An Insurance "Bubble" in Areas Facing Rising Fire and Flood Risk?
Over time, we learn “new news” about the opportunities and challenges that different pieces of real estate face. For example, the WFH shock of 2020 allowed hybrid/WFH workers to be able to work from anywhere and many moved to beautiful places bidding up prices in places such as Santa Barbara.
This Insurance Journal piece discusses a new point. Insurance prices are rising fast in areas facing rising flood and fire risk. Economic analysis offers a series of predictions of what will happen next.
#1 If insurance rates rise in a California fire zone, then home prices will decline by the expected present discounted value of the rate increases. Potential buyers will not bear the economic incidence of the “new news”. Incumbent owners of the homes will bear the asset value loss if they are unable to engage in cost effective self protection to lower their home’s fire risk. In this sense, home owners have strong incentives to seek out private market solutions and collective solutions (i.e neighbors paying for local public goods) to reduce fire risk. The rising insurance rates actually incentivizes the incumbent home owners to invest more effort and $ to reduce their home’s fire risk. If they succeed in reducing fire rates, then insurers will re-enter the market and offer fire insurance at a lower price.
#2 If insurers retreat from insuring in fire zones, then incumbent home owners may increasingly sell their homes to risk lovers and to private equity firms. Private equity firms are internally diversified. These investors can buy properties in many different locations and this allows them to hold a diversified portfolio. If there are enough private equity investors, then home sellers won’t lose a fortune in selling.
Note that I am making a “comparative advantage” point here. Who has an edge in holding a riskier asset? Who has an edge in making the risky property less risky?
The rising price of insurance creates an incentive to invest more in self protection. As insurance prices rise, this nudges people to live in relatively safer places.
Many jurisdictions in the U.S have started to reconsider zoning so much land for single family housing. For example, some cities are allowing “granny flats” to be built in people’s backyards. If more homes can be built in safer places, then a push/pull dynamic plays out. More expensive insurance in fire zones pushes people out and they will have a greater menu of housing options in safer places. So, more of us can adapt to climate change if we simultaneously “price gouge” insurance in increasingly risky places and up zone and build more housing relatively safer areas.
It IS TRUE that incumbent home owners in fire and flood zones will suffer an asset value loss. It turns out they made a bad bet. Home ownership is a bet. They have incentives now to self protect to limit their losses. California housing has been a great investment . I bet that most of the home owners have earned a huge rate of return up until now.
A critic might say; if these individuals sell then they will lose their local social capital. Well, if they sell to private equity investor — they can sign a contract to rent the housing back from the private equity investor.