The Insurer as the “Adult in the Room”

On Monday June 10th 2024,  I gave a talk at an Insurance Conference at St. Johns University in downtown Manhattan.  I want to sketch out my major points regarding the beneficial role that the insurance industry will play in helping to accelerate climate change adaptation progress.  I also want to emphasize the importance of the Federal Government stepping back from subsidizing place based insurance.

Background

In my undergraduate economics classes, I often contrast Homer Simpson and Mr. Spock from Star Trek.   Homer is not an “adult in the room” while Mr. Spock is one.  Mr. Spock knows what he knows and doesn’t know. He also recognizes that there are “known unknowns”.  As a chess player, he thinks strategically about what his opponent (Klingons, Mother Nature) are doing and he plans out his best response.  In contrast, Homer just blissfully lives his life with his friends and family.  Homer isn’t sweating climate change.

Homer owns a nice house though and this home could be at risk if his Springfield faces short term to medium term air pollution spikes, wildfires, extreme temperature shocks and other disasters.  If Homer is blissfully unaware of these risks, then he won’t bother taking costly upfront precautions for events that he doesn’t imagine can occur.  Why is Homer so ignorant?  He may form his expectations backwards as he looks to historical data over the last 20 years and uses these to calculate probabilities of weather extremes.  But, if the climate is changing such historical data may be misleading if certain trends are ignored. Homer may also believe that there are Santa Claus like figures in the Federal Government who will buy him a new house if something bad happens to his house. The anticipation of ex-post bailouts creates ugly moral hazard scenarios and discourages people like Homer from investing the time and effort to become risk mitigation experts! Our rules of the game have a causal effect of turning home owners into babies!!

Society’s Goal

We want more people to live in places that are relatively safer from weather extremes.  We want them to live in structures that are better able to “take a punch”.  These choices over location and structure together help us to be safer in the face of climate change.  Home owners should use their own money to make their own bets. Insurance pricing can play a key role here in accelerating this adaptation process.

Point #1    Insurers maximize their profits.  Their profit equals their revenue from selling premiums minus their costs. Their costs are higher if more policyholders suffer from a shock and they suffer a large loss from that shock.   So, if climate change doubles the likelihood of a shock taking place, insurers would be wise to raise rates for selling policies. State regulations often place a ceiling on such price increases.

Point #2   Competition between insurers protects property owners from being overcharged.

Point #3   There is considerable uncertainty about the extent, the timing and the geography of climate change risks but insurance contracts usually just last for one year.

Point #4     Newer structures tend to be more resilient to extreme weather events both due to building codes and the fact that new construction is usually of higher quality.

Point #5   Insurers should be free to risk price and to price discriminate based on a structure’s attributes and property’s physical attributes.   These can be cheaply verified using drone technology.  Home owners could pay for an arm’s length inspection of their home to provide the insurer with up to date detail about the home’s configuration.   The Insurer can charge a price for a premium based on all of these data.

Point #6   When state regulators and elected officials insist that insurance prices have a ceiling, they are implicitly redistributing money from people who live in low risk places to those who live in the high risk places. This creates a moral hazard effect and it slows down adaptation.  We want economic activity moving away from high risk places.

Point #7  Economic activity has been moving to high risk places in part because safer places such as our Urban Core in progressive,educated cities build very little new housing. These artificial supply constraints push middle class people out to the fringe into hotter places, featuring more pollution from wildfires.

My Worldview:  A Milton Friedman Libertarian Perspective.

I am not an expert on insurance.  I am a microeconomist.  Back in 2017, I wrote a HBR piece titled “How the Insurance Industry Can Push Us to Prepare for Climate Change”.  

A core theme in my research is that places with great quality of life have a great future.  Climate change poses specific risks to a Santa Barbara or Miami, how real estate performs determines the place’s future.

My Proposed rules

Given that Mother Nature is punching places harder, eliminate government subsidized insurance;  People who choose to live in risky places live with the consequences.  If insurance prices soar where they live, they can sell to a private equity investor who can rent the property back to them or they can invest in self protection to upgrade their home’s ability to withstand the harder punches of flooding and fires.

Insurers can charge any price but they must show that they are solvent and that they payout claims quickly. Insurers could be required to show that they can pass “stress tests”.

Insurers can price discriminate based on verifiable precaution investments

Insurers can spatially price discriminate and charge prices depending on community attributes

Allow mortgage lending companies and insurers to merge and jointly market products together. This would have the beneficial effect of creating more climate safe real estate assets. Why? The lender would lend at a lower interest rate if the home is relatively safer. The joint insurer and lender can optimize the synergies between access to capital to finance the home and disaster insurance.

Local land use regulation reform is needed so that there is up zoning in places where the climate scientists believe that these areas face relatively less weather risk. I do not believe in the takings of land use but too much of the U.S is zoned for single family housing. Communities in safer areas should be offered an incentive to up zone

The Adaptation Payoff

Bald men can buy Rogaine because the aggregate demand to offset baldness created a profit opportunity for drug companies to innovate and experiment with hair growth techniques.

The same logic applies to helping real estate assets adapt to place based climate risk. As more properties face higher insurance rates in flood and fire zones, they will seek adaptation solutions and this will unleash the next Musk to discover ways to offset such risks.

The risk of facing higher insurance prices wakes up “sleepy Homer Simpson home owners” to take protective steps beyond begging for a Federal $ bailout.

Nudges economic activity to safer places!

Many homeowners have equity in their homes and can use financial markets to extract it to finance home retrofit upgrades. Private equity firms could buy 50% of a home and be an active adaptation partner helping the Homer to adapt. Human capital fuels adaptation!!

New homes (even without building codes) will become safer;

At the conference, it was emphasized that fires jump from home to home and thus fire safety is a community issue. This raises the market dynamic of community certification. My Scarsdale, New York is known to have great schools and home prices are higher there. Communities that solve their local collective action problem will be certified as “safe” and the homes there will be charged lower insurance prices and these homes will sell for a price premium. This is a free market incentive to invest in adaptation and to monitor and engage with one’s neighbors. Local social capital will facilitate adaptation by local communities!

Conclusion

The for profit insurer as the “Adult in the Room”.   This adult will wake property owners up about the insurance pricing they will face if they and their communities fail to take pro-active steps.

Tough love; stop treating home owners as babies.   

Empower insurers to face more risk and to earn a higher rate of return;  This will incent investments, learning and experimentation.

The Empirical Test that Insurers Can Accelerate Adaptation?   

1.  Activity will migrate to higher ground

2. Homes that are riskier will sell for a discount and attract the right buyers

3. Insurers who fail to incorporate risk will lose profits.

4. Future extreme events cause less damage because of adjustments at the extensive and intensive margin