How Do We Fix Public Insurance Programs?

Key Takeaways

• Common insurance narratives dismiss public insurance programs as a solution to today’s home insurance crisis because existing federal and state natural hazard insurance programs have problems.

• Yet this narrative ignores the design flaws in these programs that set them up for problems from the start–design flaws we don’t have to replicate – and as such sets up a false equivalency that precludes creative solutions.

• Existing programs don’t spread or pool risk – basics of good insurance design, preclude diverse financing sources, purport to solve a multitude of problems they’re not well-suited for, rely – erroneously and unjustly – on the power of price to direct human behavior, and ignore the “community of fate” we’re in.

• In order to confront this growing housing safety and affordability crisis, we need to understand our fates as shared, and reimagine our insurance system into one that provides protection equitably and fairly.

Hurricane season has begun in the U.S. – and is predicted to be “extraordinary.” Wildfire season has started and thousands of acres have already burned. These and other environmental disasters are happening more frequently, and blowing hotter and stronger than they used to, thanks to climate change. They’re leaving ever more severely damaged homes in their wake. The home insurance industry, which we’re made to believe is there to help us recover after major disasters like these, is failing to keep up with the immense losses.  Insurance companies are raising rates and dropping policies, leaving people across the country with massive bills and little recovery to show for it. 

Policymakers in many states are scrambling to respond, primarily by loosening rules on private insurers and permitting further rate hikes by both private and public insurers. These moves are framed, by both policymakers and the media, as necessary to increase premium revenues and thereby re-stabilize private insurance markets. Consideration of reforming public insurance programs or even creating new ones, on the other hand, has tended to be written off with the argument that public insurance options can’t work because existing federal and state natural hazard insurance programs have problems. And indeed they do. Yet this narrative ignores the design flaws in these programs that set them up for problems from the start–design flaws we don’t have to replicate–and as such sets up a false equivalency that precludes creative thinking for solving an urgent and growing public policy crisis already affecting millions of people across the U.S.

It’s no surprise that the federally-run National Flood Insurance Program (NFIP), which underwrites most flood risk across the country, and state insurer-of-last-resort plans (typically known as FAIR plans), which underwrite fire and wind, are floundering. First of all, the design of these programs contradicts important fundamentals of good insurance design. A key pillar of insurance design is that different levels of risk should be pooled. However, the NFIP, for example, requires only homeowners in areas of relatively higher risk (“special flood hazard areas”) to have insurance policies in place, which is akin to a health insurance pool that only enrolls the sickest patients. These higher risks then come with expensive policies that people drop if they become too burdensome, leaving even fewer policyholders to cover the liabilities of the pool and worsening its overall financial solvency. 

The insufficient degree of risk spreading is exacerbated by the fact that the NFIP, as well as many state FAIR plans, only cover specific perils: the NFIP only covers flood risk; CA’s FAIR plan only covers wildfire. This, too goes against the design of how insurance can best work – the greater the spread of perils insured against, the better risk is spread. If a major wildfire hits California, the FAIR plan is suddenly on the hook for huge amounts of claims. But if it were also pooling, say, flood risk (like the major floods that hit San Diego in January), the impact to its balance sheet of a major wildfire would be much smaller as a proportion of its overall risk. Contrast this with New Zealand’s natural hazard insurance program, which provides the first layer of residential land and building insurance cover for a range of natural hazards. All home insurance policyholders get coverage for natural hazards and they pay a levy based on the coverage amount – in other words, regardless of individual risk level. 

Second, the financing structures for these programs are unnecessarily limited. One of the main critiques of the NFIP is that it’s in the red; it survives primarily by raising premiums and turning to Treasury debt. State programs can’t rely on the U.S. Treasury, of course, so their main solvency fix is to raise premiums, typically coupled with fees assessed on private insurers operating in the state, proportional to their market shares–though with private insurers scaling back or even leaving certain states entirely, those latter funds are diminishing. This heavy reliance on premium income for solvency is an unnecessary constriction on these programs. Premiums aren’t the only way a public option can generate income to fund the program: government programs can use taxes, fees, and other income to fund programs like this. We could imagine, for example, a fee on mortgage lenders to support a robust public insurance program, given that they stand to lose enormously if the nation’s housing stock remains in ruins after strings of major disasters. Or perhaps a tax on fossil fuel companies, which have profited from producing the very product causing much of the increase in environmental disasters.

Third, these programs are assumed to be able to address multiple, very complex policy areas at once. The NFIP, for example, is often described as failing because it hasn’t worked well to keep people from living in flood-prone areas; for its part, the California FAIR plan gets criticized because it hasn’t prevented people from living in the so-called wildland-urban interface, where forest fires can quickly jump to housing. Florida’s Citizens program gets similar critiques about providing insurance in areas where hurricanes often hit. But decisions about where housing is sited are land use decisions. Of course the NFIP, Citizens, and similar programs don’t work as land use programs–they’re not land use programs! If we want rational decision making about hazard mitigation, then we should design policies that directly provide for robust, comprehensive, and holistic mitigation of the harms caused by disasters. If we had this kind of rational policy making about land use decisions, then we wouldn’t need to worry about whether insurance programs were sending sufficient signals into the void.

Which leads us to the fourth reason why existing state and federal insurance programs don’t work well, and illustrates a broader flaw in the current prevailing logic of the home insurance system in the U.S.–an overly credulous faith in the power of price to change human behavior. Conventional wisdom about home insurance says high premium prices adequately signal to people to stay away from homes with high exposure to climate risk, or incentivize them to retrofit for risk reduction. In other words, the prevailing assumption is that price is the only factor, or at least the most important factor, in people’s decision making about where they live and their ability to change their exposure to climate risk.

But the assumption that price is an effective signal to shape behavior about relocation or mitigation does not hold up when we consider how people actually make decisions and the constraints on their choices. For one, people may have made decisions about where to live many years ago, before climate change impacts were locked in and when the built environment looked very different. Additionally, not everyone has full choice when it comes to where to live: the U.S. has a long history of racist housing practices that constrained the choices of people of color, especially Black Americans, directing them into “less desirable” areas. Some of those practices continue to this day, and many of the areas that were formerly “redlined” as undesirable for investment have significant overlap with areas now at high risk for climate-related disasters. And finally, the things that might best reduce risk in certain areas, like sewer upgrades in a flood zone, are not measures individuals can enact on their own. The existence of choice here is illusory.

Furthermore, those with more power and resources can often override price signals. The rich can pay extremely high insurance costs, or even self insure. Or consider private housing developers – they don’t have to worry about insurance beyond the construction phase, so they may have few qualms about building in flood or other hazard zones. Those buying or renting those properties may reasonably make the assumption that the housing is safe since it was recently built in that area. When it turns out that it’s in a flood zone, those who “chose” to live there are left holding the bag. 

Again, if we want safer and smarter land use (and we desperately need one as climate change-driven disasters increase), then we need safer and smarter land use policy. Instead, rather than changing where or how people live, the increasingly high premiums from risk-reflective pricing are leaving swathes of people without insurance to recover from extreme weather disasters including wildfire, flood, and tropical storms. 

This then uncovers a fifth element of NFIP and FAIR plan design flaws (though it’s closely related to the third element): when you take reliance on price signals to its logical conclusion you end up with many people without adequate coverage, which both sets governments up for massive unplanned spending, in the form of disaster relief, and sets the stage for widespread suffering. 

Many FAIR plans are designed to be expensive and provide limited coverage. Florida’s Citizens program, for example, requires people to be kicked off if a private insurer offers a policy at up to 20% more expensive. In a state with an average homeowners policy premium of nearly $11,000, that means, in essence, a premium hike of nearly $3,000. That translates to over $1,100 a month, which is a prohibitive sum for many families. In California, leading private insurer State Farm announced rate increase requests of 30-52% after the insurance Commissioner proposed rate-setting deregulation. 

With rate hikes like these, people are, or will likely be, forgoing insurance entirely, or, if they’re required by their lender to hold a policy, drastically reducing their coverage. Which means that when a major disaster hits, more and more people look to state and federal disaster relief programs for support. In other words, the cost of those disasters is still socialized, but because it’s done through reactive disaster response programs, it’s not rationally budgeted. 

Furthermore, the price signal theory, when taken to its logical conclusion, requires people to hit financial ruin to be effective. As discussed above, many factors influence people’s decisions about where to live, and their choices are often constrained. So as insurance prices rise, property values fall, and repair costs mount. No longer able to maintain financial stability, homeowners in this situation will turn to the already-in-crisis rental housing markets. Renters, for their part, may be unable to afford housing altogether. In other words, without a system that maintains financial security for the many and helps them reduce climate risk, like through proactive land use and disaster mitigation policies, only the wealthy few are likely to remain financially solvent as climate-driven disasters increase. 

This, then, leads us to our sixth, and final, reason why current public insurance programs are designed to fail – they ignore the “community of fate” we’re in. These existing programs are based upon the presumption that people won’t, or shouldn’t, underwrite a risk they don’t share, or don’t share to the same extent. In California, the argument might go, “I don’t live on the wildland-urban interface, so why should I subsidize those people who do.” But in a country as big as the U.S., and as climate change impacts rapidly increase, it’s folly to think our fates aren’t intertwined. One recent study found that 44.8% of all homes were at severe or extreme risk of at least one disaster. 

We’re all at risk from some kind of environmental hazard, and climate change is only making that more true. These risks are not individual ones, and the ability to mitigate them, for example by upgrading storm drains or declaring an area off-limits for new infrastructure, are also not individualized. In order to confront this growing housing safety and affordability crisis, we need to understand our fates as shared, and reimagine our insurance system into one that provides protection equitably and fairly.