Breaking down Insurance / Reinsurance to Understand LA Fires

Welcome to the 117th Pari Passu newsletter.

Before we get started, final reminder that I am doing a giveaway of the Pluralsight Deep Dive. This was my favorite and most-read article of 2024. The article is now behind paywall, but you can get it for free here. Giveaway will close in 7 days.

Let’s get to today’s post. The Los Angeles fires were a devastating catastrophe for tens of thousands of families. As the smoke clears and the ash settles, important questions begin to surface: Who will pay for the damages? Why are most people underinsured for the value of their most important assets? How can we prepare for future disasters? Many of these questions have been asked and debated by reputable news outlets and academic institutions.

However, answers provided tend to fall in one of two broad categories: surface level and easy to understand, or detailed and prohibitively technical. This article aims to bridge the gap and provide a detailed, technical, and digestible summary of the Los Angeles Fire catastrophe and its long-term implications for home ownership.

While this isn’t a typical restructuring post, the themes we’ll explore – corporate and political incentives, homeownership, and insurance – are timely, impactful, and relevant outside of finance. Let’s dive in! 

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Introduction

For many Americans, the elusive “American Dream” starts and ends with homeownership. Government home-buy assistance programs and quasi-government agencies like Fannie Mae and Freddie Mac are designed to maintain the steady supply of mortgage credit to hopeful Americans. In turn, the housing market they buttress underpins the financial health of the entire economy. Indeed, nearly all municipal governments and private commercial interests rely on a strong housing market directly for tax contributions or indirectly for strong consumer demand. For example, in 2008, lax underwriting standards and mismanaged risk crippled credit availability and jeopardized millions of jobs across all industries, regardless of their obvious reliance on the housing market. While less susceptible today to the same type of total collapse, the housing market is again under increasing pressure for a variety of reasons: high interest rates make new mortgages exorbitantly expensive, supply shortages price-out first-time homebuyers or delay purchases, and insurance coverage shortages leave existing homeowners exposed to potential catastrophic losses [1]. While interest rates and building shortages can be addressed in the short to medium term, the structural limitations imposed by current insurance solutions raise concerns for the long-term viability of the whole system. Today, we will break down the complexities of insurance in a digestible way, explain the developing situation in the distressed Los Angeles home insurance market, and explore the future problems left open for critical debate. 

The Insurance Business Model

Purchases in a market economy are a risky form of trade. Take an example where a buyer pays $500 for a new phone in cash. This exchange creates multiple layers of risk for the buyer. First, there is the possibility that the phone is defective when the buyer tries to use it. Second, the buyer may spill coffee on their new phone the next morning, frying the circuits. Lastly, the buyer may leave the phone store, check the box, and realize there was no phone at all. In the aggregate, each of these scenarios has a specific probability attached to it. At its simplest form, insurance is the business of determining the probability of each scenario, and offering economic reimbursement, or indemnity, to the buyer in case that specific scenario occurs. There are a few reasons this system works. First, because $500 is a lot of money for the phone buyer, they are willing to pay an additional $10 to protect themselves from total loss. Second, because the insurer realizes that the true probability of total loss is less than $10, they can make a profit on the difference between a $10 policy and the expected value of total loss. Using this example, it is clear how an insurer will never remain in the business of writing contracts with a higher probability of loss than profit.

While conceptually simple, insurance is fundamentally different from other businesses because an insurer’s costs are unknown when the insurance policy is written. To break this down in terms that everyone can understand, let’s think about an income statement for an insurer. Revenue is comprised of the amount people pay for protection, also called the insurance premium, and investment income (we will get to this later). Costs can be broken down into costs from payouts, known as claims expenses, and costs from sales and marketing. Take the example above and pretend the buyer paid the $10 premium to insure their new phone, covering them for the full cost of a brand-new replacement device up to 6 months after the initial purchase. Regardless of the outcome, the insurer will always make $10 in revenue. However, until 6 months have passed, the insurer cannot know its true claims expense and instead must estimate this amount using sophisticated actuarial models, also known as their best guess. Unfortunately, on a single policy, the realized claims expense will never equal the insurers’ best guess because the outcome is binary: it is either $0 or $500. For an insurer to be consistently profitable in the face of such massive payouts relative to the potential earnings, they must write enough policies to allow the aggregate expected probability of loss to be close to the realized losses they incur. In this way, insurance is “pooled” risk management where policyholders subsidize each other in exchange for a guarantee of indemnity.

Another way that insurance differs from a traditional business is in its financing structure. While traditional companies raise money through debt and equity to purchase assets, insurance has one additional source of financing – the so-called “float”. The float represents the combined value of all the premiums paid on the company’s written policies, reduced by the amount of premiums still yet to be received [2]. While this may sound complicated, every company technically has their own version of a “float”, they just call it “negative working capital”. In a traditional business, incoming cash from customers is almost immediately paid out to vendors, employees, or spent on new inventory – making the earning potential of that temporary excess capital limited. By contrast, an insurer has limited upfront expenses and a long-time horizon, so cash from premiums collected can be thought of as a payable dependent on the outcome of future insurable events, and incoming premiums as receivables. Understanding this dynamic is crucial to understanding an insurer’s balance sheet, which is primarily composed of investments on the assets side, and reserves for claims expenses, unearned premiums (money paid in advance for future coverage), and debt on the liabilities side. Most commonly, insurers will raise debt financing for one of three reasons: to meet regulatory capital requirements, make acquisitions, or to avoid selling attractive investments.While it is always the goal to create underwriting profits, insurers generally achieve a combined ratio ((claim expenses + sales and marketing expenses) / earned premiums) just under 100%, and use the investment return on the float to drive profitability. Disaster insurance, by contrast, commonly exhibits low combined ratios in good years followed by exceptionally high ratios in bad years. This volatility makes wildfires, hurricanes, and floods a more complicated (and expensive) risk factor for home insurance.

Reinsurance

Because of the difficulty associated with loss prediction, and to add another layer of security, insurance companies often seek loss protection of their own: …

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