Forecast Direct No. 36 - Regulation and Risks in the Private Insurance Market

Sayantani of the Anderson Forecast & the UCLA Ziman Center for Real Estate talks to Reid Taulor, research economist at the Dallas Fed. They discuss how regulation and increasing disaster risks can result in the unraveling of the private insurance market. The paper presents a simple model of a disaster market and an insurer of last resort operating in the market that’s not being provided for by private insurers. Using the case of California’s homeowners and insurance market, they further empirically estimate the effects of the California nonrenewal moratorium, a novel policy implemented by the California Department of Insurance to curb the growth of the FAIR plan.

Key Takeaways:

• As profit-maximizing firms, insurers rationally choose not to offer insurance to those who have an expected marginal cost above the regulated price, leading the riskiest consumers to receive coverage from the insurer of last resort (FAIR plan) in the residual market. Subsequently, the insurer of last resort does not solve any market failure but is necessary to guarantee full market coverage under strict price regulation.

• Zip codes impacted by the moratorium experienced a decrease in company-initiated non-renewals during the year the moratorium was active. However, this effect was short lived; insurers increased non-renewals by at least 80% in the year immediately following the expiration of the moratorium.

• They estimate that the moratorium did not slow the retreat of private firms from high-risk areas and may have even accelerated it. The number of policies written by the voluntary market declined by 200 one year after the moratorium, and the number of policies written by the FAIR Plan increased by 100.

• In order for firms to remain in the market in the long run, premiums must be reflective of the underlying risks. This can be achieved by either relaxing regulation, or investing in climate adaptation. Recent policy changes indicate that both strategies are being pursued in California.