The risky business of homeowners insurance

In a Q&A, economist Benjamin Keys discusses climate change and risk in the real estate market.

Homeowners inspect the ruined remains of their property after a fire. Rubble, a chimney, and a rusted truck are all that's left.
State Farm, the largest insurer in California, has stopped writing new home insurance policies in the state, citing “rapidly growing catastrophe exposure.” (Image: iStock/VladTeodor)

For years, California has been a lure for many people, but on May 26, the largest insurer in the state stopped selling new policies in the home insurance market there. In a business update, State Farm General Insurance Company cited “historic increases in construction costs outpacing inflation” and “rapidly growing catastrophe exposure.”

State Farm, which in 2021 provided 20% of California’s policies, is part of a larger trend. Allstate has announced it will not be writing any new policies in California; American International Group and Farmers’ Insurance are limiting their exposure to risk in high-risk ZIP codes, including those in California and Florida. Across the board, insurance companies are becoming increasingly wary about providing services in regions prone to fire, flood, and mudslides.

“Climate risk is driving insurer decisions like never before,” wrote Benjamin Keys in a May 7 Op-Ed in The New York Times, foreshadowing these insurance companies’ decisions. Keys is the Rowan Family Foundation Professor and professor of real estate and finance at the Wharton School.

In this environment, what is the future of home insurance and homeowning? To find out, Penn Today spoke with Keys about the interplay between private companies and state agencies, how climate change and risk are reflected in the market, and how the American dream of homeownership holds up in 2023.

How do insurance companies calculate risk?

Insurers are using cutting-edge climate models to try to assess the scope of their risk. They’re trying to collect as much information as they can on the quality of the structures, the building materials that are being used, and how that interacts with growing climate risks. So, whether that’s higher wind speeds in a hurricane or increasingly severe wild fires, they want to understand how that interacts with the structures they’re insuring. Companies are using a range of complex scientific models merged with property-level information to try to accurately gauge risk.

Insurance companies want to be in business, providing services to homeowners, correct? They don’t want to pull out of markets.

They would like to be in business, yes. And I think this is one of the misconceptions of insurance markets: Insurers don’t get to set their own prices. Insurers are in a long-run negotiation with state regulators and state lawmakers in terms of how they set their premiums. When an insurer leaves a state, it doesn’t mean that they don’t want to write insurance policies. It means that they don’t want to write insurance policies under the current regulatory environment and with the current limits on premiums. They want to make a profit.

Florida is now writing their own insurance policies for homeowners who can’t be insured for flooding. Is there a role for the state in this, and how does that interaction take place within the market?

There’s a growing role for the state. This issue is something I cited in my Senate testimony. There are state insurers of last resort plans, which are also known as FAIR plans, and these were really intended as a stop-gap measure. Say when an insurer fails and you need to find an insurance policy for a few months, this program could step in so that you have continuous coverage.

Instead, they’ve become a much larger player in these markets as private insurers have backed out. The California example is one; the Florida example is another. Both of those programs have grown substantially in recent years. These programs are administered at the state level, so every state is doing things a little bit differently.

States are playing an ever-larger role in these markets, but they’re doing so in a very ad hoc and unsystematic way. I worry that a larger state role in insurance markets will bring political pressure to keep premiums low without reflecting the growing climate risks.

To characterize these programs generally, they are offering less coverage for a higher cost. And there’s a real concern that these programs are going to lack independence to set prices in an actuarially fair way because they’re state-backed and likely to be politically captured. It’s challenging for a state-backed plan to raise rates aggressively on homeowners in that state. There’s real political tension.

Having a price signal that comes from the private market is crucial because that is ultimately how decisions get made. When there are incentives for the choices that homebuilders make, that homeowners make, that’s going to reshape where we live and where we build. When we don’t get that price signal, that distorts our perceptions of risk. So, there’s a central role for private insurers to play in these markets.

That said, there are also issues related to equity and affordability and the ways in which rising insurance costs may drive lower-income homeowners out of their communities.

If we rapidly reprice this risk, that’s going to represent a big expense shock to some households. There’s certainly a role for the government to regulate these price changes and to find ways of helping low-income homeowners, but there’s a trade-off. The more that we help ease the adjustment, the longer it’s going to take for the price signal to come through.

The short answer is homeowners are definitely better off when there is a well-functioning private insurance market and insurers are competing for their business.

It’s becoming increasingly difficult to insure homes in coastal areas and places prone to wildfire, particularly in the states of California, Florida, and Arizona because of their water shortage and infrastructure challenges. But people are still moving and buying houses in those regions. How do you think the real estate market will respond to increasing insurance costs and uninsurability?

We’re not seeing the price signals that we need to change behavior. What that means is that builders, for instance, are getting the wrong signals; they’re getting the signal that we should be building more in coastal Florida, building more in Arizona. When, in the long run, we know that there are communities that are not going to be sustainable without dramatic changes to how we live. So, there’s a disconnect when we see both rising climate risk and rising house prices in these areas.

Given the fact that federal agencies like FEMA often come in to help when there are natural disasters, are American taxpayers paying for the uninsurability of other people’s homes? Is this similar to how taxpayers pay for uninsured patients when they end up in the emergency room?

There’s a real parallel to other insurance markets. If you’re in a car accident with someone who doesn’t have insurance, someone’s paying the bill. One of the themes that I tried to play up in my New York Times op-ed was this disconnect between growing climate risks, rising insurance costs, and—in the face of that—more migration into risky areas and rising house prices in risky areas. Demographic shifts as Americans move south and west are masking the underlying risks.

We are already paying the price in a bunch of different ways. Insurers can’t raise prices as much as they would like to in certain places, so, they raise prices where they can. Everyone’s homeowners’ insurance goes up as a result of rising climate risks.

We see it in in our mortgage rates through Fannie Mae and Freddie Mac, who choose not to price regional risk at all, including climate risk that varies across the country. They set mortgage fees equally across the country for the same underlying individual characteristics.

We pay the price in terms of ex post disaster aid, aid that’s provided by FEMA or by federal disaster loans or other programs. We all, as taxpayers, pay into those, and we pay by subsidizing the National Flood Insurance Program. The National Flood Insurance Program has always run a deficit and it makes up for that on the backs of taxpayers.

On top of that, we do a bunch of other things, like having the Army Corps of Engineers replenish beach sand, to which they bear some of those costs as well. The list goes on. It’s kind of endless, the ways in which we subsidize living in riskier areas in the U.S.

Economists would call these shrouded, tax-like costs that we are paying. It’s not an explicit tax for those of living in safer areas. But payments made through state and federal programs and policies end up redistributing into riskier areas. One of the challenges going forward is making some of these transfers more explicit and determining whether people are willing to support the ways in which they’ve subsidized riskier communities in recent years.

With rising climate risks, the subsidies become that much more apparent. It’s bringing some of these subsidies into the light and recognizing that it’s a policy choice, that we encourage development, and we encourage people moving into harm’s way.

What will it take for that risk to be reflected in the market?

As a country, we’re very bad at this. Over the long run, we are willing to ignore some of these concerns and willing to, in certain ways, throw good money after bad. One example of this would be the ways in which we continually rebuild after hurricanes. There’s always a local effort to rebuild, bigger and better than ever before, in the exact same risky locations.

This is going to be a long-term, gradual process. I think there’s going to be a lot of resistance in the areas that have benefited from these subsidies. And getting back to the equity issue, there are a lot of low-income families in exposed communities that would have a very difficult time if some of these subsidies were taken away. There are real challenges to addressing all of these issues and in ‘getting the price right’ in terms of pricing climate risk that’s borne by households and communities.

How do you parse responsibility for the individual household, for the local community, and for the state and federal governments?

That’s one of the big challenges. There are communities that are struggling with the challenges of uninsurability. This is true in California and Florida, but I’ve been hearing from people who are facing these kinds of challenges all over the country. Small, Midwestern communities are struggling to find insurers who are willing to provide insurance when they’re seeing more risks related to river flooding or tornadoes or other types of risks. Ultimately, the question of who bears all these costs is a real challenge for policymakers and for households going forward.

The other thing is that a lot of the discussion has focused on homeowners. But there’s another angle here; as landlords struggle to find insurance, they then pass on the insurance costs to their renters.

Part of my research is on understanding the effects of climate on commercial real estate. If you view a construction project as being uninsurable down the line, you’re much less likely to start it at the beginning. I worry about the interaction between rising climate risks and our housing affordability crisis. Rising climate risk and the challenges of ensuring commercial properties are one more barrier to building more housing in America, whether that’s rental housing or owner-occupied housing, so thinking more about that interplay, I think, is an important issue going forward.

Flood insurance is already something that many homeowners have to add to their policies to be covered. Do you see fire insurance trending that way?

Much like the National Flood Insurance Program (NFIP), I wouldn’t be at all surprised if we saw a push for a national wildfire insurance program. Given the concentration of risk in a few areas, I think it’s a difficult thing for a single state to operate and diversify in a successful way. I think the signals that we’re seeing out of these big insurers (ceasing to write new policies in California) suggest that they’re not willing to bear this wildfire risk in the same way going forward. Something is going to have to step into the void.

Undergirding all of this is that without a functioning insurance market, you can’t have a functioning mortgage market because you need to insure the collateral and lenders will not lend without insurance policies in place. It’s a fundamental feature of the housing market that we have functioning insurance and mortgage markets, and so something is going to have to step in to take that place if private insurers are not willing to do so. There’s a general reluctance to shift to regulating insurance at the federal level. The NFIP is unique in that regard. But I wouldn’t be surprised if we saw a push for other types of climate-related risks to be insured federally.

Homeowning has long been a cornerstone of the American dream. Is this still a good strategy?

Homeownership still has a ton of benefits, and I teach this to my MBA students. For example, it has significant tax advantages. There’s no other investment where the first $500,000 of capital gains are tax free. Homeownership is also, in many cases, a ticket of entry to communities that are otherwise difficult to access as a renter: accessing certain school districts, accessing certain amenities. In many suburban communities, the only option is to own, although we’re seeing the rise of single-family rentals.

But I think, in the careful calculus that any family has to make in weighing the costs and benefits of homeownership, now we need to put more weight on the costs as they relate to climate risks. We need to think about the ways in which we’re going to have to pay more for insurance going forward, and we’re going to have to think about the costs incurred by living through disasters. The cost-benefit calculus of homeownership is tilting away from homeownership, and I think it’s tilting away most dramatically in high-risk areas.