Living benefit riders to life insurance policies: Pricing considerations and strategy
Adding benefit riders to policies provides meaningful coverage for those who need it, and carriers usually can do so at a relatively low cost.
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:
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.
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
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.
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%20Library%20Documents/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.
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.
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.
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.