Dismal economics of apartments in the hurricane zone: even a relatively mild 2006 hurricane season can't help to shake the stubborn reality that risky environments create risky investments--and pricey insurance.

The hurricane seasons of 2004 and 2005 have rudely alerted the American people to the risks that nature's fiercest storms pose to life, limb and property. Though the frequency and severity of hurricanes has been rising steadily since the early 1990s--beginning with Hurricane Andrew's brutal assault in 1992--the four Florida storms of 2004 and Katrina's destruction of the Gulf Coast of 2005 have shaken Americans' senses of security against Earth's destructive power.

Addressing the Problems

Peace of mind has given way to anxiety in the face of even greater scientific evidence that global climate change is heating Earth's oceans, melting glaciers, slowing the Gulf Stream and altering weather patterns all over the world. Yet this evidence offers little by way of actionable intelligence about nature's rhythms because the pace of climate change is so uncertain, as is the connection between specific weather events and climate change, like the number, power and trajectory of Categories 3, 4 and 5 hurricanes. This uncertainty reflects the mind-bending complexity of climate systems, which pose daunting intellectual challenges that push against the frontiers of modern mathematics, physics, chemistry, economics and insurance. Uncertainty on this scale, when the possibility of calamity forces societies to make fateful and potentially ruinous decisions no matter what course is taken, leaves room for those who would use doubt as a pretext for inaction. Yet, the Economist magazine, no environmentalist rag to be sure, has it about right: The evidence of global climate change, and particularly global warming, is just too extensive to dismiss, calling on our nation--and all nations--to make wise investments in new institutions and technologies lest calamity become our fate, should the climate scientists' growing fears be even partly confirmed.

Insurers are especially anxious about the evolution of extreme weather in the hurricane zone, not only or even primarily because of climate change, but because the number of Americans living in the hurricane zone--from Massachusetts to Texas--is growing much more quickly than the nation's overall population. The U.S. Census Bureau estimates of population growth in the coastal states along the Atlantic and Gulf coasts between 2005 and 2025 (see table and chart, page 53) are a sobering prospect for insurers who note that the level of risk exposure for residential properties--single-family homes and apartments alike--to wind and flood damage is growing far more quickly in the hurricane zone than anywhere else. More people and properties are subject to hurricane risk by virtue of population migration, land use policies, economic incentives and building patterns over the next few years even if global climate change turns out to be a gigantic scientific error--an unlikely prospect--and there were no change in the frequency and destructive power of hurricanes. Alarm about the growth of populations residing in the American hurricane zone extends to climate scientists who are skeptical of the scientific consensus in the matter of global warming.

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The insurance Dimension

The economics of apartments and insurance are both driven by economies of scale, that marvelous property wherein the per unit cost of providing a good or service falls as the number of units sold rises. An apartment building is an efficient way to provide shelter because a large number of people can share a common footprint and set of facilities, thereby permitting a builder to reap the benefits of lower primary production costs per unit. Buyers, too, reap rewards from this feature because they can indulge their tastes for special amenities that might drive costs up too much but for the fact that they often share basic costs with other residents of a property, such as heating, cooling, water and power infrastructure.

Insurance exhibits economies of scale by collecting and ranking risk policyholders in ways that permit the cost of financial protection to fall as the number of people and the amount of property covered increases. When insurers provide coverage to large numbers of people and properties whose risks of loss are independent of each of other--or in the parlance of probability and statistics, uncorrelated with each other--they create a situation in which the likelihood of large numbers of simultaneous losses is reduced, thereby permitting insurance premiums from the whole pool to cover most, if not all, losses suffered by a small fraction of policyholders. This spreading of risks is the key to insurance.

Unfortunately, the collection of people into apartments within the hurricane zone poses severe problems for insurers, who are already quite leery of the escalating loss exposures because of population growth along the Atlantic and Gulf coasts. The primary determinant of the cost of insurance is the frequency and severity of losses, whether the losses in question are because of automobile accidents or windstorm damage. Insurers faced with larger numbers of people and property at risk will expect a larger number of claims, but not necessarily an increase in the size of the average claim, so long as the odds of any particular type of property loss is unchanged or the replacement cost of property is unchanging. However, any pattern of real estate development that increases the concentration of people and property in apartment buildings in a risky environment is bound to boost insurance premiums because the probability of large numbers of simultaneous losses must rise: The risks of loss are no longer independent because more persons and their possessions are concentrated. Clustering populations along the hurricane zone is an especially risky development program precisely because more people and things lie in the path of an escalating peril.

Does the mild hurricane season of 2006 mean that insurers have reason to reduce their premiums in the hurricane zone? No. Insurers will set premiums on the basis of likely losses, which in turn depend on the historical patterns of risk they have observed in particular regions characterized by different population densities, property configurations, building codes, investments in public infrastructure and water/flood management systems, emergency management procedures and other forms of public capital and competence. The comparatively mild hurricane season of 2006 is perfectly consistent with a gradual escalation in the frequency and severity of hurricanes for the same reason that a .350 hitter in baseball can experience a prolonged hitting slump: In each case, the observed slump is an aberration from a persistent pattern reflected in the average. Hurricane frequency and loss estimates are projected averages based on historical experience, profound and sophisticated science and mathematics, multidimensional computer models requiring tens of thousands of lines of code and subtle programming skills. The price of risk reflected in insurance premiums is, and must, rise along the hurricane zone because greater amounts of property are at risk in even greater concentrations, not least in places where apartments prevail.

No Free Lunch

Economics is called the dismal science for many reasons, not the least of these being that its primary---and unwelcome--lesson is that nothing is free. Apartment development within the hurricane zone in a time of escalating storm risk because of climate change will force insurers to charge higher prices that reflect those growing risks. The vast bulk of property insurance for residences in the United States is provided via private markets, on the theory that the market mechanism is quite capable of properly pricing risk. If government regulations make it impossible for companies to charge a premium that reflects risks while earning a reasonable return because the price of coverage puts a substantial squeeze on family budgets, the supply of private insurance will dry up. If the public sector steps in to provide insurance protection for property in hurricane zones (like Florida's state-run insurance system, which covers properties that private insurance markets shy away from) then somebody must pay for the losses incurred when larger populations experience storm losses.

The simplest way to spread these losses might be to tax everyone in a state to cover losses, though this procedure is clearly unsustainahle because it is unfair to those who do not live in the hurricane zone, especially if coverage is provided without means testing so that well-off people living in risky areas are subsidized by the less affluent who live out of harm's way. Or governments can simply borrow money now to pay for losses that are pushed off until later because government borrowing for any reason is just delayed taxation. Of course, the costs of either current or delayed tax supported insurance schemes will grow with escalating climate change risks and larger coastal populations, putting even greater strains on limited state budgets that must already cope with escalating health, education, public safety, infrastructure construction and repair and other assorted costs. Then again, apartment owners could shoulder the burden of increased risks by paying for hardened residences that can withstand the wind and water damage associated with storms--though coastal living will be much more expensive and coastal populations much smaller.

In the end, the risks associated with larger and more concentrated populations in America's hurricane zone will rise as time passes, requiring someone--property owners, current tax payers or future tax payers--to foot the bill. Property owners in vulnerable states like Florida frequently express bitterness about the rising cost of insurance and demand that the government "do" something about this problem. This is a foolish demand because it presumes that insurers are pirates taking advantage of a situation of greater risks--or even that insurers are manufacturing fear to earn extraordinary profits at the expense of homeowners. But Florida's insurance markets, among the most competitive in the nation, would punish any profiteering insurer with failure as customers flee to insurers offering the lowest possible prices given the risks involved. Prices in Florida and elsewhere are rising because risks are rising. Government controls on insurance prices cannot dodge a stubborn reality: Risky environments impose costs on property owners, or on governments that subsidize residency in those environments.

The dismal science only reflects the dismal aspects of a risky world.

Marcellus Andrews Ph.D. is an Economist with Insurance Information, Institute. He can be reached at [e-mail].

Projected Growth of Coastal States' Population
in Hurricane Zones, 2005-2025

New England               7.54%
  Connecticut             6.52%
  Maine                   7.68%
  Massachusetts           7.86%
  New Hampshire           9.85%
  Rhode Island            6.02%

Mid-Atlantic              6.12%
  Delaware                2.07%
  Maryland               12.03%
  New Jersey              9.64%
  New York                2.99%

Southeast                15.67%
  Florida                27.22%
  Georgia                 8.78%
  North Carolina          7.67%
  South Carolina          9.16%
  Virginia               11.87%

Gulf Coast               20.05%
  Alabama                14.64%
  Florida                27.22%
  Louisiana              13.47%
  Mississippi             7.56%
  Texas                   8.91%

Source: U.S. Census Bureau