Under the Weather: Government Insurance and the Regulation of Climate Risks

Regulating weather risk is an increasingly urgent social issue. There is little doubt that the frequency and magnitude of weather-related disasters are rising over time. Although the precise combination of causes may be debated—emissions of greenhouse gases? natural climatic cycles? increased concentration of populations in coastal areas? —the trend is undisputed. As the magnitude and frequency of weather patterns seem to pose a risk higher than ever, a large and growing fraction of humanity’s physical assets is located in harm’s way. Thus, the combination of severe natural forces and increased human exposure pose one of the major public policy challenges of our era: how to regulate behavior so as to reduce this risk.

Putting to one side the root causes of climate change, our article, Under the Weather: Government Insurance and the Regulation of Climate Risks, explores how weather risk is and ought to be regulated. In particular, we focus on the regulation of weather risk through insurance mechanisms. Looking at insurance providers, private or governmental, as regulators of weather risk, the article asks two sets of questions. First, how does weather insurance mitigate the expected costs of weather-related disasters? Second, does the regulatory impact of insurance change in systematic ways when the government becomes the provider of weather insurance?

In addressing the first question, we reconcile two basic but conflicting insights. At one end stands the widely accepted idea that having insurance dulls the insured party’s incentive to mitigate losses. In opposition to this well-known “moral hazard” conjecture stands a different prediction—not nearly as well studied or well understood—that insurance contracts reduce, rather than aggravate, risk. Anticipating that storms may be coming and recognizing that insured property owners might capitulate to the moral hazard, insurance providers can include in their contracts powerful counter-incentives. These contractual mechanisms, and in particular the price signals that insurance policies give people regarding expected risks and the value of mitigation efforts, prompt policyholders to improve their preparedness and reduce the exposure of their property to weather-related losses, potentially to a greater extent than they would have done in the absence of insurance.

Recognizing the ways in which insurance can regulate weather risk, the article turns to address the second fundamental question: who should provide the insurance and act as the regulator of weather risk—private insurance companies or the government? While in theory the ownership and administration of the insurance mechanism need not affect the optimal content and design of insurance contracts, we show that in practice it makes a great difference. Unlike private insurance, government provision of weather insurance is less subject to market discipline and to the strict methods of actuarial pricing, and is more likely to be influenced by political considerations, redistributive preferences, and affordability concerns.

The Article shows that regulation of weather risk through government provided insurance in the U.S. is often inferior to regulation that might be implemented through private insurance markets, in two ways. First, it is less efficient. When people and firms are insured by the government through contracts or relief grants that fail to produce good incentives, those people and firms choose property locations too close to paths that devastating storms normally travel. Moreover, when these poorly placed homes and businesses are in fact destroyed, they are often rebuilt in the same place—and in the same way—largely because government insurers do not insist otherwise and do not force homeowners to factor in the true cost of their location decisions.

Second, and no less disturbing, government insurance of weather risk is strikingly unfair. Subsidies for government provided weather insurance are often justified as a way to help lower- and middle-income residents of coastal areas. But the reality we demonstrate is quite different: the beneficiaries of the subsidies are the more affluent homeowners. Employing a unique dataset from Florida’s state-backed insurance company, we show that homeowners who enjoy the largest insurance cross-subsidies are those who need them least. The magnitude of this regressive cross-subsidy is large: some of our estimates suggest that a 1% increase in household wealth is associated with more than 1% increase in the subsidy! Since the subsidies are funded by taxpayers, it turns out that less affluent residents of non-coastal areas are paying to support the rich.

The preceding post comes to us from Omri Ben-Shahar, the Leo and Eileen Herzel Professor of Law and Kearney Director of the Coase-Sandor Institute for Law and Economics at the University of Chicago Law School, and Kyle Logue, the Wade H. and Dores M. McCree Collegiate Professor of Law at Michigan Law.  The post is based on their recent article, entitled “Under the Weather: Government Insurance and the Regulation of Climate Risks” and available here.