From the Abstract:
Despite the recent rise in disaster-related property damage, the average American is under-insured. We study the homeowners insurance protection gap using nationwide state-of-the-art insurance, mortgage, and disaster risk databases at a property level and exploiting quasi-exogenous regulatory shocks to insurance pricing. We document pervasive under-insurance, particularly among the most financially vulnerable households, and show that financial constraints are a significant barrier to adequate coverage take-up. We consider household insurance choice through the lens of a standard dynamic consumption-savings model with borrowing constraints, building on Rampini and Viswanathan (2013). Our framework shows how households optimally adjust insurance coverage and debt in response to insurance price shocks and how these elasticities vary by the extent of households’ financial constraints. Using a range of natural experiments that deliver shocks to premiums, cost of credit, and financial constraints, we estimate two key parameters of interest: elasticity of coverage demand with respect to insurance prices and a cross-price elasticity of mortgage credit with respect to insurance prices. Consistent with the theoretical predictions, we show that constrained households respond to premium shocks by reducing coverage, whereas unconstrained households are able to maintain coverage by increasing debt. We also find that exogenous increases in the cost of credit reduce insurance coverage demand. Lastly, under-insurance increases mortgage delinquency. We conclude that premium increases worsen mortgage risks in two ways, by increasing household debt and by causing under-insurance. Furthermore, there are significant distributional consequences, with the most financially vulnerable households obtaining the least amount of coverage. Our results also raise the concern that financial constraints reduce the willingness to pay for insurance even below the actuarially fair price required for insurer solvency, which could lead to a new type of market unraveling with sufficiently high disaster risk.
