Failing to get insurance prices right causes problems

Dr Eric Crampton
The Dominion Post
11 November, 2019

There was a great old The Three Stooges bit about plumbing that teaches us a lot about regulation.

The Stooges were a trio of hapless idiots who produced comedy gold in the days before colour television. In 1940's "A Plumbing We Will Go", the team tried to fix a leaking basement pipe – not much noticing the damage their repairs were causing to other pipes, to the ducting, to the floors, and to the wiring.

For all the plumbing work, the basement just wasn't getting any drier — and the rest of the house was wrecked. Regulation is too often like that, creating multiple new problems for every problem it tries to solve, and a never-ending cascade of regulation trying to patch the leaks caused by the prior rounds.

Last week, the Reserve Bank warned insurers about climate change risk and the need for high-quality risk management capabilities to support risk-pricing.

Failing to get insurance prices right does cause problems.

For example, the American government subsidises flood insurance for people who decide to live on flood plains — premiums are well under a fair market rate. Unsurprisingly, lots of people decide to live in places where there is a lot of flooding risk — the National Flood Insurance Programme bails them out come the rain.

And is it any particular surprise that the beachfront homes subsidised by the programme tend to be owned by richer people?

If insurance premiums matched actual risk, rather than being distorted by subsidies, fewer people would live in places at greater risk with sea level rise. But since those subsidies are in place, governments then start worrying about what other regulatory interventions they will have to use to get people to move away from the coastline.

Bringing it back home, there is a very good case for making sure that insurance premiums reflect risk.

If the great house on the cliff-face in Mt Victoria came with a shocker of an insurance premium because of landslide risk in an earthquake, and if the historic villa in Petone were bundled with insurance premiums that correctly priced the risks of liquification and tsunami, people might check on insurance costs when deciding between Petone and safer places.

But insurance prices in New Zealand are relatively coarse. You will pay a lot more for insurance in Wellington than in Dunedin because of differences in earthquake risk, but there is not much difference within Wellington — or at least the differences seem small relative to the differences in risk.

It has puzzled me. Is there really free money sitting on the table for any insurer who wanted to offer cheaper prices in the safer parts of town? I don't often hear people complaining that insurers just aren't doing enough to increase their profits.

A new insurer entering the Wellington market, offering cheaper and fair prices in Karori and the flatter parts of Khandallah, for example, should be able to do well. And it isn't as though earthquake risk is secret knowledge held closely by insurance insiders; there is great address-level data on earthquake risk for the Wellington Region freely available online.

So, what's the problem? Why are insurers throwing away free money in ways that encourage too many people to live in the riskiest places, and too few people to live in the safest places?

Failing to price risk properly also makes councils want to restrict development in riskier places – even for people would have been willing to pay high insurance premiums.

The whispered answer I'll usually get on asking around is that insurers worry that they would be stomped on by central government if they allowed home insurance premiums to reflect risk.

Insurance prices in places like Petone would skyrocket. People would complain to the government.

Government would respond – and probably poorly. Insurance would look unaffordable to too many people – and especially if people started betting that higher rates of uninsurance would mean the government would bail them out come the quake. Both of those concerns would have the government step in to regulate insurance charges.

This kind of worry never seemed implausible, but it always seemed a bit hard to prove. But, Finance Minister Grant Robertson warned insurers last week that they should not allow risk-based premiums to result in insurance unaffordability in risky places.

And we're back to the Stooges and plumbing. If insurers price risk properly, they'll be in trouble with Robertson. If they don't, councils will increasingly look to zoning to undo the mess. And that causes cascading sequences of additional problems.

We should be careful when asking government to turn regulatory wrenches. Government plumbers too often fail to notice the other pipes they break along the way.

Dr Eric Crampton is chief economist with The New Zealand Initiative

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