Tag Archives: citizens property insurance corporation

When Nature Calls: the Need for New Models

The Earth is a living, breathing planet, rife with hazards that often hit without warning. Tropical cyclones, extra-tropical cyclones, earthquakes, tsunamis, tornados and ice storms: Severe elements are part of the planet’s progression. Fortunately, the vast majority of these events are not what we would categorize as “catastrophic.” However, when nature does call, these events can be incredibly destructive.

To help put things into perspective: Nearly 70% (and growing) of the entire world’s population currently lives within 100 miles of a coastline. When a tropical cyclone makes landfall, it’s likely to affect millions of people at one time and cause billions of dollars of damage. Though the physical impact of windstorms or earthquakes is regional, the risk associated with those types of events, including the economic aftermath, is not. Often, the economic repercussions are felt globally, both in the public and private sectors. We need only look back to Hurricane Katrina, Super Storm Sandy and the recent tsunamis in Japan and Indonesia to see what toll a single catastrophe can have on populations, economies and politics.

However, because actual catastrophes are so rare, property insurers are left incredibly under-informed when attempting to underwrite coverage and are vulnerable to catastrophic loss.

Currently, insurers’ standard actuarial practices are unhelpful and often dangerous because, with so little historical data, the likelihood of underpricing dramatically increases. If underwriting teams do not have the tools to know where large events will occur, how often they will occur or how severe they will be when they do occur, then risk management teams must blindly cap their exposure. Insurers lacking the proper tools can’t possibly fully understand the implications of thousands of claims from a single event. Risk management must place arbitrary capacity limits on geographic exposures, resulting in unavoidable misallocation of capital.

However, insurers’ perceived success from these arbitrary risk management practices, combined with a fortunate pause in catastrophes lasting multiple decades created a perfect storm of profit, which lulled insurers into a false sense of security. It allowed them to grow to a point where they felt invulnerable to any large event that may come their way. They had been “successful” for decades. They’re obviously doing something right, they thought. What could possibly go wrong?

Fast forward to late August 1992. The first of two pivotal events that forced a change in the attitude of insurers toward catastrophes was brewing in the Atlantic. Hurricane Andrew, a Category 5 event, with top wind speeds of 175 mph, would slam into southern Florida and cause, by far, the largest loss to date in the insurance industry’s history, totaling $15 billion in insured losses. As a result, 11 consistently stable insurers became insolvent. Those still standing either quickly left the state or started drastically reducing their exposures.

The second influential event was the 1994 earthquake in Northridge, CA. That event occurred on a fault system that was previously unknown, and, even though it measured only a 6.7 magnitude, it generated incredibly powerful ground motion, collapsing highways and leveling buildings. Northridge, like Andrew, also created approximately $15 billion in insured losses and caused insurers that feared additional losses to flee the California market altogether.

Andrew and Northridge were game changers. Across the country, insurers’ capacity became severely reduced for both wind and earthquake perils as a result of those events. Where capacity was in particularly short supply, substantial rate increases were sought. Insurers rethought their strategies and, in all aspects, looked to reduce their catastrophic exposure. In both California and Florida, quasi-state entities were formed to replace the capacity from which the private market was withdrawing. To this day, Citizens Property Insurance in Florida and the California Earthquake Authority, so-called insurers of last resort, both control substantial market shares in their respective states. For many property owners exposed to severe winds or earthquakes, obtaining adequate coverage simply isn’t within financial reach, even 20 years removed from those two seminal events.

How was it possible that insurers could be so exposed? Didn’t they see the obvious possibility that southern Florida could have a large hurricane or that the Los Angeles area was prone to earthquakes?

What seems so obvious now was not so obvious then, because of a lack of data and understanding of the risks. Insurers were writing coverage for wind and earthquake hazards before they even understood the physics of those types of events. In hindsight, we recognize that the strategy was as imprudent as picking numbers from a hat.

What insurers need is data, data about the likelihood of where catastrophic events will occur, how often they will likely occur and what the impact will be when they do occur. The industry at that time simply didn’t have the ability to leverage data or experience that was so desperately needed to reasonably quantify their exposures and help them manage catastrophic risk.

Ironically, well before Andrew and Northridge, right under property insurers’ noses, two innovative people on opposite sides of the U.S. had come to the same conclusion and had already begun answering the following questions:

  • Could we use computers to simulate millions of scientifically plausible catastrophic events against a portfolio of properties?
  • Would the output of that kind of simulation be adequate for property insurers to manage their businesses more accurately?
  • Could this data be incorporated into all their key insurance operations – underwriting, claims, marketing, finance and actuarial – to make better decisions?

What emerged from that series of questions would come to revolutionize the insurance industry.

Sinkhole Peril: Reducing Exposure And Managing Risk

The sensational news of Jeff Bush, swallowed by the earth while he slept, has been widely reported by the media.1 Such dramatic incidents receive a great deal of attention, likely because they are so rare. Sinkholes, however, are not rare. They do not usually threaten lives, but in Florida they have often threatened insurance companies' balance sheets, endangering their profitability and — in at least one case — their solvency.

First we must distinguish between how the terms “sinkhole” and “catastrophic ground collapse” are used in insurance in Florida. According to Florida statutes, “'Sinkhole' means a landform created by subsidence of soil, sediment, or rock as underlying strata are dissolved by groundwater.” A “catastrophic ground collapse,” by comparison, exists when all of the following four criteria are met:

  1. The abrupt collapse of the ground cover;
  2. A depression in the ground cover clearly visible to the naked eye;
  3. Structural damage to the covered building, including the foundation; and
  4. The insured structure being condemned and ordered to be vacated by the governmental agency authorized by law to issue such an order for that structure.2

Sinkholes are fairly common in Florida and even ubiquitous in some areas. But what happened to Jeff Bush was a catastrophic ground collapse, and that's rare, even in Florida.

Much of the subsurface geology in Florida consists of limestone or dolomite and both are susceptible to gradual erosion when exposed to acidic water, which arises from a chemical reaction between rainwater percolating through the soil and decaying vegetation. This erosion can produce underground voids that are not visible on the surface and these voids will expand, usually very slowly. This slow expansion leads to a subsiding surface, which can cause cracking and other damage to structures. Very occasionally, a large void will lead to sudden collapse of the surface above it.3 A well-known historical example of this is the Winter Park sinkhole.4 A more recent example is the sinkhole into which Jeff Bush's house collapsed.

Although the process that produces sinkholes occurs naturally over tens of thousands of years, it can be accelerated by human-induced depletion of underground aquifers. In Tampa, the problem has become so significant that one of the first desalination plants in the United States has been built to reduce the use of underground water supplies.5 The groundwater depletion that has resulted from increased water use has in part contributed to extremely frequent sinkholes in Pasco and Hernando counties.6

Initial Legislative Efforts
In 1981, Florida passed a law mandating that insurance companies cover the sinkhole peril as part of home insurance.7 By 2006, the sinkhole loss ratio in Hernando County for Citizens Property Insurance Corporation, an insurer created by the state for those who cannot acquire coverage elsewhere, had reached 242%. The average sinkhole claim for Citizens was about $139,000.8 Claims were often not for catastrophic ground collapse or even damage that affected the load-bearing capacity of the structure, but were cosmetic in nature. There came to be a widespread perception in the industry that marginal claims were being paid out, partially as a result of aggressive solicitation of insureds by public adjusters.

In response, Florida lawmakers passed legislation that still required insurers to offer sinkhole coverage, but allowed policyholders to exclude it. The territories that Citizens used for rating the sinkhole peril were the same as it used for other perils — generally counties divided into a coastal region and an inland region. This method did not adequately capture the differentiation in sinkhole risk and once policyholders were allowed to exclude sinkhole coverage, those who believed they were at lower risk chose to do so.

The losses for the remaining, higher-risk insureds had to be spread over a smaller amount of premium, pushing the loss ratio up, and causing Citizens to file for rate increases. Those rate increases encouraged more low-risk insureds to opt out of sinkhole coverage, creating a self-reinforcing cycle of adverse selection. The sinkhole loss ratio, especially in the area of the state susceptible to sinkholes, increased. By 2009, it had reached 683% in Hernando County. The number of sinkhole claims for Citizens in Hernando county alone had increased from 186 in 2006 to 520 in 2009 — nearly tripled — while premiums to cover them had decreased from about $9.2 million to about $6.0 million.

Private insurers began withdrawing from the market in Pasco and Hernando counties entirely, and the share of the market for Citizens increased rapidly. Between 2008 and 2010, the number of policies Citizens wrote in Hernando County increased by 50%.9 HomeWise Insurance Company was forced into liquidation in 2011, despite no hurricanes affecting Florida since 2005, because of sinkhole claims.10 The insurance of damage from sinkholes led to an insurance crisis in Florida.

Bill SB408
Although there had been several previous rounds of legislation to address the crisis in 2005, 2006, 2007, and 2009, the crisis only worsened.11 Another bill, SB408, was passed in 2011. An analysis performed by Insurance Services Office (ISO) on behalf of Citizens estimated that this bill would reduce losses by about 54.7% based on several changes:12

  • The majority of the expected savings came from a change in definition; instead of covering “physical damage,” sinkhole coverage would now cover “structural damage.” The report estimated the impact of this change in definition by reviewing a random sample of closed claims and estimating what the loss would have been under the new definition.
  • Previously, many policyholders did not use the proceeds they received from their sinkhole claims to repair damage, but instead used it to pay off their mortgages or for some other purpose. In a sample of claims from HomeWise, for example, only 27% of insureds used the money to make repairs.13 SB408 requires that loss payments be used to repair sinkhole damage based on the specifications of an engineer's report.
  • When the insured uses a public adjuster, claims for which a sinkhole is not confirmed have much higher losses than when the insured does not use a public adjuster. In the analysis performed by ISO, it was determined that the losses for claims of Citizens with no confirmed sinkhole activity were 140% higher when a public adjuster was involved. SB408 limits public adjuster compensation to reduce the incentive to inflate sinkhole claims.14
  • SB408 excludes sinkhole damage to appurtenant structures, such as driveways, sidewalks, decks, or patios.
  • Policyholders with a previously denied sinkhole claim were granted the right to sinkhole testing at the expense of the insurance company. Under SB408, the policyholder must pay part of the cost of this testing, which is reimbursed if the testing demonstrates that a sinkhole exists.

In addition to these provisions, companies can exclude sinkhole coverage until an inspection is performed. If there is evidence of prior sinkhole activity, they can exclude the sinkhole peril from coverage. They can also now require a sinkhole deductible equal to 10% of coverage A for HO-3 policies.15

The cumulative impact of these reforms and improvements in underwriting is unclear. Although the reaction in the industry has been positive, it has been less than two years since SB408 was implemented and it will take time to see if it results in a real decrease in costs. In 2006, SB1980, another sinkhole reform bill, was passed and was expected to produce up to 14.4% savings, according to a report from Deloitte commissioned by the Florida Office of Insurance Regulation.16 As it turned out, this was just before a rapid escalation in sinkhole costs. It is very difficult to predict the impact of legislation, and while there is a lot of favorable anecdotal evidence, it is probably too soon to say for certain whether the Florida sinkhole crisis is over.

What Insurers Can Do To Manage Their Risk
Excluding sinkhole coverage and offering it as a buyback with a 10% mandatory sinkhole deductible after an inspection is one of the most important tools that insurers currently have. However, the dramatic example of adverse selection that occurred in recent years in Pasco and Hernando counties should serve as a reminder of the importance of risk differentiation. Adverse selection occurs because policyholders or competitors have more information about an insured risk. Insurers can reduce this risk by adopting granular rating plans that align the premium charged as closely as possible with the expected loss.

Because insurers based their calculations on territories designed for wind risk — consisting of a coastal and inland region — they failed to adequately differentiate risk within these counties based on underlying geology, changes in underground aquifers, and claim patterns. Further, since sinkhole claims are relatively uncommon, albeit very severe, companies often lack credible data, which encourages them to utilize territories that are not homogenous.

SB408 has diminished the sense of crisis in the industry and creates an opportunity for insurers to get ahead of the risks they face. Companies are now able to charge a separate premium for the sinkhole peril and they should begin utilizing territories that better reflect the variation in the underlying risk from that peril. Doing so, coupled with other important risk management strategies, will decrease the likelihood that they will have the sort of unfavorable experience that has been so damaging to the industry in recent years.

Although Florida has by far the highest rate of sinkholes in the United States, they also occur in many other parts of the country, such as Alabama, Kentucky, Missouri, Pennsylvania, Tennessee, and Texas — anywhere, in fact, where acidity erodes subsurface limestone. About 20% of the United States is susceptible to sinkholes.17 Less than two months after Jeff Bush was swallowed by the earth, a sinkhole in Chicago devoured three cars.18 Insurers would be wise to review their policy language and the law in all states where they have potential sinkhole exposure and consider steps to address this exposure. The most dangerous peril for any insurer is the one they did not realize they were covering.


1 New York Times (March 2, 2013). Crews halt effort to find man lost in Florida sinkhole that swallowed his room. Associated Press. Retrieved April 18, 2013, from http://www.nytimes.com/2013/03/03/us/florida-sinkhole-growing-as-engineers-investigate.html.

2 Section 627.706(2)(a), Florida Statutes.

3 Beck, B.F. & Sinclair, W.C. (1986). Sinkholes in Florida. Florida Sinkhole Research Institute, Universityi of Central Florida. Retrieved April 18, 2013, from http://publicfiles.dep.state.fl.us/FGS/FGS_Publications/FGS Library Documents/SinkholesInFlaAnIntroBeck1986a.pdf.

4 In May 1981, the Winter Park sinkhole in Central Florida swallowed a house, five Porsches, and part of the city's swimming pool. The sinkhole eventually measured 350 feet wide, 75 feet deep and had caused $4 million dollar in damage. Orlando Sentinel (November 13, 2013). Looking back at Winter Park's famous sinkhole. Retrieved April 18, 2013, from http://articles.orlandosentinel.com/2012-11-13/news/os-fla360-looking-back-at-winter-parks-famous-sinkhole-20121113_1_sinkhole-orlando-sentinel-winter-park

5 U.S. Geological Survey (November 2003). Ground-Water Depletion Across the Nation. Fact Sheet 103-03. Retrieved April 18, 2013, from http://pubs.usgs.gov/fs/fs-103-03/.

6 U.S. Geological Survey (January 2013). Groundwater Depletion. Retrieved April 18, 2013, from http://ga.water.usgs.gov/edu/gwdepletion.html.

7 Florida Senate (December 2010). Issues Relating to Sinkhole Insurance. Interim Report 2011-104. Retrieved April 18, 2013, from http://publicfiles.dep.state.fl.us/FGS/WEB/sinkholes/FlaSenateSinkholeIssues.pdf.

8 Florida Senate, ibid., p. 18.

9 Florida Senate, ibid., p. 26.

10 Florida Dept. of Financial Services (November 18, 2011). Notice of Liquidation of HomeWise Insurance Company. Retrieved April 18, 2013, from http://www.myfloridacfo.com/agents/industry/news/hwicliq.htm.

11 Florida Senate, ibid.

12 Ericksen, P. (July 19, 2012). Citizens Property Insurance Corporation: Senate Bill 408 Sinkhole Analysis. Insurance Services Office. Retrieved April 18, 2013, from https://www.citizensfla.com/about/mDetails_boardmtgs.cfm?show=PDF&link=/bnc_meet/docs/419/07AH_Citizens_SB408__Sinkhole__Analysis.pdf.

13 Florida Senate, ibid.

14 Ericksen, ibid.

15 Section 627.706 (1)(b), Florida Statutes. Retrieved April 18, 2013, from http://www.leg.state.fl.us/Statutes/index.cfm?App_mode=Display_Statute&Search_String=&URL=0600-0699/0627/Sections/0627.706.html.

16 Florida Office of Insurance Regulation (September 7, 2006). Press release: Sinkhole factor adoption will lead to consumer savings. Retrieved April 18, 2013, from http://www.floir.com/PressReleases/viewmediarelease.aspx?id=1480.

17 U.S. Geological Survey (March 11, 2013). The Science of Sinkholes. Science Feature. Retrieved April 18, 2013, from http://www.usgs.gov/blogs/features/usgs_top_story/the-science-of-sinkholes/.

18 Jamieson, A. (April 18, 2013). Sinkhole swallows three cars on Chicago's South Side. NBC News. Retrieved April 18, 2013, from http://usnews.nbcnews.com/_news/2013/04/18/17810648-sinkhole-swallows-three-cars-on-chicagos-south-side.