The Orange County Register – Government failure in the California property insurance market


California has recently been described as, “a state riven by billion-dollar wildfires, mudslides, and the ever-present threat of a catastrophic earthquake.” For instance, the 2017 and 2018 fires in the state reportedly wiped out decades of insurance industry profits. And State Farm, the largest property insurer in the state, lost $5.9 billion last year. At the same time, several major property insurers, including State Farm, announced they would stop writing new property insurance in California. State Farm, in a press release, blamed increasing natural disaster risk, higher rebuilding costs, and “a challenging reinsurance market.”

On the surface, the causal connection involved would seem to be straightforward. But by itself, it is not. It is missing a crucial element if we are to understand and cope with the property insurance crisis. That element is that the crisis is not a market failure, to be blamed on the insurance companies, but a combination of government failures undermining the market. 

The reason State Farm’s press release alone is insufficient to understand the issues is that while higher risks would increase insurers’ costs, insurance markets are all about pricing risk. As long as the risk is predictable, higher costs do not prevent insurance from being offered. The cost would be higher, but it wouldn’t require a halt to writing new policies. To make sense of such a withdrawal requires that we ask what state policies do to raise those costs and what they do to prevent issuers from being compensated for them. 

There are several aspects of those issues, stretching to home-building permits in high-risk areas to state wildfire policies. But even if we limit our focus solely to insurance policy, there are several ways state policies undermine the California property insurance market. 

One of them is Proposition 103, passed narrowly in 1998. It mandated an immediate 20% rollback in property and casualty insurance rates in the state, and that insurance companies in the future would need to get rates approved by an elected State Insurance Commissioner. Both have pushed the rates insurers are allowed to charge down; the first directly, and the second indirectly, because of the political pressures on insurance commissioners to justify their existence to the customers who elect them by “saying no” or “standing up to” insurance companies by forcing them to charge less (much as rent control forces down rental housing prices to satisfy current renters who dominate local elections, which leads both interventions to cause market crises). 

When coverage prices are held below what would make insurance profitable, insurers will act as suppliers do in every case where government mandates cause shortages. They will cut back on what has been made unprofitable to supply. That, then, precipitates a crisis they did not cause but are routinely scapegoated for. 

Beyond Proposition 103’s direct effects, its implementation has piled on further problems. 

California uniquely forces insurers in the property and casualty market to price current risks based on 20 years of historical risk patterns, rather than their forecast of current and future risks. When those risks rise sharply, as of late, that means that policy rates cannot reflect the actual risks insurers must bear from its policies. As Karen Collins, vice president of property and environment at the American Property Casualty Insurance Association, has pointed out, writing insurance for homes in areas where homes didn’t use to be because of the high risk must treat that risk as far less than it really is. Highlighting the unfairness are the facts that every other state allows what California bans for wildfire risks, and that while home insurers in the state are not allowed to use future risk forecasts to set their rates, earthquake insurers are. 

In addition, any effort to raise premiums more than 6.9% can be challenged by consumer protection advocates and delayed or denied as a result, in an expensive, time-consuming and therefore profit-eating process for insurers. 

California also has a unique “efficient proximate cause” rule that forces property insurers to include coverage for damages from post-fire flooding and mudslides in their policies, which can dramatically raise their costs and risks, but not their ability to charge to cover it, especially when there have been new homes built in areas that are both fire and mudslide prone. 

Another unique aspect of California’s insurance rate-setting process is that it does not allow reinsurance costs, incurred when risks are so large even the insurance companies want to reduce their exposure, to be included in the determination of rate increases. With one broker reporting reinsurance increases of 25% in 2022 and 33% more in 2023 and another reporting a 40-60% increase this year, that means insurance companies are not allowed to be compensated for huge costs they can be forced to bear. Consumer Watchdog, the organization that supports Proposition 103, led by the Proposition’s author, has reported that incorporating those costs could raise insurance rates by 40%, but opposes allowing insurers to be reimbursed for them. 

Even the FAIR Plan, the limited insurance plan Californians unable to get private coverage can resort to, threatens to impose huge costs on private insurers. That is because its costs in excess of claims paid are levied on private insurance companies in the state, in proportion to their market shares. With catastrophic risks increasingly moving to the FAIR plan, it is increasingly at risk of bankruptcy, which is also threatening private insurance companies with additional multi-billion dollar liabilities. 

In almost every place someone who really wants to understand the issues involved in California’s current insurance crisis looks, they will find California government the primary cause, with insurance companies’ main roles being patsies and scapegoats. In that case, the solution is for those at fault to stop pointing their fingers at others, then to do less of the things that have caused the problems. But that is unlikely. 

One illustration is that the Rural Caucus of the California Democratic Party, along with Insurance Commissioner Ricardo Lara, have reportedly already drafted a new proposed platform that would, “Prevent insurance companies from canceling or declining to offer homeowner, property, and fire insurance policies, and bolster the state-funded insurance of last resort (e.g., FAIR Plan) to provide comprehensive coverage.” That platform would mean they would make it even harder for insurers to avoid the impositions California’s insurance regulations and regulators, backed by the Democratic Party, want to impose on them. 

Further, it means they plan to double down on those burdens by expanding FAIR plan options, and the added losses that would result, which would force insurers to pick up the tab for their “generosity.” However, adding more policies guaranteed to expand government failure is not a solution for the multitude of failures and crises they have already created. 

Gary Galles is a professor of economics at Pepperdine University.

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