The insurance market sucking wind

Posted by Marc Hodak on September 4, 2007 under Unintended consequences | Comments are off for this article

Today, a writer for the WSJ inked a piece about the rise in premiums for wind coverage. The author discusses how much the premiums have gone up and what people are doing in response to the increase in premiums, etc. In 1300 words, the author never mentions a major contributor, if not the most likely cause, of the dramatic increase in premiums. He simply takes it for granted, as most of his readers presumably do, that a company dropping clients and foregoing business via significant price increases requires no explanation. At least that’s a step better than most journalism that would assume that the explanation is some sort of conspiracy by the insurance companies to make more money.

The basic problem is that this article is all about the property the author could see–the real estate that had been damaged, or might be damaged, and was going uninsured. What is missing is the notional property that is a contract. Insurance companies contract with homeowners to insure their property for possible future damage. In this case, the source of that damage would be wind; insurers aren’t supposed to be on the hook for water damage. When a hurricane comes along, the wind comes with water, and it’s sometimes difficult to distinguish the source of damage. When enough citizens plead with enough politicians to insist that the insurers err heavily on the side of assuming wind damage, the insurers pay out the nose for damage they did not insure. Ever heard of this happening? Oh, after every hurricane.

So, insurance companies, in an rabid attempt to protect their profits, now have to assume that “wind” means “wind or water,” and must, if they have a shred of concern for their shareholders, charge accordingly . Why else would they raise their premiums? Well, the newspapers often get this wrong. They say companies must raise their premiums after a bad storm to help pay for those (past) damages. That, of course, makes zero economic sense. Insurance is a prospective game. If I were to enter the market and offer to insure you for wind damage, basing your premiums on the actuarially correct amount needed to cover your expected losses with a profit for my risk, then I would kill off all my competitors overcharging you based on past, unrecovered damages, i.e., their sunk costs.

Of course, the state won’t let me just start up a competing insurance company. The regulatory hurdle is simply too great. And the insurers would rather feed you the story about having to pay for past damages because, unlike my readers, that is all the average reader understands. They simply wouldn’t have the patience to learn the economics of insurance markets from scratch. I don’t blame the insurance companies. I blame the boards and trustees of schools that refuse to include basic econ in the curriculum. Like the school this article‘s author no doubt attended.