There is a prevailing notion among some media outlets, that insurers are leaving California due to increased wildfire risk. The idea is that the risk of destruction from wildfires is making it unprofitable for insurers to cover new homeowners. This isn’t incorrect, but what’s missing is that insurers usually increase rates to match the added risk. The likely reason insurers are refusing to admit new applicants isn’t due to increased risk, but a legal inability to match that risk with added rates.
Insurance operates on a simple framework. Consumers buy insurance to cover unexpected disasters, such as flooding, earthquakes, health complications, car accidents, and in this case, home fires. Depending on the likelihood of each scenario, insurers will offer different rates. For a sustainable business model, the rates pay the insurer more than it costs to cover a fraction of their customers who experience a disaster. If the likelihood that customers will experience a disaster increases, rates follow, maintaining the company’s profitability.
In California, however, all rate hikes must be approved by the Insurance Commissioner. As an elected official, current California Insurance Commissioner Ricardo Lara also has a political incentive not to be too hasty with raising rates, as potential homeowners are also voters. Politicizing insurance rates has led to shortsighted efforts to keep rates the same or even to lower rates.
In 2014, then-Commissioner Dave Jones’ ordered State Farm to reduce their insurance rate by 7 percent despite the insurer requesting the commission to raise the rate cap by nearly 7 percent. In 2013, a Tuolumne County fire had destroyed 257,314 acres of land, and State Farm correctly believed that larger fires were yet to come.
Insurers’ inability to price according to risk goes further. Instead of being able to create models on expected future risk and set insurance rates accordingly, insurers have to set rates according to the average damage accrued over the last 20 years. This severely lagging calculation forces insurers to take massive losses before they are allowed to adjust their rates. When the risk of wildfire damage increases rapidly, this model prevents insurers from profitably providing coverage.
State Farm stopped accepting new insurance applications last month. State Farm did not go into detail on why they were ceasing to admit new applicants, only citing “wildfires” and “inflation.” Though not explicitly stated, California policies that prevent State Farm from offering rates befitting risk had to have been a prime factor. With 21 percent of homeowners currently using State Farm, this exit will heavily restrict consumer options moving forward.
It remains to be seen whether California policymakers will take a hint and ease price controls before another large insurer leaves the state. Optimistically, the California Department of Insurance has announced a public workshop to explore new risk assessment tools to help insurers properly set rates. This may be the start of implementing a reasonable insurance policy, but only time will tell.
Isaac Schick is a policy analyst at the American Consumer Institute, a nonprofit education and research organization. For more information about the Institute, visit www.TheAmericanConsumer.Org or follow us on Twitter @ConsumerPal.