HURRICANES, INSURANCE, BEHAVIORAL ECONOMICS

Behavioral Economics and Insurance in the Face of Natural Disasters

Etinosa Agbonlahor

10/24/20247 min read

“I’ve lived here since 2017, and I feel like I’ve been dodging hurricanes every year since.”
—Tampa Bay Resident after Hurricane Milton

I spend a lot of time in Tampa, Florida, which was recently hit by Hurricanes Helene and Milton. Before a hurricane, palpable anxiety stretches through the city; group chats ping back and forth, tracking the hurricane, layering in commentary from meteorologists, elected leaders (Mayor Castor to residents in evacuation zones: “You're going to die”), those who don’t want to leave, and those who can’t afford to leave. Rushed conversations between grocery store aisles, “Are you staying, do you need anything?” Panic crescendos as the hurricane draws closer, and then the hurricane comes, and it goes.

As we breathe a sigh of relief that the damage wasn’t greater, the death toll wasn’t higher, our conversations shift to insurance. Questions swirl about the future of insurance rates—will they rise? Will more insurance companies pull out of Florida? Hurricane-related anxiety is slowly replaced by fear and uncertainty around spiking premiums, paltry coverage, and the risks inherent in what should be the safest part of the American Dream—owning a home—as extreme natural disasters become the norm.

ii.

The Insurance Crisis – Fear, Uncertainty, Risk Aversion

The most useful component of insurance is peace of mind. I’ve often cited Pete Fortunato’s insight that people don’t want money; they want what money can get them. In the same vein, people don’t want insurance; they want peace of mind that if anything extreme happens, they or their loved ones will have access to safety, protection, and resources.

That peace of mind is becoming rarer and more expensive in Florida. Florida homeowners insurance premiums are the highest in the U.S, and are expected to keep rising. Thirty-two insurance companies have either left the state entirely or gone insolvent in recent years. In Insurance and Behavioral Economics, the authors suggest that when insurers incur unusually large losses after a disaster, they often leave that area. They give the example of the severe Mississippi floods of 1927, after which no insurer wanted to offer flood coverage in that area. We’re seeing a similar phenomenon in Florida. From an economics perspective, this is a fallacy. Logically, if there is a demand for insurance (a seething, frothing, anxiety-ridden demand in Florida), there should also be a market for it—a market that can charge premium prices.

So why are insurance companies leaving Florida? A friend in the insurance industry explained this skewness using the analogy of a stockbroker: “If you were an insurance company, you’d think about your policies as a large diversified portfolio. Less risky areas, like Colorado, may help subsidize more risky areas, like Florida. But as more unpredictable and extreme events occur, it becomes harder to keep a balance across the portfolio.” For example, specialists suggest California’s 2017 and 2018 wildfires wiped out decades of insurance companies’ profits in the state. Note that hurricanes tend to be the deadliest, most costly natural disaster. This, combined with Florida-specific nuances like frivolous lawsuits (Florida accounted for 14.9% of the nation’s homeowners' claims but 70.8% of the nation's litigation costs), fake claims, and rising inflation, also make it harder for insurers to keep risky areas insured.

Insights from behavioral economics suggest uncertainty and risk aversion likely play a role in insurers' decisions. The kinds of weather events we’re experiencing are unusual. I was recently speaking with someone who lived in the Tampa Bay area decades ago, and they mentioned they experienced fewer than three hurricanes across their entire childhood. I’ve been in Tampa for three years, and I’ve experienced four major hurricanes and been asked to evacuate for all four. This is not normal. And it’s hard for insurers to both predict "not normal" and incorporate that into their modelling.

This means it’s also more difficult for them to get the capital that backs up our policies in the reinsurance market. Reinsurance is insurance for insurance companies. It generally allows primary insurers (the companies that sell policies directly to us, consumers and businesses) to transfer some of the risks they underwrite to another insurer. While the main purpose of reinsurance is to reduce the financial burden of large or unexpected claims, especially after disasters like hurricanes, floods, or earthquakes, when reinsurance becomes more expensive or unavailable, primary insurance suffers, and people are left with fear, worry, and anxiety about how to protect their homes.

iii.

Risk Preferences, Haunted Houses and Apple Orchards

Before buying insurance, people generally think about the chances that they’ll need the coverage—assessing and teasing out the risks they’re trying to avoid. Evaluating risk is complex and ever-evolving because people have different general risk-taking tendencies (would you be more excited to walk through a haunted house or prefer a stroll through a sunlit apple orchard?). We also have different risk tolerance levels about specific events (a hurricane-tested friend might evacuate every time they are asked to do so, while another might prefer to wait until the last possible moment to make that decision).

Our general risk-taking tendencies combined with our risk tolerance tend to lead us to different conclusions about what insurance to buy, when to buy it, and how much coverage to get. For example, I was recently chatting with a real estate investor in Tampa who told me he has been self-insuring some of his properties since the 1980s. Facing rising insurance costs in the early '80s, he and his brother built a $100,000 fund to cover any property damage, opting not to carry insurance on some properties they owned outright. His risk tolerance, and assessment of any possible risks to his portfolio led him to value peace of mind at $100,000 in cash reserves.

On the other end of the spectrum, I have friends who are new parents buying their first family home. They’ve been trying to find the most comprehensive insurance possible because they need the peace of mind that their young family will be safe should anything happen.

iv.

Complications - Wiser, More Experienced?

Not only are our risk predispositions different, they also change with experience. Behavioral economists make a distinction between decisions we make from descriptions (for example, deciding where to purchase a home by reading about the likelihood of a natural disaster occurring in the area) and decisions we make from experience (determining where to buy a home after having experienced a hurricane). Interestingly, when making decisions from descriptions, we are more cautious, overweighting the probability of rare events, whereas when making decisions from experience, we underweight the probability of rare events.

One reason for this is that exposure reduces sensitivity over time. After a major disaster, there is often a spike in insurance purchases, driven by the fresh memory of the event. However, this heightened perception of risk wanes over time, especially as the immediate threat subsides or as we become more used to living with the risk. This aligns with the availability heuristic, where we assess the likelihood of future disasters based on recent, memorable events. Over time, people may downplay the risk of future disasters due to optimism bias, leading them to reduce insurance coverage.

Complications – We Simply Can’t Afford It

There are also clear socioeconomic disparities in access to insurance. For lower-income families, the cost of home insurance may be prohibitive, leading them to forego it entirely. Insurance literacy is also a significant issue; many people may not fully understand their options or the benefits of being insured, especially in high-risk areas.

Behavioral biases experienced by people under financial distress—such as focusing on immediate needs at the expense of future risks—compound these challenges. Vulnerable populations may not have the bandwidth to figure out complex insurance systems or file claims efficiently, leaving them more affected by disasters.

vi.

Taking Action: What Can Insurers Do?

Given the increasing frequency and severity of extreme weather events, insurers need to take proactive steps to protect their customers and their businesses. By using insights from behavioral economics, insurers can implement strategies that not only reduce risk but also encourage preventive action among customers.

1. Use Behavioral Science Insights to Incentivize Preventative Measures
Behavioral science-informed choice architecture can play an important role in encouraging policyholders (customers) to take preventive measures. Insurers could offer incentives for installing storm shutters, taking courses on steps to reduce water intrusion in a home, and installing hurricane-resistant features. Insurers could also introduce experiences and features that guide homeowners around specific steps to proactively reduce risk.

2. Use Behavior-Informed Designs for Real-Time Risk Management
Real-time feedback through IoT (Internet of Things) devices could be a game-changer. Just as telematics help insurers monitor and reward safe driving behavior, IoT sensors in homes could provide data on conditions like rising water levels, giving homeowners real-time alerts to take preventive action and helping insurers assess risk more accurately.

3. Use Behavioral Audits to Identify Hassle Factors in the Claims Process
Imagine bouncing from couch to couch at friends' and relatives' homes after spending days wading through your rapidly mildewing house, trying to salvage personal belongings destroyed by the flood. On top of that, you're faced with piles of paperwork requiring exact details on the extent of your losses, just to get your claim placed in a long queue for evaluation.

Information overload is a real concern after disasters, as victims are overwhelmed with the sheer volume of tasks they need to accomplish to recover. Effective communication is critical during the claims process, especially when customers are already mentally and emotionally exhausted, and may not be processing information as effectively as they usually would. Insurers need to build experiences that take this into consideration. Simple language, clear, step-by-step instructions to help policyholders file claims efficiently.

4. Use Behavioral Science Insights to Rebuild Trust
The fairness heuristic is another factor at play here. People's perception of whether the claims process is fair can shape their trust in the insurance system. For example, if they feel they are receiving less than expected or being unfairly denied, it can erode trust in insurers, even when the company follows its policies. Research suggests that operational transparency can help businesses (and governments) increase customer trust. Essentially, taking customers behind the scenes to help them better understand where they stand in the process can make a big difference. In an industry marked by information asymmetry, where customers are used to opaque and arbitrary onboarding and claims processes, companies that provide a little transparency into what customers can and should expect will differentiate themselves.

Resources (to help and to use) Tampa Bay Residents Affected by Hurricanes

Read my last post: Anchoring and Adjustment in Harlem