Breaking down Insurance / Reinsurance to Understand LA Fires

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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: reinsurance. Just like regular insurance offers a mechanism for pooled risk distribution at the individual policyholder level, reinsurance offers a similar product at the insurance company level. The initial underwriter called the “primary carrier”, or “ceding insurer” establishes a contract with a reinsurer to share the risk of its policies. There are two ways these contracts are generally structured: proportional and nonproportional reinsurance. 

Proportional reinsurance essentially means that the reinsurer owns a percentage of the underlying policy risk, receiving commensurate net premium payments as a result. In non proportional reinsurance, the reinsurer agrees to cover all costs above a certain threshold on an individual policy or portfolio of policies. Often, these types of contracts are sold to many different reinsurers and used to limit left tail downside for primary carriers – lessening the possibility of a “perfect storm” liquidation event where all risk converts to realized losses at the same time. In addition to receiving premiums without the administrative underwriting burden, reinsurers also structure contracts with shared loss provisions (above a certain loss threshold) to align incentives with the insurers they are indemnifying.  

To keep it simple, let us explore an example of each proportional and non proportional reinsurance where an insurer writes a $1mm policy to a homeowner with a $50,000 annual premium. In a 50% “quota-share” proportional contract, the reinsurer would earn $25,000 per year in premiums in exchange for taking $500,000 in potential liability. By contrast, in a non proportional example, the reinsurer would agree to insure any losses above $200,000, up to a $1mm maximum. So, if the losses total $700,000, the primary insurer will pay $200,000 and the reinsurer will indemnify the remaining $500,000. Also, instead of passing through a fixed percentage of the premiums paid by customers, the reinsurer will generally negotiate an annualan lump-sum annual payment in exchange for the risk it is assuming. In both of these cases, the underlying policyholder receives $1mm in insurance coverage, but the liability is divided at the insurance company level. Lastly, in the case the primary insurer is insolvent, it is important to note that individual policyholders are not allowed to “look-through” their primary insurer to collect their payout directly from the reinsurer. This would allow policyholders to achieve vastly different outcomes depending on how much of their policy was ceded to reinsurers.  To achieve a more equitable outcome, the bankruptcy estate will instead collect the reinsurance indemnity payment, and then distribute the proceeds among all policyholders or creditors based on the priority rules of bankruptcy.

From the insurer’s perspective, the reinsurance structure is attractive too. Outside of limiting or completely capping unmanageable downside, depending on the contract, reinsurance also enlarges the primary insurer’s underwriting capacity. If an insurer views a particular risk as attractive, but it does not have the reserves necessary to underwrite additional policies, it can use reinsurance to pass through the excess risk while continuing to expand. For example, take an insurer who offers auto insurance in a major market but cannot afford to also offer home insurance there. As a result, customers in the area have been switching to the company’s competitors because they offer convenient home and auto bundles, forcing the company to downsize despite the attractive opportunity. By underwriting homeowners’ insurance, and ceding the risk to a reinsurer, regardless of the type of reinsurance, the company can maintain its competitive position in the city without straining its loss reserves [3].

If nothing else, remember this: insurance spreads risk by pooling resources and distributing costs, ensuring financial protection for individuals and businesses alike.

Economic Reality

In theory, the expected price of risk should be the determining factor for insurance policy premiums. In practice, the price of insurance is as much a political question as it is a function of actuarial output. The price of home insurance directly impacts the ability for new homebuyers to secure mortgages, and for existing homeowners to continue living in properties passed down over generations. In California, but also across the nation, the economic realities of mispriced risk are clashing with the political feasibility of the American Dream. 

Background on California

Theoretically, the best way to ensure competitive pricing in any market economy is through competition. When consumers have the luxury of choice, producers must compete to keep costs reasonable, benefiting society. Sometimes, though, industries have too high a barrier to entry, allowing a syndicate of well-positioned firms to control prices without fear of being outcompeted. In this case, light-handed regulation is necessary to balance consumer protections with competitive incentives; this is an extremely difficult needle for policymakers to thread. In California, regulators tipped the scales too heavily, forcing insurance companies to begin the process of non-renewing policies in the riskiest areas of the state. The domino effect that culminated with severe underinsurance for thousands of burned homes in Los Angeles began 8 years ago.

In 2017, more structures burned in California wildfires than in the previous 9 years combined. At the time, it was the most destructive fire year in the history of the state [4]. Faced with massive liability related to its role in starting these fires, Pacific Gas and Electric (PG&E) famously declared bankruptcy in 2019 [5]. Simultaneously, burdened with heavy losses, insurance companies began reevaluating their understanding of the substantial and growing fire risk in California’s residential real-estate market. Indeed, for the previous 4 years 2013-2016, home insurers had earned an underwriting profit in the state with a combined ratio of ~85% (remember the combined ratio is defined as (claim expenses + sales and marketing expenses) / earned premiums). In 2017, however, the destruction was so vast that the average 5-year combined ratio reversed and rose to 161%. Insurers, realizing that their models failed to adequately account for new catastrophic climate risks, lobbied policymakers for permission to raise premiums and reprice policies to incorporate the increased risk associated with operating in California. In California, insurance rate increases are governed and legally constrained by Proposition 103, the “Insurance Reduction and Reform Act”. Passed in 1988, this bill was initially meant to prevent insurance companies from charging exorbitant rates based on overly conservative loss projections. Instead, Proposition 103 artificially placed a price-cap on insurance premiums, leading to mismatched price and risk in the state [7]. Rather than allowing insurers to raise premiums to match increased risk, regulators forced insurers to request rate increases from the California Department of Insurance (CDI). In their requests, insurers were i) prevented from justifying premium increases based on future loss estimates, forcing insurers to rely solely on historical loss data ii) prevented from passing through reinsurance costs to consumers, regardless of how reinsurance premiums fluctuated for the insurer itself. These regulations squeezed insurers by forcing them to wait for another disaster to reset their loss projections, while the threat of climate change continued to grow. Unable to justify writing underpriced policies, insurers began pulling out of what they viewed as the riskiest neighborhoods. 

Homeowners in these areas were suddenly left without insurance policies on their most valuable asset. Additionally, without home insurance, it is impossible to get a mortgage because a bank will refuse to lend against uninsured collateral. In essence, Proposition 103 left a ticking financial time bomb in California’s residential real estate market.

The California FAIR Plan

Politically speaking, leaving hundreds of thousands of people uninsured or unable to purchase a home was an untenable outcome, which is why most states have what is known as the “insurer of last resort.” The California Fair Access to Insurance Requirement (FAIR) plan is the state’s insurer of last resort. In the event a homeowner is unable to find insurance from any other source, they can apply for protection from the FAIR plan. The FAIR plan finances itself through the premiums it collects, and while not a government agency, it is overseen and managed by the California Department of Insurance (CDI). In the event of insolvency due to catastrophic loss, the FAIR plan can force private insurers in the state to pay for its capital deficit via an “assessment” This will be important later, so keep it in mind. Two things make FAIR plan coverage less attractive to consumers than typical home insurance: coverage and price. First, the FAIR does not cover vandalism or personal liability and only insures a home’s value up to a maximum of $3mm. To compensate for the difference, some policyholders also purchase a “Difference-in-Conditions” policy from private insurers, which offers supplemental protection to create comprehensive insurance on a home. Second, the FAIR plan is almost twice as expensive as traditional private home insurance ($3,200 vs $1,429 per year not including a difference-in-conditions policy) [8]. The difference in rates is representative of i) the increased liability associated with operating in higher-risk areas and ii) the FAIR plan’s exemption from Proposition 103 requirements as the insurer of last resort [16]. While the FAIR plan is undoubtedly a necessity in a state plagued by fire risk, it was never designed to be an attractive permanent solution for the state’s homeowners. 

The January 2025 Wildfires

Now that we have a clear baseline to understand the perspectives of insurance companies, policymakers, and homeowners in California, let’s examine the events preceding and following the Los Angeles Fires in January 2025. 

Underinsurance: In 2024, State Farm infamously dropped ~70% of its customers in the Pacific Palisades because of high fire risk. While seemingly prescient timing, this non-renewal decision was a continuation of similar trends across the state which began in 2018. Figure 2 below shows the growth in FAIR plan policies as a percentage of total policies in California. 

While these numbers seem relatively modest compared to the entire residential real estate market in California, it obfuscates the true severity of the situation. While only 3.7% of the total market, 33% of homes in the top 10 counties with the highest wildfire risk were insured by the FAIR plan in 2023. In those areas, this represents a 1,550% increase compared to 2018 [9]. Additionally, as you may remember, FAIR plan coverage is an imperfect substitute for traditional home insurance – requiring additional “Differences in Coverage” policies to make up the coverage gaps. Unfortunately, while the number of FAIR plan policies has skyrocketed, half of those new plans do not have any additional wrap-around insurance. This means that over 110,000 of the riskiest homes in the state, which were fully covered in 2018, are underinsured today. In Pacific Palisades, which was one of the wealthiest neighborhoods in California, median home values exceeded the $3mm coverage limit of the FAIR plan. For those that did not have any additional coverage, losses in excess of that cap will be difficult to recover.

FAIR Solvency: The FAIR plan has an impossible task – grow coverage in the riskiest areas of the state while also maintaining reasonable premiums to counteract the effect of adverse selection. To many, this rapid growth and insufficient capitalization set off alarm bells for an inevitable catastrophe. Faced with $4.75bn in potential liability in Los Angeles according to the plan’s latest published estimates, FAIR “only have about $300mm in the bank” [10],[11]. While there are other liquid investments on their balance sheet that the program will sell to cover much of the liability, but FAIR also insures billions of unaffected properties in other areas of the state that it must maintain adequate reserves for, creating a financing gap. There are two ways that FAIR is dealing with the projected shortfall. First, relying heavily on non-proportional reinsurance contracts it established before the fires. As a reminder, non-proportional reinsurance takes effect after a certain threshold of losses is surpassed. In the FAIR plan’s case, there are multiple tiers of reinsurance it can access depending on its loss amount. For example, after paying out $900mm in claims and related expenses, the plan can access its first $350mm in reinsurance commitments. Practically speaking, given the severity of the financial loss, to access its full $5.78bn in reinsurance, FAIR is responsible for paying at least $3.5bn in claims itself. This is money FAIR does not have even after selling its investments, which brings us to the second way that the program is financing itself: a private insurance assessment. By statute, the FAIR plan has the right to “assess”, or force, private insurers operating in the state to help cover losses on its claims. This assessment is an option of last resort for FAIR administrators (and we will see why in a minute). On February 11^th, 2025, the FAIR plan announced a $1bn assessment, the largest in California history and the first since 1994 [12]. These costs will be distributed to each private company according to its market share in California, meaning that State Farm will end up paying the most. Ultimately, private insurers will still end up paying for some of the losses in the areas they failed to insure, but the overall total will be far lower than if they continued writing policies in Palisades and Altadena. By combining its loss reserves, reinsurance commitments, and assessment funding, the FAIR plan has committed to fully covering all insured claims from the Los Angeles fires.

Future Implications

While the Los Angeles fires could be some of the most expensive natural disasters in state history, they will not be the last. There are a few major near-term and long-term impacts of the crisis that require debate and political action. 

First, all Californians can expect their insurance premiums to increase both short-term and long-term. Recognizing the drawbacks of Proposition 103 in late 2024, the CDI began rolling back some of its restrictions impacting the home insurance market. In exchange for writing “comprehensive policies in wildfire distressed areas equivalent to no less than 85% of an insurer’s statewide market share”, California will allow insurance companies to i) use wildfire catastrophe models for ratemaking ii) pass on reinsurance costs to consumers [14]. In other words, this means insurers will be able to continuously reprice their risk and charge higher premiums across the state as the expected cost of climate change increases. Already, State Farm has requested a 22% average premium increase from the CDI [13]. In the short term, insurers will also charge their policyholders a fee to pass through 50% of the costs of the $1bn FAIR plan assessment. Under the same regulatory changes that rolled back provisions in Proposition 103, the CDI approved a measure that allows private insurance companies to avoid the loss from any FAIR assessment by sharing the costs with their policyholders. Practically, this means that homeowners in unaffected areas are paying for the damages incurred by residents in Pacific Palisades and Altadena – a controversial and potentially immoral outcome [15]. 

The second implication of these changes is an increasingly unaffordable housing market. In the short term, tens of thousands of people who lost their homes need a temporary place to live in the already-strained Los Angeles housing market. This imbalance of supply and demand will push costs up and continue to price out average families [15]. In the long term, the increase in insurance costs will delay or shrink the cohort of first-time home buyers. There is no easy solution to these issues. On the one hand, the price of insurance must be reflective of the risk of total loss. On the other hand, what happens when that cost is unaffordable for most residents living and working in those areas? One possibility is focusing on the root cause of increased risk–pricing in the cost of climate change at all levels of the economy. While theoretically sound, negative externalities are difficult to assign in practice. Another possibility is pooling risk across the country, instead of just statewide. In this way, insurers are able to justify more affordable rates in riskier areas by spreading the costs to less vulnerable communities. Obviously, this is extremely politically unpopular and ethically questionable. The bottom line remains: to keep the American Dream alive, these issues must be dealt with sooner rather than later.

[1], [2], [3], [4], [5], [6], [7], [8], [9], [10], [11], [12], [13], [14], [15], [16]

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