Fixed indexed annuities with Market Risk Benefits
This paper focuses on the cash flow modeling aspects of Market Risk Benefits on fixed indexed annuities contracts, especially the methodology for projecting indexed account growth.
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Rebecca Driskill: Hello and welcome to Critical Point. My name is Rebecca Driskill, and I’ll be your host for today’s podcast. If you’ve watched the news recently, it will come as no surprise that flooding has become a major issue for communities across the country. On our episode this morning, we’re going to be talking about the future of flood insurance and what protecting your home against flood could look like a few decades from now. At Milliman, we have some of the country's foremost experts on flood risk. Nancy Watkins is a principal and consulting actuary and serves on the American Academy of Actuaries Flood Insurance Workgroup. John Rollins is a consulting actuary based in Tampa, and the former chief risk officer for a large state-backed insurer. Good morning to you both.
Nancy Watkins: Good morning.
John Rollins: Good morning.
Rebecca Driskill: So let's just start Flood Risk 101. What is it, and what's the biggest public misconception about flooding?
Nancy Watkins: In the insurance context, flood is water that enters your home from the ground. That’s a non-technical definition. There are types of water intrusion that would typically be covered by homeowners insurance, such as a leak in your roof. But if the water enters the home rising up from the ground, whether it comes from rain, whether it comes from the ocean, whether it comes from a rising river, that is considered a flood.
Rebecca Driskill: Great. And just from a consumer standpoint, John, you were talking there are some sorts of public misconceptions out there about flood risk and flood insurance that the public needs to know about.
John Rollins: Very much so. So most consumers know that their insurance policy covers fire, covers water leaks from the inside of the home, and so on. But many think erroneously that their policy covers floods, rising water from outside, and that's a big misconception. They have other misconceptions as well, which are related. One of those is that they might not need flood coverage because they don't see floods around them very often, and perhaps their insurance agent or their mortgage banker has told them you are, quote, "Not in a flood zone, so you don't have to buy flood insurance." Well, not having to buy something doesn't mean you shouldn't buy it. So that's another misconception. And even if you can get past those two misconceptions, the very fact that disaster aid is highlighted after major flooding disasters is itself another misconception because it brings the consumer to a natural state of saying, "Well, my neighbors got assistance, or my fellow Americans in another state got assistance after a previous flood. Therefore, if it happens to me and I don't have insurance, I'll get it, too." And finally, many people just think it costs too much.
Rebecca Driskill: And so right now, the majority of Americans get their insurance through the NFIP, the National Flood Insurance Program-- that's correct, right?
Nancy Watkins: The majority of people who have flood insurance have purchased it from the NFIP whereas the vast majority of single-family homeowners have no flood insurance at all.
Rebecca Driskill: Why do we get flood insurance through a federal program and not through private companies?
Nancy Watkins: When the NFIP was created about 50 years ago, flood was considered an uninsurable risk by the private industry. The nature of the risk varied over very short distances. So within one neighborhood block, you might be able to find that there are houses that are up high on the street that were less risky than the houses that maybe were downslope construction or lower elevations on the street. So people would know their flood risk, but insurers would not know their flood risk because we didn't have the kinds of maps and data and computing power that we have now.
The other problem with flood was that one event could create extremely high losses. And so an insurance company could have its solvency threatened by offering flood insurance. They might not be able to pay their obligations to their policy holders. So as a result of the private industry's not being able to cover the catastrophic risk of flood, the NFIP was formed. Over time, the requirements for the NFIP have changed, but the major source of policies within the program would be from people who were required to buy flood insurance. They would typically find out that they were required at fairly non-frequent times of their lives, such as when they were buying a house or refinancing a mortgage. So over time, insurance companies have gone away from wanting to offer and pushing flood insurance as a desirable thing for everyone to buy, until quite recently.
Rebecca Driskill: Yeah. Can you guys both talk a little bit about what's changing now that is creating more of a market for private insurers?
Nancy Watkins: When I first started getting interested in flood insurance, it was after Superstorm Sandy, which was an event that pushed water onto the shore, which insurers did not think that they were required to cover, even within the homeowners policies. And then wind, which also created damage to the home. It's a very bad situation for a person who's paid their homeowners insurance premiums and thinks that they're covered to have an adjuster say, "We'll only pay 60% of your claim," or "Thirty percent of your claim because the rest was caused by flood and we don't cover flood." It's also a bad situation for an insurance company who is in the business of taking premiums and paying claims and wants to keep their policyholders happy, and wants the regulators to be happy with how they operate in the market, to have to continually say, "No, we are not required to cover that claim." The entire dynamic is fraught with conflict. Even if a person had bought an NFIP policy, they might have two adjusters who disagreed on what percentage was from wind and what was from water. And they might also have gaps in coverage because the NFIP's policy is typically not as rich as private insurance would be in terms of coverage. So I remember being on a panel at that time, and saying, "Wouldn't it be great if the insurance industry figured out a way to offer flood coverage to all their homeowners policyholders?" And the other panelists said, "That'll never happen. The NFIP's rates are too low. The NFIP loses money. We don't want to lose money. If we want to pick up policies, we have to be cheaper than the NFIP, so it will never happen." But what did happen was Biggert-Waters. Congress tried to get the NFIP's financial soundness more towards what they call an actuarially sound equilibrium, which meant raising rates. And that signal from Congress created some hope, I think, from some entities that there might be a flood market after all. So after that, investors started creating catastrophe models, which had not existed in the past-- generating data which had not been available in the past. And making it possible for companies to start managing and measuring the flood risk the way they had other catastrophic perils like wildfire, like tornadoes, like hurricanes. So that was probably five or six years ago that things really started to change. And everything's kind of snowballed since then.
Rebecca Driskill: Yeah, I mean, I think, John, you had some numbers. What trends are we seeing in the market? Is there growth in the private flood market in the past couple years?
John Rollins: Yeah, there's a lot of growth. It started in my home state of Florida. And at this point, there are over 20 private flood programs approved for use in Florida. I have a slightly different story about how the private market got so big and why in a state like Florida, which is after all a very risky state for floods, and has nearly 40% of the federal government's flood policies in it, why would that be an epicenter? You might think private flood insurance would start in Nebraska, not near the river, or some place with very low risk. But it turns out that capital is attracted to risk. And it turns out that capital is attracted to problems the government is having trouble solving.
And what I mean by that is when Biggert-Waters passed, we observed it in Florida. I was working in windstorm insurance at the time, but I started getting calls from realtors, from local state legislators and so on saying, "What will this mean for us?" And I looked at bill and I said, "Well, it means a lot if you're selling a home because if you're with the federal government's National Flood Insurance Program, and you stay with it, you don't really have a problem because your rates are not going to skyrocket. However, if you turn and sell your home, and the new policyholder now has to be underwritten again, the protections that were in place would have gone away."
And so the realtors said, "But there's got to be a better way. What do we do?" And a lot of discussion ensued about creating a government facility in Florida, for example, to ensure floods and so on. But we had recently had very successful experience de-risking a government program, the Windstorm Government Program, Citizen's Property Insurance, and so the prevailing political mood was if the government is having trouble solving this problem, and the government is going to essentially make our lives miserable in the realty business by making it harder to sell a home, maybe the private sector can help us.
So there was sort of an alignment of legislative and regulatory sentiment in the risky states that said, "Maybe it's worth trying something else if the NFIP is not serving the people who elected us." And at the same time, a lot of technology and data and computing power was advancing and putting many private sector actors in position to become part of a value chain that had never been built before for underwriting, managing, and analyzing private flood insurance. And in fact, as Nancy said a few moments ago, the Biggert-Waters bill actually required the answers to unanswerable questions. At the time, there were no flood catastrophe models. And so when Congress mandated that the NFIP report on its one-in-a-hundred-year flood loss and how much that would cost the taxpayer, they had no way to do that because the technology hadn't been built yet. So the catastrophe modeling firms and other analytic spenders responded to that process by building models and then trying to find a way to get paid for selling those answers to both the federal government and many of the private sector players that wanted to come along in some of the risky states. And so that confluence of events coupled with just a general consumer awareness, because of so many floods, like the severe floods we saw in Superstorm Sandy, kind of all came together and the forces aligned toward private market involvement, which starts in these risky areas where the solution is most needed right now. And as we've seen, it has spread to some other areas up and down the Atlantic Coast, and now into the interior of the country as well.
Nancy Watkins: I see the evolution of the private flood market as a hero's journey. At the beginning, you can just see our hero, and there's absolutely no chance he's getting where he's supposed to go. The NFIP first is, "The rates are too low. I can never compete with the NFIP." And then Biggert-Waters changed, not necessarily the NFIP's rates, because they actually mostly rolled back Biggert-Waters subsequently, but just signaled that the NFIP was going to evolve, and that signal was enough to create interest.
The next thing was the catastrophe models and the ability to measure the risk. Once that was behind our hero, the next big question was, "Will the reinsurers want this risk? Will we be able to manage our aggregation of risk as insurance companies from flood, especially because some floods are going to make the hurricane losses even higher? They will be correlated with hurricane events in areas that are exposed to hurricanes." So there was a question about whether the reinsurance market would be in this for the long haul. But the reinsurers have really been taking the lead. Multinational entities who have the capital, have the expertise, have reinsured flood and other parts of the world, really want this big market, this untapped potential to do what they do in the United States. And so they have really stepped up and showed leadership in putting new programs and products out on the market. I think the next big question or obstacle for the hero was whether lenders would accept private flood as being an acceptable substitute for the National Flood Insurance Program. That seems to have just worked itself out through a combination of time and some congressional clarification that has taken place over the last few years.
I think the next big issue is state regulation. We still have most of the companies that are very big in homeowners insurance not offering flood as just a normal add-on to their policies. I think that the reason that most homeowners are not buying flood is that most homeowners insurance agents are not selling it to them. There are a lot of people who could probably get a policy for a few hundred dollars, or maybe even less added on, or an endorsement added onto their insurance policies if their homeowners insurers thought that was desirable. My hope is that between the new players entering the market, creating better coverage that will be attractive to consumers and between the leadership of FEMA in putting out Risk Rating 2.0, which is going to be a much more sophisticated view of risk, that the larger companies will feel more comfortable with this risk, and state regulators will understand the risk better and regulate it differently from homeowners, which I think will be important to give the large insurers a feeling that it's worth the effort to develop this product and put it out on the street.
Rebecca Driskill: Because who is the target customer here? Will private insurers want to cherry-pick existing homeowners that are part of the NFIP?
Nancy Watkins: I think the target customer is usually people who don't have flood insurance. Over 80% of homes in the country -- who could be paying more premiums, which from an insurance company perspective is typically desirable, and having much better coverage, which from a consumer perspective is also desirable. So if a company that's offering homeowners policies in all 50 states perceives that five of them are good places to do business for flood, that's not a lot of incentive. If they think 45 of the 50 states are good, well, that's a lot more incentive. If they think that the states are good places for them to do business now, but they're not sure what's going to happen three or four years from now when the market matures a little bit, that's going to disincentivize them. One of the reasons that Florida's been so successful is that the Senate bill John was talking about that encouraged private market investment actually put a timeline on its provisions.
John Rollins: Essentially as long as the legislature still feels like the flood insurance experiment is on the right trajectory in Florida, they can—politically, it's much easier to extend a sunset date than it is to come up with a brand new idea on a whiteboard and pass a new law. So that's been a little bit of ingenuous bit of political mechanics that's gone along with giving the business community a lot of certainty in that state. And I think other states could potentially learn from that approach, though they certainly don't have to adopt it as a whole. And I think that's something Nancy's very passionate about.
Nancy Watkins: I like the use of the word "experiment." It really kind of crystalizes what's going on. I mean, these flood catastrophe models that we're talking about are definitely the best science for measuring a changing risk that has fairly low frequency and high dollar amounts. But the models are, by and large, new and have not been used for very long. And models have to get broken in. When users find anomalies, they report them to the modelers and the modelers investigate them, and they try to recalibrate and fix and upgrade. And over time, the models get better and better. I mean, think about self-driving cars. They're not perfect the first time out. So the only ways for the models to get better is to be used.
However, the companies who are relying on these models to set their initial rates and their underwriting strategy and figure out how to monitor their portfolios don't have much experience in this market, and so they need to be able to change. They need to be able to change their rates, to change their underwriting strategy. I imagine most companies don't want to go into a market and then pull out wholesale. That's a very-- that's kind of a black eye if you're an insurance company. And it's definitely a financial investment that typically doesn't work out the way you want it to. So if they want to stay in a market for the long haul, they need to be able to evolve very quickly. And that's where I said state regulation makes it very difficult because many state regulations that are currently being applied to flood evolved over many years to suit the homeowners market, which is things like fires and dog bites, and you know, leaks of your washing machine, things that are different for insurance companies to manage. So these regulations might unwittingly make it difficult for companies to evolve. That's why I said it's the next obstacle on our journey.
Rebecca Driskill: Let's play futurist for a second, and talk about what the flood insurance market could look like, 20 years from now, given the past couple weather events that we've seen if they continue to mirror what's happened the past couple years or get worse.
Nancy Watkins: Well, it's possible that there are some areas that will be very difficult to find insurance for. And the government is likely to have to make decisions about what to do with those communities if they flood so regularly that they're deemed non-insurable by the private industry, then there will be decisions to be made. My hope is that entities like FEMA, and hopefully partnering with the insurance industry, can anticipate this over time, and be able to show scenarios with sea level rise that are realistic, that allow policy makers to work with communities and figure out what are the best plans. Should there be new levies? Should there be new sea walls? Should the homes be elevated? Should some areas be vacated? I mean, there will need to be reality-based discussions about what's the best option.
From an insurance perspective, what would be great is if communities and individual homeowners had a clear understanding of the cost and benefit of different mitigation actions. And not just for next year, but for the life of a mortgage or the life of a bond to pay for urban infrastructure-- like if you spend a certain amount on a sewer system upgrade, how much water will be displaced? And if you paid twice as much for a bigger upgrade and displace more water, what will that do to your anticipated flood in your city over time? I'm hoping that there can be a way for communities to make those decisions without reinventing the wheel every time. Through…I'm going to say public/private partnerships between entities like FEMA and the experts that serve the government and serve the private industry to be able to work together and come up with efficient ways for people to make good financial decisions for the long term.
John Rollins: Well, Nancy discussed mitigation extensively, and I agree with her that one of the keywords associated with the flood insurance policy 20 or 30 years from now is definitely going to be mitigation-driven. I guess that's two words. But if you ask me to sort of play, "I'm going to write an episode of the Jetsons now, give you a wonderful peek into the future of flood insurance," in addition to the policy itself incenting mitigation for the consumer and for the consumer's community, I would say that the policy would satisfy another few keywords. It would be inclusive, right? It would be a package policy that covers most of the other common homeowners perils and flood. So it would solve the problem that Nancy originally talked about, which is that the inherent conflict between having multiple policies covering the same structure would be resolved.
It would be risk-aware, in particular climate-risk aware, because with all the mitigation actions that are underway now at the community and at the individual level, you have to ask yourself is it enough and what margin for error do we have in those actions if the climate is trending a certain direction. Right now, we've got multiple problems, right? We've got people running toward the risk, building homes in low-lying areas and on the coast, and the increased losses we've seen from these recent weather events have been partially just driven by current behavior. Running toward the risk is not a good idea when you're trying to mitigate risk.
But then you have the problem stacked on top of that of people are running toward the risk, and they're not thinking about what the risk might look like 20 or 30 years in the future when they're thinking about paying off that mortgage or when the community is paying off that bond that they issued to fund an urban improvement. So a sense of the uncertainty associated with climate, and whether you believe the climate is changing solely due to man's influence or through natural cycles of the earth, is practically irrelevant in answering that question. The right policy is to be on guard against uncertainty in the way you structure your personal view of risk and the way you mitigate that risk either through laying it off through insurance and/or through taking specific mitigation actions. So let's hope that the consumer and the business get more educated over that same period of time, and the private sector and government work together to provide them some empowerment in the form of tools to mitigate and lower their risk levels when it's cost effective.
Nancy Watkins: I'd also like to add there's a role for architects and engineers and landscape designers as well. There are so many things that could be done to get rid of water. Which is the real problem with flood through better landscaping, better design, more permeable materials. I think if more investments were to be made in those areas, that green building and flood-smart building were to become economical and part of every consideration, or every homeowners consideration when they're designing a new home, that could be another way of reducing losses before a property is even constructed.
Rebecca Driskill: So from a consumer perspective as this market emerges, what can be done to help raise awareness?
Nancy Watkins: I think consumers are never going to want to be insurance experts. There's a reason that kids don't grow up thinking, "I want to work as an actuary. I want to be in the insurance industry." That's just not the way that most people are wired, and I think that's fine. I think the insurance industry can do a better job of putting crucial information in front of people when they are making decisions.
Homeowners rely on experts for expert advice. And no matter how much easier you make it to buy insurance, I suspect that there's still going to be a need for experts in the transaction. Insurance agents and realtors are considered experts now, and I'd be surprised if they are not necessary experts in the future. So to have them well-informed about the current and future risk and able to talk with their customers about their options in an informed way will be a powerful benefit for consumers and for the country, too.
John Rollins: You know, it strikes me that as you said, Nancy, kids today, Generation Z may not want to grow up to be insurance executives. But I'll tell you what they do want to be, and that's influencers. If my teenagers are any guide, they want to be famous on YouTube, they want to be designing games, they want to be designing unique graphics. Everything is about having a brand. And so this generation is going to want to make sure that they are playing a key role in helping their communities thrive, their neighbors stay happy, their economies stay resilient against today's flood risk and maybe tomorrow's flood risk. And so I think a lot of this, as Nancy talked about the insurance agents, the realtors, they influence a lot of people. They influence these groups about what your risk is, what you can do about it, what the best action to take is and when the best time to take that action is. So I think some of this is about repackaging the work, and calling it what it is, which is an attempt to influence people's well-being, not only now but into the next phase, whatever that looks like and whatever climate we have to face and whatever demographics we may have to face.
Rebecca Driskill: So last question for you guys. I'm just curious, if you are buying a house, let's say you go out and buy a house tomorrow, what do you look at, what do you do to determine your flood risk in the house that you're buying?
Nancy Watkins: Well, I think I would look out the door. I would look and see how far away sources of water were and if the house is low-lying or high-lying. I would certainly ask if the house had any prior flood claims. I think I would definitely talk to the insurance agents about the area and find out if other houses nearby had flooded. But I will say, it's pretty hard right now. FEMA has not solved the problem of reporting prior flood claims without violating the protected information of individuals. It would be good if there were a source of information about prior flood claims on a house so that people aren't surprised when they are putting in the fourth claim. Maybe that's another thing in our future projection is that individuals could get-- just like you can get your own credit score, you could get your flood score and understand what it means with respect to risk.
John Rollins: Well, I'll tell you what I would do, if the notion hit me to understand my potential flood risk as I was walking through a house I wanted to buy. I would do, again, what my teenagers do-- press the button on my phone and say, "Hey, Siri, how do I assess my flood risk at this address?" And an answer would come back, right? And today that answer is, as Nancy said, is maybe not very satisfying because we're talking about catastrophe models and large-scale technology that's sort of locked up, and we're talking about an imperfect understanding of the prior data on what happened to that house. But that in itself is changing rapidly. So perhaps we won't get a privacy-protected claims record on that house, but we might get an algorithmic process of a Google street view photo of that house that tells me something about the elevation of that house, the profile of that house relative to its neighbors, and maybe other commercially or publicly available information that can be synthesized to give me an answer. And this generation is going to want that answer on demand when they press a button and when they ask a question. And the logical next step is to say, "You have the answer. Now do you want insurance for it?"
Nancy Watkins: Right, I mean, when you buy a car, you definitely want to know if it's been wrecked before. And I think you're entitled to know that. I don't see anything different with respect to buying a house. In fact, I think it's even more important-- the investment is much bigger.
Rebecca Driskill: Those are some really good points. Thank you, Nancy and John, for joining me. You've been listening to Critical Point, presented by Milliman. To listen to other episodes of our podcast, visit us at Milliman.com or you can find us on iTunes, Google Play, Spotify, or Citrix. See you next time.