Opinion | Our Insurance System Subsidizes Moves to Disaster Zones

Fires are still raging across Los Angeles in what is shaping up to be one of the most expensive calamities on American soil, with estimates of the economic damage and losses running as high as $275 billion. Thousands of residents have lost their homes, which are often their most valuable asset.

Yet there are few signs that policymakers and regulators are grappling with the decisions that brought so many people into high- risk areas to begin with. Their refusal to do so sets the stage for an even bigger, and potentially deadlier and even more expensive disaster down the line.

Financial markets, if left to their own devices, would naturally force Americans to confront the ugly realities of our changing climate and deter them from flocking to places where human habitation is increasingly untenable. Unfortunately, this basic system of supply and demand has been stymied by regional and federal policies — policies supported by both Democratic and Republican lawmakers in both blue and red states who buckle under the short-term political pressure to keep home insurance premiums artificially low.

The result is highly unfair and distorts the market. It endangers our economy by sending scarce resources into the path of natural disasters and will likely devastate still more lives.

In theory, insurance prices quantify the risks of living in a certain place. Of course it should be more expensive to insure a home in an area buffeted by disaster. But in practice, states vary widely in their willingness to allow insurance premiums to increase, with some making it far harder than others for insurers to raise prices. California is one of the most resistant, and until recently refused to let insurers raise premiums or reflect climate-catastrophe risks in their pricing.

Insurers doing business in such heavily regulated states, finding themselves unable to raise premiums when needed, wind up shifting some of the costs to homeowners who happen to live in states that are more accommodating to premium increases. That is, in part, how middle-class communities, such as Enid, Okla., can end up subsidizing the owners of million-dollar houses in Malibu. And under our current regulatory regime, that dynamic is only expected to strengthen, as climate losses continue to cut into insurance companies’ bottom line.

The voices loudly criticizing California for its rigid control of insurance pricing are ignoring numerous similar examples from the rest of the country. In 2023, after the federal flood insurance program began to adjust its premiums to better reflect climate realities, 10 states across the political spectrum — including reliably red Louisiana, Florida and Texas and moderate blue Virginia — sued the program. And California isn’t the only state that failed to raise premiums to properly fund its FAIR plan, the state-sponsored insurer of last resort often relied on by those living in climate-vulnerable areas; Florida did as well.

Home insurance is just one way our financial system encourages Americans to move to flood-prone sections of Florida or parched, air-conditioning-dependent Arizona. The government mortgage giants Fannie Mae and Freddie Mac, which guarantee about 70 percent of mortgages on single-family homes, charge the same fees regardless of climate risk. Nobody intends to move into harm’s way. Many people settle in places like Texas because housing is generally more affordable. But that affordability is a mirage: Their mortgage and insurance risks are being subsidized by everyone else. This system, and the continually building in risky areas, portends ever-rising disaster losses.

We get why change is hard. Losing one’s home can be economically and emotionally devastating. Rising insurance premiums can stress homeowners who are already struggling. For households that have their entire life savings tied to their home, hefty premiums combined with lower home values tied to the cost of insurance could even lead them to default on their mortgage.

That may explain why a growing number of households living in imperiled areas are not only taking on more debt to pay for higher premiums, they are reducing coverage altogether, leaving them dangerously exposed to disasters.

Regulators can and should monitor insurers so they don’t use their market power to charge excessive rates. But we are at the other extreme in many high-risk areas: At some point, regulators will have to allow prices to go up so insurers remain solvent and private insurance stays available, even in places hard hit by climate change. The longer they delay, the larger and more disruptive the price increases will be.

Premiums in Florida nearly doubled from 2018 to 2023. And by the time premiums catch up to risks, more households will have moved to dangerous areas, lured by artificially low prices that mask the true cost, and sunk their life savings into their homes. It is pain now versus even more pain later. But eventually, once prices reflect risks, incentives will rebalance, and people will be discouraged from migrating to and building in disaster-prone areas.

For state and federal policymakers, the question they must face is not whether we should move to insurance pricing that reflects risks, but how.

The federal flood insurance program can point to an approach. From 2021 to 2023, the program phased in risk-based pricing. Policies for new customers were adjusted first. Existing customers in high-risk areas have a much longer adjustment period. This gives households information and time to adjust to the new pricing regime.

If climate change creates more frequent, intense and correlated disasters, insurers may continue to leave high-risk areas, even with risk-based pricing. If so, the government could step in, by creating, say, a federal reinsurance backstop. If policymakers choose to go in this direction, it is paramount for this coverage to be priced correctly. Otherwise, we risk adding yet another implicit subsidy for disaster-prone areas.

We don’t have to live this way. Our policies were designed for a world where the gap between high- and low-risk areas was smaller and less persistent. But these gaps have been growing rapidly. And the longer we wait, the more we, and our society, will suffer.

Parinitha R. Sastry is an assistant professor of finance at Columbia Business School. Ishita Sen is an assistant professor of finance at Harvard Business School.

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