Posted by: Dirk | September 3, 2007

Robert Shiller offers insurance against falling home prices

Robert Shiller answered seven questions at the blog of Foreign Policy. This is the last one:

FP: For people who aren’t financial experts, what do you mean by “hedging your risk”?

RS: There are two main ways of protecting yourself. One is to buy insurance, and another way is to diversify your portfolio. We’ve been campaigning for years for home-equity insurance so that people could buy an insurance policy on the loss of value of their home. And we’re working on that; I think it’s coming.

The other thing is portfolio diversification. People have very concentrated wealth in housing. For most people it’s the dominant asset that they retire with, and it’s all in one city. We have seen substantial drops in home prices in the past, and we run the risk of that again. This exists now: One can buy a put option on home prices that will pay you if they decline, or you can take a position in a futures market, which is a venerable financial method that’s been around for well over 100 years. It’s always been, however, a very sophisticated method that the general public doesn’t appreciate.

The one thing about insurance is that you have to buy insurance on your house before it catches on fire, not after. Already, the futures markets are predicting between 3 and 8 percent declines in home prices over the next year. So that’s already priced in and already—you might say—lost. You can’t protect yourself against the first 3 to 8 percent losses in the futures market, because the market’s expecting them. So we would be planning for the next crisis, whenever that comes.

This kind of insurance makes sense, but in the long run we are all dead. If people buy a house so that they don’t have to rent when they are old, they might not care about its price. Paying no rent is nice, so why take a gamble and pay for insurance against falling home prices? Even if the homeowners plan to give the house to their children, they can assume that house prices will rise again. And their children probably have enough time to see it happen. So it might be rational for people to not care about house prices. The US sees its baby boomer generation going into retirement these years. Maybe this can explain why few people buy Shiller’s type of insurance?

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Responses

  1. It’s easy to think that bad things happen to other people and not ourselves, but the facts suggest that isn’t a risk we can afford to take. In the UK, one in three of us will get burgled at some point in our lives yet about a quarter of households are not protected by any form of home insurance.


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