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Wednesday, May 28, 2008

Insuring against Insurance Risk

Robert Shiller says we need to move to long-term home owners' insurance:

Insuring Against Insurance, by Robert J. Shiller, Project Syndicate: ...Almost universally in the world today, homeowners’ insurance is short term. Typically, it is renewed annually, which means that it does not cover the risk that insurance companies will raise rates at any future renewal date.

Yet we have seen major changes recently in homeowners’ insurance rates. For example, the average homeowner premium in Florida soared from $723 at the start of 2002 to $1,465 in the first quarter of 2007. Such rapid increases represent a risk that is on the same order of magnitude as many of the damage risks that the policies are supposed to address.

In a study..., the economists Dwight Jaffee, Howard Kunreuther, and Erwann Michel-Kerjan called for a fundamental change in policy aimed at developing true long-term insurance (LTI) that set insurance premiums for many years. Unless we do that, homeowners are unsure from year to year whether their insurance policies will be canceled or that their premiums will skyrocket unexpectedly as they have ... where there is hurricane and flood risk. As the authors point out, for insurers to even consider a long term policy they must have the freedom to charge premiums that reflects risk.

Urbanization itself is also a source of risk, as evidenced by the recent earthquake in China.... Moreover, global warming appears to be increasing the intensity of storms. ...

Of course, we do not know for sure that these risks will mean higher insured losses in the future. Population growth in coastal areas may ... favor more central areas. And urbanization, if done right, leads to better catastrophe planning and stricter construction standards, which might actually reduce risks. In fact, long term insurance may encourage homeowners to invest in risk reducing measures because the premium discounts ... will justify incurring the cost of investment.

The course of global warming, and its impact on future storms, is also the subject of considerable uncertainty..., so future losses must remain essentially unknown. This means that the problem is not a certain increase in homeowners’ insurance losses, but rather a risk of increase. ...

Insurance regulators are certainly well aware of the risk of future increases in homeowners’ insurance premiums. But trying to address these risks by limiting such increases doesn’t work well, because if insurance companies are not making any money, they will withdraw from the market. Nor can this problem be solved by imposing fees on insurance companies that withdraw from the market in response to premium caps, because the companies will eventually learn to consider the possibility of such fees even before entering an insurance market.

Sometimes, governments have become directly involved in providing insurance. ... But replacing private insurance with government insurance plans is far from optimal. Like other forms of saving and investment, it is better that insurance be allocated by a market, rather than in a political arena.

The beauty of the LTI plan proposed by Jaffee, Kunreuther, and Michel-Kerjan is that it would allow market forces to determine long-term (20 years or more) insurance premiums. The premiums would be set so that there would be no reason for insurance companies to withdraw from the market in response to greater risk. Homeowners can rest assured that they can continue to insure their property at known rates.

Moreover, the premiums would provide price signals that would guide new construction. In areas where scientists think that there is a likelihood that greater risks will prevail in coming years, high insurance premiums would provide a market incentive to curtail development. Everyone would end up better off.

Why don't insurance companies offer these plans now? Generally, factors such as myopia, hyperbolic discounting, low probability event bias, incomplete information - the usual suspects - are cited as reasons for the market failure, and hence the need for regulation to overcome underinvestment in measures and locational decisions that can limit the damage when natural disasters strike.

    Posted by on Wednesday, May 28, 2008 at 12:24 AM in Economics, Regulation | Permalink  TrackBack (0)  Comments (20)

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