Natural disasters including floods, hurricanes, and wildfires displace thousands of Americans each year and leave consumers and insurers on the hook for millions in losses to homes and other structures.
In a recent article in the Virginia Journal of Social Policy & the Law, California Western Associate Professor Kenneth S. Klein explores the growing problem of underinsurance, the complicated reasons behind it, and offers a proposal to better educate consumers while protecting the ability of insurers to compete in a free market. Klein looks to the ENERGY STAR program backed by the U.S. Energy Department and Environmental Protection Agency as a model for his “Coverage Guide” proposal.
The high costs of underinsurance
Today marks the 20-year anniversary of the Oakland Hills Fire that destroyed more than 3,300 homes and caused losses exceeding $1.5 billion, making it the most costly fire in U.S. history. The struggles homeowners faced in dealing with their insurance providers led to major changes that are still felt today.
The 2007 wildfires in San Diego County, which happened four years ago this week, left more than 1700 homes and outbuildings completely destroyed. More than 40% of those who lost their home did not have enough insurance coverage to pay the full replacement cost, with the average amount of underinsurance exceeding $240,000.
While nearly half of American homeowners lack adequate replacement coverage in the case of total loss, more than 2/3 of respondents to a 2010 Zogby/MetLife poll stated that their insurance policy would pay for complete replacement of their home if destroyed.
This knowledge gap leads to costly litigation, as consumers struggle to cover the cost to replace their homes and personal belongings, as well as disruption to personal and professional lives as families wait to rebuild and resume their lives.
Risk behavior, market forces lead to underinsurance
According to Klein, the insurance system is not broken, because an adequately informed consumer can purchase adequate coverage. He instead points to motivation on the part of both insurer and consumer as the cause of widespread underinsurance.
Klein cites research finding that the more remote a risk, the less likely a consumer is to insure against it. Since less than 2% of property insurance claims are for total loss, there is an economic incentive (lower premiums) to insure one’s home for less than the full replacement value.
Since property insurers compete on price, and since they would need to over-insure to provide full coverage because of unstated risks, insurers are motivated to provide less than full coverage, as well as to undervalue the replacement costs of a home.
ENERGY STAR label serves as example for new disclosures
Klein looks to the federal ENERGY STAR program as a model for his disclosure proposal. The ubiquitous yellow label provides clear, intuitive information to appliance consumers about energy efficiency and greenhouse gas emissions.
Klein’s Coverage Guide system would provide similarly clear and understandable information to consumers before an insurance policy is purchased. The Coverage Guide label would disclose:
• The amount coverage a policy provides
• The value of the full replacement cost of a home
• That the consumer would be responsible to cover additional replacement costs in case a policy does not cover the full cost
The proposal would further mandate that in cases in which the insurer provided an inadequate quote for full replacement coverage, the policy would automatically become a full replacement policy.
The final element of Klein’s proposal would forbid litigation based on underinsurance claims when insurers meet all of the above provisions.
About Kenneth S. Klein
Klein’s interest in the topic is both an intellectual and a personal one. In 2003, Klein and his family lost their home to the disastrous Cedar fire. Although his home was fully insured, Klein witnesses the distress faced by families whose policies fell short.
Klein serves as an Associate Professor of Law at California Western, teaching Evidence, Civil Procedure, and a class titled “Legal Lessons of Katrina and Other Natural Disasters.” He received the State Bar of California's 2008 President's Pro Bono Services Award for his work counseling victims of the 2007 San Diego County wildfires.
A strong advocate for pro bono work, Klein twice received the Wiley E. Manuel Award for delivery of pro bono services and was the pro bono partner at the San Diego office of Foley & Lardner LLP, as well as leading up that office’s appellate practice, prior to joining the California Western faculty.
