16 July 2023
Edward Lotterman
The invention of insurance more than five centuries ago was at least as key to the development of modern economies as the steam engine.
Being able to spread risk from those engaging in an enterprising activity to others who were willing to absorb it for a fee facilitated greater trade and investment.
Virtually every household and business buys insurance. But the property and casualty part of the industry is in rough waters. Some companies are insolvent. Others are no longer serving large geographic markets.
Longstanding policyholders suddenly find that firms with which they have done business for years are not just raising rates, but rather refusing entirely to renew coverage. Homeowners — and condo owners associations — scramble to get coverage that, if for no other reason, understandably is required by mortgage lenders.
Commercial property owners, including farmers, face the same price and coverage shocks.
State insurance regulators and legislators often seem overwhelmed in their searches, not just for solutions, but for temporary palliatives. Costs and disappearing coverage already are hot political issues in traditionally disaster prone Florida and California, and will be joined on the public radar as changes ripple through to other states not historically impacted.
What can economics offer? Certainly not solutions. But an explanation of some of the underlying terms and institutions may help.
Start with a simple distinction made by an Iowa farm boy who went on to build the economics department at the University of Chicago. Frank Knight’s work distinguished between “risk” and “uncertainty.” Both concepts deal with future situations in which one does not know what will happen. However, there are some unknown futures for which there is enough information by which one can estimate the probabilities of different things happening.
We don’t know when anyone will die, but there is enough information available that one can estimate the likelihood of the average person dying in a given year. This can be tweaked with information on past health and on risk factors such as smoking. So insurance companies are willing to write life insurance policies on the lives of most people. Ditto for cars. There are crashes every day from slight fender-benders to multiple death pileups. Again, there is enough historical information for actuaries to calculate the premiums that must be charged for a profitable business to take on the risks of property damages and liability for harm to people.
Knight argued that if an unknown peril can be managed with insurance or investment instruments such as futures contracts or options, then the situation is one of “risk.” But if there is insufficient information to estimate probabilities and no insurance or other loss-mitigating tool is available, then one faces “uncertainty.”
Me crashing my pickup is risk. China making a military gram of Taiwan is uncertainty. Hail in Stearns County in August is a risk. Eruptions of Mount Rainier or the caldera under Yellowstone are uncertainty, as are possible asteroid strikes or outbreaks of pandemics like COVID-19.
It is not that some perils are subject to the laws of nature and others not. Physical or biological processes drive asteroids, volcanoes and pathogens. But their harmful events are so infrequent that one cannot calculate the statistical likelihood of one happening with enough precision for anyone to be willing to contractually commit to compensation.
Note that differences in the amount of data and its variability prompt a division of the insurance industry into life insurance versus “property and casualty.” We have data on many hundreds of millions births and deaths and human lives don’t vary nearly as much as hail storms or hurricanes. So insuring lives is a more serene activity than insuring dairy barns, retirement condos, oil tankers or football arenas.
Because of the variability of large losses, there are greater fluctuations in rates for property insurance. Indeed, there is an “insurance cycle.” For companies, losses are low and, perhaps, returns on invested reserves are high, so short-term profits are high. Property and casualty insurance often is very competitive and so rates get cut. Then there is some large adverse event, the San Francisco earthquake, a hurricane or Asian cyclone or an oil rig blowout. Claim settlements surge, black ink turns to red in insurers’ ledgers and rates rise.
Introductory econ theory assumes that as higher risks become apparent, policy costs would escalate smoothly up some supply curve, the way the price of corn rises as successive news of a spreading drought emerges. But there are times when insurance companies feel they effectively are facing uncertainty rather than risk. The prudent action is to get out of certain markets entirely.
Houses on California seaside cliffs that stood for decades are falling into the breakers. Idyllic towns in wooded mountains can turn into ashes in a few hours. Luxury yachts can be tossed around like toy boats in a single day. And while these climatic events are happening more frequently, and therefore more predictably, their precise location, and therefore actual risk, can not be known.
These events are no longer just short-term blips in a stable set of physical relationships, but rather are becoming a fundamental reordering of the variables. What was thought to be risk is emerging as uncertainty. Even the most skilled actuaries can do little more than guess. Hence the four or more large national insurers that are withdrawing from California entirely rather than merely raising premiums. There is a similar withdrawal from Florida.
Less visibly, large losses on condominiums have led all insurers to raise rates on these properties, including in the Twin Cities, or to decline renewing policies. This includes the one we live in.
This brings us to government. In our nation there is virtually no federal regulation of insurance as there is of stock markets and banks. Rather, it has always been a state function, one that states guard jealously. Regulation does vary in detail from state to state, but generally agrees on broad measures.
Complete lack of coverage can be disastrous, so there are some restrictions around insurers cutting off customers. Yet regulators cannot force insurance businesses to write loss-making policies over the long run. So states have created “high-risk pools” or state sponsored insurers of last resort. Florida did so in 2002, but this entity is in deep trouble as storm damage mounts. Our state has the Minnesota FAIR Plan similar to ones in many other states.
These pools were created by state legislatures but are intended to operate without taxpayer funds. These can prevent gaps in coverage for properties like the condos currently being dropped by their historic carriers. But as climate-shift driven losses mount, expect greater funding of state pools.
Climate is changing, whether one wants to admit it or not. We face huge adjustments. Current disturbances in the force of insurance markets are just one manifestation of this, and may be one financial incentive to spur environmental action on the policy level, but many more challenges are coming down the pike.
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St. Paul economist and writer Edward Lotterman can be reached at [email protected].