Mandate Guaranteed Replacement Cost
Instead of allowing insurance companies to underwrite an amount determined in advance, why not force them to sell insurance that guarantees replacement no matter what the cost? It is important to understand why this is a very bad idea that would make consumers worse off. The problem involves a key concept called moral hazard.
Moral hazard is the risk of insured customers acting dishonestly in some way that increases the frequency or severity of a loss. Any insurance policy must be designed to minimize moral hazard as much as possible. The challenge with guaranteeing replacement cost without limit is it creates the moral hazard that customers will inflate costs when filing claims.
Insurance carriers significantly curtailed offering guaranteed replacement cost in the 1990s due to high losses from inflated claims. Today, guaranteed replacement cost requires much stricter underwriting and is only offered in certain cases. Mandating that carriers offer guaranteed replacement cost would almost certainly lead to a significant capacity reduction plus higher costs — the very opposite of what would make customers better off.
This is a very good example of how the answer to a policy problem is often not, “We want X to happen, so we should mandate X.” Instead, skillful legislation or regulation requires understanding how to create the conditions that allow X to happen.
Increase Competition for the Key Software Tool
Verisk’s Xactimate software tool has dominant market share in the United States and Canada, with estimates around 80% being common. Based on my knowledge of Verisk, I believe a plausible hypothesis is that Verisk has been able to use its vast suite of software and services to bundle its Xactimate tool and push competitors out.
More competition should lead to more innovation. More innovation could lead to one set of products that offer more accurate pre-loss reconstruction estimates coexisting with another set of products that offer reasonable post-loss reconstruction estimates.
Unfortunately, antitrust enforcement is outside the purview of the department of insurance. Maybe someone could take a meeting with the California attorney general to explain the situation?
Increase Legal Liability for Insurance Companies
This is the path explored by Klein in his recent ABA article. He lays out a set of observations about the adequacy of insurance company disclosures as “food for thought” about how a litigator might bring a lawsuit. He notes that although, “there is a menu of approaches” state regulators might take, they all “involve degrees of political risk,” so he holds “no expectation of their adoption in the immediate future.”
But wherever possible, good regulation is generally a better solution than rampant litigation. Lawsuits increase costs for insurance companies, which are then passed along to consumers. Lawsuits take years to resolve, they are costly, and even when successful the settlement amounts must be shared with lawyers.
Lawsuits are crucial to hold insurers accountable, but they are a suboptimal way to try to solve a market failure. If available, a good regulatory solution can lead to better outcomes with less social cost.
Mandate Extended Replacement Cost Offerings
Extended replacement cost is an endorsement that increases the amount of the replacement cost offered by the policy. Requiring insurance companies to offer sufficient extended replacement cost over and above the reconstruction estimate ensures the customer can purchase the sufficient coverage they want to have.
SB 876 is a bill authored by Sen. Steve Padilla and co-authored by Senators Dawn Addis and Ben Allen. It tackles a number of issues around homeowners insurance, including underinsurance. Gov. Gavin Newsom recently signed it into law. One of its provisions requires extended replacement cost of at least 50% to be offered to consumers. It builds on an earlier law that tried, unsuccessfully, to address underinsurance by alerting consumers to the availability of extended replacement cost without mandating that it be offered to them.
This is a promising approach. But the fact that something similar was tried before with no success shows that promising approaches do not always work. SB 876 will require skillful regulation to achieve the desired outcome. There are two key issues: (1) ensuring pricing is fair; (2) getting customers who would benefit to purchase it.
Pricing must be monitored, but should not be especially problematic. The extended replacement cost endorsement will be subject to the same regulation as all home insurance premiums. Since it will be required of all carriers, it should be subject to the same market dynamics as homeowners insurance. So long as the homeowners market generally heals, pricing and availability for extended replacement cost endorsements should follow alongside.
Uptake will be the greater challenge. How do we ensure customers purchase the right amount of extended replacement cost coverage so they are fully covered without buying more than they need?
I would like to see the California Department of Insurance (CDI) test different mandatory messages to customers and then analyze which messages best achieve the desired outcome of matching customer uptake to coverage need. This “test and learn” approach is routinely used by private industries, and Klein’s analysis was based on data from the CDI. Since they have the data, the CDI should be able to test and learn what messaging works best to get the right customer uptake.
This “test and learn” program should be accompanied by robust communication to explain what the CDI is doing, and why. The public needs to understand that it will take a few years to figure this out. As part of its outreach, the CDI should commit to reporting regularly on its progress and making its data publicly available.
Homeowners’ underinsurance is a problem that has bedeviled policyholders across the United States for decades. We owe a great debt both to Klein and the three reporters at the San Francisco Chronicle for their work elevating and analyzing this issue. With SB 876 becoming law, the CDI will have an opportunity to demonstrate its commitment to solving this problem. If the CDI is successful, a similar approach could be adopted by states all around the country.
Patrick Wolff is a financial analyst, former candidate for California Insurance Commissioner. He lives in San Francisco. This is reprinted with permission from his Substack, Wolff’s Den.