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Firefighters battling wildfires in California last year © NIC COURY/AFP via Getty Images
The role of risk-sensitive insurance prices in climate adaptation is crucial. When premiums are accurately priced, they can inform households about local risks and influence their behavior in terms of risk mitigation. For example, they can encourage people to move to lower-risk areas or build disaster-resilient homes.
However, the regulation of insurance premiums at the state level in the US creates persistent cross-subsidies and distorts pricing. This undermines the effectiveness of insurance prices in driving climate adaptation and poses challenges for policymakers, insurers, and consumers.
Let’s imagine you’re a homeowner in Virginia. Living far away from the devastating wildfires in California, you might think that insurance premiums in California are extremely expensive. In reality, when wildfires occur in California, it’s the homeowners in Virginia who end up bearing a significant portion of the financial burden.
Our research on the $15 trillion homeowners’ insurance market has found that this phenomenon is a result of state-level price regulation, which is a pervasive aspect of the market. California, with its extensive regulation, makes it difficult for insurers to change their rates. As a result, insurers end up raising premiums in states like Virginia, effectively subsidizing their operations in California. Over time, this has led to a growing disconnect between premiums and risk, with regulated states having the least reflective insurance premiums.
In the US, insurance premiums are heavily regulated at the state level. We identified states with more stringent regulations through official filings and examined insurers’ pricing behavior by comparing zip codes along state borders with different regulations but similar underlying risk exposures.
Our findings reveal that in more regulated states, insurers adjust premiums less frequently and by a smaller magnitude after experiencing losses. Instead, they increase premiums in less regulated states. In other words, a significant portion of households ends up paying an unfair price for their insurance. These cross-subsidies are particularly prevalent in states with less competitive insurance markets, suggesting that increased competition could alleviate pricing distortions.
While cross-subsidies are common in publicly provided insurance, such as flood insurance in the US and UK, the large subsidies observed in a privately administered market are surprising. These subsidies have significant consequences.
Firstly, insurance prices theoretically serve as a way for households to learn about their local risks. Insurers, with their access to big data and sophisticated climate models, are better equipped to assess these risks than consumers. However, when prices don’t reflect risks, this learning process breaks down and can result in distorted incentives. For example, low insurance prices may lead to more construction in risky areas, inflating real estate prices in those regions.
Secondly, the disconnect between prices and risk can indicate how insurers may respond to increasing climate risks. They may choose to exit certain markets or eliminate important coverage features. We’ve already seen smaller insurers leaving highly regulated states, and larger insurers, like Allstate, Chubb, and AIG, following suit. They cite onerous price regulation as their reason. This raises concerns about the long-term sustainability of the current regulatory landscape, especially as natural disasters become more frequent and severe.
The policy implications of these findings for regulators are complex. On one hand, regulators could adopt equally strict measures across all states to address the price distortions and maintain affordable insurance premiums nationwide. However, this could lead to the insurance industry stagnating as more insurers exit.
On the other hand, removing regulations altogether could result in soaring insurance prices, with far-reaching consequences for real estate markets, housing development, and state budgets. Ultimately, regulators are facing the challenge of striking a delicate balance between the affordability and availability of insurance in the face of increasing disaster losses. This is a complex problem that requires careful consideration of trade-offs.
As the insurance sector’s role in managing climate risk becomes even more critical, it is vital to understand these trade-offs. Ishita Sen, an assistant professor in the Finance Unit of Harvard Business School, along with Sangmin Oh and Ana-Maria Tenekedjieva, is the author of “Pricing of Climate Risk Insurance: Regulation and Cross-Subsidies” (2021, SSRN), which won the European Finance Association 2022 Best Paper Prize in Responsible Finance.
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