Human Capital Investment Fuels Climate Change Adaptation
An Example from Fire Insurance in California
The New York Times reports that another major private insurer is retreating from selling new insurance policies in California. Free markets usually allow buyers and sellers to make mutually beneficial trades. In California, there are home buyers who want to insure their homes against various risks such as fire risks. There are for profit insurers who seek to sell policies. Why aren’t there gains to trade here?
Parts of California have always faced fire risk but climate change is raising such risks in certain parts of the state. First Street Foundation’s data can be used to see whether your property is situated in such a fire zone.
Of course, home buyers want cheap insurance. I wish that I had spaceship. If your $1 million dollar home now faces a 2% chance of being burned down each year, can you really expect that any insurer will charge you less than $20,000 to write this policy? Whether you will be charged $50,000 for this policy depends on whether there is competition in the private insurer industry. If there is competition, the price will be competed down to roughly $20,000. If climate change raises the risk your home faces to 3% a year to be destroyed, then your policy will rise to at least $30,000.
What is going on in California is that regulators in the state must approve rate hikes. These regulators think that they are protecting incumbent home owners from “price gouging”. These incumbent home owners have built up equity in their home due to the California price boom and they can use reverse equity loans to extract $ to pay for their higher insurance. The California Regulators are inhibiting the insurance market and insurers fearing such regulatory risk are retreating.
This is bad news on several levels.
Imagine an economy where there is no regulator who must sign off on rate hikes. Imagine if insurers can charge any price and offer any contract to home owners who seek a policy. What I want to achieve here is to sketch to you the contract innovation that would take place.
Point #1; There would be competition in the insurance industry. There wouldn’t be a single monopolist. Many entrants could enter. Amazon could even enter and use its Big Data about home owners to know things about their personality and their propensity to engage in risky behavior.
Point #2 Consider the fire risk parts of California. Smart insurers would offer the following type of contract to Matthew.
“Dear Matthew,
You live in a fire zone and your 1988 year built home is at risk. You can pay us X dollars per year for insurance. Or, if you take the following 5 verifiable steps, we will offer you a cheaper insurance for the next 4 years. A drone will fly over your house to verify that you have taken these steps and we reserve the right to inspect your house.
regards, The Smart Insurance Company
Note that this contract encourages self protective investment by the home owner. The home owner has an incentive to take these steps to reduce her insurance bill. She will compare the cost of taking the precautions (such as removing vegetation near the home) versus the cost savings from taking these actions on reducing her insurance rate.
If enough home owners take these precautions then the local climate damage function flattens. In English, this means that hot , dry summers cause less fire damage to the housing stock.
As more households demand adaptation innovations to further lower their insurance prices, capitalist entrepreneurs will spend more effort creating these and virtuous cycle of innovation targeted at furthering adaptation plays out. Allowing for price spikes in insurance accelerates this path.
Readers of the New York Times need to think about, when does government action crowd out private sector adaptation and when does it encourage such effort? My 2021 Yale Press book explores this theme in detail.
If we start to allow for fire zone price gouging, then more people will seek to live in safer places that face lower insurance prices. If we change our zoning code to allow for taller buildings in the less risky areas, then more of us can live in safer places and concerns about “climate gentrification” are overstated.
The title of this piece pertains to the following point. For profit insurers will invest more in great people focused on flood and fire zone areas if there are profit opportunities from understanding the risks and ways to mitigate risks in these areas. If the regulators cap prices in these areas, then this destroys the incentives of such firms to invest in pinpoint risk knowledge and understanding how to encourage home buyers to offset this risk.