House of Cards Season '24: Will the homeowners insurance market collapse?
Major insurance providers have abandoned states like Florida and California. What next?
To anyone keeping track, my goal is to publish a weekly post for the rest of the summer. I missed last week due to a combination of factors, but mainly because it’s too easy to get distracted by the internet and life in 2024, especially when you are self-employed. As always, I appreciate all feedback and thoughtful comments. Email replies are also always welcome! 🙏
Fax machines. Dial-up internet. Floppy disks. Foldable maps. Pay-phones. Blockbusters full of VHS and then DVDs. Physical newspapers delivered to your doorstep. The list of things that my future child will likely never experience in their own lifetimes is long and plentiful. Today I’d like to propose one more thing to that list. Homeowners insurance.
Honestly, I’ll admit it: this is both a bold and boring take. If I’m right, I don’t think too many glasses will be poured out in honor of the unsexy but nearly universal American tradition of homeowners insurance. I also don’t think we’re actually that close to the complete collapse of the homeowners insurance market (we likely have at least another decade to fix things). But being realistic, with the current average age of first-time homebuyers at 36 (source), the likelihood of my child purchasing a homeowners insurance policy in 2060 feels pretty darn close to zero.
In short, the market for homeowners insurance in the US has begun to fail. Today we’ll explore the reasons why, what we can do about it, and whether any of the potential solutions are actually worth pursuing.
Insurance 101 - why do we need insurance to begin with?
Believe it or not, insurance markets have not existed since the beginning of time, but pretty close. The concept of insurance has been around since early humans discovered their aversion to risk. They could be more resilient to risk when they joined forces. Early civilizations were more likely to survive extreme risks such as drought or famine, when those risks were spread out and absorbed across larger numbers of people. The first written insurance contracts date all the way back to the 1300s, covering the survival of merchant marine ships sailing from Europe. The basic market theory of insurance is fairly straightforward, and goes as follows:
Insurance buyers recognize there is a low probability event would be devastating if it were to occur to them. They desire to protect against that downside risk, and are therefore willing to pay a small fee (premium) up front for a promise to be taken care of if that devastating event occurs.
An insurance underwriter recognizes that there are hundreds or thousands (or more) individuals with that same fear and desire for protection. The underwriter thus offers to sell insurance protection to all of those individuals, in exchange for assuming all of the downside risk.
So long as the true probability of the risk is properly understood, and is uncorrelated across the buyers, the aggregate risk level will be lower when spread across a large number of policies. This means the underwriter can generate more money from the aggregate premiums collected than from the claims it pays out.
Some years might be luckier than others, and so profits may ebb and flow. In the long-run, if the risk premiums are priced correctly, the insurer expects to make a profit, and can remain in business.
In a similar spirit to modern portfolio theory, so long as the insurer is aggregating a portfolio of uncorrelated risks and pricing their premiums accurately to account for true probabilities of claims, the business has a positive expected value.
This basic model applies to all types of insurance markets, from health insurance to auto insurance, to commercial liability and homeowners policies. However, with respect to homeowners insurance, we’ll next explore how difficult it is to maintain this simple business model in practice.
Homeowners insurance -- uncorrelated vs. correlated risk
The quickest answer for why so many homes in Florida are now uninsured is simple, yet incomplete: climate change. More specifically, hurricanes. Hurricanes can cause devastating property damage such as Hurricane Ian in 2022, which destroyed 5,000 homes in Florida and severely damaged 30,000 more, inflicting over $100 billion in damages. Such risk is what we call correlated risk, in that entire swaths of a geography share a similar exposure to the risk of destruction. According to portfolio diversification theory, the aggregate volatility (risk) is only lower for the portfolio if the underlying risks are uncorrelated. Most non-weather related damages typically covered by a homeowners insurance policy are uncorrelated. For example, if a bear breaks into my home and causes $50,000 of damages to bedrooms and furniture, the same bear probably wouldn’t have also broken into each of the 500 other homes in our neighborhood (unless it was Hank the Tank and he was really hungry). And so just like it makes sense to invest in a portfolio of stocks from different industries, it is beneficial for insurers to underwrite policies across homeowners from different states and counties that have different risk profiles.
Unfortunately, the reality in Florida today is that nearly all counties in the state face a substantial risk of hurricane damage. Similarly in California, the risk of wildfire has become so prominent in the last decade that 25 percent of the state’s population now lives in a high fire-risk area. When downside risk is so highly correlated, there are few gains to be found from diversification across a larger risk portfolio, and then the only way for insurance companies to make money is to raise premiums.
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Regulatory failure - misguided state governments share in the blame
While climate change has certainly played a role in the higher incidence rate of wildfires and hurricanes over the last decade, climate change alone cannot explain the pending collapse of our insurance markets. In a free market, as the aggregate risk-levels rise, insurance companies should simply raise their premiums to remain profitable and stay in business. While price hikes may cause homeowners to perhaps balk and resent said higher prices, pay them they would, so long as the risk of losing their home was sufficiently severe to justify the price.
Unfortunately, regulatory policies in California and Florida have made the insurance market anything but laissez faire. CA proposition 103 was passed way back in 1988 with the intention of curtailing exorbitant industry profits and to help out homeowners. It requires all insurance rate changes to be reviewed and approved by the state commissioner each year, with an onerous set of restrictions on what types of expenses an insurer can include when setting rates. As such, major national underwriters such as State Farm, Allstate, and Progressive have opted to simply close up shop, and hundreds of thousands of homeowners have had their policies dropped in recent years. The state of California does at least offer the FAIR (Fair Access to Insurance Requirements) plan policy, which is a state-operated insurance program of last resort. With major insurers pulling out, the FAIR plan has seen a 600% increase in customers since 2018. However, this state-run program has also been described as a “ticking time bomb” because the remaining active insurance companies in the state are all legally on the hook to bail out the FAIR plan (via an annual assessment) if another major wildfire such as the 2018 Camp Fire or the 2021 Caldor Fire were to strike and deplete the FAIR plan reserves.
In Florida on the other hand, it was small government rather than big government that created the circumstances for a failing market. In short, many enterprising and arguably fraudulent contractors in Florida discovered a loophole in Florida’s “assignment of benefits” law. From FIU professor Shahid S. Hamid:
It generally looks like this: Contractors will knock on doors and say they can get the homeowner a new roof. The cost of a new roof is maybe $20,000-$30,000. So, the contractor inspects the roof. Often, there isn’t really that much damage. The contractor promises to take care of everything if the homeowner assigns over their insurance benefit. The contractors can then claim whatever they want from the insurance company without needing the homeowner’s consent. If the insurance company determines the damage wasn’t actually covered, the contractor sues. So insurance companies are stuck either fighting the lawsuit or settling. Either way, it’s costly.
If these policies sound too crazy to be true, I’d happily recommend diving into the rabbit hole that is the 250+ comments in this recent Reddit thread from May 2024.
Potential Solutions
While there are unsurprisingly infinite opinions online surrounding matters like this, there are really only two categories of solutions for saving the homeowners insurance markets over the long-term.
Stop climate change.
Fix problematic state regulations.
While I may be a self-described eternal optimist, even I recognize the wishful thinking required to believe either type of solution will be easy. Some state policy reforms are at least in the works, with the latest proposal in California supported by Governor Newsom and with Florida Governor DeSantis signing a reform bill last year. However, even if these reforms succeed in allowing insurers to charge the correct price for homeowners policies that allow them to generate a profit and stay in business, those prices will inevitably be higher. Yours truly saw his previous policy dropped by Progressive this spring, and with no other choice but the FAIR plan, our cost of insurance jumped from $3,000 to $6,600. The list of things for which I would much rather spend an additional $3,600 is also long and plentiful, such as an additional ~50 days of skiing next winter. And with housing affordability already such a challenge today, many future or prospective homebuyers may simply choose to opt-out.