The California Fires And What Comes Next

As some of you have speculated, I had been planning to write about the California FAIR plan for quite some time, but never quite got around to it.

That, unfortunately, is the downside of subscribing to a free newsletter. I have no market incentive to publish in a timely manner!

That being said, there is still plenty left to talk about, so let’s jump in.

So what would I have written last year? That’s easy. The FAIR plan is severely underfunded and will eventually go bankrupt leading to large assessments that will likely break the home insurance market.

That is still true today, post the fires. The assessment system buys a little time, but it’s nothing more than a band-aid for a patient who is bleeding out.

So how will this all play out? Before discussing that, I think it’s worthwhile to have a brief recap of how we got here.

FAIRly Overleveraged

Many of you have likely seen some of these charts. FAIR’s exposure has tripled in three years while PIF has more than doubled.

Why did exposure grow faster? FAIR raised its policy limits to $3M in 2019. Yes, just as they were getting more adverse selection (after all, why else would one choose a FAIR policy), they decided to grow their underwriting appetite. Brilliant!

Here’s a stunning chart to demonstrate. Since 2018, FAIR’s market share has grown from 2% to 4% statewide, but in the ten riskiest counties for fire, it’s gone from 3% to 33%!!!

Note, since this is done at the county level, it likely understates risk. For example, Los Angeles county only has 10% of homes at risk, so it’s in the low bucket, even though the absolute number of high risk policies is the highest in the state.

If you were to zoom in on pieces of LA county, you would likely find FAIR has something like that 1/3 share in the riskiest parts.

Capital Light

So how much capital do they hold against what is likely now over $500B of risk?

Nobody really knows. FAIR does not have to disclose their financials! That is incomprehensible to me.

How can they sell policies without a prospective buyer being allowed to assess the risk of getting paid???

Anyway, public comments suggest FAIR had somewhere around $200-300M of surplus before the fires.

What do they have left now? Well, they have a $900M retention on their reinsurance, so we’re already significantly negative.

But they also participate up the side of their tower. They have nearly $5B of cover and roughly a 50% participation. If they exhaust the tower, their net loss would be $3.15B.

Of course, they could bust out over the tower in which case things get even worse. But for simplicity, let’s assume they have a $5.75B gross loss and $3.15B net, thus completely exhausting their reinsurance.

That means they need to find $3B…and quick. How would they do that?

Assessments

You’ve likely heard there is a plan. It’s not a good plan, but it’s a plan. The plan is to use assessments to make all the other insurers pay for FAIR’s losses.

Note, assessments are based on state wide market share, so those responsible insurers who avoided fire zones get assessed for the bad underwriting of their competitors. In California, this is considered fair (or FAIR?).

Assessments works well in a static world, but no so much in our real and dynamic world as I’ll show.

First, though, let me address the mechanics. There doesn’t appear to be an upper cap on assessments. The first $1B of residential (and first $1B of commercial, though there will not likely be that much) assessments can only be 50% passed on to the consumer.

After that, it can be entirely passed on in customer premium. So, that would suggest the industry only has $500+M of risk.

And better news…most reinsurers were dumb enough to agree to pay for assessments, so the primaries will absorb none of this.

So problem solved? Soak the reinsurers and the customers and everything is good? Not so fast.

While there will be some public outcry about the surcharge on customer’s bills, this is manageable. After all, the average home insurance premium in CA is ~$1500.

If the surcharge is in the 15-20% ballpark, that’s only an additional $200-$300 per home (those who wisely chose to live outside fire zones will be subsidizing the losses of those who built in them).

However, this ignores the elephant in the room.

The Day After

All these assessments do is get surplus back to $0. Then what?

They still have $500B of exposure next year…and growing as more insurers will certainly retreat.

It is incomprehensible that California can say FAIR will accept the same, or even more, customers with no way to pay them back – outside of larger assessments which basically means homeowners are paying for their losses themselves.

In other words, FAIR is in the process of transitioning from an insurance program to a tax where general revenues from the many pay out benefits to the few.

But it seems unlikely FAIR will ever be in a position to build a material surplus to support its risk profile.

Given that, how can it be allowed to continue assuming risk?

The Capacity Vacuum

I know California is doing all kinds of things to force insurers to renew business against their will. And that will work for a little while, but it’s an unstable situation with an obvious outcome.

When government forces industry to play Russian roulette, industry will find a way to escape and not play anymore.

If California wants to play hardball with State Farm, what will State Farm do? They’ll abandon their local CA subsidiary and walk away. California has no jurisdiction over the State Farm corporate balance sheet.

If 20% of the market walks, California has an unimaginable crisis. And it won’t just be State Farm who walks either.

This event has already made clear the recent “reform” to allow insurers to finally use cat models if they grow in wildfire exposed zones is a non-starter.

Even insurers aren’t dumb enough to fall for that after these losses. Nobody is going to choose to grow when they can’t have confidence they can raise price or non-renew when necessary.

So if private insurers are going to retreat and FAIR has no surplus to absorb further demand, where do Californians go for insurance?

Prices Are Way Too Low

The biggest problem for insurers in California is they underprice the product. Not by choice, of course, rather by mandate. Between Prop 103, politically motivated insurance commissioners, Consumer Watchdog, etc., it is impossible to get an actuarially necessary rate approved.

California should be one of the most expensive states for home insurance up with Florida, Texas and New York. Instead, it’s in the middle of the pack. The chart below is a little dated, but the conclusions haven’t changed.

Note, this picture doesn’t tell the whole story. It’s not just that California is at the median for home insurance premium. It’s actually well below once you adjust for the fact that California has much higher home prices.

The average home price in California is double or even triple states with similar average insurance premiums. Scroll to the data in this Reuters article that shows how a home in Illinois has higher insurance costs than a similar one in California.

And note I didn’t even mention that California has among the highest natural peril risk between quakes and fire.

Rates need to at least double. Until they do, California will be in a perpetual state of crisis.

Fear Is The Best Motivator

A lot of people aren’t going to be able to get insurance. And you know what? Maybe that’s a good thing.

Maybe the best thing that can happen to the market is for people who had losses to move to safer places in the state where they can rebuild for less and insurance is available.

If you live in one of those high risk counties that has avoided fire to date, maybe it’s for the best that a lack of insurance forces you to sell and move now before a future fire.

Just as in Florida, the simplest way to solve the problem is to not live in the most dangerous places.

The second best way is to build with materials that won’t burn. Yes, it costs more, but you can choose to self insure and, in time, insurers will seek out homes like yours that are lower risk and insure you for far less than your neighbors.

Will there be some financial hardship in the transition? For sure, and this would be a wise place for government to intervene.

Provide financial incentives for people to leave dangerous regions where insurance isn’t available rather than wait for the inevitable fire and spend a ton of money on the cleanup afterwards.

But if California doubles down on FAIR, there is no catalyst for people to respond with their feet and move to safer places, or at least build safer homes in the existing places.

The Demand Surge Crisis

The most likely way people will end up leaving the Palisades is because they can’t afford to rebuild. Many Californians were underinsured before the fires, as they hadn’t adjusted their level of coverage to the surge in housing prices.

Even those who did have the proper coverage for a “normal” loss will find themselves underinsured due to the likely unprecedented demand surge.

Think about how hard it is to build one home in a place like the Palisades given California regulation. Now, you have to build thousands all at once.

There isn’t enough infrastructure to allow it, even if the state waived every onerous permit requirement. I don’t know how they’re going to figure out who gets to rebuild first, but the queue will be long.

That means a home that might normally cost $2M to rebuild, might cost $4 or $5M. That is now way more than the insurance coverage which means you’re better off selling the land and moving somewhere else cheaper.

Also, while people are waiting in queue, they will exhaust their loss of use limits. Many policies have a 12 month limit. Even those without a time limit will find it doesn’t take long to blow through 10% of your policy limit on alternative housing.

If you are going to be waiting three or four years to rebuild your home, you are, again, far better off, selling the land, taking the insurance proceeds, and moving somewhere else.

The Opportunity For Excess

If I were going to start a new insurance business, I would create a coastal E&S home insurer. You evade all the political hurdles in CA and FL and, more importantly, don’t have to take all comers.

Underwrite it like facultative. Sure, it costs more upfront, but you avoid a lot of losses on the back end and you can charge plenty of premium relative to the market.

People are desperate. They will pay a high, but fair, price, especially if they trust you will pay their claim quickly and not drop them afterwards.

There is also the ability to provide meaningful discounts for better building standards and other risk mitigation.

There are some creative things that can be done to incent (and reward) good behavior and there is certainly lots of demand for alternatives to standard markets.

However, given that doesn’t exist today, I suspect we are going to be in the situation I described above where a lot of people end up uninsured.

Incentives For Capacity

The only way the market will ever function properly again is when reforms are introduced that acknowledge insurers aren’t the enemy and they weren’t unfairly profiting off the backs of Californians.

Forty eight other states understand this. There are only two dysfunctional states that refuse to accept this reality.

When California is ready to allow reasonable price increases that reflect the above average risk California poses to insurers, they will magically find the FAIR plan exposures will shrink because the private market will return.

In fact, let me speak more plainly and directly to Commissioner Lara in case somehow this ends up on his desk. I’m going to let you in on a dirty little secret about the insurance industry. Are you ready?

The more insurance companies you get to come to your state, the more prices will fall. You know why?

Because most insurance companies are stupid and, once they’re in a market, they will usually compromise on returns to keep their share, even if it results in subpar financial results.

If you need evidence of this, look up the nationwide homeowner’s insurance combined ratio over the last 25 years. It’s over 100%!

Insurers will write business at a loss if you just let them!

It’s only when you do reckless things that push them to a breaking point that they finally say no mas.

So congratulations, Commissioner, on making things worse for all Californians. If you really want to serve them, you can start by repealing Prop 103 and begging insurers to write more business at higher prices.

What Have We Learned

This has gotten lengthy, but there is also so much I didn’t even get to. So what are our key conclusions?

• FAIR is not a viable alternative for homeowners who can’t get private insurance
• More private insurers will leave the state due to onerous regulation
• Californians who live in fire (or quake) zones are going to face an availability crisis and may have to move to safer areas or self insure
• It is better to pay a fair price for insurance that pays you when you need it than to whine about how “expensive” insurance is (when it’s actually cheap) and not be able to find coverage
• “Pro-consumer” regulation is the enemy. It saves you a few bucks in the short run, but forces you out of your home in the long run

I’m guessing this won’t be the last time I write about these issues. Insurers and homeowners are going to have to make some difficult decisions in the coming years about whether California can have a viable insurance market.