Insurance Markets, Real Estate, and Natural Disasters: A Growing Concern
The role of insurance markets in mitigating the risks associated with natural disasters has never been more critical, with Hurricanes Milton and Helene making headlines in the U.S. Insurance serves as a key tool for managing financial exposure to climate-related risks. However, the escalating losses after each of these events are not solely due to the increasing frequency and severity of extreme weather. A significant additional factor is the growing concentration of population and assets in high-risk areas, which are particularly vulnerable to hurricanes, floods, and wildfires. This trend, combined with an insurance market structure that appears inadequate to handle rising climate risks, has led to increasing premiums and heightened concerns about how effectively risk is being managed.
Free riders and Business Relocation
Conventional wisdom suggests that businesses and households would move out of flood-prone areas as climate related risks increase. Instead, not only are more people settling in regions exposed to extreme weather events, but businesses in flood zones have also grown 10% faster than the number of businesses in non-flood zones over the past two decades, according to a study by An et al. 2023.
This counterintuitive result can be explained by a free-rider problem in the flood insurance market. The National Flood Insurance Program (NFIP) provides coverage for properties in flood zones, but enforcement of flood insurance requirement is much stricter for residential properties than for commercial properties. In 2020, only 20% of commercial properties in flood zones carried NFIP insurance, compared to 70% of residential properties. This discrepancy, combined with public insurance subsidies and persistent government aid after disasters, creates inefficiencies in the market.
The mechanism is simple: commercial property owners avoid the cost of flood insurance while still benefiting from government aid when floods occur. This allows them to offer lower rents, attracting more businesses to high-risk areas. However, this dynamic is most effective in areas with a significant concentration of commercial properties. In commercial districts, lower rents draw in businesses, while in more residential areas, rising flood insurance costs are passed on to tenants, pushing residents and businesses out.
For instance, in central business districts with high flood risk (between 0.5% and 2%, according to First Street Foundation’s flood risk measure), the number of businesses grew 10% faster over a 10-year period after these areas were designated as flood zones. The long-term consequences of this misallocation are significant. By allowing businesses to locate in flood-prone areas without bearing the full cost of the risk, the current system increases economic exposure to future flood damage.
Risk Selection and Regulation
The homeowners' insurance market is also under immense pressure, with premiums rising sharply in response to escalating climate risks. Insurers face significant challenges in accurately pricing policies, especially for infrequent but catastrophic events like wildfires or hurricanes.
One of the major challenges is the inconsistency in the quality of risk information used by insurers. The study of Boomhower et al. 2024 shows that insurers' pricing strategies vary widely depending on the level of information they have about wildfire risks. Insurers that rely on less detailed risk assessments tend to either overprice policies or withdraw from high-risk markets, reducing the availability of insurance. Meanwhile, the cost of adopting better risk assessment tools remains a significant barrier. Only insurers with large market shares can afford these advanced tools, leaving smaller, less sophisticated insurers more exposed to high-risk customers. As a result, better-informed insurers capture lower-risk clients, while less-informed insurers raise their prices to avoid selling unprofitable policies to high-risk customers.
State-level regulations exacerbate the problem, particularly in states like California, where laws limit how much insurers can raise premiums. This regulatory environment restricts insurers' ability to adequately cover the growing risks posed by climate change. Additionally, insurers are often prohibited from using simulation-based stochastic risk models to price insurance, forcing them to rely solely on historical claims data. As a result, some insurers are now pulling out of these markets, leaving homeowners with fewer options and, in many cases, forcing them to rely on the state’s insurance safety net, the California FAIR Plan, which offers less comprehensive coverage.
Takeaway
As climate risks continue to rise, existing insurance market design are increasingly inadequate. Whether through improved risk modeling, regulatory reform, or better enforcement of insurance mandates, there is a clear need for policies that address the growing threat posed by natural disasters. Without such changes, both human and economic cost will continue to escalate.
