How Are Insurance Markets Adapting to Climate Change? Risk Classification and Pricing in the Market for Homeowners Insurance

Property insurance is critical for reducing household exposure to severe weather risks and aiding in recovery when disaster strikes. As climate risks escalate, insurers are investing in more sophisticated methods to classify and price complex disaster risks. We use proprietary data on parcel-level wildfire risk, together with insurers’ regulatory filings, to investigate how wildfire risk insurance is being priced and provided in a large market for homeowners insurance. We document striking variation in insurers’ risk classification and pricing strategies. Firms that rely on coarser measures of wildfire risk are exposed to potentially severe adverse selection as a result of their information disadvantage relative to insurers with richer models. Consistent with this fact, firms relying on simpler pricing methods charge relatively high prices in high-risk market segments – or choose not to serve these areas at all. A theoretical model of a market for natural hazard insurance that incorporates both asymmetric risk classification and market regulation helps rationalize the empirical patterns we document. Our results highlight how the winner’s curse can increase prices and limit participation in insurance markets for large, hard-to-model risks.