Recent searches
Search options
#Insurance is weird. #Government action makes it weirder. If you have perverse #incentives, you get perverse results.
An example.
Every spring, there are floods somewhere in North America. Maybe the Red River that flows up through North Dakota to Winnipeg and beyond. Maybe the winter snowpack is heavy and melts quickly in the Rockies, flooding out parts of B.C. Maybe torrential rains in Atlantic areas cause overland flooding throughout Quebec.
[...]
What is common among all these cases is that people tot up the damages and exclaim about how horrible it is, and then come the stories about how there are people who weren't fully insured, or who were insured but their coverage didn't include the specific type of flooding they experienced, or they had no insurance because it was too expensive.
[...]
A little while after that, the media starts filling up with stories about how people in the affected areas are seeing large increases in their insurance costs, whether they were specifically affected by the flooding or not. Usually these stories have a "#greedy insurance #companies" or "opportunistic #capitalism" flavour.
There are calls for someone - the government, usually - to arbitrarily lower the insurance costs for the affected people.
[...]
They call for #legislation to impose #caps on increased insurance costs, or to mandate certain #coverage be available. Or they call for government to start issuing its own insurance, at nominal cost and covering high-risk events and insureds, to people who would otherwise have high commercial insurance costs.
And governments frequently take up these calls to action.
But they're making the #problem #worse.
[...]
Why is the damage so bad? Why is the total #economic #loss increasing year after year?
It's not because insurance costs are too high.
It's because people are building in flood plains. Homes, businesses, farms, whatever.
The name kind of gives it away - these are areas that regularly flood to some degree or other. It's natural and expected. And traditionally, people were smart about it, and didn't make significant improvements - buildings, etc - on such land.
[...]
They might farm such land, or graze animals on it, but they wouldn't build the homestead house on it, or anything else of value that would be damaged by flooding.
In recent generations, people are building houses and everything else in such areas. After all, they haven't flooded in the last X years, it must be safe, right? It's got a great river view, a lot of the other land is already in use and expensive.
So they build, and get flood insurance.
[...]
Then the inevitable happens, and the area is flooded. People lose the contents of their basements, or worse. And insurance pays out, or not, and insurance companies raise rates in the affected area, or reduce flood coverage.
The media cycle starts.
So what happens when government starts mandating flood coverage in areas that insurance companies have decided is too high-risk to be commercially viable? Or mandates costs lower than those expected losses?
[...]
It encourages people to build, or rebuild, in the same flood-prone areas. After all, the insurance is available and much cheaper than the actual expected costs associated with it.
Government incentivizes building in the high-risk areas. Perverse incentives. It makes the problem worse; in 5 years, or 10, or 20, there will be another periodic flooding, and the costs will be higher.
[...]
What should naturally happen is that when a high-risk area is flooded, insurance companies pay out losses for the insured, and recalculate their rates for that area. Rates are normally set such that the average cost of a catastrophic event, multiplied by how frequently that catastrophe is expected to occur, is covered by the insurance premiums collected from insured in the area over that span of time, plus a margin for safety and profit.
This is the #market in action.
[...]
In areas with very high risk, this calculation may result in numbers that are simply too high to commercially justify. There's no way the insurance company can provide insurance against that risk at a rate that people would actually be willing and able to pay.
The natural outcome here is they don't offer such insurance in that area.
This is where the media stories really go off the rails. It's "unfair". It's punitive. It's greed.
[...]
But it's not. The natural outcome of such an action is that they pay out losses, and stop offering that coverage in money-losing areas.
People can't rebuild their flooded-out house -- in that specific place. Or they can, but they can't insure it. This should be an incentive to rebuild elsewhere, where the flood risk is lower.
Instead we get calls to artificially mandate coverage in high-risk areas, at rates below the actual cost of providing such coverage.
[...]
And it incentivizes such building in high-risk areas, guaranteeing future losses, and the cycle starts anew.
Charlie Munger, Warren Buffet's partner, famously said "Show me the incentives, and I'll show you the outcome."
It's true here. Incentivize building on flood plains and other high-risk areas by subsidizing or socializing the true costs of doing so, and you get more of the high-risk behaviour, and more losses.
We need to stop the cycle.