Homeowners Insurance: Multiple Challenges Make Expanding Private Coverage Difficult
Released: 2014-01-30T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: Homeowners insurance protects against a range of perils, but policies do not insure against all risks. Owners whose homes are damaged by natural and other disasters not covered by their insurance can be exposed to serious financial losses. Federal and state initiatives provide some assistance for catastrophes, which can involve significant taxpayer expense. With coastal populations growing and the possibility of more frequent and severe weather, more homeowners could experience heavy losses not covered by homeowners insurance, putting increasing financial pressure on government programs and thus on taxpayers.

GAO was asked to study the possibility of private insurers providing more comprehensive insurance. This report addresses (1) what perils homeowners policies typically cover and exclude, (2) how exclusions impact homeowners and taxpayers and the potential benefits of more comprehensive coverage, and (3) what additional perils insurers might be willing to cover and what challenges are associated with expanding policies. GAO reviewed homeowners insurance policies and conducted interviews with the National Association of Insurance Commissioners, other industry organizations, consumer advocates, and risk experts, among others.

GAO requested comments on a draft of this report from the Federal Insurance Office and the National Association of Insurance Commissioners. Both provided technical comments which we incorporated into the report as appropriate.

section_title: What GAO Found
paragraphs: Homeowners insurance policies typically protect homes, garages and other structures, and personal belongings from damage caused by perils such as fire, hail, lightning, explosion, and theft, among others. The insurance industry considers these perils insurable because they are accidental, predictable, and do not involve catastrophic losses. These policies also typically exclude losses from a number of perils, including disasters caused by floods, earthquakes, and war. Industry officials said that such events are difficult to predict and involve extensive losses that are a challenge for private insurers to cover. Insurers also exclude losses from defective products, which industry participants said could be addressed by manufacturer warranties and commercial general liability insurance. Intentional losses; damage from wear, tear, or neglect; and losses caused simultaneously by covered and uncovered perils, such as wind (covered) and flood (uncovered) during a hurricane are also generally excluded.

Policy exclusions can impact homeowners, communities, and state and federal governments. When excluded losses occur, they can create significant costs for homeowners to repair homes and replace possessions. Wide-scale catastrophes can also cause shortages of building materials and contractors that delay reconstruction and substantially increase the costs of repairing homes. When damage to properties caused by excluded losses is not repaired, affected communities may experience blight and face reduced tax revenue. When federal and state governments have stepped in to cover what private insurers exclude, taxpayers may face a significant expense. In addition to federal disaster assistance, the National Flood Insurance Program (NFIP) paid more than $7 billion in claims after Superstorm Sandy. In Florida, insurers and policyholders can be assessed extra charges to help pay for state efforts to cover wind damage where it is not covered by insurers. Industry participants suggested that expanded private coverage could provide additional protection for homeowners and reduce reliance on government programs, but the resulting policy premiums would likely be prohibitively expensive for many homeowners.

Multiple factors make expanding private coverage challenging and several conditions would need to be addressed for insurers to offer more comprehensive insurance. A main challenge is that expanded coverage would have higher costs, potentially limiting consumer demand. Even if insurers charged higher rates that were based on risk, the severity and unpredictability of catastrophic losses could still jeopardize insurers' solvency. Some industry participants said that insurers and others are discussing possibilities for expanding private homeowners coverage, with a focus on risk-based premiums, mitigation efforts, effective building codes, and sound land use policies. The challenging mix of financial risk, political and regulatory issues, policy cost, and consumer demand has thus far prevented private sector insurers in the U.S. from offering flood insurance to homeowners, let alone more comprehensive or all-perils policies. Because of this mix of factors, some in the insurance industry have suggested that a continuing financial role by federal and possibly state governments may be required, and that ensuring a response to the impact of disasters and other perils will require the cooperation and resources of government, homeowners, and insurers, as well as balance in the assumption of risk and cost by each of these parties.

section_title: Letter
paragraphs: Homeowners in the United States are exposed to a wide range of  disasters, including hurricanes, earthquakes, floods, and wildfires, and  may also experience losses from lightning, hail, and fire, among other  perils. When these and other catastrophes occur, they not only devastate  individuals and communities by destroying homes and other possessions,  but also have a significant financial impact on homeowners, insurers, and  state and federal governments. Superstorm Sandy, for example, caused  over $18 billion in privately insured property losses, according to industry  estimates, and the Federal Emergency Management Agency (FEMA) has  paid more than $7 billion in claims through the National Flood Insurance  Program (NFIP).

At the same time, the population of coastal states facing possible weather  risks such as floods and hurricanes is growing. As of 2010, approximately  39 percent of the nation’s total population, approximately 123 million  people, lived in coastal counties, a 39 percent increase since 1970. As of  2012, properties in hurricane-prone areas on the coast had an insured  value of about $15 trillion, with Florida, New York, and Texas having the  greatest risk exposure. In addition to floods and hurricanes, some states  such as California face risks such as earthquakes and wildfires while  Florida faces risks from sinkholes. With more people moving to coastal  areas, the possibility of more frequent and severe weather could impact  the ability of homeowners and insurers to protect homes and other  property. These and other risks underscore the importance of insurance  to help protect homes and property from various hazards. Homeowners  insurance, however, does not cover all types of perils and some  homeowners may not clearly understand what protection their policy  includes and excludes until after an event occurs. Homeowners count on  insurance to help rebuild their lives and minimize financial burdens and  may suffer severe losses depending on the type of peril and the coverage  offered in their policies.

In light of recent concerns about homeowners’ ability to protect their  assets, GAO was asked to examine issues associated with the possibility  of more comprehensive homeowners insurance. This report addresses  (1) the perils homeowners policies typically cover and exclude; (2) the  impact of exclusions on homeowners, communities, and taxpayers and  the potential benefits of more comprehensive coverage; and (3) the  additional perils insurers might be willing to cover and the challenges  associated with offering expanded coverage. To do this work, we  reviewed a standard homeowners policy from the insurance industry and  policies from select property/casualty insurers that were chosen by  market share based on premiums written and participation in different  geographic markets. We also interviewed insurance industry association  officials, consumer advocates, and academic experts. Further, we  interviewed selected state insurance regulators from states that  experience major perils such as floods, hurricanes, and earthquakes,  among others. Finally, we obtained information from a panel of insurance  experts who participated in a roundtable discussion on issues associated  with private insurers’ willingness and ability to cover floods and other  natural catastrophes. We discuss our scope and methodology in more  detail in appendix I.

We conducted this performance audit from December 2012 to January  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Homeowners Insurance Policies
paragraphs: Homeowners insurance provides consumers with financial protection  against unexpected losses. Most homeowners policies provide a package  of coverage that protects against damage to different types of property  and liability for injuries and property damage policyholders cause to  others. The following are the main types of coverage:

Dwelling. Pays for damage to a house and to attached structures,  including plumbing, electrical wiring, heating, and permanently  installed air-conditioning systems.

Other structures. Pays for damage to fences, tool sheds, freestanding  garages, guest cottages, and other structures not attached to the  dwelling.

Personal property. Pays for the value of personal possessions,  including furniture, electronics, appliances, and clothing damaged or  lost even when they are not on the subject property—for instance,  when they are in an off-site storage locker or with a child at college.

Loss of use. Pays some additional living expenses while a home is  being repaired.

Personal liability. Pays for financial loss from lawsuits for injuries or  damages to someone else.

Medical payments. Pays medical bills for people hurt on the property  or by a pet.

Homeowners can purchase several types of insurance policies. These  policies differ based on the perils they cover (see table 1). For example,  named perils policies insure against losses caused by perils that are  specifically listed in the policies. Open peril policies are broader policies  that insure against losses caused by all perils, except those that are  specifically excluded. However, according to industry participants with  whom we spoke, currently no homeowners policies are available that  cover every possible peril a homeowner could face.

In addition to different policy types, homeowners may choose between  three different levels of coverage for their homeowners policies. These  options are:

Actual cash value. This type of coverage pays to replace the home or  possessions after deducting for depreciation. Value is determined by  taking into consideration the age of the home and wear and tear.  This level of coverage may not be enough to fully repair or replace the  damage.

Replacement cost. This type of coverage pays the cost of rebuilding  or repairing the home or replacing possessions, up to the coverage  limit, without a deduction for depreciation. It allows for the repair or  rebuilding of the home by using materials of similar kind and quality.

Guaranteed (or extended) replacement cost. This option is the most  comprehensive and expensive. It pays a certain percentage, typically  20 to 25 percent, over the coverage limit to rebuild the home in the  event that materials and labor costs increase as a result of a  widespread disaster.

The HO-2, HO-3, and HO-5 policies typically provide replacement cost  coverage on the structures. Contents coverage under homeowner  policies is typically provided on an actual cash value basis, unless the  replacement cost option is purchased. The HO-8 typically provides  coverage for older homes on an actual cash value basis. Full replacement  cost policies may not be available for some older homes.

section_title: Cost of Insurance to Homeowners
paragraphs: Several factors affect the premiums consumers pay for their homeowners  policies, including the type and characteristics of the home. For example,  homes that are primarily brick or masonry typically have lower premiums  than wood frame homes, and older homes and homes in poor condition  tend to have higher premiums than newer homes and homes in good  condition. A homeowner’s characteristics, such as a history of filing  claims, and choices, such as the dollar amount of coverage selected, may  also impact the premium cost. Other factors that impact the premium cost  include the degree of exposure to catastrophes (such as hurricanes or  earthquakes), the type of protection devices in the home (such as  sprinkler or security systems), and the type of structures on the property  (such as swimming pools or trampolines).

In addition to paying premiums for their insurance policies, homeowners  generally have to pay a deductible when they file a claim—that is, an  amount of money a policyholder must pay before an insurance policy will  pay for a loss. The deductible applies to both home and personal property  coverage and is paid on each claim. Higher deductibles generally mean  lower policy premiums. In some locations, there are also catastrophe  deductibles that a homeowner must pay when a major natural disaster  occurs. They are expressed as a percentage of a claim instead of an  insured amount.

section_title: State Regulation of Insurance
paragraphs: Insurance in the United States is primarily regulated at the state level.  State insurance regulators are responsible for enforcing state insurance  laws and regulations, including through the licensing of agents, the review  of insurance products and premium rates, and the examination of  insurers’ financial solvency and market conduct. The insurance regulators  of the 50 states, the District of Columbia, and the U.S. territories created  and govern the National Association of Insurance Commissioners (NAIC),  which is the standard-setting and regulatory support organization for the  U.S. insurance industry. Through the NAIC, state insurance regulators  establish standards and best practices, conduct peer review, and  coordinate their regulatory oversight. NAIC staff supports these efforts  and represents the collective views of state regulators domestically and  internationally. NAIC members, together with the central resources of the  NAIC, form the national system of state-based regulation in the United  States.

section_title: Risk Management by Insurers
paragraphs: Insurers assume some financial risk when writing policies, but also  employ various strategies to manage risk so they can earn profits, limit  potential financial exposures, and build the capital needed to pay claims.  For example, insurance companies establish underwriting standards,  such as refusing to insure customers who pose unacceptable levels of  risk, or limiting coverage in particular geographic areas. Insurance  companies may also purchase reinsurance, or insurance for insurance  companies, to cover specific portions of their financial risk. For  catastrophic losses, insurers may also sell financial instruments such as  catastrophe bonds. Reinsurers use similar strategies to manage their  risks.

Both insurers and reinsurers must also predict the frequency and severity  of insured losses with some reliability to best manage financial risk. In  some cases, these events can be fairly predictable. For example, the  incidence of most automobile claims is predictable, and losses generally  do not occur to large numbers of policyholders at the same time.  However, some infrequent events, such as hurricanes, are so severe that  they pose unique challenges for insurers and reinsurers. The  unpredictability and sheer size of these types of events can result in  substantial losses that deplete insurers’ and reinsurers’ capital. If a  company believes that the risk of loss is unacceptably high given the rate  that can be charged, it may decide not to offer coverage.

section_title: Government Involvement in Homeowners Insurance
paragraphs: If the private sector will not insure a particular type of risk, the public  sector may create markets to ensure the availability of insurance. For  example, several states have established Fair Access to Insurance  Requirements (FAIR) plans, which pool resources from insurers doing  business in the state to make property insurance available to property  owners who cannot obtain coverage in the private insurance market, or  cannot do so at an affordable rate. In addition, some states have  established windstorm insurance pools that pool resources from private  insurers to make insurance for wind risks available to property owners  who cannot obtain it in the private insurance market.

At the federal level, Congress established NFIP in 1968 to provide flood  coverage to homeowners where voluntary markets do not readily exist.  FEMA is responsible for the oversight and management of NFIP.  Designed to help reduce the cost of federal assistance after floods, NFIP  may be the sole source of insurance to some residents of flood-prone  areas. Participating communities are required to adopt and enforce  floodplain management regulations, thereby reducing the risks of flooding  and the costs of repairing flood damage. Under the program, the federal  government assumes the liability for covered losses and sets premium  rates and coverage limitations. Like private insurance companies, federal  and state government insurance programs also collect premiums, but  their rates do not always reflect the risks that the programs assume, in  part because they are designed to keep insurance affordable for most  homeowners.

section_title: Policies Cover and Exclude Various Perils Based on Policy Provisions and Other Factors
paragraphs: Homeowners policies provide protections against a number of perils that  can impact individuals and families. Policies, however, do not protect  against all perils that homeowners could face. Various sections of a  homeowners insurance policy outline perils covered and those the policy  excludes. Policy provisions and other factors, such as location, can  impact the coverage insurers offer homeowners.
subsections: section_title: Homeowners Policies Typically Cover a Range of Perils
paragraphs: Homeowners insurance policies typically cover a range of perils and are  critical to providing financial protection against losses such as fire and  theft, among others. According to many industry participants, the  Insurance Services Office’s (ISO) HO-3 policy is the most commonly  purchased homeowners policy and outlines the typical coverage and  exclusions found in most homeowners policies. The HO-3 covers a  person’s dwelling or home and other structures—such as detached  garage, or shed—against all perils except those specifically excluded.  This is commonly known as “open perils” coverage. For possessions, or  personal property, the HO-3 covers only those perils listed in the policy,  typically the 16 outlined below in table 2. Insurers refer to this kind of  coverage as “named peril” coverage.

Private insurers determine which perils are insurable risks on the basis of  certain characteristics or criteria of the losses associated with them,  including the following:

Losses that are definite and measurable. The loss should be definite  or determinate in time, place, and cause, and the insurer must be  capable of setting a dollar value on the amount of the loss.

Losses that are sudden, random, and accidental. The loss must result  from chance and not be something that is certain to happen. If a  future loss were sure to occur, coverage would have to be priced at  the full value of the loss plus an additional amount for the expenses  incurred.

Losses that are not catastrophic. The losses should not affect a very  large percentage of an insurance company’s policyholders at the  same time in, for example, a limited geographic area. The losses  should be independent of each other in order to spread and minimize  risk. Additionally, the peril should not be so catastrophic that the  insurer would be unable to charge a sufficient premium to cover the  exposure.

Losses for which the law of large numbers applies. There must be a  sufficiently large number of homogeneous units exposed to random  losses, both historically and prospectively, to make the future losses  reasonably predictable. This principle works best when there are  many losses with similar characteristics spread across a large group.  The greater the experience with losses, the better insurers can  estimate both the frequency and severity of future losses.

When these criteria are generally satisfied, the insurer can add other  expenses and profits to the expected losses and determine a price that is  appropriate for the risk. Insurers may still decide to offer insurance for  risks that deviate from these ideal characteristics. However, as one or  more deviations occur, the ability of the insurer to estimate future losses  decreases, the risk increases, and the insurer’s capital is more exposed  to inadequate prices for the coverage that the insurer offers.

section_title: Homeowners Policies Also Exclude Other Perils
paragraphs: Despite covering a range of perils, insurers also exclude a number of  perils. Insurance companies may determine that a peril is uninsurable and  exclude it from an insurance policy by inserting a provision that excludes  coverage. These provisions can be located in different sections of a  homeowners policy. For example, the HO-3 contains a section titled  “Exclusions,” but other policy provisions that exclude coverage are  located elsewhere. Table 3 lists typical perils excluded under this section.

Other policy provisions that exclude coverage are located under “Perils  Insured Against” in the HO-3 policy. Under this section, which applies to  the dwelling and other structures, but not to personal property, damage  caused by certain perils will not be covered (see table 4).

Insurers exclude these perils from homeowners policies for various  reasons. According to some industry participants, some perils are  excluded because they do not meet the criteria for insurable risks. For  example, perils that result in catastrophic losses are generally infrequent,  high-impact events that are difficult to predict and measure. The chances  of these events occurring are difficult to calculate, and the losses can be  so large and simultaneously impact so many homeowners that they could  jeopardize a company’s solvency because the insurer may not have  sufficient capital to pay out the large number of claims. Examples of these  types of risks include flood, earthquake, war, and nuclear hazard.

Other risks are excluded because they could raise moral hazard issues if  they were covered and because they are not accidental. Moral hazard is  an increase in the probability of loss caused by the policyholder’s  behavior—for example, intentional loss, neglect, deterioration, and lack of  maintenance. According to some industry participants, if these risks were  covered, homeowners could, for example, neglect their roofs or not  address mold problems and then file claims for replacement and  remediation. Further they noted that these types of risks also fall outside  the realm of insurance because they are not sudden or accidental and are  generally unpredictable.

Some industry participants also said that homeowners policies list  defective products as exclusions for a couple of reasons. First, they said  that defective products are listed as exclusions because insurers would  find it difficult and impractical to evaluate the wide range of manufactured  products to determine the likelihood and extent of defects and price this  risk for policies accordingly. Second, they suggested that manufacturers  are responsible for defects in their products, and product warranties and  commercial general liability insurance can help affected homeowners.  For example, some homeowners affected by defective drywall may  receive compensation from settlements partly funded by commercial  general liability insurance policies held by companies responsible for the  distribution or installation of defective drywall. Additionally, some  homeowners impacted by defective drywall have filed insurance claims  through their homeowners’ insurance policies, and litigation in multiple  states will determine the extent to which coverage for this drywall is  covered by homeowners insurance.

section_title: Coverage Depends on Several Factors, Including Policy Provisions and Location
paragraphs: Certain provisions found in homeowners policies can also affect  coverage. Some industry participants cited as an example anticoncurrent  causation clauses. For example, under these clauses, if damage is  simultaneously caused by both an excluded peril (such as flood) and a  covered peril (wind), coverage is excluded for that loss. They noted that  these clauses presented a particular challenge for owners of coastal  properties when hurricanes occurred. Cases challenging the  enforceability of the anticoncurrent clause arose after the 2005 hurricane  season because damage to properties may have resulted from a  combination of high winds and flooding. According to reports, this clause  may similarly become an issue for homeowners in the aftermath of  Superstorm Sandy. In addition to the anticoncurrent causation clause,  policies may also contain conditions that policyholders are required to  comply with in order to maintain coverage. Under the HO-3 policy, for  example, homeowners must provide prompt notice to their insurance  company or agent following a loss and are also required to protect  property from further damage once a loss has occurred. Failure to comply  with these types of requirements may result in a loss of coverage.

In addition, the facts and conditions surrounding the loss event—including  the cause of the damages and court decisions—may also impact  coverage. For example, according to some industry participants, an HO-3  policy typically excludes mold damage. However, mold damage that is  hidden within walls or ceilings, or beneath the floors of a structure, that  results from the accidental discharge or overflow of water or steam from  within a plumbing or heating system may be covered, among other things.  Further, the HO-3 policy typically covers theft of personal property from a  home. However, theft in a home that is under construction, for example,  may not be covered. Court decisions may also impact coverage when  disputes between policyholders and insurers end up in litigation,  something that can take time to resolve. Ultimately, whether a loss is  covered in these cases may depend on how the court interprets the  policy. Following Hurricane Katrina, for example, some coverage disputes  raised the question of whether a policy’s flood exclusion language clearly  excluded a water-related event, such as storm surge, that caused the  damage at issue.

Coverage may also depend on where homeowners live and whether they  have purchased endorsements—optional coverage that alters a policy’s  terms and conditions that can be added at an additional cost—or have  other insurance policies. For example, homeowners policies typically do  not cover flood damage, but flood insurance may be available through  NFIP, depending on where a home is located. Additionally, private  insurers sometimes exclude coverage for wind-related damage to  properties in coastal areas, requiring policyholders to either pay an  additional premium for wind-related risks or purchase a supplemental  policy for wind-related damages. In such cases, this supplemental  coverage is typically provided by a state-sponsored wind insurance pool  that has been created to address shortages in the availability of private  insurance for wind-related risks. In Florida, for example, coverage is  provided through its state insurance entity, the Citizens Property  Insurance Corporation (Citizens).

Earthquakes and sinkholes are two other perils that are also typically  excluded from homeowners policies but that may be covered by a  separate policy or an endorsement in some states. In California, for  example, state law requires all residential property insurance companies  to offer earthquake coverage to homeowners. In offering earthquake  coverage, insurance companies can manage the risk themselves,  contract with an affiliated or non-affiliated insurer, or become members of  the California Earthquake Authority (CEA), a publicly-managed but  privately funded entity that offers residential earthquake policies.  Similarly, sinkhole coverage is typically excluded under the earth  movement exclusion found in standard homeowners policies, but in  Florida, the state requires insurers to offer catastrophic ground cover  collapse, which is a narrow form of coverage that protects against the  total loss of a home due to sinkholes. Florida does not require any other  sinkhole coverage to be included in homeowners policies, but insurers  are required to offer additional sinkhole coverage. Homeowners in some  states may also be able to purchase coverage through endorsements for  other perils typically excluded from homeowners policies, including  ordinance and law, sewer or drain backup, and mold.

section_title: Policy Exclusion Impacts Could Be Reduced by Expanding Homeowner Coverage, but Premiums Would Likely Increase
paragraphs: Losses due to policy exclusions can financially impact homeowners by  causing significant out-of-pocket expenses. Communities can also be  impacted by perils excluded from homeowners policies, particularly if  unrepaired homes result in blight and affect whether others in a  neighborhood rebuild. Expanded coverage could offer homeowners more  protection, potentially reducing the cost of repairs that homeowners would  have to cover with their own resources. However, policies that offered  expanded coverage would likely be much more expensive than current  policies.
subsections: section_title: Policy Exclusions Can Impact Homeowners and Communities
paragraphs: According to industry participants, the biggest and most significant impact  on homeowners from policy exclusions is out-of-pocket costs to cover  losses. If a loss occurs that is excluded by insurers, and coverage is not  available through an endorsement or federal or state program,  homeowners will have to use their own resources to rebuild and replace  what they had. Some industry participants said that excluded losses can  cause significant damage to homes and possessions. In some cases,  homeowners may not have the means to rebuild after a disaster. Figures  1 and 2 illustrate the damage caused by two perils, floods and sinkholes,  which are typically excluded from homeowners policies.

In addition to paying for excluded losses on their own, one industry  organization said that homeowners may have to pay additional out-of- pocket expenses for temporary housing or a car rental that may not be  covered by a homeowners policy. When impacted by a disaster,  homeowners may need these types of rentals for many months, and they  can be costly.

Further, industry participants said that rebuilding after a disaster can  present additional challenges for homeowners. One industry organization  said that catastrophes can cause shortages of building contractors and  building supplies that can delay reconstruction. This phenomenon is  known as “demand surge.” In these circumstances, the short-term costs  of repairing and rebuilding homes can escalate substantially. Another  industry participant noted that homeowners can also have their policies  cancelled if home repairs are not adequate.

Disasters and excluded perils also sometimes highlight differences  between consumers’ expectations for insurance and actual policy  coverage, resulting in added frustrations for homeowners. According to  some industry participants with whom we spoke, some consumers may  not learn what their policy actually covers until losses occur. For example,  one industry association recalled that some consumers who had recent  problems with drywall sourced from China filed insurance claims through  their homeowners policies. As noted earlier, litigation in multiple states  may determine the extent to which homeowners insurance applies to  losses associated with this drywall.

Others may not understand their coverage well enough to know what is  covered, what is excluded, and what loss events and circumstances  might result in paid, partially paid, or denied claims. For example,  according to a 2013 survey conducted by one industry organization, many  homeowners mistakenly believe that their homeowners policies cover  flooding from a hurricane. According to some industry participants,  homeowners policies can be difficult to understand because they often  are long, technical, legal documents. One consumer advocate we spoke  with suggested that few tools exist to help consumers understand their  coverage, and noted that even though some states have policy readability  requirements and disclosure rules about coverage and exclusions, these  measures do not help consumers understand their policies. Other  participants said that many homeowners do not read their policies or  study them closely. Additional analysis would be needed to determine to  what extent readability requirements, disclosure rules, or other factors  impact homeowners’ ability to understand their policies.

In addition to the devastation disasters may cause homeowners,  neighborhoods and communities can also be impacted if some  homeowners are unable to rebuild because they do not have coverage for  a loss. Damaged homes that are not rebuilt can result in blight and affect  the willingness of others to rebuild. A neighborhood where property is  vacant or deteriorated will also likely impact the property value of  surrounding homes. In addition, when some homeowners do not rebuild,  communities may experience a diminution of the tax base. Collecting less  in property taxes can impact the ability of communities to fund schools,  libraries, parks, and roads, among other uses.

section_title: Government Coverage of Excluded Losses Can Involve Costs and Risks to Taxpayers
paragraphs: Both the federal and some state governments offer disaster assistance  and other programs to help homeowners with some of the perils that  private insurers do not cover, and this support can rely on taxpayer as  well as policyholder resources. At the federal level, the government  provides a range of assistance to individuals after major disasters. This  assistance is generally made available after the President issues a  disaster declaration under the authority of the Robert T. Stafford Disaster  Relief and Emergency Assistance Act (the Stafford Act), and is  administered by various federal agencies through various programs.  FEMA, for example, provides disaster relief and recovery assistance to  individual citizens through its Individuals and Households Program (IHP),  which is intended to provide money and services, including assistance in  repairing and replacing damaged homes, to people in a disaster area  when losses are not generally covered by insurance. The growing  number of major disaster declarations has contributed to an increase in  federal expenditures for disaster assistance, however. For example,  through January 31, 2012, FEMA obligated $80.3 billion in disaster relief,  including $23.5 billion in individual assistance, for 539 disasters declared  during fiscal years 2004 through 2011. More recently, Superstorm  Sandy has also involved significant federal disaster assistance. In  January 2013, Congress passed and the President signed the Disaster  Relief Appropriations Act of 2013 and the Sandy Recovery Improvement  Act of 2013, which provided about $50 billion in federal assistance to  support rebuilding efforts.

In addition to providing disaster assistance, the federal government also  offers flood insurance to homeowners through NFIP, a program that  involves significant costs for the government and ultimately for taxpayers.  According to FEMA information, as of September 2013, there were 5.6  million flood insurance policies in force in almost 22,000 communities  across the United States. In years when losses were high, NFIP has used  statutory authority to borrow funds from the Department of the Treasury  (Treasury) to pay claims and keep the program solvent. For example,  NFIP borrowed $16.8 billion from Treasury to cover claims for the 2005  hurricanes—primarily Hurricane Katrina—and received additional  borrowing authority in the amount of $9.7 billion following Superstorm  Sandy in 2012. As of October 2013, NFIP owed Treasury $24 billion.  NFIP is generally expected to cover its claim payments and operating  expenses with the premiums it collects. However, NFIP has sold some  flood insurance policies at subsidized rates to help keep flood insurance  affordable, and these subsidized policies have been a financial burden on  the program because of their relatively high losses and premium rates  that are not actuarially based. As a result, the annual amount that NFIP  collects in both full-risk and subsidized premiums is generally not enough  to cover its operating costs, claim payments, and principal and interest  payments for the debt owed to Treasury, especially in years of  catastrophic flooding, such as 2005. This arrangement results in much  of the financial risk of flooding being transferred to the federal government  and ultimately the taxpayer. As shown in figure 3 below, NFIP has  handled a significant number of claims and paid losses for flood events  caused by hurricanes and a superstorm since 2005.

Some states, such as Florida, have created residual insurance pools to  cover what the private market will not, sometimes at a cost to  policyholders and taxpayers across the state. In Florida, Citizens  provides homeowners coverage, including for wind damage, for those  who cannot find coverage from private insurers. If Citizens’ funds are  depleted by paying claims after a catastrophic event, Florida law requires  that Citizens charge assessments until any deficits are eliminated.  Citizens’ policyholders are the first to be assessed, and if necessary,  additional assessments can be levied against certain private insurance  companies, who can then pass the cost of these assessments on to their  policyholders.  This ability to levy assessments provides Citizens with  resources to pay claims to policyholders.

Storms in 2004 and 2005, for example, resulted in more than $30 billion  in insured damage in Florida. Citizens sustained deficits of $515 million  and $1.8 billion, respectively, in those years. To fund its 2004 deficit,  Citizens assessed insurance companies and surplus lines policyholders  over $515 million in regular assessments. To fund the 2005 deficit, the  Florida legislature appropriated $715 million from the Florida general  revenue fund, reducing the size of the regular assessment from $878  million to $163 million. In 2005, the Florida legislature also directed  Citizens to amortize the collection of the emergency assessment for the  remaining $888 million deficit over a 10-year period, resulting in an  emergency assessment levied beginning in June 2007. According to two  industry organizations, Florida’s property/casualty policyholders generally  bear the cost of having Citizens provide coverage to participating Florida  residents, regardless of whether they live inland or on the coast.

section_title: Expanding Private Coverage Could Offer Benefits, but Homeowner Premiums Would Likely Rise
paragraphs: If private insurers offered expanded homeowners coverage, homeowners  could see a number of benefits. First, according to some industry  participants homeowners would have more protection because more  perils would be covered under their policy. Second, some industry  participants noted that more comprehensive coverage could lead to less  ambiguity for consumers seeking to understand their policies. Policies  with fewer exclusions and conditions for coverage would be simpler and  more efficient for insurers to write and consumers to understand than  having separate policies for homeowners, flood, and in some states, wind  coverage. Third, some industry participants said that enhanced coverage  could reduce litigation and disputes between policyholders and insurers  over coverage. For example, a policy that offered more comprehensive  coverage could reduce disputes over the anticoncurrent causation clause,  often over whether wind or water caused residential damage, something  some industry participants noted is a particular challenge for homeowners  when hurricanes occur.

Assuming homeowners purchased expanded private coverage without  government subsidies, these policies could also reduce reliance on  federal and state programs. According to some industry participants, if  homeowners policies covered flooding, for example, fewer taxpayer  resources may be needed for paying NFIP’s claims and subsidized  premiums. In addition to having benefits at the federal level, greater  private coverage could also reduce or eliminate the need for state-based  insurance mechanisms, such as state wind pool coverage, and the  insurer and policyholder assessments they can involve. Moreover,  expanded coverage could encourage more informed decisions by  homeowners. For instance, expanded coverage with more accurate  pricing for risk could provide beneficial information to consumers on the  risk associated with their housing location decisions and could encourage  more consumers to mitigate risks to their property or to not locate to high- risk areas.

Notwithstanding these potential benefits, expanded coverage would likely  increase insurance premiums for homeowners. According to some  industry participants with whom we spoke, the increase could amount to  several times what some homeowners currently pay. For example, one  industry organization said that a policy that covered flood, earthquake,  sinkholes, and some other perils could cost homeowners anywhere from  three to five times what homeowners pay now, while another estimated  that the cost of a policy that covered nearly all the currently excluded  perils could exceed $15,000 annually. Other industry participants said the  cost for this coverage would be so high that many homeowners would be  unable to afford it. Additionally, FEMA information on the changes to the  cost of flood insurance following the Biggert-Waters Act and the  elimination of some subsidized rates may further illustrate how costly  expanded coverage could potentially be for some homeowners.  According to FEMA information, the cost of a NFIP policy for a home  located in a very high-risk area without a subsidy could exceed $20,000 in  annual premiums for certain policyholders.

section_title: Multiple Challenges Make Expanding Private Coverage Difficult
paragraphs: Several factors make it challenging for private insurers to offer all-perils  homeowners insurance, or even more comprehensive policies. These  include consumer demand for greater coverage and the higher premiums  such coverage would involve, the ability of insurers to adequately price  policies that covered more perils, and the regulatory challenges  associated with getting approval for risk-based rates. A few industry  participants with whom we spoke said that insurers and others are  discussing possibilities for expanding private homeowners insurance, but  cautioned that policy premium rate, affordability, and other conditions  would need to be addressed.
subsections: section_title: Insurance Cost and Risk Pricing Are Issues for Consumers and Insurers
subsections: section_title: Consumer Demand and Incentives
paragraphs: Higher premiums for more comprehensive homeowners insurance are not  only an affordability challenge for homeowners, they also represent a key  challenge for insurers. Some industry participants said that the higher  premiums required for more comprehensive coverage raises questions  about whether sufficient demand would make expanded coverage  impractical in the private market. Some said that many homeowners try to  keep expenses for insurance as low as possible, citing as evidence low  participation in NFIP, despite federal subsidies. They also questioned  whether consumers would buy much more expensive expanded coverage  even if it were offered by insurers.

Additionally, many industry participants with whom we spoke said that  adverse selection—or the tendency for those who live in places most  prone to risk to be most likely to purchase insurance—could challenge  insurers’ ability to expand policy coverage. Insurers manage risk by  charging appropriate rates and diversifying their risk pool. Industry  participants with whom we spoke said that if only riskier households—for  example, those located near the coasts or rivers—were the primary  purchasers of expanded coverage, insurers might end up with an  insurance pool with concentrated risk and policies that could cause losses  that may jeopardize insurers’ profitability and solvency.

A requirement that insurers offer and homeowners purchase more  comprehensive coverage may reduce this problem but raises questions  about how such a requirement would be implemented. Further, some  questioned whether it would be fair to require those living in low-risk  areas to purchase expanded coverage they may not need, in effect  subsidizing those living in high-risk areas. One industry organization said  that legislative or regulatory attempts to mandate all-perils coverage could  destabilize the insurance marketplace in certain high-risk areas such as  coastal regions and floodplains. It could also cause private insurers to  further limit their exposures in disaster-prone areas, and some insurers  may withdraw from the market altogether. Industry participants suggested  that offering policies that covered all losses could also raise issues of  moral hazard, or incentivize risky behavior by homeowners. For example,  comprehensive policies may encourage people to locate their homes in  high-risk areas. Others said that higher premiums associated with more  comprehensive policies would send a better signal to homeowners about  the risk associated with their housing location, something that could  prompt homeowners to properly insure their homes or take steps to  mitigate their risk.

section_title: Risk Pricing and Claims Processing
paragraphs: Industry participants said that another important challenge is the difficulty  of pricing catastrophic risks and handling the claims that they cause.  Some industry participants said that accurately modeling the broader  range of risks that more comprehensive policies would cover was critically  important. Having loss data and accurately modeling risk is necessary for  appropriately pricing insurance policies and for ensuring insurer solvency.  Some industry participants said that because expanded coverage would  be new to the private domestic market, modeling experience would need  to be developed over time and could be challenging, particularly for  multiple catastrophic losses. Others said that insurers might also lack the  expertise to handle claims for perils that were typically excluded, and that  it could take time for insurers and adjusters to develop the expertise to  handle some disaster situations and subsequent claims.

section_title: Approval for Risk-based Rates and Insurer Capital Pose Additional Concerns
subsections: section_title: Regulatory Rate Approval
paragraphs: Industry participants said that insurers could also face critical regulatory  challenges in offering more comprehensive coverage. One important  challenge is that state regulatory approval for the higher premiums more  comprehensive coverage would likely demand is uncertain. Insurers need  to charge risk-based rates that are determined on an actuarial basis in  order to stay solvent and meet their policy obligations to homeowners.  However, some industry participants with whom we spoke said that  getting regulators to approve rates that insurers determined would be  appropriate for certain risks has been difficult and that getting approval for  rates that could be several times more expensive than those currently in  force would be an important challenge. One regulator, however, said that  inability to charge higher risk-based rates might not be an issue because  loss experience is a critical factor that drives rates. If insurers faced  greater losses by covering more perils, they would likely be able to justify  and gain approval for higher premiums. Industry participants also said  that different state insurance laws and regulations and different rate- setting and approval processes could make it difficult for insurers to sell  more comprehensive policies with risk-based rates across states.

section_title: Insurer Capital
paragraphs: Offering coverage for a broader set of perils would also require insurers to  have the capital necessary to pay claims without risking insolvency. The  greater the risk, the more capital insurers need to hold. Insurers may not  be willing to maintain the higher capital levels needed for insuring against  higher risk events if that capital could be used for other insurance or  investment purposes. In addition, disasters such as floods and  earthquakes are relatively infrequent but often severe events, so that  insurers cannot always know how much they will need in reserves.  Industry participants said that the unpredictability of catastrophes could  prevent insurers from accurately calculating and setting aside the sums  necessary to cover losses. One insurance regulator suggested that even  if insurers could charge rates that reflected the full risk of disasters, they  still may not be able to offer coverage for additional perils.

section_title: Several Conditions Would Be Needed for Insurers to Expand Private Coverage
paragraphs: For additional coverage to be possible, insurers would need the ability to  conduct actuarial analyses and accurately model risks involved with  greater homeowners coverage. Some industry participants thought this  capability may already exist or could be developed for floods and  earthquakes, the two perils they said hold some promise for greater  private insurer involvement. In order to offer coverage for flood or other  perils, insurers would have to be able to charge risk-based rates, a critical  part of meeting their policy obligations to consumers and staying solvent,  but something that would also raise concerns about higher premium  costs, policy affordability, and consumer demand.

Two industry organizations said that mitigation efforts, effective building  codes, and sound land-use policies could also help reduce risks from  natural catastrophes. Another highlighted how building codes set by  states can differ, which can lead to inconsistencies that make it difficult to  ensure properties can withstand loss events. Others said that it is  important for the insurance industry to encourage consumers to become  better informed about their risks and insurance so that they could take  available steps depending on where they live to mitigate losses.

The catastrophic nature of flood and other natural catastrophe losses,  according to industry participants, may require a continuing role for  federal and state government in financing coverage. We recently reported  on strategies to encourage greater private-sector involvement in flood  insurance that included the possibility of insurers charging homeowners  full risk rates with the government providing targeted subsidies to help  with affordability. Private insurers could play a greater role in coverage  with the federal government possibly serving as an insurer for only the  highest risk properties. Yet another option is the combination of greater  private-sector involvement and the government acting as a reinsurer by  providing a backstop to private insurers for losses over a certain  amount.

The size of the losses and the magnitude of the risk associated with more  comprehensive policies underscore the complex challenges of addressing  the costs of catastrophes and other perils that place homeowners’  properties at risk. A mix of factors—financial risk, large potential losses,  political and regulatory issues, policy affordability, and consumer  demand—has thus far made it challenging for private-sector insurers in  the U.S. to offer flood insurance to homeowners, let alone more  comprehensive or all-perils policies. The possibility of improved data,  better risk modeling, and emerging private-sector interest, however,  suggest that some additional coverage may be possible. For this to  happen, private insurers must be able to assess and diversify risk and  charge rates adequate for the risk they are assuming. At the same time,  consumers will need to better recognize the risk and cost of their housing  decisions and the likely higher rates that come with protecting homes and  possessions in certain locations. One of the most fundamental challenges  is achieving a policy premium rate that allows insurers to stay solvent and  meet their obligations to consumers, yet is affordable enough so that  consumers are willing and able to buy insurance. Addressing this  important challenge and ensuring a collective response to losses caused  by disasters and other perils will require the cooperation and resources of  government, homeowners, and insurers, as well as balance in the  assumption of risk and cost by each of these parties.

section_title: Agency Comments
paragraphs: We provided a draft of this report for review and comment to the National  Association of Insurance Commissioners (NAIC) and the Federal  Insurance Office (FIO) at the Department of the Treasury. Both provided  technical comments which we incorporated into the report as appropriate.

We are sending copies of this report to the appropriate congressional  committees, NAIC, and FIO. In addition, the report is available at no  charge on the GAO website at http://www.gao.gov.

If you have any questions about this report, please contact me at (202)  512-8678 or cackleya@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made key contributions to this report are  listed in appendix V.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: In this report we examined (1) the perils homeowners policies typically  cover and exclude; (2) the impacts of exclusions on homeowners and  taxpayers and the potential benefits of more comprehensive coverage for  homeowners; and (3) the additional perils insurers might be willing to  cover and the challenges associated with such coverage.

To determine what perils homeowners policies typically cover and  exclude, we analyzed the Insurance Services Office’s (ISO) standard  homeowners insurance policy (HO-3) and examples of private insurers’  homeowners policies. We reviewed documents by insurance industry  organizations and professional associations, including the National  Association of Insurance Commissioners (NAIC) and the Insurance  Information Institute (III). We also interviewed a nongeneralizable,  judgmental sample of property/casualty insurance companies and state  insurance regulators, insurance and reinsurance associations, an  insurance agent and broker association, consumer groups, academic  insurance and risk experts, and the Federal Insurance Office (FIO) at the  Department of the Treasury. We selected our sample of insurers based  on market share by direct premiums underwritten and participation in  different geographic markets. We selected our sample of state regulators  based on geographic diversity and experience overseeing insurers with  portfolios of different perils, including floods, hurricanes, and earthquakes.

To determine the impacts of exclusions on homeowners and taxpayers  and the benefits of more comprehensive coverage, we spoke with  consumer groups, including the Center for Economic Justice, academic  experts, selected state insurance regulators, NAIC and FIO officials, and  other insurance association officials. To illustrate some of the financial  impacts of policy exclusions on taxpayers, we obtained publicly available  data from the Federal Emergency Management Agency (FEMA) on the  National Flood Insurance Program’s (NFIP) claims costs. For the NFIP  data we used, we interviewed officials on usability and reliability. We  determined that these data were sufficiently reliable for our intended  purposes. In addition, we reviewed our previous work on natural  catastrophe insurance, academic and other studies, and results from an  annual survey conducted by Insurance Information Institute (III) on  homeowners insurance, flood insurance, and disaster preparedness.

To identify the additional perils that insurers might be willing to insure and  the challenges associated with such coverage, we spoke with a sample of  insurance companies and state insurance regulators, insurance and  reinsurance associations, an insurance agent and broker association,  NAIC and FIO officials, consumer groups, academia, and others. We also  reviewed our previous work on natural catastrophe insurance,  Congressional Research Service (CRS) reviews, and academic and other  studies on these issues. We gathered additional perspectives on all perils  policies from a round table discussion on privatizing flood insurance that  we organized and conducted at GAO headquarters in Washington, D.C.  Participants in the round table included insurance industry association  representatives, select state regulators, and NAIC and FEMA officials.

We conducted this performance audit from December 2012 to January  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

section_title: Appendix II: Information on the National Flood Insurance Program
paragraphs: Established in 1968, the National Flood Insurance Program (NFIP) makes  federally backed flood insurance available to residential property owners  and to owners of nonresidential property such as businesses, churches,  governments and nonprofits. Under NFIP, the federal government  generally assumes the liability for the insurance coverage and sets rates  and coverage limitations, among other responsibilities, while the private  insurance industry sells the policies and administers the claims. The  Federal Emergency Management Agency (FEMA) is responsible for  administering NFIP.

Community participation in NFIP is voluntary. However, communities  must join NFIP and adopt FEMA-approved building standards and  floodplain management strategies in order for their residents to purchase  flood insurance through the program. Additionally, communities with  Special Flood Hazard Areas (SFHA)—areas at high risk for flooding— must participate in NFIP to be eligible for any form of assistance for  acquisition or construction purposes in connection with a flood.  Participating communities can receive credits on premium rates on flood  insurance if they establish floodplain management programs that go  beyond the minimum requirements of NFIP. FEMA can suspend  communities that do not comply with the program, and communities can  withdraw from the program. As of September 2013, almost 22,000  communities voluntarily participated in NFIP.

Consumers can purchase flood insurance to cover both buildings and  contents for residential and commercial properties. NFIP’s maximum  coverage for residential policyholders is $250,000 for building property  and $100,000 for contents. This coverage includes replacement value of  the building and its foundation, electrical and plumbing systems, central  air and heating, furnaces and water heater, and equipment considered  part of the overall structure of the building. Personal property coverage  includes clothing, furniture, and portable electronic equipment. For  commercial policyholders, the maximum coverage is $500,000 per unit for  buildings and $500,000 for contents (for items similar to those covered  under residential policies). Coverage for personal property and coverage  for nonresidential buildings is written on an actual cash value basis.

NFIP offers two types of flood insurance premiums to property owners  who live in participating communities: subsidized and full-risk. The  National Flood Insurance Act of 1968 authorized NFIP to offer subsidized  premiums to owners of certain properties. Congress originally mandated  the use of subsidized premiums to encourage communities to join the  program and mitigate concerns that charging rates that fully and  accurately reflected flood risk would be a burden to some property  owners. According to FEMA, Congress made changes to the program  over the years to encourage further participation in NFIP through low  premiums. FEMA estimated that in 2012 more than 1 million of its  residential flood insurance policies—about 20 percent—were sold at  subsidized rates; nearly all were located in high-risk flood areas.

Since 2000, NFIP has experienced several years with catastrophic  losses—losses exceeding $1 billion—and has needed to borrow money  from the Treasury to cover claims in some years. The losses resulting  from Superstorm Sandy, which caused extensive damage in several  states on the eastern coast of the United States in October 2012, also are  catastrophic, reaching over $7 billion. As of October 2013, FEMA owed  Treasury $24 billion. As a result of the program’s importance, level of  indebtedness to Treasury, substantial financial exposure for the federal  government and taxpayers, and FEMA’s management challenges, NFIP  has been on our high-risk list since 2006.

section_title: Appendix III: Information on the Citizens Property Insurance Corporation
paragraphs: Established in 2002, Florida Citizens Property Insurance Corporation  (Citizens) is a not-for-profit and tax-exempt government entity that  provides property insurance to homes and businesses that cannot get  coverage in the private sector. It consolidated two residual market  mechanisms: the Florida Windstorm Underwriting Association (FWUA),  created in 1970 to provide high-risk, windstorm, and hail residual market  coverage in select areas of Florida, and the Florida Residential Property  and Casualty Joint Underwriting Association (JUA), created in December  1992 following Hurricane Andrew to provide residual market residential- property multiperil insurance coverage, excluding wind if the property was  within FWUA-eligible areas. A primary driver for the merger was that the  combined entity obtained federally tax-exempt status, allowing it to save  federal income taxes that otherwise would have been paid by FWUA and  JUA. As an integral part of the state rather than a private insurance  company, Citizens is also able to issue tax-exempt post-event bonds and  taxable pre-event bonds, which can help finance loss payments in the  event of a major disaster.

Florida law determines the standards Citizens uses to establish its  premium rates. Citizens’ rates are required to be actuarially sound, but at  the beginning of 2007, an approved rate increase was rescinded and rate  levels were frozen by the Florida legislature at the 2006 rate levels. The  rate freeze remained in effect through December 31, 2009. On January 1,  2010, Citizens began implementation of a statutorily required path to  achieve actuarially sound rates over time. Except for sinkhole coverage,  the path limits annual rate increases to 10 percent for any single policy  issued by the corporation, excluding coverage changes and surcharges.  According to Citizens officials, Citizens’ rates are moving towards  actuarial soundness, but are not yet there.

Citizens allocates approximately 18 percent of every premium dollar it  collects to pay hurricane and catastrophe claims, but in the event that  losses exceed its surplus, it is required by statute to levy assessments to  recover the deficit. Assessments can be charged in up to three tiers,  policyholder surcharge, regular, and emergency. Each additional tier is  charged only if the level before is insufficient to eliminate Citizens’ deficit.  Citizens’ policyholder surcharge is the first tier of assessments and can  be levied one time for up to 45 percent of the policyholder’s premium in a  single year. If a deficit remains in one of Citizens’ three types of accounts,  Citizens can levy regular assessments of up to two percent against  certain private insurance companies, who can then pass the cost of these  assessments on to their policyholders. Finally, if a deficit persists,  Citizens can impose an emergency assessment on both Citizens and  non-Citizens policyholders. This ability to levy assessments provides  Citizens with resources to pay claims to policyholders. For example,  following the 2004 storms, Citizens had to levy over $515 million in  regular assessments to fund its deficit.

Citizens’ resources also come from its reinsurance arrangement with the  Florida Hurricane Catastrophe Fund (FHCF). Established in 1993 by the  Florida legislature, FHCF is a state-run reinsurer created to provide  additional insurance capacity and help stabilize the property insurance  market by reimbursing insurers for a portion of their catastrophic  hurricane losses. As a tax-exempt entity, FHCF can accumulate premium  payments on a tax-free basis. If the revenue generated from premiums is  insufficient following a loss event, FHCF, like Citizens, is required by state  law to levy assessments on a broad base of property/casualty insurance  lines to fund revenue bonds to pay the losses. For example, FHCF issued  bonds in the amount of $1.35 billion in 2006 and $625 million in 2008,  which are being financed by a 1 percent assessment levied on  property/casualty insurers in the state.

As of October 2013, Citizens had more than 1.2 million policies in force,  most of which were homeowners policies. According to a Citizens official,  Citizens has recently engaged in depopulation efforts by seeking ways to  return policies to the private market, but these efforts have been met with  challenges. For example, Citizens has faced challenges with establishing  rates higher than those available in the private market. The insurance  distribution process is also a challenge. For example, according to a  Citizens official, private insurers that decline to sell a homeowner a policy  may refer that homeowner to Citizens instead of recommending they  shop the market for coverage, which has impeded a freely competitive  insurance market.

section_title: Appendix IV: Information on the California Earthquake Authority
paragraphs: Established in 1996, the California Earthquake Authority (CEA) is an  instrumentality of the state that sells earthquake insurance policies for  residential property throughout California. CEA is a publicly managed,  privately funded entity. After the Northridge Earthquake that struck the  San Fernando Valley in January 1994, insurers in California began to limit  their exposure to earthquakes by writing fewer or no new homeowners  insurance policies. In 1995, California lawmakers passed a bill that  allowed insurers to offer a reduced-coverage earthquake insurance  policy. In offering earthquake coverage, insurance companies can  manage the risk themselves, contract with an affiliated or non-affiliated  insurer, or become a CEA-participating insurance company and offer  CEA’s residential earthquake policies. CEA is the largest earthquake  insurer in California, with approximately 840,000 policies in force as of  2011, which represent approximately 70 percent of the residential  earthquake insurance policies in the state.

CEA offers a basic residential earthquake policy to homeowners, which  includes coverage for the insured dwelling and limited coverage for  contents and loss-of-use if the residence is uninhabitable due to an  earthquake. For an additional premium, CEA policyholders can  significantly increase insured limits on contents and for loss-of-use, and  homeowners can lower their CEA policy deductible from 15 percent to 10  percent. CEA coverage is available to homeowners only from the  insurance company that provides their residential property insurance and  only if that company is a CEA-participating insurance company.  Participating insurance companies process all CEA policy applications,  policy renewals, invoices, and payments and handle all CEA claims.

In determining premium rates, CEA is required by law to use the best  science available and is permitted by law to use earthquake computer  modeling, to establish actuarially sound rates. CEA will examine rating  factors, such as the rating territory (determined by ZIP code), age, and  type of construction of a home, in determining the premium rate. The  CEA governing board establishes premium rates, subject to the prior  approval of the Insurance Commissioner. In 2011, for example, a request  for a 12.5 percent average statewide rate decrease was approved  beginning with new and renewal policies that became effective on and  after January 1, 2012. The change was a result of a reduction in the  estimated average annual loss, as derived from new scientific  information, according to CEA information. Given that the rate decrease is  expressed as an average statewide rate impact, individual policyholders  may have seen their rates increase or decrease, depending on CEA  product, location of the risk, and other rating factors.

CEA is funded principally from policyholder premiums, contributions from  and assessments on participating insurers, returns on invested funds,  borrowed funds, and reinsurance. Assessments on participating insurers  may not be directly passed through to policyholders. CEA is authorized to  issue bonds, and may not cease to exist so long as its bonds are  outstanding. As of 2012, CEA had approximately $10.2 billion in claims- paying capacity, but if an earthquake causes insured damage greater  than CEA’s claims-paying capacity, then policyholders affected will be  paid a prorated portion of their covered losses or may be paid in  installments.

section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact

section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Paul Schmidt (Assistant  Director); Emily Chalmers; Alma Laris; Marc Molino; Erika Navarro; Steve  Ruszczyk; Jessica Sandler; and Andrew Stavisky made key contributions  to this report.


Question-summary annotations: questions: question: What damages are typically covered by homeowners insurance policies?
answer: Homeowners insurance policies typically protect homes, garages and other structures, and personal belongings from damage caused by perils such as fire, hail, lightning, explosion, and theft, among others.
child_questions: question: Why are these perils insurable?
answer: The insurance industry considers these perils insurable because they are accidental, predictable, and do not involve catastrophic losses.

question: What perils are typically not covered?
answer: These policies also typically exclude losses from a number of perils, including disasters caused by floods, earthquakes, and war.
child_questions: question: Why are these perils not covered?
answer: Industry officials said that such events are difficult to predict and involve extensive losses that are a challenge for private insurers to cover.

question: What other damages are excluded?
answer: Insurers also exclude losses from defective products, which industry participants said could be addressed by manufacturer warranties and commercial general liability insurance. Intentional losses; damage from wear, tear, or neglect; and losses caused simultaneously by covered and uncovered perils, such as wind (covered) and flood (uncovered) during a hurricane are also generally excluded.

questions: question: What effects do policy exclusions have?
answer: Policy exclusions can impact homeowners, communities, and state and federal governments. When excluded losses occur, they can create significant costs for homeowners to repair homes and replace possessions.
child_questions: question: How is this issue further complicated by wide-scale catastrophes?
answer: Wide-scale catastrophes can also cause shortages of building materials and contractors that delay reconstruction and substantially increase the costs of repairing homes.
child_questions: question: How can this further damage communities?
answer: When damage to properties caused by excluded losses is not repaired, affected communities may experience blight and face reduced tax revenue.

question: How does this affect taxpayers?
answer: When federal and state governments have stepped in to cover what private insurers exclude, taxpayers may face a significant expense. In addition to federal disaster assistance, the National Flood Insurance Program (NFIP) paid more than $7 billion in claims after Superstorm Sandy.

question: How do industry participants suggest approaching this issue?
answer: Industry participants suggested that expanded private coverage could provide additional protection for homeowners and reduce reliance on government programs, but the resulting policy premiums would likely be prohibitively expensive for many homeowners.

questions: question: What factors stand in the way of more comprehensive insurance?
answer: Multiple factors make expanding private coverage challenging and several conditions would need to be addressed for insurers to offer more comprehensive insurance.
child_questions: question: What is the main challenge to providing comprehensive insurance?
answer: A main challenge is that expanded coverage would have higher costs, potentially limiting consumer demand. Even if insurers charged higher rates that were based on risk, the severity and unpredictability of catastrophic losses could still jeopardize insurers' solvency.

question: What alternatives are insurers considering?
answer: Some industry participants said that insurers and others are discussing possibilities for expanding private homeowners coverage, with a focus on risk-based premiums, mitigation efforts, effective building codes, and sound land use policies.

question: How might the government be involved in a more comprehensive insurance solution?
answer: Because of this mix of factors, some in the insurance industry have suggested that a continuing financial role by federal and possibly state governments may be required, and that ensuring a response to the impact of disasters and other perils will require the cooperation and resources of government, homeowners, and insurers, as well as balance in the assumption of risk and cost by each of these parties.

questions: question: How extensive is homeowners insurance?
answer: Homeowners insurance protects against a range of perils, but policies do not insure against all risks.
child_questions: question: How can this affect homeowners?
answer: Owners whose homes are damaged by natural and other disasters not covered by their insurance can be exposed to serious financial losses.
child_questions: question: How does the government help homeowners in these situations?
answer: Federal and state initiatives provide some assistance for catastrophes, which can involve significant taxpayer expense.

question: How is the number of uncovered losses changing?
answer: With coastal populations growing and the possibility of more frequent and severe weather, more homeowners could experience heavy losses not covered by homeowners insurance, putting increasing financial pressure on government programs and thus on taxpayers.

questions: question: What was GAO asked to review?
answer: GAO was asked to study the possibility of private insurers providing more comprehensive insurance.
child_questions: question: What does this report cover?
answer: This report addresses (1) what perils homeowners policies typically cover and exclude, (2) how exclusions impact homeowners and taxpayers and the potential benefits of more comprehensive coverage, and (3) what additional perils insurers might be willing to cover and what challenges are associated with expanding policies.

question: How did GAO collect data for this report?
answer: GAO reviewed homeowners insurance policies and conducted interviews with the National Association of Insurance Commissioners, other industry organizations, consumer advocates, and risk experts, among others.