Nationalization by stealth: The effect of climate change on the insurance sector

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Those who follow the climate risk literature, however cursorily, will get a regular flow of articles about the impact of climate change on the insurance industry.  

This recent one, from the BBC, describes the range of factors that caused Frances Acuña, a resident of Austin, Texas, to see her flood insurance quote rise from $450 to $1,893 over the past year.  It seems that changes in flood mapping have led to a significant reappraisal of the risk posed to her property.  Other factors, like the rise in the cost of building materials, would have exacerbated the situation, but there’s little doubt that Ms Acuña’s insurance burden has increased as a result of global warming.  

Like many of her neighbors, she has opted to self-insure.

Other articles, like this one from the FT last summer, suggest that many parts of the US are becoming uninsurable.  It seems that two huge insurers – Allstate and State Farm – have opted to stop selling property insurance in California because of increasing climate risk and the rising costs of repairs. At the same time, there are also numerous reports that demand for residential properties in high climate risk areas is surging, even given these insurability problems. 

Let’s face it, living by the seaside or in a fire-prone mountain forest are pleasures people are generally willing to pay for.  The key question is whether they will have to, either in the form of increased insurance costs or by personally accepting the risks associated with destruction due to natural disasters.

Or perhaps they can get someone else to pay?

Here I want to offer some random views about the impact of climate change on the insurance industry.  I suspect that the biggest impact will manifest in the form of reduced industry scale as opposed to a deterioration of solvency. 

When thinking about climate and insurance, it’s always important to consider the views of Warren Buffet, the mercurial Nebraskan investor, who remains heavily exposed to the insurance sector.  In 2016 he was quoted as saying: 

“We’re not denying climate change is an incredibly important subject.  We’re not denying its existence.  But it will not hurt our insurance business, and it’s immaterial compared to other things that could affect our insurance business.”

His reasoning was based on the fact that insurers tend to re-price on an annual basis, while the effects of climate change accumulate more slowly.  This dynamic means that even if his companies take their eye off the ball they will not fall too far behind the curve in dealing with the problem.  Premium increases, in Mr Buffet’s view, will cover rising costs due to a manifestation of climate risks and the insurance sector will remain profitable.

One aspect that Mr Buffet may not have predicted in 2016 was the potential effect of climate change on the scale of the insurance industry.  As premiums rise, many clients like Ms Acuña will choose to forego the products offered by insurers and either self-insure or seek cover provided by the government.  If Ms Acuña’s neighborhood is ever inundated, you could imagine the state stepping in to provide relief, even if the residents are not formally covered by the publicly owned flood insurer.  

Supply side decisions, like the choices made by Allstate and State Farm, will also impact the scale of the industry.  For the companies in question, their own businesses would obviously be bigger if they had opted to remain active in California.  The decision to leave the Golden State will protect the profitability of their remaining businesses while potentially reducing the actual size of their profits.  Given the market position of these businesses, it is unlikely that smaller entities will be able to completely fill the void created, meaning that the private Californian market will shrink in overall scale, relative to the baseline of a climate stable world.

One way to think of these dynamics is that we are observing an incremental nationalization of the US insurance market.  I’m certain that similar forces are at play in other parts of the world.  One key consequence of this is that we will lose the valuable price signals provided by active private markets.

Imagine Ms Acuña’s choice set if she was certain that the government would not help her after a flood.  She could either stay put and risk property annihilation or choose to move to a new location with more manageable insurance costs.  If she is risk averse, she will first extract as much value as she can from her existing house and then move.  I wonder the extent to which the potential for future government bailouts is prompting the observed flow of people into climate sensitive areas.  It seems to me to be a textbook example of adverse selection.

In summary, therefore, I think that Mr Buffet is correct in his view that climate change is largely an irrelevance for insurance companies in terms of solvency and profitability.  The effect of climate change on the scale of the industry, though, is much more pressing with the government – either implicitly or explicitly – likely to fill the void created.  

As the prominence of government insurance increases, many of the classic problems of public provision of fundamentally private services will come to the fore.  People will stay put when they should move and taxpayers will have to underwrite these ostensibly private choices.  

And it is this feature of the insurance industry that will slow our preparation for the rigors of global warming.