South-Western College Publishing - Economics  
Insurance Companies-Economics 101 and Policy Revisions.
Topic Utility and consumer choice
Subject Post Katrina, insurance companies are re-thinking their property insurance policies.
Key Words hurricane, insurance, private markets, public insurance, incentives, game theory; public policy
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Reference ID: A146799441

News Story 2005's storm season with its star attractions Katrina and Rita-following on the heels of the very active 2004 storm season--caused almost $55 billion in damage. This year's storm season is also predicted to be particularly active, though not as bad as last year. In the wake of huge payouts associated with past years' hurricanes, insurance companies are coming up with policyholder incentives as the companies revise their policy offerings. As a result, a state-run self-insurance pool in Florida could see up to 1.5 million policies this year, almost double the number issued last April.

Several insurance companies, most notably State Farm and Allstate, indicate that they will no longer insure property in many coastal states, including Florida, New York, Texas and others. Those companies that continue to issue property insurance are increasing policy premiums by up to 200% in many of these same places. They blame the re-insurers (the companies that insure the insurance companies), but it's all about placing incentives where incentives need to be placed.

This year, the National Oceanic and Atmospheric Administration (NOAA) predicts 16 tropical storms in the Atlantic, of which 10 are predicted to be hurricanes. This is bad enough news, but not as bad as last year's 27 named storms. The forecast bodes poorly for insurance companies. Individuals wanting to live on the coast in the path of these storms are at increasingly high risk for property damage, warranting the higher premiums.

The danger? Many people expect the government to bail them out when they can't get private insurance coverage for their beach home on the east coast of Florida. If the federal government does step in--at the cost of higher taxes and less spending elsewhere to handle the burden--individuals no longer bear the entire risk of living within well-known hurricane paths. Incentives to build only in safer areas disappear. While many economists call for the federal government to serve as a "stop-gap insurer," picking up the insurance tab during a calamity, they also recognize that FEMA's assistance only encourages individuals to migrate to the coasts.

It appears, though, that insurance companies are beginning to remember their economics training and are charging people for insurance commensurate with the risks involved.

Discussion Questions:
1. What does it mean for public policy to be "incentive compatible"? How are current federal insurance policies not incentive compatible?
2. Is competition counterproductive in the market for insurance? Why or why not?
3. Explain how asymmetric information is a problem in the insurance market and how insurance companies are compensating for that asymmetric information.
Multiple Choice/True False Questions:
1. True/False. Previous insurance policies on homes in coastal areas did not adequately reflect the risk involved.

2. According to the article, why have insurance premiums increased?
  1. Insurance companies are understanding risk better.
  2. Insurance companies are more accurately reflecting the risk involved.
  3. Insurance companies are pushing the risk onto homeowners more.
  4. A, B and C
3. According to the article, what is the danger with federal emergency assistance?
  1. Is an example of the Tragedy of the Green.
  2. Potentially increases taxes on everyone, not just the policyholder.
  3. Encourages irrational behavior.
  4. All of the above.
Source "The price of sunshine." The Economist. June 8, 2006.
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