California to equip insurers to price in forward-looking models & reinsurance costs

California is moving to avoid a developing insurance crisis in the state that has seen major companies pull-back on underwriting property insurance there, or exit the state entirely, with plans announced to enable insurers to better cover their loss costs and expenses within their pricing.

In order for the private insurance market to function, there is a need for both insurance and reinsurance carriers to cover their costs of underwriting over the cycle, with rates needed to be actuarially sound and sufficient to cover their costs of losses, expenses, cost-of-capital and deliver a margin.

In California that had become untenable, at least if writing business in wildfire exposed parts of the state.

As a result, we saw the exit and pull-back of insurance capacity accelerating in California in recent months and one of the key drivers for this was that insurers felt unable to cover their costs of operating there.

As we had written previously, the California legislative appeared to have ignored the issues that are making writing wildfire-exposed property more challenging in the state, as more carriers pulled-back from writing business there.

Allstate had been one of the first to pause underwriting new homeowners, apartment and commercial property insurance in California in late 2022, followed by AIG and Chubb which both reportedly pulled-back on high-value property risks in the state.

This year, State Farm announced it was exiting the California property insurance market, ceasing to write business and personal P&C property as it cites exposure growth, rising catastrophe risks and reinsurance market challenges as reasons for the move.

Which was followed by Farmers Insurance, citing similar issues as State Farm, saying that writing business in California is fraught with challenges related to severe weather loss events, inflation and soaring reconstruction cost values.

Now, the goal is to enact new legislation that will help insurers to operate more sustainably in California, including the risks of wildfire more completely within their underwriting pricing, while also factoring in California specific reinsurance costs into their rates.

Which are two key elements that insurers have been calling for the ability to factor in, so yesterday’s announcement by the Insurance Commissioner Ricardo Lara and a, perhaps lacking in detail, executive order from Governor Gavin Newsom are likely to be well-received by both the insurance and reinsurance markets.

Lara announced the package of executive actions, which are “aimed at improving insurance choices and protecting Californians from increasing climate threats while addressing the long-term sustainability of the nation’s largest insurance market.”

It’s set to be the largest insurance reform since California voters’ passage of Proposition 103 nearly 35 years ago.

Termed California’s Sustainable Insurance Strategy, it’s designed to stabilise the marketplace, increase interest from insurers to underwrite there, with the goal of making insurance more available to Californians.

The announcement states, “The actions announced today are aimed at addressing problems fueled by climate change and being experienced by states across the nation including global inflation and increased costs for rebuilding that have led to several insurance companies pausing coverage for writing new homeowners and commercial insurance policies, non-renewing existing consumers, and increasing rates to maintain their financial stability. Unlike public utilities, which are required by law to cover all consumers, insurance companies will not write insurance, especially in high-risk areas, unless they are able to ensure they have the capital and reserves to fully meet all insurance claims submitted by consumers, cover their expenses, and earn a fair return. Insurance company actions following multiple years of major wildfires and winter storms have pushed more people to the FAIR Plan, which is intended as California’s insurer of last resort but has become the only option in some areas of the state.”

Commissioner Lara further explained, “We are at a major crossroads on insurance after multiple years of wildfires and storms intensified by the threat of climate change. I am taking immediate action to implement lasting changes that will make Californians safer through a stronger, sustainable insurance market. The current system is not working for all Californians, and we must change course. I will continue to partner with all those who want to work toward real solutions.”

“This is yet another example of how climate change is directly threatening our communities and livelihoods. It is critical that California’s insurance market works to protect homes and businesses in every corner of our state,” Governor Newsom added. “A balanced approach that will help maintain fair prices and protections for Californians is essential. I look forward to continuing to work with Commissioner Lara and others to strengthen our marketplace and protect Californians.”

Key elements of the proposal include plans to encourage policyholders to transition back to the private insurance market and out of the FAIR Plan.

It calls for insurance companies to cover all parts of California, by writing no less than 85% of their statewide market share in high wildfire risk communities, meaning that if a company underwrote 20 out of 100 homes statewide, it must write 17 out of 100 homes in a distressed area.

On the use of forward-looking catastrophe models, rather than the previously legislated use of models that take into account the last 20 years of loss activity, California aims to introduce rules to support the review of climate catastrophe models, also noting that these must also recognise the benefits of wildfire safety and mitigation actions at the state, local, and parcel levels.

The goal, on introducing the ability to use forward-looking risk models, is to “allow for long-term sustainability of coverage and rates,” Lara said.

The Fair Plan will be mandated to expand available commercial coverage to $20 million per building, in a goal to close insurance gaps for homeowners associations and condominium developments.

The other key one for the industry is that the state will hold public meetings to explore incorporating California-only reinsurance costs into rate filings, which would allow insurers to factor in the cost of reinsurance into their offering.

The new legislation will also aim to improve the rate filing procedure and timelines, by enforcing the requirement for insurance companies to submit a complete rate filing.

Interestingly though, a flyer published by Commissioner Lara states, “Exploring California only reinsurance regulation protects consumers from paying costs of other global catastrophes.”

But, the global reinsurance market benefits consumers in high-risk peak catastrophe zones through that global diversification, as if reinsurers were to price California wildfire risk as if it is the only peril in their portfolios, the costs would be much, much higher, as the benefit of diversification is gone.

It might even cost insurers writing property business in California more if they chose to purchase reinsurance for the state only, rather than it being incorporated into their diversified nationwide property reinsurance towers.

So it will be interesting to see how this specific aspect, of a move to allow insurers to incorporate only California specific reinsurance costs in their pricing, plays out.

There’s been a mixed response to the proposals, with insurance and some consumer groups backing the move to try and make property insurance more sustainable in California, while others have objected.

Consumer Watchdog said that Lara’s proposals will “allow insurance companies to use secret algorithms to set rates for homeowners’ coverage for wildfire and to add reinsurance costs to premiums”, which the group said will lead to higher insurance premiums.

But the issue is that premiums have been held unsustainably low and California’s reality is that wildfire costs have not been priced in actuarially, meaning that without change the state would face a steady decline in its insurability and would have to shift more risk onto taxpayers.

Harvey Rosenfield, the author of Proposition 103, said that, “Insurance companies are using their economic power to create shortages for the purpose of pressuring elected officials to change the rules that have kept insurance premiums in California stable, affordable and available for decades.”

But again, keeping premiums affordable and stable is great, but it is not keeping insurance available, as has been seen in recent years.

With no change, California faces a future of much lower insurance availability and would likely need to move beyond the Fair Plan, to introduce a state-backed insurer for wildfire risks akin to a Florida Citizens, or California Earthquake Authority.

If there is a desire to have a functioning private insurance market that covers those wildfire exposed areas, then enabling insurers to adopt risk commensurate pricing is the very first issue that needs addressing and that has to include factoring in catastrophe loss costs, including the current climate reality and expectations for the coming years, as well as the cost of hedging that risk through reinsurance.