How Will U.S Home Owners Adapt to Rising Insurance Prices Caused by Rising Local Climate Risks?
Some Adaptation Optimism
I predict that my mother will call me tonight because she will want to discuss this new New York Times piece. This substack provides my script that I will read to my mommy.
Point #1 This headline about “bleed cash” is not fully correct. Yes, if Matthew owns a home in an area in California that now faces more fire risk then Matthew’s property will face a higher annual insurance premium. Yes, if California’s regulators place ceilings on how high insurance prices can be then the insurers may not even offer him a policy.
BUT, suppose that Nancy lives in a part of Santa Monica that doesn’t face increased fire risk. The fact that Matthew’s area now faces higher insurance prices means that the demand to live in Santa Monica increases (the cross-elasticity!) and the home owners in the relatively safer areas GAIN an increase in housing prices. The smart reporter named Chris Flavelle ignores this point because such cross-elasticities are difficult to measure. The “zero sum game” nature of the shock also doesn’t help the narrative that he wants to convey to my mother and the other New York Times readers.
Point #2 Continuing the example —— Matthew isn’t a passive victim here. As a home owner in a place that now faces objectively more risk he has a growing set of strategies to protect his home. The Insurance Institute for Business and Home Safety does a great job discussing these cost-effective strategies.
What do I mean by the words; “cost-effective”. Any adaptation investment by a homeowner has an upfront cost and an uncertain future benefit. The expected present discounted value of this adaptation investment depends on how much it reduces the probability of a wildfire each year and what damage the wildfire would have caused for the home.
Suppose that Matthew and his other neighbors choose on their own to each invest $400 each year to protect their homes from wildfires and this reduces the probability that a wildfire destroys their homes by 17% each.
Insurers make profits by selling policies and lose more money when they have to pay out more claims. As Matthew and his neighbors make these adaptation investments, the probability that their neighborhood burns down declines and the Big Data and drones fly overs would reveal this. Insurers would re-enter the market and actively market cheaper insurance to Matthew and his neighbors because it is now profitable to do so. This is market capitalism at work!!
So note my point, the rising cost of insurance might lead Matthew to think hard about what adaptation upgrades he can make to reduce his home’s risk. As the home becomes objectively less risky, the insurers re-enter the market. This type of strategic interaction is completely missing in the “doom and gloom” reporting about climate risk.
Point #3 Suppose that Matthew and his neighbors are liquidity constrained and can’t afford to invest in any steps to adapt to the rising climate risk. The beauty of our market economy is that the home owner can sell to someone else. I predict that we will see private equity firms buying up these risky homes. A private equity firm can self-insure and buy homes scattered around the nation. Such an investor doesn’t put “all of its eggs in one basket”. The deep pockets of private equity means that the incumbent home owners won’t suffer a deep asset loss for the emerging fire risk. The private equity team may knock down the existing home and build a better more location specific resilient home on the land. This is especially true if the local area has great fundamentals (i.e close to San Francisco).
Point #4 If incumbent home owners have no capacity to cope with emerging climate risks, then they could continue to own and live in their home but sell 1/2 of it to an investor who has an edge in handling the risk. Here you can read this book that sketches out the details;
Throughout this column , I have sketched how markets help us to adapt to the emerging threat. This is the theme of my 2021 Adapting to Climate Change book.
If rate setting is done right, by improvements that reduce vulnerability to loss. In the longer run, by faster growth in less vulnerable areas and slower or negative growth in vulnerable areas.
Cursing policy makers for not having taxed net CO2 emissions in the ‘70’s does no good.
Good points. The adaptation need is technically an additional cost of insurance. I wonder if we can determine whether there is sufficient insurance market competition to price the true benefit of this adaptation.
Separately, the risking insurance premia could be an interesting way to calculate the negative externality (and thus the tax/fee) of polluting behavior. Right now the externality falls directly on homeowners in this instance.