The Personal Finance Podcast - The Insurance Crisis Nobody Is Talking About (With Bob Litterman)

Starting point is 00:00:00 The mispriced risk is climate risk. It's that we're not pricing emissions. And so what that means is that there's too much emissions going on in the atmosphere, and that's going to lead to real damages down the road. And those damages are starting to show up now in extreme weather events and in insurance markets. Homeowners, many of them say, I can't afford that, and they drop their insurance. We've seen a very worrying increase in the number of homeowners that don't have insurance. It's almost inevitable that there's going to be an event that's going to cause the state plans to run out of money.

Starting point is 00:00:42 And then they're going to have to decide what are we going to do. The cost of homes is going up. The cost of the insurance is going up. The cost of construction is going up. The cost of electricity is going up. All these things are going up. And so it's an affordability crisis. We're talking about a long-term destruction of wealth, which is really sad.

Starting point is 00:01:02 We're not prepared. We're not doing the right things to be prepared. This episode is brought to you by the Coalition for an Insurable Future. What if the biggest threat to your net worth isn't the stock market? It isn't inflation, and it isn't your mortgage rate. What if it's a line item on your insurance renewal that most people glance at in toss in the drawer? Today's guest is Bob Litterman. Bob spent 23 years at Goldman Sachs running risk for the insurance.

Starting point is 00:01:30 the entire firm. He co-created the Black Litterman model, which still is one of the most widely used frameworks in institutional portfolio construction. And he is now saying that what is happening inside U.S. home insurance market is one of the most misprice risk that he has ever seen in his entire career. Now, here's what that means for you. Insurance prices are up 74% since 2008. That's not a typo. No, you did not mishear me there. 74%. Far faster than inflation, far faster than wages, and 95% of Americans have already seen their premiums go up. And the people who price this stuff for a living are quietly exiting entire states. Your home is probably your largest single asset.

Starting point is 00:02:11 For a lot of Americans out there, your home is a huge portion of what your assets are. And today, Bob is going to walk us through exactly how a weather event becomes a coverage problem, how a coverage problem becomes an unmortgageable home, and how an unmortgable home becomes a property market in free fall. Now, this is not an abstract conversation. This is already happening. And by the end of this episode, you're going to know some of the things that you can do about it. Bob and I talk through how this can impact your wealth, how this can impact long-term wealth building,

Starting point is 00:02:37 and how this is really going to hit your bottom line if we don't pay attention. So this is a riveting conversation. I want you to welcome Bob Litterman to the Personal Finance Podcast. So Bob, welcome to the Personal Finance Podcast. Thank you. It's great to be here. We are so excited to have you here because we're going to have a great conversation around insurance and some of the things that we are seeing.

Starting point is 00:02:59 I want to wave some red flags when it comes to the insurance industry and a lot of things that we see happening right now. But I want to dive into you first because you spent 23 years at Goldman Sachs. You became a partner. You ran firm, wide risk, and you co-created one of the most used models in institutional investing. So I want to hear some of your background because we have a lot of listeners here who are really interested in finance and investing in everything that comes in between there. So can you kind of talk about your background and some of the things that you have done in the past? Sure, happy to. You know, I've had kind of a long journey here.

Starting point is 00:03:30 I started out in physics, and then that was at Stanford. They started this new interdisciplinary program that I joined in the inaugural class. That was back in 1973. We graduated. It was in human biology, which was, I thought, great, kind of a wide open interest in humans and how we are part of nature and all that, but also biology. economics, political science. It was very broad. I really enjoyed it and thought I was going to be a journalist. In fact, my first job was as a reporter for the San Diego Union. But they sent me out to El Centro, which is kind of in the middle of nowhere in California. And I thought, you know, I got to get back to civilization. And so I went to, I applied to graduate school in economics, not really knowing what it was all about. But I met my wife there. And she was, from Minnesota. I followed her back and joined the economics department at the University of Minnesota,

Starting point is 00:04:34 which was an amazing place at that time. I had no idea what I was getting into, but my two advisors both got Nobel Prizes. There was a student one year ahead of me, Lars Hansen, who also got Nobel Prize. And it was just an amazing place. So I studied. I became an economist. I got a job, actually at MIT, teaching economics, but decided early on that I was not really an academic. I wanted to be more practical, more applied. And I had enjoyed what I was doing at the Minneapolis Fed. So I went back there as a staff economist, and I thought that was going to be my career when a few years later, I got a call from Goldman Sachs. And they said, Bob, we're going to make you an offer you can't refuse, which they did. And so my wife and

Starting point is 00:05:25 I packed up, we went to Wall Street, and I became one of the first quants on Wall Street. Fisher Black was already there. They talked about him as kind of a rocket scientist, and I showed up and had some good programming skills, and I just found Wall Street was full of interesting problems. So I became, you know, a quant building models, various different kinds of models. And relatively early on in my career, Fisher Black came up with this site. idea of building an equilibrium into an asset allocation model. And that became the Black Litterman model. And we started using it to build portfolios. And it's all about balancing risk and return. And so that became kind of my forte. And Goldman invited me to become head of risk management,

Starting point is 00:06:18 which I did. And so I got very involved in understanding and managing the firm's risks. And so that's really my background. It's not insurance, it's risk management, and especially pricing risk, because that's what Wall Street is all about, finding mispriced risks that are, you know, either too cheap or too expensive. And I know for most listeners, that sounds very abstract. What does it mean to price risk, you know? It's all about understanding portfolios and correlations and so on. And I give you a story that kind of illustrates, I think, what is it makes it interesting. I had built this asset allocation model, and at Goldman, we were kind of reverse engineering it and saying, let's put in our positions and see what are the expected returns, the views that would justify the positions we're holding. And so we created this what we called implied views report.

Starting point is 00:07:19 it. Well, one day, the head of our trading desk in London pulled me over and he said, Bob, there's something wrong with your risk system. It says that we're bearish on U.S. treasuries. Well, we own $800 million worth of U.S. treasuries. That can't be the case. So I thought, oh, geez, we must be bad data or something. I went back into the system. And sure enough, it showed they were long 800 million of U.S. treasuries. But it also showed that they were long, I think it was a long, I think it was a lot of, long, three billion of Deutsche Mark dollar, you know, for an exchange. And that's much riskier, actually, than U.S. Treasury. Is the U.S. Treasury position was negatively correlated with this huge

Starting point is 00:08:04 position in Deutsche marks. And so I went back over to the head of the desk. I said, well, you know, you got to understand that's a hedge. That's actually reducing the risk of your Deutschemark position because of the correlation. I said if you actually increase it to a billion two, that's your risk minimizing position. And then if you really want to express a positive view on U.S. Treasuries, you have to go to like, you know, a billion aid or something. Absolutely. And I think that's a really interesting way in a great example of kind of what you did. Because overall, for listeners out there, a lot of the stuff that Bob did was he was managing risk for Goldman Sachs, which is the obvious gold standard when it comes to Wall Street. I'm sure that was a great

Starting point is 00:08:45 phone call to get when you originally got that phone call because it is one of those things that I think is such a powerful lesson on was kind of what a lot of these firms are doing or a lot of times, you know, if they are, you know, investing in something specifically you are making sure, hey, we're managing this risk. We are hedging. We're, you know, hedging some of these positions. And I think that's a really, really important thing a lot of people are looking at here. So since you've done this and you've priced risk for your entire life, what was the moment that you looked at things like, you know, climate insurance and realized that this was one of the most misprice risk you have ever seen. Yeah. Well, I would say that that really started when I was retiring from Goldman Sachs.

Starting point is 00:09:25 And one of my partners pulled me aside and he said, Bob, are you interested in the environment? And I said, well, you know, this climate change thing, it seems like a risk problem that we're not managing appropriately. And he said to me, well, Bob, you know, brilliant insight for an economist, he says, but, you know, the problem is no one knows where to price it. And I thought, well, that's kind of weird. I mean, I'm an economist. There must be a literature. People have looked at this. So I started digging into it.

Starting point is 00:10:00 And that's really when I kind of got the whoa moment. because what I saw was that actually the main work that had been done was by an economist I knew, Bill Nordhaus. And in his writing, he was treating the economy as the main risk, you know, recessions and so on, and macro risks. And he said, well, look, climate could be negatively correlated. We just don't know. because if the economy grows strongly, we're going to have more pollution, and that'll reduce it. And if the economy grows weakly, we'll have less pollution. And so there'll be less damage.

Starting point is 00:10:43 And so correlation is such that, you know, maybe it lowers the price. I thought, this is crazy. There's something fundamentally wrong with this. And so for me, it was kind of that was the aha moment, that we have to think about climate risk differently. And if you think about climate risk as potentially the major risk, not macroeconomic fluctuations, you know, if you think about worst case scenarios and what could happen in the long run, well, then you get a totally different answer. And so to me, that was the thing.

Starting point is 00:11:19 We have to think about, you know, how big this risk is and what could happen in the future and what these economists are saying. And the basic policy prescription that Bill Nordhaus had come up with was that we should have what economists have called the slow policy ramp, that you start out with a low price on carbon. And then over time it rises slowly. Okay. Well, that's fine if there's no real risk. But if the future is highly uncertain and worst case scenarios could be really bad, then the prescription is very different. You have to, I call it slam on the brakes. You have to be very cautious and make

Starting point is 00:12:04 sure that you're prepared for the worst case scenario. And the price should be high initially, high enough that you expect it to come down as you solve this problem. So for me, that was kind of maybe it seems a little bit, I don't know, mathematical or whatever, but it was an aha moment for me because if you think that the right price for carbon should be low and rising over time, then whether you start today or you start in five years or 10 years, it's not really that important. But if you realize, no, this is a slam-on-the-break scenario, then if you don't start today, you may not have enough time. When you're managing risk, time is a scarce resource.

Starting point is 00:12:48 And so we've been wasting time. We haven't priced carbon. And by the way, I should say something you asked about mispricing insurance risk. And what your listeners have to understand is that insurance risk is not mispriced. The mispriced risk is climate risk. It's that we're not pricing emissions. And so what that means is that there's too much emissions going on in the atmosphere, and that's going to lead to real damages down the road.

Starting point is 00:13:20 and those damages are starting to show up now in extreme weather events and in insurance markets. So it's actually the insurance markets are reflecting the poor risk management that we've done about climate, but insurance itself is not mispriced. And in fact, what you're seeing in the insurance markets is a rational response to extreme weather events that are becoming more and more common. insurance markets depend on some things that most people probably haven't thought much about, which is, first of all, that the things that are being insured are rare events. And secondly, that they're very predictable.

Starting point is 00:14:05 If you have a long period of constant climate, then you know how often you get, you know, a hurricane of a certain size, category four, let's say. They happen this often. Well, if all of a sudden they start happening. more often, then you can't price your insurance the way it had been priced. The actual risk has gone up, and you have to reflect that actual risk. And so that's what you're seeing in insurance markets. And if you can't actually measure the probabilities of these rare events very well, then you have to be cautious about your pricing. And so what you're seeing in the insurance markets is a very rational pullback by

Starting point is 00:14:47 insurers and increasing in prices because the real risk has increased. And so the question is really not, you know, why are insurance companies mispricing risk? They're not. The question is who's going to pay for the real risk that has increased significantly and is accelerating over time? And when you look at this, so we're looking at, you know, a lot of different events that are happening over the course of the last couple of years. I was telling you before the show, hey, I live in Florida. We have hurricanes that are hitting Florida. Once a year, we always have hurricane season. Everybody's worried that we're going to have one, two, three hurricanes kind of hit the state. And we see that time and time again. But it's happening even more so, you know, if you look up the coast and some

Starting point is 00:15:29 shifts in the weather events there, we've had tornadoes. We've had all these different shifts in terms of what is happening there. And so a lot of times when we're looking at, you know, climate change, this could be something where it's not even visible. It's not something we can actually see. And so we're trying to figure out what that risk is overall. And like you're saying, it's not a mispriced risk over. It's more so just kind of figuring out who's going to pay for this long term. And it seems like the insurance industry is kind of looking at this in a way where, you know, after some of these events start to build up or a lot of these events happen, all of a sudden prices just continue to rise over that time frame. So what happens if we're looking at this and, you know, we have this

Starting point is 00:16:04 priced out and then the entire industry gets this catastrophically wrong? What does that look like? Or what does the industry look like if they don't price this in properly ahead of time and we're paying for it on the back end? Is that something that could be a snowball effect? Or Is this something that we need to really start to worry about as consumers here? Well, it's complicated, and we do need to worry about it. It depends. As I say, the real risk is increasing, and you get that. So the question is, who's going to pay for it? And the answer is, well, it could be the individual homeowner. It could be the policy owners of that insurance company. could be all policy owners in the state, and ultimately it could be all taxpayers in the state

Starting point is 00:16:50 or even in the country. It could fall on the federal government. So that depends really a lot on the regulators, what the politicians decide, but at the end of the day, someone is going to have to pay for it. Now, what we can do is we can certainly try to harden our infrastructure. We can try and prepare for extreme weather, and that will reduce the overall cost. But that preparation, you know, hardening our homes or getting rid of the dry brush around our homes and things like that to prevent wildfires as we do here in California, those things are expensive. And so ultimately, you know, someone is paying for that. And there is a right thing to do, which is to be prepared. We all should do those things that make the events less damaging,

Starting point is 00:17:44 but ultimately the extreme weather, whether it's hurricanes in the Atlantic Coast or wildfires in California or there's more extreme weather even in the middle of the country. You've got tornadoes, you've got heavy downpours, floods, all of these things. The way to think about it is just that the energy in the atmosphere, in the atmosphere has increased, and the energy in the oceans as they've been warming has increased. And so you get more volatile weather, and these extreme events are becoming more likely than they

Starting point is 00:18:20 used to be. And that's why the insurance rates are going up. And they're going up dramatically, depending on where you are. But there's kind of a set of things that happen in high-risk areas. So in areas that, for instance, in California, some areas are very exposed to wildfires relative to other areas. And in the areas that are exposed, well, the insurance companies are pulling back. They're saying, we're not going to write any more policies. Or, you know, and insurance policies are usually one or two years, and so we're not going to renew. Or we'll renew, but the rate has just gone up 30%. And so what happens is homeowners, many of them say, I can't.

Starting point is 00:19:04 can't afford that, and they drop their insurance. And we've seen a very worrying increase in the number of homeowners that don't have insurance. In high-risk areas, especially, people have just been either unable to get insurance, they aren't able to afford insurance, or they go into these state programs. And many of the states have now high-risk programs that are run by the state, they're not capitalized like standard insurance. And so you end up with a growing, in fact, a rapidly growing population of homeowners that are insured by the state, not capitalized appropriately. They're high risk homeowners. And so it's almost inevitable that there's going to be an event that's going to cause the state plans to run out of money. And then

Starting point is 00:20:00 they're going to have to decide what are we going to do? Are we going to force other insured policy owners to pay for it? Are we going to force the cost onto taxpayers? Or are we going to go to the federal government and ask them to bail us out? So those are kind of the steps that are going to go forward. And as that happens, it makes it harder and harder for people, especially in those high risk areas, to afford insurance. And then if you get another catastrophe, you've got a much higher proportion of folks who don't have insurance and get wiped out. It used to be single digits just five years ago. Now it's maybe one in more than one in 10, one in seven, something like that, who don't have insurance nationwide. And in those high risk areas, it's even much higher than that.

Starting point is 00:20:52 And those are some alarming numbers. I know people, you know, even in my area, you know, I see them foregoing flood insurance when they're in a pretty heavy flood zone. I've heard of people, you know, if we're going all different sorts of home insurance when it comes to some of this stuff. And so some people here, you know, have been saying things like this is a climate insurance collapse. And you're a markets person. Is that the right framing? Or is this just normal repricing that kind of feels uncomfortable right now? Well, you know, it's hard to say a collapse, but it's a very alarming direction. And it's not going to fix itself. I mean, the underlying problem is that the real risk is increasing. And in fact, I think we start, as we've been talking about,

Starting point is 00:21:36 with homeowners insurance, but that's just the first impact, really, of climate change, you know, as we move forward. And these impacts are going to get larger and larger. Well, I say they're going to get larger and larger. That we can be pretty confident of. But how bad it's going to be, that's very uncertain. So I don't want to suggest that we know what the future is going to look like. And, you know, things may change. Maybe the worst case won't be so bad. But maybe the worst case will be so bad. And so, you know, the scouts motto, be prepared. We're not prepared. We're not doing the right things to be prepared. If you are someone, because I want listeners to kind of understand why their bill is going up, if they do see their insurance bill going up. And they're kind of thinking through, okay, well, I just saw my insurance bill, you know, increase, you know, 20, 30, 40 percent. And I want to understand why. So, I want to kind of do just a case study here and like pretend where, you know, you're a 34 year old homeowner in the middle of the Midwest. And, you know, you get, you're not on the coast. You're not in an area where there's fires like in California, but you are someone who's kind of in the middle of

Starting point is 00:22:43 the country. And you just got a letter that said, hey, your premium just went up 30%. Can you walk me through kind of the math behind what that would mean or why that would happen to someone's insurance bill who may be not even in a high risk area? Yeah. Well, they may not think of themselves as a high risk area, but certainly if they're in the middle of the country, they may be exposed to hailstorms, to floods, to tornadoes, just to strong winds. And the strong winds are stronger than they used to be. And so there's all these different hazards that they may be exposed to. And the insurers are looking at that, and they're saying, well, we have to be prepared for those kinds of events, those extreme events that can happen and are happening more and more frequently. So, you know, one of the things

Starting point is 00:23:30 that the insurers are doing is they're using these climate models to simulate the future. You know, we don't know exactly what's going to happen, but we have some pretty good ideas from the physics of what happens when you increase the amount of energy in the atmosphere. And so you start looking at these events happening more and more frequently and what that might mean for the damages that are coming down the road and the insurance companies are saying, we have to be prepared for that and therefore we have to raise our rates. Or in some cases, just say we can't provide insurance here. We're pulling out. So that's what's going on. And, you know, I wish there was a simple thing that we could say, well, the insurers are the

Starting point is 00:24:13 bad guys. They should do this, this, and this, and that'll solve the problem. No, the insurers are not the bad guys. The bad guys is the fact that the atmosphere is becoming more and more dangerous. And that's because we've put this pollution into it and are continuing to put the pollution into it. That's where the mispricing is. We should have stopped the pollution years ago. Had we priced emissions appropriately 20 years ago, well, we wouldn't be having this problem. It's not too late. Well, in some ways, it is too late. You know, if we start pricing emissions now, it'll have a big impact on what it's like in 2100. It's not going to have a big impact on what it's like in 2040.

Starting point is 00:24:58 And there's a stat recently that I looked at that completely kind of stopped me in my tracks. And it showed that, hey, insurance prices are up 74% since 2008. That number, if you don't understand that number, is an astounding number when it comes to looking at some of these prices. Because that is far faster than inflation. that is far faster than the increase that we have seen in wages over the course of the last couple of decades. And as a personal finance question, obviously this is a finance show and a personal finance show. What does that number tell us about what's really going on underneath all of this? Because if that continues to happen over the long term, we need to really be concerned of what is going

Starting point is 00:25:33 on here. Yeah, no, you're absolutely right. We do need to be concerned. And those prices going up are reflecting the real risk going up. And it's going to continue to go up. Our infrastructure was built for a different climate. Okay. And so with this new climate, and the climate is changing and getting worse, you know, each year, that's going to mean that there are going to be significant expenses. It's uncertain how big they're going to be, but the insurers are trying to be prepared for it and get ahead of it. And so they're doing what they have to do. It's, again, it's not them being irrational.

Starting point is 00:26:08 It's that society is not prepared for this change in the climate. and we're going to have to get prepared. We're going to have to harden our infrastructure. And so what that means for individuals is that there's going to be, you know, an impact on affordability. It's going to be more expensive. At the same time, your construction costs are going up because you're going to have to build, you know, homes that are hardened for the stronger winds and the potential floods and so on. some people are going to have to pull back.

Starting point is 00:26:43 Most people won't, but if you're right on the coast and, you know, you're right at the area where you're getting battered by hurricanes, well, in 10 years or 20 years, you may not be able to be there. But for most people, it's really more a matter of affordability. The cost of homes is going up. The cost of the insurance is going up. The cost of construction is going up. The cost of electricity is going up.

Starting point is 00:27:07 All these things are going up. And so it's an affordability crisis. And the other thing I would say is that, you know, many people worry about could this cause a market crash, you know, a recession. Well, I think that's probably the wrong way to think about it because that kind of suggests that what we're talking about is a cyclical phenomena. You know, maybe it'll be a crash. Well, this is not a cyclical phenomenon. This is a long-term phenomena. And so what it really means is it's going to cut into our wealth.

Starting point is 00:27:44 Over time, our homes are going to become less valuable because they're going to be more exposed to these hazards. And so how big that impact is going to be is very uncertain. But we're not talking about a short-term recession. We're talking about a long-term destruction of wealth, which is really sad. And that's the reason why we need to pay attention to this because I think, you know, I want to kind of think through the chain reaction here. There's a there's something that is happening overall and I want people to kind of understand just how this kind of work. So let's say there's a weather event that happens. How does that happen where, you know, they have this weather event that happens and all of a sudden it hits or goes on to someone's balance sheet? Because I want the listener who thinks, oh, this is nowhere near me. This is not going to impact me. You know, I'm in a place where we don't have as many events as some of these other locations or maybe they don't have even tornadoes and they're in the middle of the country. So how does this kind of impacting anybody? There could be a chain reaction for any of this stuff and how it's pricing into kind of what they're looking at when it comes to their insurance rates? Sure.

Starting point is 00:28:48 Well, it depends who you are and where you are. And, you know, it's not that the average affects everyone the same. So if you're in a high risk area, I live in California. Well, California has a lot of risks, especially from the wildfires. And we saw that, oh, you know, maybe five years ago. There were these wildfires up here in the Bay Area a couple of years ago down in California, down in Los Angeles. And those wildfires just wiped out, you know, communities.

Starting point is 00:29:22 And what you saw then was the insurance companies reacting. In fact, I saw that before the L.A. wildfires, a huge proportion of the insurance. homes in those areas were losing their insurance and they were falling into the what's called the fare program, the state, you know, program for high-risk insured homes. And many lost their insurance and didn't get into the fair program. So you had all these homes that were, had lost their insurance just a year or two before and then got burned down. So you see this, especially in California, a tremendous.

Starting point is 00:30:04 growth in the number of insured in that state back plan, the number of homes that are uninsured, and then the catastrophic impacts when a fire does occur, as occurred in L.A. So it just depends who you are. Now, I live in an area of California that's not high risk, but I've seen my premiums go up dramatically because any insurer who insures policyholders in California has to pay into this fair plan. And so my insurance company has to pay. And so I have to pay. They pass that on. And so, as I said before, the real issue is who pays? And all of us end up paying at some point. So that's where we're at. And how does this become something where right now we're seeing, you know, insurance is getting more expensive. A lot of people are feeling that they're probably

Starting point is 00:30:56 looking at their insurance bills across the board in seeing that, you know, these prices are rising. And it is something that I think for a lot of people, you know, they're, they're feeling this at home. But is there a point in time where this becomes something like, okay, the insurance is expensive, but now my home or the insurance prices are rising so much that it feels as though my home is almost unmortgageable. Because if you are going to go out and get, you know, a loan on your home, most people don't realize this, but it requires that you also have insurance in place to be able to go out and get a mortgage. And so when you think about this, is there a point in time where this gets so expensive that your mortgage just rises so rapidly that

Starting point is 00:31:31 that's going to impact your ability to even buy or purchase a home. And obviously, we're starting to see that and the implications of that right now. But as this continues to rise, how bad can this get? Well, you're absolutely right. We're already seeing it. And this is part of the wealth destruction that I was talking about. The home values themselves go down when the cost of maintenance, which is really what we're talking about here, goes up. And so it's part of the affordability or the last.

Starting point is 00:32:01 of affordability of home ownership, which we've been seeing for a number of reasons. You know, the average homeowner today, the first purchaser, the age, has gone up and up and up because it's just harder to afford a home. It's just become more expensive. And the insurance is a part of it. And going forward, it's going to be a big part of it. These trends are not going to turn around. They're just going to increase. And as I say, this is really the first impact of climate change, which will just grow over time. It's a very slow process, but it's inexorable. And it's getting, you know, stronger and stronger over time. And so at some point, I assume that we're going to actually price this risk. We're going to say, no, we shouldn't be

Starting point is 00:32:52 emitting carbon dioxide into the atmosphere. People who do that, are polluting, and they should pay for it. And that's what we've got to do. That's the fundamental mistake we've made for the last, you know, 30, 40 years. That's the fundamental mispricing of risk, not the insurance. And that makes sense because I think overall for a lot of folks out there, it's really what is causing that domino effect, that chain reaction is you start from first principles. You go back and look at what actually is happening here that is causing this to, you know, to happen. And this is where it's really starting is that car. So I think overall, when we look at this, if you were around, you know, at any point in time in the

Starting point is 00:33:31 financial markets, if you're around during Wall Street during this time frame, like in 2008, that is a historic time to be around. That was a wild time for sure. And I think this is one of those things where some people have called this similar to 2008. And I don't know if that's a drastic statement or if that's something that we really are seeing going forward. But is this something that is genuinely different than 2008 when we're looking at some of the pricing risk? Is this more of a slow buildup over time like we've been talking about here because I do see that the prices of housing is going to become a problem if insurance prices continue to rise or the cost to renovate continues to rise because of all of these issues that we are seeing. So do you kind of see a similarity

Starting point is 00:34:07 of 2008 when we had the housing crisis or is this something just drastically different? Well, there's certainly some similarities. And I guess what the main thing about 2008 was there was a perception that if you put all these mortgages, together. And when I say these mortgages, there were a lot of mortgages made, issued to people who couldn't necessarily afford them. You know, they were given all kinds of breaks and people bought two homes and leveraged up and everything. And what the banks and investors who were investing in these markets and providing the funds assumed was that all the mortgage defaults would be independent, and therefore you could kind of mix up all these mortgages and the benefit of

Starting point is 00:35:00 diversification would mean you don't have to worry about it. But in fact, the risk was increasing and the defaults were correlated because they were impacted by the economy. When the economy went into recession, you know, everyone felt it and the probabilities of defaults increased in all these different mortgage pools. And so what happened is there was a fundamental mispricing of the risk embedded in those mortgages. And it was revealed when the economy went into recession. Now, that's very different, I would say, than what's going on here in the insurance markets. But what you could say is that there is a lot of mispriced, you know, unrecognized, let's say, risk in the insurance markets today in the sense that as the climate changes, the cost of those

Starting point is 00:35:57 insurance products is going to increase. So what's got to be recognized over time is that those are going to increase those premiums, and we're just starting to see it, and people are starting to recognize it. So now, do I think that is going to cause the economy to go into recession, the way that? that the mortgage recognition did, I don't think so. That's uncertain. That would require a sort of massive waking up all at once, and I don't think we're going to see a massive waking up all at once. What we're seeing is the inexorable increase in the prices of insurance and people dropping that insurance. And then, so what you could have is in high-risk areas, let's say

Starting point is 00:36:42 areas that are prone to flooding or prone to wildfires, those are areas where you're going to have massive dislocations. People are either going to have to move away or the values of the homes are going to collapse in those areas. So question is, are there going to be major impacts on wealth? Yes, for sure. Is it going to be a recession like was caused by the mortgage meltdown? I don't know. Not so clear. That's the thing that, yeah, it'll be probably one of those areas where we have to continue to monitor and continue to watch this slow burn that could be happening right now. It's very important for listeners right now to make sure that they are monitoring their insurance bills, understanding kind of what is happening in their specific area. But who is getting hit hardest right now?

Starting point is 00:37:30 Like, who do you see as the consumer out there who potentially is getting hit the hardest? Is it the folks in those high-risk areas? Is it folks, you know, across the country that are really getting hit? or who do you see is really having the major impact right now? Well, certainly the individual homeowner who's in that high-risk area. They should be aware of it and they should look at their insurance policy, as you said, to see what's been happening, what kind of coverage do they have. You know, it could be that the insurance company has lowered the payout or, you know,

Starting point is 00:38:04 put in limits on the payout. And that's implicitly an increase in price. It doesn't show up, but it shows up in terms of your lack of coverage. And so you really want to be very careful about looking at what insurance you do have. If you can afford it, is it going to go up? Should I be thinking about moving? You know, one of the things that I would say is true today is that most people don't think about climate change when they're thinking about their home value or where they want to live.

Starting point is 00:38:36 I would guess that in 10 years, almost everyone will be thinking about that. So maybe you want to get ahead of the curve and plan now to move into an area that's not as hazardous if you're in a hazardous area. Now, if you're in a hazardous area, maybe what you can do is you can, you know, harden your home. Maybe you put on a stronger roof if you're, you know, exposed to high winds or you clear out the debris if you're exposed to wildfire. And maybe in some communities you can work together. Maybe the whole community has to do things and should be getting together to do that. So there's a lot of things to think about. It depends very much on your particular location.

Starting point is 00:39:22 So there's no one right answer for everybody. But definitely think about it ahead, be prepared, take the actions that you may have to take either individually or collectively as part of the community. But, you know, ultimately, we don't know what's going to happen in the future. We don't know how bad it's going to be. We don't know what the states and, you know, the insurance regulators are going to do, and that will impact, you know, the cost of my insurance. It may impact whether or not I want to stay where I am, whether I have to pay for it, etc.

Starting point is 00:39:57 So really hard to say, you know, and it's very individual, very tailored to the particular circumstance of the individual. And even folks who are listening right now who say, oh, I don't own a home, I am renting my home. This still is going to impact you because the cost is going to go up for the folks who own your home with a landlord or whoever is, you know, owning that rental property. That is going to be something where those costs are going to be handed down to the consumer, the person who is renting that property because the only reason why they're doing this in a lot of situations is to make some sort of profit.

Starting point is 00:40:25 And so we see this time and time again where, you know, even impacts to housing is going to pretty much impact everybody, even if you don't own your actual home. And so when we think about this, who should pay for this? You know, should homeowners just accept the fact that this is now a permanent part of their cost for owning a home? This is just the cost of doing business and build this into their financial plan. Or what do you think about that? Well, earlier in this conversation, I said polluter should pay. Absolutely. That's true. But that, of course, is about different. That's a different cost. That's the pollution itself. In terms of the insurance, you know, we're all going to end up paying for it. It's just going to be, you know, a bigger expense and it'll have to be shared. Obviously, those who live in the hazardous areas are going to have higher risk. And that should be reflected in their decisions. So, you know, I guess there'll be some people who think that's worth it to them to live in a high risk area, perhaps.

Starting point is 00:41:30 on a coast or something, and they'll have to pay more for it. And others will say, no, I don't want to pay for that. I'll live where I can afford it, and they'll be in less risky areas. So people will adjust, and ultimately those who are taking the risk will have to pay for it. And I've noticed folks that are in those high risk areas, a lot of times they will say, no, it's worth it for the view or it's worth it for the location, it's worth it for some of those things. And then once they get hit two or three times in a row, then all of a sudden they're like, maybe this isn't worth it. And I noticed that, you know, there's a shift in the mindset there. So there's psychology behind it.

Starting point is 00:42:02 There's a lot of things that are happening on that front as well. When we think about who should pay, what about insurers? Isn't pricing risk part of their entire business model? Is this something that they should kind of do a better job with? Well, it is. They are experts at pricing risk. And they are focused on it. They have models that they use to look into the future.

Starting point is 00:42:22 They try and do it. And it's a competitive industry. So I don't think you can look at the insurers and say, oh, it's clear they're mispricing the risk. They're catching up to a changing environment. It makes it harder for them to price the risk for sure. Because if you live in an environment that's been very stable for a thousand years, you have plenty of data to look at that helps you to really understand and be very accurate about very low frequency events. When you're all of a sudden in a new world where the climate is changing, where you're reliance, on models to forecast what the future is going to be. And so there's a lot more uncertainty

Starting point is 00:43:02 about what the hazard is going to be. You have to build that into your prices. And that's what the insurers are doing. They're trying to do it as best they can. But it's a lot harder. And so because it's harder for the insurance companies to be sure about what the risk is, they have to build that into their premiums for homeowners as well. Absolutely. I think a lot of times they have to react to certain situations they kind of are on the tail end of some of this stuff, and it's really important to kind of see that portion as well. And then there's the argument that the companies that are actually, you know, creating this pollution that are causing this to happen should be paying something or

Starting point is 00:43:39 should bear some of this cost. And you've actually built kind of carbon pricing models. Is there a realistic policy position here that we should be thinking about when it comes to, you know, should these companies actually be paying for this? Should they actually have something, something going on here to make this shift where it is much more difficult to create some of this pollution. Yeah, I mean, absolutely, but, and it's a longer conversation, but there's a lot of difficulties that have caused us not to price carbon pollution appropriately. The most important one is the fact that it's what economists call a free rider problem, that it's a global problem. Anyone who pollutes anywhere in the world, it goes into the atmosphere and it has the same impact. So one country can

Starting point is 00:44:25 fight pollution very difficult, very hard. They can put a high price on emissions and they still get screwed by the pollution that comes from all the other countries. And so every country has an incentive to say, well, I hope everyone else does, you know, the right thing, but I'm not going to because my individual action has very little impact on my outcome. And but everyone is saying that globally. And so it leads to a paralysis and people not. moving. And in fact, it's even worse than that because we're not all in it together in some sense. There are certain countries, you call them petro states that have, you know, most of their wealth is in fossil fuels under the ground. There's other countries that have very poor endowments

Starting point is 00:45:12 of fossil fuels. So it's in their interest to move very quickly, whereas in the countries, the petro states, they move very slowly. And so you are actually seeing that in the world today, The Europeans, the Chinese, they're moving very quickly to decarbonize their economies. Other countries like the U.S. moving very slowly. So there are a number of countries out there that do have significant prices on carbon in Europe in particular. They've had prices as much as $100 a ton, which is a pretty good incentive to reduce emissions. actually that's gone down in recent years because of the war in Ukraine. And so some of those governments have increased subsidies to electricity, and that's reduced the price in Europe.

Starting point is 00:46:02 In the U.S., we have essentially a zero price. There's all kinds of subsidies on fossil fuels. And on the one hand, they're not that big, but they're there. And then on the other hand, you have only a few states that have carbon taxes or emissions trading systems they're called. California is one of them. But even there, the prices are much lower than in Europe. And so you have different countries that are moving at different speeds. The U.S. happens to be on the wrong side right now.

Starting point is 00:46:34 We are moving much too slowly. But there are attempts now to create coalitions of countries to move together. That's something that you may have heard. It was Mark Carney at the World Economic Forum this past year gave a speech about coalitions of countries that have common, you know, interests moving together outside of the context of the U.N. And we're starting to see that with respect to carbon pollution. And so I hope there is, you know, some optimism that we'll be able to see significant pricing of carbon moving forward. And, boy, that would be thankful if it does happen.

Starting point is 00:47:15 That'd be a huge shift. And I think overall, when we look at this, you know, like you're saying, incentives matter, especially that's economics 101. And when we look at these incentives of some of these countries, we've got to figure out a way to incentivize them to kind of work together to make this happen long term because I think that's a huge, huge shift. Where does this story go if nothing changes over the course the next 10 years? What do you see happening there if we have no changes or, you know, maybe even, you're doing nothing at all? What would happen in your eyes? I know you don't have a crystal ball, but what do you think could happen? Well, you know, the impacts are just going to get larger and larger. They're not going to go away. And it is going to become a significant issue for individual homeowners and renters, as you say, for all of us, because it's just going to cause increasing damages, you know, impacts on wealth, impacts on affordability of homes, increasing construction costs, et cetera. And so we're going to have to pay attention. It's only a question of

Starting point is 00:48:14 plan. I think it's coming sooner than most people think, but I've been an optimist for a long time. I remember 10 years ago thinking, this can't keep going for another five years. Well, here we are 10 years later, and it has kept going. It's very sad because, as I said earlier, the cost of delay is just, you know, growing, it's just growing faster and faster. And here we are. We've got to slam on the brakes. And when you think about this, you know, as we start to wrap this up here, you know, as I start to think through all of this, what do you want listeners to walk away remembering when they, when they listen to this episode? There are some great, incredibly valuable information here that I think people really need

Starting point is 00:48:57 to be made aware of and most people may not have even realized this is happening to them. What do you want listeners to walk away from when they hear this? Well, the first thing is, you know, they have to be concerned about the insurance that they have on their home. and, you know, are they living in a high-risk area? What are the risks? What can they do to address the risks, either individually or as a community? Certainly in terms of getting to the underlying cause, we have to think about, okay, let's put

Starting point is 00:49:26 a price on pollution. Let's make the polluters pay. In terms of going forward, we need to work together with other countries and have these kind of global coalitions to address the problem. I would say that there are hopes that there will be new technologies that will make it a lot cheaper to, you know, create electricity and other, you know, energy without pollution, and also to pull the carbon dioxide, the pollution that's in the atmosphere out and clean it up. Those are probably going to take a long time, but we don't really know. So we've got to be prepared for the worst case scenario, and we've got to hope and try and do everything we can to make. the problem go away as soon as we can. Well, Bob, this has been absolutely wonderful. And I truly

Starting point is 00:50:16 appreciate you coming on here and kind of create an awareness around this. I think this is one of those areas that most people, this is going to impact your wallet. This is going to impact your wealth long term. And we need to be aware and do what we can to kind of make a shift and help make change when it comes to some of this stuff. So where can people learn more about you, Bob, and what you have going on and some of the work that you're doing? Oh, well, you know, I'm, I sit on a lot of boards. And so I would suggest that they might want to get some of that information from, for example, the World Wildlife Fund, where I sit on their board. They have a lot of good information. Resources for the future has a lot of good information. For those who are more politically inclined, I would suggest the Niskanen Center,

Starting point is 00:50:57 which is a think tank based in D.C. I chair the board there. And we're doing great stuff on a bipartisan basis on many different issues, but one of them is climate. So there's a lot of different places where people can get more information and get involved. And I hope they do. Wonderful. Well, thank you so much, Bob, for coming on here. This has just been a wonderful conversation, and I am so glad that you came on here. Thank you.

Starting point is 00:51:25 It's been my pleasure, and good luck in the future.

The Personal Finance Podcast - The Insurance Crisis Nobody Is Talking About (With Bob Litterman)

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