Adaptation to Fire Risk Through Insurance Price Gouging
State Farm will no longer issue new insurance policies for home owners in California. How could a for profit firm exit a market where there is a demand for its product? Economics 101 tells to ask what is the price that “can be” charged. An example. Suppose that there is $1 million dollar home that faces a 2% chance of being burned down each year. An actuary would say that a $1 million insurance policy for building the home should have a .02*1 million = $20,000 a year premium. Every property faces different risks. Consider another property facing a 1% chance of being burned down, its insurance premium would be 50% cheaper and this would nudge new construction towards the safer area where premiums are lower (this is especially the case of land use zoning allows for densification in such areas).
Suppose that the State of California has a “nice” Governor whose regulators say that any price of insurance over $5000 a year is “price gouging”. In this case, the insurer loses $ issuing the policy and thus chooses to retreat.
Note what I just sketched. Government regulation introducing a price ceiling causes inefficiency by not allowing two private parties (the home owner and the insurer) to trade with each other.
This was a theme in my 2010 Climatopolis book. Elected officials have to allow markets to function. Now let’s turn to my co-authored 2017 Harvard Business Review piece;
Imagine if this insurer is allowed to “price gouge” in fire zones. If it overcharges , a rival will enter and under-cut the price. California’s leaders have not created rules of the game that encourage competition and research investment by insurers to see what are the profit opportunities in California.
Suppose that many home owners in California want to insure their properties and that more properties face fire risk. The insurer who can charge any price, without worrying about facing government imposed price caps, will devote costly effort to hire talented climate scientists and economists to design contracts of the following form.
“Dear Home Buyer,
Climate Science indicates that you live in a fire zone. If you want to purchase insurance from our firm, you have a choice. Either you can pay $ Z dollars per year or you can pay $ Z/2 per year but you must take the following verifiable steps to lower your home’s fire risk. If at any time, we find that you have not taken these steps , we will cancel your policy"
MY POINT?
If the State of California and localities deregulate local land zoning constraints AND deregulate insurance pricing then millions of people would move to housing in safer places. Existing homes in risky places would be upgraded in order for the home owner to pay less for insurance.
This non-linear contract would incentivize the home buyer to take pro-active steps to protect the home. The next fire season fewer of these homes that have been upgraded will burn down and the insurer will have to pay out fewer claims. The insurer could sign longer term contracts with the home buyer to create a long run relationship.
Note my point here. We choose how much climate risk we face here by where we live and how we live. Government regulation over urban land use and fire zone insurance rates distort our ability to adapt. My 2021 Yale Press Book discusses this issue in depth.
Free markets can play a key role in adapting to climate change if we unleash them! Price gouging for insurance in flood and fire zones will help us to adapt. Less housing will be built there and insurance companies would design resilience contracts that reward real estate owners for being proactive in adapting to the serious risks we face.
Why don’t people read my 2021 book?
A final point. It is true that incumbent home owners in places that are now fire zones will suffer a wealth loss as their homes are now less valuable. They have an incentive to minimize their losses and non-linear insurance contracts incentivize them to do so. Should we feel sorry for people who made a bet on a place based asset whose value declined because of climate change? They are adults. They made this bet. If the home’s value had soared, they wouldn’t have shared much of the gains with us (capital gains tax aren’t that high). Why do they have the right to nationalize their losses from their ex-post bad bet? We shouldn’t be allowed to bet with “other people’s money”.