Thursday, May 9, 2013

What does Citizens do?

Recently, I have noticed insurance literature referring to Citizens as the "so-called" residual market mechanism   This conjures memories of a Manic-Panic punk-red, Claire Daines lamenting her So- Called Life.  It is the same situation.

The angst ridden, fictional teenager, Angela Chase, felt she had little control over her daily coming and goings.  What was supposedly her life, to live guided by her own expectations, was heavily influenced by the decisions, wants, and needs of those around her.

Insurers believe they should have control of Florida's residual market mechanism (RMM) as a tool to stabilize the property insurance market.  Their decisions ought to dictate what risks are put into the RMM and at what cost.  A so-called situation arises when insurers feel that the RMM has fallen out of their control, overtaken by the decisions, wants, and needs of others.  Hence, the tragic angst regarding Citizens, the so-called RMM.

Despite teenager and insurer disgruntlement, many saw Angela Chase as a bright promising young adult, similar to those that appreciate Citizens as a saving grace.  In order to understand the dissatisfaction with Citizens, we must first understand what it is intended to do...

Fundamentally, Citizens controls probabilistic "tail risk" by providing coverage for the stuff that insurers don't want because they think it is too risky.  In other words, it "caps" the private market risk.  As a state run entity the tail risk becomes the public's responsibility.  The controversy comes from deciding where the tail begins and how thick is the tail.

Below is a generic probability distribution of losses.  The graph shows a high probability of small loss with gradually lower probability of large loss.  When Citizens sets its rates, it inadvertently designates the tail because the price an insurer can charge is a limiting factor of the amount of risk they can take.  Where decision makers draw the line between private market risk and RMM tail risk is arbitrary, negotiable, and controversial because it defines winners and losers in society.

Claims made about whether or not Citizens is truly an "insurer of last resort" speaks to this negotiation about the tail.  If an insurer believes that the unwanted tail risk begins at the blue arrow, then Citizens rates at the purple arrow will appear unfairly competitive.  Citizens does this to help control policy cost in the (very) short run.  However, the decision may be at the sacrifice of public long run benefit because the public gets stuck with more large loss risk.

But we also have to decide the thickness of the tail or rather, how quickly the probability of large loss diminishes... that is, if it diminishes at all.  The below graph shows a "fat tail," where the probability of big losses is greater than that in the above graph as well as non-diminishing.  With the fat tail, there is a relatively substantial probability that really big loss, (limited only by your wildest imagination) will occur.
Fat Tail
Choice of tail thickness has implications for how wise or good a rate decision appears to an onlooker.  If one believes to have information that indicates a thick tail, then the decision to make rates based on a thinner tail would appear to be willful ignorance.  On the contrary, those that believe the tail to be narrower view those peddling a thicker tail to be exaggerating the uncertainty.  In both cases, either party waves their modeled information around and looks to the other as being foolish at best, and manipulative at worse.  

Dissatisfaction arises because all conflicting opinions involved believe to be doing the public a so-called favor.

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