CA Wildfires & Insurance Crisis: Expert Analysis

TL;DR

California's insurance crisis is a perfect storm of restrictive regulations, rising reinsurance costs, and climate change. Expert Tom Mercer explains why the market is failing and what needs to change. #VentureStep #Insurance #Wildfire

INTRODUCTION

California is burning. ¹With major blazes like the Palisades and Eaton fires raging with minimal containment, thousands of buildings have been damaged, and potential losses are climbing into the tens of billions. ²²²²²This recurring disaster has ignited a fierce debate over who is to blame for the state's collapsing insurance market: is it insurance companies, government mismanagement, or a combination of factors? ³The answer, as is often the case, is complex and multifaceted. ⁴

In this episode of Venture Step, we sit down with Tom Mercer, a seasoned insurance executive with deep expertise in launching commercial property programs and first-hand experience living and working in California. ⁵⁵⁵⁵Tom has spent years navigating the complexities of catastrophic risk, making him the ideal guide to unpack the layers of this crisis. ⁶ He provides a clear-eyed analysis of the regulatory hurdles, market forces, and climate trends that have brought California's insurance industry to a breaking point.

Tom walks us through the critical but often misunderstood role of reinsurance, the state's FAIR Plan, and the regulatory decisions that inadvertently pushed private insurers out of high-risk areas. ⁷⁷⁷⁷⁷⁷He also explores potential solutions, from adopting advanced AI risk models to implementing smarter building codes and mitigation strategies that could create a more resilient and sustainable market for the future. ⁸⁸⁸⁸

KEY TAKEAWAYS

• Restrictive state regulations, like rate caps and the historic inability to include reinsurance costs, have forced private insurers to flee high-risk wildfire areas to remain solvent. ⁹⁹⁹
• The California FAIR Plan, the state's insurer of last resort, is now shouldering an unsustainable amount of risk, the cost of which will eventually be passed on to all policyholders across the state through special assessments. ^1010101010
• Global climate events, from hurricanes in Florida to floods in Europe, have dramatically increased the cost of reinsurance—the insurance that insurance companies buy—squeezing carriers who were unable to factor these costs into their California rates. ^1111111111
• Long-term solutions require a multifaceted approach, including smarter regulation that allows for risk-based pricing, the adoption of advanced AI risk models, and proactive mitigation strategies like those implemented in Florida after Hurricane Andrew. ^{1212121212121212}

FULL CONVERSATION

The Uncontrollable Nature of the California Wildfires

Dalton Anderson: Today we are going to be discussing California. ¹³California, as you know, has been burning and has been burning for some time. ¹⁴A lot of the fires are not controlled. ^15151515The most notable fires are Palisades and the Eaton fire. ^16161616The Eaton fire, I think has 0% containment and the Palisades has 6% containment. ¹⁷ So I'll just start off real quick and kind of level set. Why are the fires not contained? ¹⁸

Dalton Anderson: When a wildfire starts and the wind is over 40 miles an hour, there is nothing that can stop the wind. ¹⁹

Dalton Anderson: The wildfire is in general wild and can't be tamed until the wind dies down. ²⁰The firefighters need to be on standby and wait for the wind to die down and then they can attack the fire. ²¹But as soon as those winds get to those dangerous levels where you can't predict where the fire will go, they have to pull out and come back when the winds have died down again. ²²The issue is now, the last couple weeks, there's been some sustained gusts over a hundred miles an hour. ²³So just to put that in perspective, that's why the fires can't be controlled. ²⁴The current damage done so far is about 5,000 buildings in the Eaton fire and then 5,000 buildings in the Palisades fire. ²⁵For both all in is about $25 billion in losses potentially if they were all total losses. ²⁶Tom, do you want to include anything that I missed there? ²⁷

Tom Mercer: No, I think you covered it. ²⁸We can spend some more time about the FAIR Plan and what that means. ²⁹²⁹That's a state market of last resort and that's grown in wildfire exposed areas and we'll touch on why that has happened. ³⁰It's because of what's been going on with the private market and the regulation challenges that exist in the state. ³¹As Dalton says, when the winds are blowing this strongly, it's very hard to contain, basically impossible to contain a fire. ³²

Tom Mercer: A combination of really any fire and high winds is truly deadly. ³³

Tom Mercer: As things burn, as houses burn, embers come off, and those embers can ignite. ³⁴What we had going on in the Palisades and all of Southern California is they've had very light rains, my understanding, since last spring, well below normal. ³⁵So you had a very dry environment coupled with the winds. ³⁶As far as the source of ignition, that's to be determined, but there's all kinds of things that can be doing that: a person careless with a cigarette butt, a car could conceivably cause this, a homeless person potentially cooking a meal somewhere, or what's happened before is the power lines can actually cause and spread fires as well. ³⁷

The Critical Role of Embers and Building Materials

Dalton Anderson: The winds also contribute to embers flying. ³⁸Embers are one of the leading causes of a fire spreading. ³⁹It's not that your home is directly impacted by the fire and it catches fire because it's engulfed in flame. ⁴⁰A lot of times, multiple embers latch onto a home and then that home burns over time. ⁴¹I think over 70% or something like that, so definitely over 50% of the time an ember is what's causing the fire. ⁴²

Tom Mercer: The other interesting thing there, my understanding is in both of these areas, there are still older homes that had wood shake roofs. ⁴³These wood shake roofs are literally made of slabs of wood. ⁴⁴You can imagine a place like California, those wood shake roofs will dry out. ⁴⁵And so an ember lands on those and can start a fire. ⁴⁶Those have been banned now for over 50 years, but they've allowed grandfathering of existing structures as long as they keep those roofs repaired, so that's a problem. ⁴⁷

Admitted vs. Surplus Lines: The Two Worlds of Insurance

Dalton Anderson: The next thing is to talk about the regulation lag or the over-tightening of regulations within California related to wildfire risk. ⁴⁸There's two markets. ⁴⁹There's admitted lines, which is an insurance company that is registered and accepted by the state, and they have to follow what the department of insurance does. ⁵⁰There's a lot of requirements regarding rate changes; they need to be approved by the DOI. ⁵¹There is another section of insurance called non-admitted, which has been serving California in a greater, more prominent stance than it normally would because of the lack of supply in the admitted market. ⁵²This is simply because there isn't the ability for these admitted companies to provide the right premium to the higher risk areas, thus making it unprofitable and not very competitive. ⁵³

Tom Mercer: Yeah, if you want to expand on that a bit. ⁵⁴

Dalton Anderson: One thing admitted lines can't do that a surplus lines carrier could do is that they can include their reinsurance costs. ⁵⁵ This has been a recent change as of early December; California did change the rules where you could include your reinsurance costs, but the caveat was it needs to be within what they deem to be industry standard. ⁵⁶The issue with that is reinsurance is very customized, very complex, and overall there is no standard. ⁵⁷

What Is Reinsurance and Why Is It So Expensive?

Tom Mercer: Yeah, let me elaborate on this a bit and explain what we mean by reinsurance. ⁵⁸What insurance companies will do is they buy protection for large events and they go to these global capital providers for that. ⁵⁹Whether it's a major wildfire, a major hurricane, or a tornado, at some point the losses for these large events are more than an individual insurance company wants to bear. ⁶⁰So they then buy protection for those larger losses from these global reinsurance companies, and these companies are covering these sorts of risks around the world. ⁶¹

Tom Mercer: Those costs have been rising across all lines of coverage because of the higher climate activity. ⁶²We've had an impressive number of Cat 4 hurricanes make landfall in the last year. ⁶³We've had massive hail events and tornado events. ⁶⁴Because this is the global reinsurance market, there's events around the world—events in Japan, events in Asia, a big flood in Europe last year. ⁶⁵All these events are drawing on this capital, so as this capital has to pay out, they need to charge higher and higher rates to compensate for these losses. ⁶⁶We've seen rates on reinsurance going up 20, 30, 40% a year in recent years. ⁶⁷

Tom Mercer: But until just literally weeks ago, as Dalton said, insurers in the state of California could not pass on these costs to consumers. ⁶⁸

Tom Mercer: They couldn't include these costs in their rate filings to the state. ⁶⁹They were getting very much squeezed for profit. ⁷⁰

How California's Regulations Squeezed Insurers Out

Tom Mercer: The other thing that was going on is the state would typically limit rate increases to 7% per year. ⁷¹That was a long-term max that they were not willing to breach. ⁷²Well, the cost of this reinsurance was outpacing the amount that they could get in an additional rate. ⁷³The state wouldn't approve more rate, and yet their reinsurance costs were going up. ⁷⁴They had to take active measures to lower the reinsurance bill. ⁷⁵In California, your big natural peril risks are wildfire and earthquake. ⁷⁶

Tom Mercer: The way you have to get your reinsurance cost down if you're an insurance company is you've got to shed, you've got to get rid of, risk that is in these highly wildfire exposed areas. ⁷⁷

Tom Mercer: So, ever since the series of very large wildfires in California, like the Camp Fire in 2018, companies had been non-renewing policies in the most exposed areas—areas like the Palisades, areas where the Eaton Fire is, areas around Lake Tahoe and so forth. ^78787878They simply had to get their reinsurance costs down so they wouldn't be losing money. ⁷⁹

The FAIR Plan: California's Insurer of Last Resort

Dalton Anderson: Yeah, I think that would be good. ⁸⁰

Tom Mercer: So what's been happening is in every state there are insurance markets of last resort. ⁸¹They're state entities that are designed to step in and provide critical insurance when the market won't. ⁸²In California, that's called the FAIR Plan. ⁸³As these companies have needed to flee the wildfire areas to preserve profitability, a huge number of homes have been coming onto the FAIR Plan. ⁸⁴I think as we looked, something like over 70% of the homes in the Palisades were on the FAIR Plan. ⁸⁵The private market had abandoned that much of the market. ⁸⁶It's highly likely that the FAIR Plan, through these most recent events, will actually exhaust their reserves and their reinsurance and will need to replenish. ⁸⁷

Tom Mercer: So again, all of California is going to have to, all of the California policyholders are going to have to step up and pay higher rates for years to restore the balance, if you will, on the FAIR Plan. ⁸⁸

Tom Mercer: And that's gonna create even more pain for the insurance customers of California. ⁸⁹

Beyond Wildfires: The Impact of Social and Climate Inflation

Tom Mercer: It's hard to deny climate change as being a driver of cost, but it's not the only driver of cost. ⁹⁰We are certainly seeing a higher frequency of high-intensity hurricanes and a higher frequency of high-intensity hail events. ⁹¹But it's not the only thing that's going on. ⁹²The other thing that's going on is general inflation. ⁹³Inflation post-COVID peaked around 9% overall, and that's increased building costs. ⁹⁴The other thing is what's called social inflation, which is litigation trends. ⁹⁵

Dalton Anderson: The roof thing with social inflation, that example, that's a huge issue in Florida until Florida eventually cracked down. ⁹⁶In Florida, they had a multiplier effect for attorneys. ⁹⁷So if you won a case against an insurance company, even if it was a dollar, you would get two and a half to three times what you would normally have gotten. ⁹⁸So there was an incentive to take insurance companies to court. ⁹⁹The sad thing about it is the free roof that you're getting, you're the one that gets the free roof, but everyone else has to pay for your roof that you've gotten, and you multiply that by thousands of people, it adds up quickly. ¹⁰⁰

Deconstructing Risk: How Catastrophe Models Work

Tom Mercer: All these reinsurers use these industry-standard catastrophic risk models. ¹⁰¹The big names in that are Verisk, the Verisk Touchstone product, and Moody's RMS model. ¹⁰²These models run thousands of years of simulations, and in that, they've come up with what they would expect for hurricanes, earthquakes, and wildfires. ¹⁰³Insurers and reinsurers will run these models against their portfolio of exposures. ¹⁰⁴A 100-year probable maximum loss really is what the model is telling you is there's a 1% probability per year that the loss will be at this level or greater. ¹⁰⁵The 250-year probable maximum loss is there's a 0.4% probability per year that the loss will be that much or greater. ¹⁰⁶It allows insurers to quantify the risk. ¹⁰⁷The idea is that by buying to that 250-year level, which is quite common, you've bought enough protection so that in most viable scenarios, companies aren't going to go insolvent. ¹⁰⁸

The State Farm Dilemma: Between a Rock and a Hard Place

Tom Mercer: State Farm, for example, is getting a lot of heat because just in the last six months, they non-renewed a lot of the Pacific Palisades policies. ^{109109109109109109109}They were trying to work with the state, trying to get the rates they needed, but they were getting rebuffed by the state. ¹¹⁰They ultimately decided, "Hey, we have to start exiting the state, particularly in these high-risk areas." ¹¹¹They were in a bit of a bind between a rock and a hard place. ¹¹²

Tom Mercer: And I know they're facing bad press right now, but I can tell you being a professional in this space, you get to the point where there's nothing you can do. ¹¹³You can't, as a private company, be losing money year after year because the costs have outstripped their ability to charge appropriate premiums. ¹¹⁴

Dalton Anderson: State Farm, from what I read, requested a 30% rate increase for homeowners and a 50-plus rate increase for renters. ¹¹⁵And as you mentioned, 7% is the max. ¹¹⁶

What Can California Do to Fix Its Insurance Market?

Dalton Anderson: I think one thing that they are opening up to is more advanced AI models to recognize and price risk. ¹¹⁷Zesty is currently the only wildfire vendor authorized in the admitted market. ^{118118118118118118118}I think that California potentially is opening up their horizons to allow other vendors with advanced models to enter the state. ¹¹⁹Being able to include wildfire costs within their pricing, which they couldn't do until recently with reinsurance, would be a big help in segmenting the pricing. ¹²⁰I think if we're in the state that they were in in California, it's better to work with the insurers and see, "Hey, what do you really need for us to be able to write here?" ¹²¹

Tom Mercer: Yeah, you know, I think another thing they can do to bring the cost down over time is more mitigation. ¹²²

Tom Mercer: When you have the kind of regulation California had where you couldn't use these models, where you couldn't pass along the reinsurance cost, it was inhibiting those natural market forces that can promote better buildings, better fire management practices, and so forth. ¹²³

Learning from Florida: The Case for Mitigation and Better Building Codes

Tom Mercer: There's an interesting case study with Florida. ^124124124124After Hurricane Andrew, a massively devastating hurricane, they saw whole neighborhoods that were just reduced to sticks. ¹²⁵Florida building codes came in and they've continued to be strengthened. ¹²⁶These impose wind design parameters for the high-risk parts of Florida. ¹²⁷A roof has to be able to withstand 130-mile sustained winds. ¹²⁸The roof has to be held down by hurricane straps. ¹²⁹The windows need to have a certain amount of impact protection. ¹³⁰All these things help make buildings more resistant to hurricanes. ¹³¹Had Florida not had those things, I guarantee you, these recent storms would have been far worse than they actually were. ¹³²

Tom Mercer: In the wildfire regions, there hasn't been robust practices in terms of building codes or management codes to prevent losses. ¹³³There are some regulations in California around clearing nearby brush from a property, but those aren't enforced as well as they can be. ¹³⁴We absolutely can do more with roofs and with the way we structure eaves and so forth to make buildings more fire-resistant and do a better job of clearing brush. ¹³⁵

The Future of Insurance: How Technology Can Solve Key Problems

Dalton Anderson: What do you see on your perspective as something that needs to be solved in commercial lines? ¹³⁶

Tom Mercer: More manual processes can be automated. ¹³⁷With these AI tools, we can machine-read paperwork, interpret it, and then put it in our data. ¹³⁸The other thing that's going on with the Internet of Things or internet-enabled devices and sensors can be very helpful. ¹³⁹Another huge loss category for the industry is water damage from an overflow toilet or a broken water pipe. ¹⁴⁰In modern structures, they're putting in water sensors, so if water's running constantly, the line gets shut off. ¹⁴¹One of the challenges with earthquakes is they can sever gas lines and create fires. ¹⁴²More advanced homes are built with automatic shutoff to gas lines. ¹⁴³All these things cost money, but as we're seeing here, replacing a home is very expensive. ¹⁴⁴As these other costs rise, these mitigation measures can become more cost-effective. ¹⁴⁵

RESOURCES MENTIONED

• Companies: State Farm, Zesty, Verisk, Moody's, Equicat, Safe Lease, ICAT, Velocity Risk, MSI, Ryan's Specialty Group ^{146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146146}
• State Entities/Plans: California FAIR Plan, California Earthquake Authority ^147147147147
• Models/Products: Verisk Touchstone, Moody's RMS ¹⁴⁸
• Events/Locations: Camp Fire, Eaton Fire, Palisades Fire, Hurricane Andrew, Hurricane Ian, Hurricane Helene, Hurricane Milton ^{149149149149149149149149149149149149149149149149}

INDEX OF CONCEPTS

Tom Mercer, Dalton Anderson, State Farm, Zesty, Verisk, Moody's, Equicat, Safe Lease, ICAT, Velocity Risk, MSI, Ryan's Specialty Group, Admitted lines, surplus lines, reinsurance, FAIR Plan, social inflation, demand surge, probable maximum loss (PML), catastrophe risk models, wind hardening mitigation, non-admitted market, state guarantee fund, admitted market, Eaton Fire, Palisades Fire, Camp Fire, Hurricane Andrew, Hurricane Ian, Hurricane Helene, Hurricane Milton, Pacific Palisades, Lake Tahoe, California Department of Insurance (DOI), California Earthquake Authority