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Wednesday, August 15, 2018

How Insurance Regulations Create Perverse Incentives

"There are regulatory constraints on your ability to reduce exposure or to manage exposure differently."

In Leslie Scism, “The Problem With Government Flood Insurance,” Wall Street Journal, August 13, 2018 (print edition), an interview with Evan Greenberg, CEO of Chubb, Scism asks:

Will state insurance departments approve the large rate increases that insurers may feel necessary for homeowners if extreme weather leads to higher claims costs?

Greenberg answers:

For insurance lines that require filing rates with state regulators, premium increases are based on evidence of loss. You have to be able to justify the rates you charge customers. Some jurisdictions understand this and balance the needs of their constituencies. And some, for politically expedient or populist reasons, choose to ignore the need to raise prices, and I think that’s ultimately not in the interests of their constituents. When we can achieve an adequate rate, which we can in most instances, we are amenable to both maintaining and increasing our exposure. Where we can’t, we will shrink our exposure.

See the problem? I’m sure Greenberg does but is simply happy to be able to raise rates based on past experience.

Here’s the problem: In insurance markets that are unregulated, insurance companies tend to base rates on expected future payouts. Past losses are sometimes a good guide to future payouts, to be sure, but they’re often not a good guide. Fires in California this year, for example, could easily mean fewer fires in the future because so many of the forests and trees otherwise at risk are now burnt.

But state insurance regulation doesn’t allow rates to be based on expectations of future payouts.

Interestingly, the following was left out of the print version:

WSJ: Does Chubb have the ability to reprice or otherwise modify its contracts annually to adjust for climate changes?

MR. GREENBERG: Contracts are annually renewable but the ability to reprice depends on the kind of coverage and the jurisdiction. In the United States, making changes in pricing personal lines coverage is subject to a regulatory process. You can’t just do it at the drop of a hat. There are regulatory constraints on your ability to reduce exposure or to manage exposure differently. In the commercial-lines business, you can reflect the price of the exposure more quickly, and you can manage exposures on a more nimble basis. But you’re not looking to change your portfolio on a seasonal basis. Changes generally evolve over time.

The whole interview, which also discusses pricing insurance for climate change, is well worth reading. Unfortunately, it’s gated.

Reprinted from the Library of Economics and Liberty.

  • David Henderson is a research fellow with the Hoover Institution and an economics professor at the Graduate School of Business and Public Policy, Naval Postgraduate School, Monterey, California. He is editor of The Concise Encyclopedia of Economics (Liberty Fund) and blogs at