The next casualty of the epic Los Angeles fires, appropriately, will be the casualty industry. What has gotten immediate press attention is the impact of the fires on local homeowners and on the California state insurer of last resort, the FAIR Plan, which only has about $700 million in cash. The Pacific Palisades alone has nearly $6 billion in insurance exposure, and the total L.A. losses are projected at $20 billion to over $50 billion counting spillover losses to economic activity.
In addition, insurance companies have been raising rates, canceling or non-renewing policies, or pulling out of the state entirely. There will be massive pressure on the state to make up for these gaps one way or another, both for homeowners who have suffered uninsured losses and for others whose insurance is becoming unavailable or unaffordable.
But that is only the beginning of the story. Basically, there is a massive disconnect between what is financially prudent and what is politically possible. Paradoxically, insurers haven’t been raising rates enough to cover risks.
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The ideal solution, from the perspective of prudence and loss limitation, as our colleague Harold Meyerson has suggested, would be to prohibit rebuilding in areas that are almost certain to burn again. But no California politician is going to do that.
More broadly, insurance commissioners in climate disaster–prone states such as California and Florida, whether Democratic or Republican, have favored overly lenient regulation of insurers in terms of the adequacy of their loss reserves, in order to encourage them to keep providing insurance at all. The result is a serious disconnect between risks and rates.
Measured against home values, insurance costs are cheaper in Pacific Palisades than in 97 percent of U.S. ZIP codes, according to a Reuters analysis of a national database. Homeowners in Pacific Palisades, Reuters reported, paid a median insurance premium in 2023 of $5,450—less than residents paid in Glencoe, Illinois, an upscale Chicago suburb where homes are two-thirds cheaper and the risk of wildfire is minimal.
The broader risk to the financial system operates through several channels. One, as David Dayen recounts in this companion article, is through mortgage foreclosures on uninsured and lost homes, with resulting damage to bank balance sheets, as well as reduced mortgage lending generally.
Measured against home values, insurance costs are cheaper in Pacific Palisades than in 97 percent of U.S. ZIP codes.
A more insidious trend is the rise of insurers that are not regulated at all. As regulated insurers have been quitting high-risk areas, a new kind of sketchy enterprise is filling the gap. According to former Federal Reserve governor Sarah Bloom Raskin, now at Duke University, where her research specialty is the impact of climate on finance, these are thinly capitalized companies that don’t meet normal regulatory standards.
Detailed research in this Harvard Business School paper on “climate losses and fragile insurers” reports that the market share of homeowner insurance in Florida provided by these lightly regulated insurers grew to 50 percent by 2018. A new, nontraditional rating agency called Demotech gives these companies high ratings.
Despite the fact that these companies were nominally regulated by the Florida insurance commissioner, presumably for capital adequacy, during the period of the HBS study, at least 15 of these Demotech-approved insurers became insolvent, according to professor Ishita Sen, one of the authors, “The fact that 20 percent of the Demotech insurers become insolvent,” she told me, “while none of the insurers rated by [mainstream rating agencies] AM Best or S&P did, shows that regulation has been inadequate.”
Why would banks, which require homeowner insurance, accept this subprime (!) form of insurance? Because banks and other mortgage lenders seldom hold onto the mortgage paper. They stick someone else with the risk of loss.
If this sounds like an echo of the subprime mortgage crisis and the 2008 financial collapse, the parallels are exact. The Harvard Business School paper also warns of the risk of the government-sponsored and -guaranteed secondary mortgage market institutions Fannie Mae and Freddie Mac getting stuck with this bad mortgage paper. That could require a taxpayer bailout, as happened in the 2008 collapse.
And why do state insurance commissioners turn a blind eye to the balance sheets of these sketchy companies? Because in the near term everyone gains. Homeowners get their affordable insurance, even if the undercapitalized companies lack adequate loss reserves. Banks get to keep on making mortgages. The political pressure on the commissioners and the legitimate part of the insurance industry subsides. By the time the companies go belly-up, at the expense of policyholders and investors, their founders have made out well.
In the run-up to the 2008 crisis, there was a cynical slogan among Wall Street innovators and traders: IBGYBG. When the whole financial house of cards collapses, I’ll Be Gone, You’ll Be Gone. We will have made our bundle and the ensuing mess will be someone else’s problem.
The current insurance crisis, and the multiple flawed responses to it, are the next crash and bailout waiting to happen. “The short-term insurance problem,” says Raskin, “is making homeowners whole. The longer-term insurance problem, which can collapse quickly into the shorter-term one, is the risk to the entire financial system.”
Fittingly, an insurance crisis worsened by the climate crisis is unfolding on the watch of the great climate denier, Donald Trump. He may also inherit a financial crisis.