In Wake of California Fires, Insurance Faces Complex Future, Says Professor

Before the latest wildfires raged across Southern California in January, several major insurers had already paused or canceled coverage in the state, citing the high risk of fire, state caps on premiums and increased construction costs there.

With losses expected to exceed $250 billion from this year’s fires alone, the question isn’t if someone will pay, but who, says Professor Kenneth S. Abraham of the University of Virginia School of Law. Whether it is through rising insurance premiums, taxpayer-funded bailouts or homeowners absorbing significant losses, the financial burden of these catastrophes must ultimately be shouldered by someone, he explains in a new essay published by the Harvard Law Review Blog. “About the California Fires” considers the challenges and principles of insurance in the state, particularly in the context of increasing wildfire risks and their implications for homeowners and insurers.

Abraham, a David and Mary Harrison Distinguished Professor of Law, is one of the nation’s leading scholars and teachers in the fields of torts and insurance law. He answers questions regarding the past, present and future of fire insurance in high-risk areas.

In broad strokes, what are some lessons you draw from the California fire disaster when it comes to insurance?

All the states, but especially states where there are high risks of fire or flood, have to pay more attention to ensuring that everyone who wants insurance against such risks has access to it. It’s going to be expensive, however, because the risks of loss are high. You can’t get around that.

Where did the idea of fire insurance come from?

Fire insurance goes back a long way. It was introduced after the Great Fire of London in 1666. It was sold in the colonies before the Revolution. And it was a risky enterprise. The new insurers had no actuarial data on the probability of fire or on the magnitude of risk posed by different properties. They knew intuitively that stone and masonry buildings posed less risk than wood buildings, but until there had been a lot of fires, they could not know the precise difference, and, therefore, could not meaningfully calibrate the level of premiums they charged to cover these risks. So, they risked insolvency if they underestimated risk and charged too little for coverage. Eventually they solved this problem by pooling their data on losses to create a statistically more reliable basis for setting premiums, arguably at a cost to competition.

You write in your essay that fire insurers quickly realized the consequences of “correlated risk,” an issue still affecting densely populated areas today. Tell us more about that.

In the densely constructed towns and cities of colonial America, fires could easily spread from building to building, causing catastrophic losses. Major fires in Charleston and New York put a number of the early fire insurers out of business. Today, correlated risk is still a threat, as the California experience confirms. Insurers now reinsure some of their risk, thus spreading their exposure into the global financial markets.

There had been stories about insurers canceling policies in at-risk areas in California even before the latest fires. What does an insurance shortage mean for Californians or others facing a lack of insurance options?

It means that homeowners will have to search for coverage from other insurers, or that California (through its FAIR Plan) will have to provide more state-backup coverage.

In your essay, you note that some California homeowners have gone “bare,” exacerbating the financial impact of their loss after fire — what does that mean?

Homeowners who have paid off their mortgages have sometimes gone “bare” — i.e., uninsured. That’s what happens when premiums rise to a point that they are not affordable to some. Those whose homes have now been destroyed by fire will regret their decision not to renew. But many, if not most, of the nonrenewals could be framed as insurers’ decisions: because of insurers’ desire to reduce their exposure in high-risk areas, because of regulatory limits on premium levels that threaten profitability, or to play “chicken” with regulators in an effort to obtain future approval of premium increases greater than would otherwise be approved.

Can California require insurers to cover homes?

Requiring insurers to take all comers would be pretty extreme and probably would never happen. It is true that regulators can require those who sell auto insurance, which is profitable, to continue selling homeowners insurance generally, or even, as California has recently, reach an agreement about how much they will sell, if they want to keep their licenses to sell auto insurance. Maybe California could do that for a prolonged period, because California is such a big state with a lot of auto insurance revenue. But that’s not feasible in smaller or even medium-sized states. So there is a practical limit on what regulatory suppression of premium levels can accomplish without throwing the baby out with the bathwater.

What other tools can states deploy?

States can create facilities that provide insurance that is otherwise unavailable or too expensive for some. In the end, whether the private facilities and the insurers backing them up lose money or break even depends on whether the state facility charges high-enough premiums. Charge enough, and the facility is a going concern, but typically only when premiums are about as high as what the private market charges. Keep premiums lower because of political pressure, and something has to give. Either the facility fails or additional state backup is necessary.

California’s FAIR Plan issues homeowners insurance to those who cannot obtain it in the private market, often because they are in high fire-risk zones. But the maximum coverage limits are $3 million. If you owned a $5 million home in Pacific Palisades, the FAIR Plan would not cover the full value of your home.

Will state-backed or state-funded insurance just encourage people to build in areas prone to fires, floods or hurricanes? Should we instead let market forces encourage building in less problematic places?

Those are tough policy choices, and no state has been willing to prohibit housing in particular places across the board. I would favor long-term discouragement of construction in high-risk fire or flood zones, but it’s politically highly unpopular.

What are the arguments for and against federal intervention in the high-risk fire insurance market?

That’s a very big, deep question. I would say that the key question is whether the increased risk of fire is a national problem, because the increased risk is caused heavily by climate change, or a local problem, because it is so heavily related to where people are permitted to live and what safety requirements are imposed on them.