Reducing the Cost of Property Insurance in Hawaii through Disaster Mitigation

Hawaii’s Insurance Crisis

Commercial carriers on the Big Island have not offered earthquake insurance since the late 1980s. Lava flow damage from Kilauea Volcano, as well as Hawaii Volcano Observatory’s assessment of the risk of lava flows, resulted in a decision by commercial insurance companies not to issue new property insurance policies for large areas of the island.

In September 1992, the property insurance crisis went state-wide. Hurricane Iniki resulted in $1.6 billion in insurance losses. One insurance company went bankrupt; a second stopped issuing new policies. Forty thousand property insurance policies were canceled, and for several months only a single carrier offered new property insurance policies.

In 1993, the State Legislature created the Hawaii Hurricane Relief Fund (HHRF) to provide hurricane coverage for homeowners. A combination of deductibles, an insurance industry assessment, reinsurance, and accumulated reserves was intended to cover the Fund’s exposure to losses. To cover the cost of operating the HHRF, premiums and special mortgage recording fees are deposited into a hurricane reserve trust fund. Participating private insurance companies service HHRF policies.

In response to the Iniki losses and the establishment of the HHRF, most private insurance carriers eliminated hurricane coverage and chose to participated in the Fund. Premiums for many property insurance policies, however, remained near pre-Iniki levels – even though hurricane coverage had been dropped from the "base policies." In other words, the cost of hurricane coverage from HHRF was added to the total cost of property insurance for Hawaii’s homeowners.

Implementation of the 1994 National Flood Insurance Program (NFIP) regulations further increased the cost of property insurance. This program how requires all property owners (including high rise condominiums) in "special flood hazard areas" to insure their properties against flood damage equal to 80% of replacement value. In addition, the National Flood Insurance Reform Act (1994) directs Federal loan agencies and Federally regulated or insured lending institutions to "require flood insurance when making, increasing, extending, or renewing loans and to maintain the coverage for the life of the loan" for all homes in special flood hazard areas. As a result of this change, additional homeowners in Hawaii have been required to buy flood insurance.

Other Changes in the Insurance Industry that Affect Hawaii

Other States have suffered extensive property insurance losses in recent years. Hurricane Hugo cost the insurance industry $4.9 billion. Hurricane Andrew (1992) was the most expensive disaster in United States’ history, with property insurance losses totaling $15.5 billion. A 1993 winter storm in the northeast resulted in $1.8 billion in insured losses. The Northridge earthquake in 1994 had almost $7 billion in losses. All in all, sixteen of the twenty most costly disasters in U.S. history have occurred since 1989 (The Economist, 12/3/95).

A longer-term trend in the industry has compounded increasing insurance costs from losses, beginning in the early 1990s. Insured values in hurricane-prone areas of the U.S. grew form $1.1 trillion in 1980 to an estimated $2 trillion in 1994 (The Economist, 12/3/95). This growth has increased the demand for reinsurance. Unfortunately, the amount of money invested in reinsurance has not expanded as rapidly as the demand for reinsurance has grown. Moreover, heavy losses to reinsurance investors in the early 1990s has made those investors more cautious about providing reinsurance to areas perceived as "risky" – including Hawaii. This attitude not only increases the cost of reinsurance for these areas, but also results in a reluctance to provide any coverage at all.

The scarcity and high cost of reinsurance directly affects Hawaii property owners. The fund spends virtually all of its income on reinsurance and has only been able to secure $500 million in reinsurance coverage. The combination of this reinsurance, an additional $300 million in coverage to be provided by participating private insurance companies, and a line of credit, add up to the $1.3 billion the Fund has available to cover losses.

Ability of the Hawaii Hurricane Relief Fund to Cover Future Losses

For the 1995 hurricane season, HHRF had 134,000 policies in force and a total exposure of over $29 billion. If the number of HHRF residential policies increases to 160,000 for the 1996 season (as expected by Fund staff), potential losses will increase by 23 percent. Thus, if the island of Oahu experienced an Iwa-strength storm this year, the Fund probably would be able to cover all losses. If all islands were struck by the same (Iwa) strength storm, which is highly unlikely, losses would exceed the total amount of coverage available by $300 million. In a third scenario, if an Iniki-strength storm hit Oahu (which is, again, unlikely), losses would exceed the amount of coverage by $1.5 billion.

If the State experiences major losses from a hurricane in the future, the cost and availability of reinsurance to the Fund would undoubtedly change. Another major loss would probably make it very difficult for HHRF to purchase reinsurance at any price. At the very least, the cost would be higher than it is now. Thus, the ability of the Fund to provide any hurricane coverage after the next major hurricane is in serious question.

Future Changes in the Insurance Industry that May Affect Hawaii

Insurance companies are trying to get a better fix on the risks of losses in the communities to which they sell policies, which, in turn will allow them to adjust their cost projections and premiums to reflect the "true" risk. Several U.S. mainland consulting firms have developed computer models to assess the risk of losses for insurance companies and reinsurers. HHRF is currently evaluating one such model. If employed, HHRF rates for individual structures could change.

A Building Code Effectiveness Grading Schedule has been developed to rate the risk of damage from natural disasters. The grading system provides insurance companies and reinsurers with another tool to determine the relative risk of damage in different communities around the United States. The Insurance Service Organization on the U.S. mainland is administering the Grading Schedule, and will assign grades to communities on the mainland in the next year or so. Two years ago, member companies of the Hawaii Insurance Bureau have asked their (local) insurance service organization to administer the grading system in each of Hawaii’s four counties. Whether or not the Grading Schedule is administered in Hawaii, insurance and reinsurance rates could increase.

The National Flood Insurance Program (NFIP) is undergoing changes that could have an impact on Hawaii’s property owners. A Community Rating System was instituted several years ago to provide premium credits for flood insurance policy holders of up to 45% in those communities that take steps beyond the minimum program requirements to reduce the risk of flood damage. In order to qualify for credits, communities or counties can institute public information programs about the flood risk, develop more detailed flood maps and institute regulations restricting development in special flood hazard areas, acquire properties in those areas, "retrofit" older structures to comply with NFIP regulations, or institute new flood preparedness activities. In the future, the CRS may include credits for reduce the flood risk in erosion prone areas.

Some insurance companies are considering instituting a more sophisticated risk-based premium structures for residential property. For many years, larger commercial insurance premiums have been negotiated on the basis of the risk of loss, and professional risk managers have been employed to institute loss control programs. As part of its mitigation program, HHRF is developing a risk-based premium structure. If approved, property owners with structures less subject to damage, such as those with hurricane clips and special fasteners and hurricane shutters, will be charged a lower premium than property owners with more risky buildings.

Several bills have been introduced in the U.S. Congress to help reduce the cost of natural disasters to the Federal government. The Natural Disaster Protection and Insurance Act of 1995 (S. 1043 and H.R. 1856), introduced signed by Senator Inouye and other members of Congress, was intended to establish an insurance corporation to provide catastrophic disaster insurance to states and territories. The bill introduced by Senator Inouye established a mitigation fund intended to support mitigation activities undertaken by State and County governments. The bill included provisions that require the development of mitigation plans and the adoption of the most recent version of the building code, in Hawaii’s case the 1994 Uniform Building Code.

Opportunities for Reducing Property Insurance Costs in Hawaii

As already noted, HHRF is developing risk-based rates. If adopted, the rates will bring down the cost of hurricane insurance for people who own less risky structures. Policy holders could up-grade their structures and receive lower premiums. If approved, credits will also be provided for "wind storm protection devices" such as storm shutters.

County governments could adopt more stringent flood mitigation standards. This would bring down the cost of Federal flood insurance. Currently, only Maui County has taken advantage of the Community Rating System (CRS) program. Flood insurance policy holders on Maui will receive a five percent premium credit as a result. Funds have been authorized by the Congress for FEMA to provide grants to States and Counties for mitigation activities. This money can be used to assist communities to reduce the flood risk and reduce premiums through CRS.

County governments could adopt the latest version of the Uniform Building Code. In the short run, this will do little to reduce the risk of hurricane damage because the percentage of homes built to a higher standard will remain low for many years. Its adoption, however, will give the Counties a better score on the Building Code Effectiveness Grading Scale, if, and when, it is administered in Hawaii. If insurance providers begin to use the Effectiveness Scale to set rates, property owners in Counties with a better score will pay less for property insurance than they would otherwise. If used by reinsurers, the cost of reinsurance for he HHRF may also come down, as the Fund may be able to purchase additional reinsurance to cover potential losses.

The State or County governments could develop a mitigation program to reduce the risk to existing structures. This could include a disaster mitigation public awareness program, tax incentives and soft loans for disaster mitigation, and changes in land use regulations designed to move structures out of hazardous areas. It could also include new insurance regulations designed to provide incentives for mitigation. Government mitigation plans would improve building code effectiveness scores. They would also meet the requirements of the various bills proposed in the 104^th Congress, which, as already indicated, includes a requirement for a State disaster mitigation plan.

The State and County disaster mitigation initiatives discussed here appear to be the only viable options for reducing the cost of property insurance in Hawaii. Imposing lower rates on private insurance companies by statute will probably force companies out of the Hawaii market, reduce competition, and, eventually, result in higher insurance costs. Imposing lower rates on the HHRF will make it impossible for the Fund to cover its existing reinsurance costs. If residents of Hawaii want lower property insurance premiums, they should work with the State Legislature and County Councils to adopt mitigation measures that will reduce insurance costs now and prevent them from increasing the future.