Tuesday, October 4, 2016

REPOST: Why doesn't insurance cover floods, earthquakes, or bed bugs?

Friday, October 3, 2014

Why doesn't insurance cover floods, earthquakes or bed bugs?

Planet Money has another episode that is making me rethink my opposition to government subsidies for public broadcasting.  In The Fine Print, a reporter reads his homeowner's insurance policy.  In it, he discovers that the policy does not pay for:

  • Floods: because floods hit all the homeowners in an area at the same time, so insurers cannot spread the risk around (called "correlated risk");
  • Earthquakes:  due to adverse selection (only the homeowner knows if she built on an active fault); and 
  • Bedbugs:  due to moral hazard (if you knew you were covered for bedbugs, you could pick up furniture off the street without any worry).  


  1. From an investment standpoint, I would hesitate investing in an insurance company with a high load of flood insurance coverage. I looked at homes on the south shore of Long Island which were inside of the flood zones. Most viable insurance companies wouldn’t insure them. I ended up purchasing a home that I could properly insure. Those who do obtain flood insurance may find themselves in a long line waiting to collect from an insolvent insurer.

    Earthquake insurance comes at a hefty price for security. The typical deductible is approximately 15% in California. That means, unless its catastrophic damage, a homeowner will have to cover the first $75,000 in damage before the policy kicks in on a $500,000 home. This is probably an indication of why on 17% of California homes have earthquake insurance. Like flood insurance, it’s hard to think of the unthinkable. Sadly, when catastrophe strikes, even those with insurance have much to complain about.

    Moral hazards stretch far beyond bed bugs. For those who scam insurance companies and reach far beyond the actual financial setback, the rest of the policy holders are left to flip the bill. Everyone else’s insurance premiums go up to cover the difference.

    Esuarance on Allstate Company. (2016, October 17). Retrieved from Does my insurance company cover bed bugs: https://www.esurance.com/info/homeowners/do-homeowners-and-renters-insurance-cover-bed-bugs
    Geology.com. (2016, October 17). Retrieved from Homeowners Insurance Does Not Cover Many Types of Damage : http://geology.com/articles/homeowners-insurance.shtml

  2. This post really hit home for me. With purchasing a house fairly recently, less than two years ago, I have to admit, I am one of the many who didn’t read through their homeowner’s insurance policy. The insurance agent did make it clear that the policy doesn’t cover floods; however, they said I may have to get flood insurance since I live less than a mile away from a large river and a home assessment would have to be completed. Turns out my house isn’t in a flood zone, so I didn’t need it.

    I understand that the insurance agencies have to anticipate adverse selection and attempt to protect themselves from it, but the screening process I had to go through with the first insurance agency I tried to get homeowner’s insurance through was horrendous. An insurance inspector came to my house, saw I had dogs, which I had to prove were not pit bulls (this was the easiest part, since my dogs are not pit bulls), told me I had to fix my gutters that were leaning out a little more than they should, and said I had to replace the ceiling tiles that had stains on them in my basement. The inspector then informed me I had 15 days to complete these things otherwise they wouldn’t cover me.

    Long story short, the insurance company refused to cover me, even after I completed everything they asked me to do in the time frame they had given. To me, I don’t think the insurance company did a good job with their screening process. I had been using the company for just over 5 years at that point for car and motorcycle insurance, always made payments on time, and never submitted a claim. Why didn’t they take this information into account when I applied for homeowner’s insurance?

  3. The Economic Times defines moral hazard as “a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other. In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan” (Economic Times). And one of the biggest controversial topics in regards to moral hazard is insurance – healthcare AND property – but we will be discussing property here. A growing outrage is in regards to moral hazard and insurance in regards to natural disasters. When individuals buy home insurance, they are under the assumption that their home is covered in case of one of life’s unfortunate curveballs such as a fire, flooding or God forbid, bedbugs. Hudson, Botzen, Czajkowski & Kreibich states that insurance plays an important role in managing natural hazard risks and promoting recovery from disasters by reducing financial risks due to spreading risk over many policyholders (Hudson, Botzen, Czajkowski & Kreibich). Moreover, insurance can also provide incentives for risk reduction by acting as a price signal of risk or by providing premium discounts to policyholders who protect their property against disaster damage (Kunreuther).
    Yet one may be surprised to find out that two of these items (floods and bedbugs) AREN’T covered under their insurance. There is a few reason for this; one of which is the fear that by increasing disaster losses will led to more governmental and private support because policy holder’s premiums wouldn’t be enough to pay for the damages. “The possible negative relationship between risk reducing measures and insurance can be viewed as giving rise to moral hazard because the possession of insurance coverage can directly reduce the incentive to employ risk reducing measures. Moral hazard poses problems if the resulting behavior cannot be observed by the insurer, meaning that increased risk-taking is not completely reflected in a higher insurance premium. Hence the presence of moral hazard would result in insured individuals suffering greater losses during natural disaster events and the moral hazard effect combined with the strong likelihood that the magnitude of extreme weather events will increase may result in an increasing reliance on government or charity schemes when the societal costs of natural disasters increase (Hudson, Botzen, Czajkowski & Kreibich). Another reason is that insurance firms just don’t have the most faith in their customers. Frobe even states that insured customers exercise less care because they have less incentive to do so when covered, hence causing the moral hazard (Froeb, McCann, Shor and Ward). If insurance companies feel as if customers aren’t going to take caution and do their best to prepare themselves for disasters – and they have to foot the bill for it – then insurance firms are less likely to do so.

    Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2016). The One Lesson of Business. In Managerial Economics: A Problem Solving Approach (4th ed., pp. 18-26). Boston, MA: Cengage Learning.

    Hudson, P., Botzen, W. J., Czajkowski, J., & Kreibich, H. (2017). Moral Hazard in Natural Disaster Insurance Markets: Empirical Evidence from Germany and the United States. Land Economics, 93(2), 179-208. doi:10.3368/le.93.2.179

    Kunreuther, Howard. (1996). Mitigating Disaster Losses through Insurance. Journal of Risk and Uncertainty 12 (2–3): 171–87.


  4. In this case insurance companies act as a risk-averse sellers by moving risk from those who don’t wanted (insurance companies) it to those who minded (I would say who don’t aware-in this case homeowners) it. This is arising from information asymmetry in which one party has information about items not insured, insurance companies, and the other party doesn’t (homeowners). For instance, insurance companies are aware that earthquakes happen in California State frequently, and insuring all those expensive houses against earth quacks are very costly. Also, insurance companies are aware of flooding frequency, and know that almost every location in the country can be exposed to flood. On the other hand, most homeowners, especially first time homebuyers are not aware of items that are covered by insurance companies and items don’t. There are a long list of fine prints in every policy that is out time and patience of holders to read.
    In overall, an insurance policy divided into two categories: losses insured and losses not insured. Also, there is a term insurers called “correlated risk:” it’s like a domino effect. Flood or earthquakes doesn’t hit only one house, it hits all houses in its way (correlated risk) that’s why insurance companies don’t cover these items: earthquake and flood.
    Insurance companies however don’t cover stuff that is not in correlated risk category such as bed bugs. Their justification maybe is that bed bugs are not a disaster on the scale of an earthquake, or they don't want to give you an excuse to do bizarre things, including collecting stuffs from the street or garage sale. As mentioned in chapter 20 Foreb, moral hazard deals with insured customers less likely exercise care, and they have less reason to be careful because the insurer will pay for it.
    Personally, bed bugs are grouse, and people who buy stuff from garage sale don’t mean to invite bed bugs inside their house. This particular item has health issue and it’s not easy to get rid of it; therefore, moral hazard is not an excuse for bed bugs.
    https://weather.com/safety/floods/news/flooding-united-states-frequency. Accessed 15 April 2017
    http://www.npr.org/sections/money/2014/10/03/353030214/bedbugs-lava-and-bowling-balls-inside-my-homeowners-insurance-policy. Accessed 15 April 2017
    Froeb & et al. Manegeral Economics: A Problem Solving Approach. Cengage Learning. Boston, MA. Print.