For some strange reason, a small town in Oklahoma has the unwelcome distinction of being one of the most expensive places in the country to get home insurance (relative to property values). Pundits may point to Enid, Oklahoma’s relatively low population levels (pop. 50,000 – home to the state’s railroad museum) as a cause – perhaps there aren’t enough people to share the risks around – but the state’s ninth largest city doesn’t sit below sea level like New Orleans. It doesn’t sit in a 100% wildfire risk county such as Riverside in California which is expecting $319m loss this year.
Research by the New York Times shows that the middle of the country, and some of the Southeast, is disproportionately picking up the costs that appear to be being transferred to them by highly regulated states such as California.
A recent report by Sangmin S. Oh from Chicago Booth, Ishita Sen from Harvard Business School, and Ana-Maria Tenekedjieva from the Federal Reserve Board delves into the complexities of homeowners’ insurance in the US The study focused on the consequences of state-level price (rate) regulations, revealing a tangled web of economic implications and regulatory challenges. The market is “incentivizing all sorts of crazy behavior,” Sen told the NY Times.
Homeowners’ insurance is a significant market in the US, providing protection against property damages from natural disasters such as wildfires, hurricanes, and windstorms. With annual sales exceeding $15 trillion and premiums amounting to $120 billion, the market is both vast and vital. However, the regulatory environment within which this market operates varies dramatically across states, influencing how insurers set their rates and manage risks.
One of the study’s key findings is the presence of significant “rate-setting frictions” in states with strict regulatory environments. Insurers in these high friction states adjust their rates less frequently and by smaller amounts after experiencing losses, compared to their counterparts in low friction states. This discrepancy forces insurers to compensate by adjusting rates in less regulated states, leading to a phenomenon known as cross-subsidization.
This cross-subsidization results in a decoupling of insurance rates from the underlying risks. Essentially, households in low friction states are partially bearing the risks of those in high friction states, creating an uneven distribution of climate risk across the country.
The report also highlights, unsurprisingly, that insurers in high-friction states tend to have lower profits compared to those in low-friction states. Higher levels of regulatory friction are linked with reduced future profitability, indicating that stringent regulations may hinder insurers’ ability to price risk appropriately. Over the long term, high-friction states have seen slower growth in insurance rates relative to the increase in expected losses, while low-friction states have experienced the opposite trend.
Another critical aspect of the study is the identification of asymmetric rate spillovers. Rates in low friction states respond to out-of-state losses occurring in high friction states, but the reverse is not true. This finding underscores the burden placed on less regulated states to absorb the financial shocks originating from more regulated environments.
“The following hypothetical example helps to summarize the main findings. Suppose an insurer operates in two high friction states (California and North Carolina) and two low friction states (Virginia and New Hampshire). Our results imply that if losses occurred in California, rates would not change significantly in California itself or in North Carolina, both of which are high friction, while they would rise meaningfully in Virginia and New Hampshire, both of which are low friction” the report said.
The implications of this asymmetry are profound. It suggests that regulatory differences across states are leading to a distortion in risk sharing, with households in low-friction states indirectly subsidizing the insurance costs of those in high-friction states.
The disconnect between insurance rates and actual risk in high-friction states poses several challenges. For consumers, it means that insurance premiums may not accurately reflect their true risk levels, potentially leading to misguided financial decisions. For insurers, the inability to adjust rates in response to actual losses could prompt exits from high-friction markets or reductions in product offerings, further impacting the availability and affordability of homeowners’ insurance.
The study concludes that a balanced regulatory approach is crucial. Policymakers need to ensure that regulations protect consumers while allowing insurers the flexibility to price risk accurately. This balance is essential for maintaining a robust insurance market that can effectively distribute climate risk and support household financial stability.
As climate risks continue to escalate, the findings of this report highlight the urgent need for regulatory reforms in the homeowners’ insurance market. Ensuring that insurance rates are reflective of actual risks and that regulatory frameworks are harmonized across states will be key to building a resilient insurance system capable of withstanding the challenges of a changing climate. This report provides a valuable blueprint for policymakers, insurers, and consumers as they navigate the complexities of climate risk and insurance regulation.
Riverside County faces an exceedingly high risk of wildfires, earning a perfect risk index score of 100%. The county’s expected annual loss from such fires amounts to a staggering $319 million, with a 2.4% chance of occurrence each year. Historically, Riverside has maintained a relatively low loss ratio.
Similarly, San Diego County holds a very high wildfire risk, also rated at 100%. It surpasses Riverside in expected annual losses, projected at $382 million, and has a slightly higher annual frequency of 2.7%. Like Riverside, its historic loss ratio remains relatively low.
San Bernardino County shares the very high-risk category with a close-to-perfect rating of 99.9%. The county’s anticipated yearly loss stands at $134 million, with a 0.97% annual chance of wildfires. Despite this, it has maintained a relatively low historic loss ratio.
In Los Angeles County, the risk is also rated very high at 99.9%. The expected annual financial loss due to wildfires is $109 million, occurring with an 0.8% chance each year. Historically, this county has seen a relatively moderate loss ratio.
Ventura County, while rated slightly lower at 99.8%, still faces a significant wildfire threat. The county’s expected annual loss is $48 million, with wildfires likely to occur at a frequency of 1.3% per year. Its historic loss ratio is relatively low.
Orange County has a similar risk profile to Ventura, with a 99.8% overall rating. It is projected to lose around $50 million annually from wildfires, which have a 1.5% chance of happening each year. The historic loss ratio in this county is also relatively low.
Kern County holds a relatively high risk index at 99.7%. The expected annual wildfire loss here is $28 million, with a 0.7% yearly frequency of such events. Kern has a relatively moderate historic loss ratio.
Madera County, also with a relatively high risk index of 99.6%, is projected to face $20 million in annual wildfire losses. The chance of wildfires occurring each year is 0.8%, and the county has a relatively moderate historic loss ratio.
In Santa Barbara County, the risk index is relatively high at 99.5%, with expected annual losses from wildfires at $24 million. The frequency of wildfires stands at 0.8% per year, and the historic loss ratio is relatively moderate.
Lastly, Tuolumne County shares a similar risk index of 99.5%, with an expected annual loss of $21 million from wildfires. The probability of wildfires each year is 0.96%, and the county maintains a relatively low historic loss ratio.
