whether it wanted to undertake the risk of hurricanes along the Eastern Seaboard, Allstate retained Applied Insurance Research (AIR) to model the areas of the state and region that were catastrophe-prone, and those that were not. It concluded that some or all of certain Maryland counties were at a substantially heightened risk of higher levels of hurricane damage than other areas. The model was explained: "What it did, in order to get down to the zip codes, statistical level, generated the next year 100,000 times. That is, it's doing simulations of the next year, 100,000 times. And what they do in order to do that is they look at the last 100 years of meteorological data to try to come up with a probability of various hurricane strikes."
In those 100,000 simulations AIR concluded that there would be eight hurricane strikes that would cause half a billion dollars in damage in Maryland alone. Because Allstate insured a substantial number of properties in these risky areas, it made the "business judgment that further growth at this time could jeopardize [its] anticipated long-term strength." The court quoted the Commissioner in holding that Allstate complied with the law: "I conclude that Allstate's geographic designation of Hurricane Bands 4-6 had adequate factual support and, therefore, was not arbitrary or unreasonable. Allstate's hurricane bands were developed based on objective and reasonable factors, including modeled hurricane loss data, proximity to water and geographic contiguity. Through its use of the hurricane models, Allstate developed [Average Damage Ratios] ADRs at a zip code level. The higher the ADR, the higher the potential damage the area in the band is likely to sustain in the event of a catastrophic storm."
This section of the Insurance Article forbids an insurer from refusing a "particular insurance risk or class of risk" for "any arbitrary, capricious or unfairly discriminatory reason." The court first held that a decision to stop doing business did not address a particular individual or group of individuals; therefore, because Allstate's decision was "broad-based", section 27-501 simply did not apply.
But even if it did, the modeling demonstrated that the decision was not unfairly discriminatory, arbitrary or capricious. The Division asserted that ""Allstate was legally required to show the probability of a catastrophic hurricane striking Maryland in order to justify its no-write decision." The court was dismissive and characterized the Division's contention as "unreal". The issue faced by Allstate was very plain, syllogistic in fact:
THE ENTIRE EASTERN SEABOARD OF THE UNITED STATES IS AT RISK FROM HURRICANES.MARYLAND IS PART OF THE EASTERN SEABOARD OF THE UNITED STATES.THEREFORE, MARYLAND IS AT RISK FROM HURRICANES (capitals in original).
The court then went on to enumerate the details that the model considered such as historical hurricane reports, weather databases, and property values. It came down firmly on the value of the model: "Allstate's use of the AIR Hurricane Model V7.0 cranked out, zip code by zip code, predictive statistical data for 100,000 model years. We are hard-pressed to understand exactly what more the Division could want."
As to the Division's last argument (that prior Court of Special Appeals precedent required Allstate to demonstrate that its rate plan was insufficient to cover catastrophe losses) the court was scathing. Referring to the Division's argument as "fantasy analysis," it demonstrated that the precedent on which the Division relied suffered from a fundamental error in its understanding of the source materials and, as it "was wrong in 1987, ..., as it most assuredly was, it is still wrong 24 years later."
The court concluded its analysis with a discussion of catastrophe risk. It pointed out that for the usual risk, say fire or car accidents, insurers diversify their risk by taking on more insureds. Where a catastrophic risk is present, however, taking on more insureds increases the risk to the insurer, rather than decreases the risk, because if the catastrophe strikes, all of the insureds will make a claim. It concluded that catastrophic risk was "unique" and that case law that focused on individual insureds was completely irrelevant.
People's Insurance Counsel is significant at a number of levels for those following climate change insurance issues. First, the modeling data and results were unchallenged. There are three dominant modeling companies (AIR, EqeCat and Risk Management Solutions) so the Division was not stymied here because Allstate's modeler had a lock on the market. More likely, it was recognized that while a different model might preserve coverage for a few zip codes, the models would not reach fundamentally different outcomes. If the goal was to ensure that Allstate (and by extension all other insurance companies) could not abandon the front lines of hurricane risk, no model would show that Worcester County (on the ocean) would have a similar risk as Garrett County (at the headwaters of the Potomac). Businesses should take note. In most businesses, profit is made at the margins. Employing models to ascertain where the weather-related risks change their character could yield real monetary benefit - as Allstate demonstrated by giving up underwriting in only parts of some counties.
Second, AIR looked at historical weather records. It made no predictions about the future more severe weather called for in climate change models. This reluctance to face the future is not unique to insurance companies. The Federal Emergency Management Agency takes the same approach in its analysis of flood plains. We have written elsewhere concerning the head-in-the-sand mentality that afflicts many that are subject to altered climate change risks. Catastrophe modeling is no different. We await the case that tests the insurer's ability to rely not on what has happened in the past, but on what is predicted for the future.
Third, there is (at the moment anyway) a great belief in the efficiency of the market in identifying the appropriate path for society. The insurance markets are taking steps to halt the migration to the shore by determining not to insure it. It remains to be seen whether governments will abide by those business decisions or force dislocations onto the market in order to preserve continued growth in hurricane-prone areas. Maryland, for the moment, appears to be one state that is allowing the insurance market to shape the future of the shore. As we have blogged before, other states (notably Florida), are not so laissez-faire.