DISTORTIONS IN INSURANCE PRICING

Property insurance is priced according to the underlying risk, right? That’s the idea, but many would be surprised at the distortions that can occur in some markets.

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When a disaster destroys a home or business, that is exactly the moment when owners can least afford to pay for repairs. Pooling risk (insurance) is a great financial innovation. We all pay when times are good, and then we get help if we have bad luck.

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But insurance works best when people pay into the insurance pool according to their level of risk. In many cases, regulation distorts this.

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States such as Florida have created regulations that are supposed to protect consumers from excessive rate increases. This sounds nice in theory, but in reality, these rules are distorting the market, and in some cases hurting the very people the rules are trying to protect.

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When insurers cannot raise rates enough to reflect increasing risk (i.e. in coastal areas), they still need to gather enough money to cover their potential payout liabilities. That money has to come from somewhere, and it ends up coming from other policy holders whose properties are at lower risk.

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The crazy result is often that poorer inland property owners end up subsidizing the insurance policies of wealthier coastal residents.

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Another unintended consequence is that lower priced insurance incentives more building in these higher risk places.

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At Alliance, we conduct our own very deep and rigorous risk assessments on every potential investment. We’re particularly attuned to hurricane risks, and are very deliberate on locations we chose (e.g. proximity to flood plains), even if there might be a near term insurance advantage.

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Distorted markets are bad for everybody in the long run, so we keep a sharp lookout for these situations and, as an investor, proceed with caution.

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