The WSJ reports that weather shocks are causing increasing losses for major insurance companies. They face a choice; raise insurance rates or retreat from geographic areas facing more crazy weather. Their choice is constrained. State regulators are placing price ceilings on rates and this limits the ability of insurers to sharply raise rates.
Back in 2017, I co-authored a piece for the Harvard Business Review on the positive role that the insurance industry can play in helping to accelerate climate change adaptation progress. In this brief substack, I want to share some new thoughts.
Point #1
Incumbent home owners bear the economic costs of bad “new news”. If fire risk is higher than expected in Carpinteria, California then fire insurance will be more expensive there and the resale value of local homes will decline by roughly the amount of the increase in the fire insurance premium. When you own a placed based asset, you gain from good “new news” and you lose from bad “new news”. Of course, the incumbents in such a place want to be able to buy cheap fire insurance. This can only occur in a risky place if the state regulators require the insurer to cross-subsidize these policies but this means that home owners in safe places are subsidizing people who chose to buy in risky places. That’s not good adaptation policy. That’s moral hazard!
Point #2
Incumbent home owners in places where insurance is getting more expensive now have a choice. They can sell their homes and cash out. They would sell their home to an informed buyer who anticipates that insurance will be more expensive. Suppose that a real estate management company buys 10 adjacent homes. This company has the deep pockets, the data and the management quality to self-insure. It may be a national company that is able to diversify its own risk exposure. It would take the homes, make them more “climate safe” (perhaps by engaging in greater vegetation pruning and installing better durables) and then rent them out to other people. The company could even rent out the home to the original tenant! In this case, the tenant who has been price gouged on the insurance can keep her old life and social capital and sleep well at night because she no longer faces the fire risk to her asset. She will take her sales $ and invest in a diversified index fund.
Point #3 As we discuss in our Harvard Business Review piece, insurers can offer people in risky places a menu of contracts that incentivize the owner to take defensive precautions that help to “climate proof” the home. Drone fly overs can verify that these precautions have been taken. Those who take these costly steps would receive an insurance price discount.
This approach would stimulate the demand for resilience products and a future Musk would enter this business. Future fires in a Carpinteria would cause less economic damage if incumbents invest more in self protection to protect their assets.
A point made by the Nobel Laureate Gary Becker is that the absence of ex-post market insurance often encourages risk averse investors to invest more ex-ante effort in self-protection. Have you read this paper?
Ehrlich, Isaac, and Gary S. Becker. "Market insurance, self-insurance, and self-protection." Journal of political Economy 80, no. 4 (1972): 623-648.
My Bottom Line
While I wish that the insurers could simply “price gouge” and then they wouldn’t drop their coverage, I foresee that our real estate will become more resilient to wild storms and fires and floods over time because of risk pricing by insurers and dropping insurance coverage will also help us to adapt because risky assets will be sold to investors who have the skill to manage these assets.
Capitalism solves problems and climate change is a problem. Capitalism accelerates our adaptation if regulators don’t muffle price signals. Let markets operate!
When you mention increasing crazy weather and climate change be aware that there is no general increase in extreme weather events. (See the IPCC report -- NOT the summary for policymakers.) Where there is increasing fire damage, for instance, consider that this may be due to poor forestry management (compare different parts of the world with differing approaches) as well as deliberate sabotage -- for instance, the arsonists who caused a major fire in Greece.