A Prospective Evaluation of an Innovative Insurance Policy Proposal to Lower Rates in Increasingly Risky Areas in Florida
Can we agree that the following statements are true? First, there is valuable real estate in Florida. Second, some of this real estate faces intense flood risk and going forward this flood risk may intensify. Third, insurance companies cannot be asked to lose money. Fourth, there is “no free lunch”.
My favorite policy solution is here to allow insurers to charge any premium price they want to. If their algorithm predicts that a specific home is risky, then that firm will charge a high price. If this prediction is “too pessimistic” about the risk then another insurer with a more accurate model will offer a premium at a lower price. Competition protects home owners from being “price gouged”.
What happens in a scenario where an insurer under-prices too many risky properties and a disaster occurs? This insurer will have to make many payouts. The question arises has this firm implicitly insured itself by either selling off some of these policies to form “Insurance Backed Securities” or has it purchased Catastrophic Bonds on global capital markets to hedge its bets. If the insurer is a publicly traded firm, it will face pressure to price risk accurately and it will hire climate science consulting firms to advise it and it will upgrade its predictive algorithms.
In my 2017 piece for Harvard Business Review, I argued that insurers can accelerate climate change adaptation by offering non-linear contracts that reward home owners for taking pro-active climate fortification steps to reduced flood and fire risk. Drones can fly by and verify the steps have been taken. Such home owners would receive a discount on their insurance because their properties would face less ex-post risk from disasters because they have been fortified.
NOTE that I haven’t mentioned government here.
NOW the new Florida’s policy proposal to reform local insurance pricing
This piece taught me about House Bill 809
House Bill 809 would allow insurance companies to offer policies exclusively based on the remaining mortgage balance of a home.
Let’s consider an example. Suppose that back in 2015 that Jane bought a $1 million dollar home with $200,000 in cash and a $800,000 loan. In 2024, the home is worth 1.3 million and she owes $780,000 on her loan. She now has $520,000 in equity in this home.
Suppose that it is common knowledge that her home has a 1% chance of being destroyed each year. If the home is destroyed, she can’t live in it. Suppose that it would cost her $900,000 to build back the identical home that she now lives in. The current market value of the home reflects the 1% disaster risk. Potential buyers will shade down their bids because they anticipate that 1% of the time, the home will be destroyed. If they expect that this probability will rise over time, then they will further reduce their bid. Despite such risk, the home’s price may rise over time if it features other great features that compensate for this risk.
CASE #1 No Insurance Market exists
In this case, Jane faces an expected loss of .01*900000 = $9,000. There is a 1% chance that her home will be destroyed and if this happens and she rebuilds, she is out $900,000.
CASE #2A Competitive insurance markets
Market competition leads to an actuarial price of $9,000 for a $900,000 policy. If Jane is risk neutral then she is indifferent between buying insurance or not. Risk averse people will buy the insurance.
CASE #2B Insurance markets exist where insurers have market power
The insurer offers Jane a $900,000 policy for $18,000 per year. Jane pays the insurer $18,000 AND IF a disaster occurs Jane receives a check for $900,000.
If Jane can borrow at the market rate of interest, then she will choose to have no insurance. If she is risk averse and if she is capital constrained, she will prefer case #2 to case #1.
CASE #3 House Bill 809 is passed.
Jane owes her bank $780,000 on the loan. This bill says that she can hold less insurance and simply pay $15,600 for a policy that pays $780,000 if a disaster occurs.
IF no disaster occurs, then Jane saves $2,400 a year because of this law. The insurer does not collect this money.
If a disaster does occur, Jane still needs to find 900,000 -780,000 = 120,000 in cash to rebuild her home after the disaster.
The LENDER to Jane will like House Bill 809 because it lowers loan default risk.
House Bill 809 lowers short run insurance bills for incumbent owners but exposes them to more disaster risk if a disaster occurs. If Federal tax revenue would be used to bailout such “victims” then House Bill 809 does create a Moral Hazard effect.
People can take gambles when they bet their own $!
Have you read my 2015 paper?
Home insurance protects the owner of the asset from terrible shocks. It also protects the asset’s lenders from default risk. House Policy 809 focuses on achieving the latter goal at a lower price to the borrower but exposes the borrower to more risk. Tradeoffs!
Other than being a blunt instrument to reduce premiums for homeowners, is there an economic reason HB 809 chooses remaining mortgage balance to calculate the value of the house? On its face, it seems to commit to making the bank whole and the homeowner. Is that a fair assessment?