For nearly 35 years, California has been famously protective of insurance policyholders through laws and policies aimed at limiting rate increases.
But the system is coming under scrutiny following the stunning announcement Friday by State Farm — the largest property insurer in California — that it is no longer writing new policies for homeowners or businesses in the state.
Experts say State Farm’s decision highlights a flaw in California policies that effectively blocks insurers from considering climate change in setting premiums and discourages them from seeking rate increases sufficient to cover the state’s growing wildfire risk. In addition, the policies have created insurance premiums that are far too low and are forcing insurers to pull back their coverage in California to remain profitable.
State Farm’s retreat could compel other California insurers to take similar action, said Michael Wara, director of the Climate and Energy Policy Program at Stanford University’s Woods Institute for the Environment.
“The other insurers learned on Friday, and now they are all meeting to decide, how do we respond? Do we follow the lead?” Wara said. “If experience is any guide, probably they will. It’s like they’ve been given permission. If it was some small insurer, maybe no one would care. But this is State Farm.
“For State Farm to take this action, it’s essentially saying we don’t want to grow in the California market, and we would prefer to shrink in the most valuable real estate market in the country,” Wara added. “This is a situation that threatens the broader economic picture of California.”
Many of the restrictions on insurers originated with Proposition 103, a ballot measure California voters approved in 1988 amid soaring automobile insurance rates.
For property insurers, Prop 103 has made it almost impossible to set premiums based on computer models that project future risks including climate impacts, said Mark Sektnan, vice president for state government relations at the American Property Casualty Insurance Association. That’s because Prop 103 requires modeling used by insurers to be made public, which modeling companies want to avoid, Sektnan said.
Instead, insurers are setting rates based on their losses over the preceding 20 years.
“It’s a little bit like driving your car using the rearview mirror when your windshield is right there in front of you,” Sektnan said.
When insurers analyze the past 20 years to set rates, they are not fully capturing recent increases in California’s wildfire risk as climate-driven hotter temperatures have made the state’s forests and grasslands drier and more combustible, experts say.
For example, in the 20 years from 2003 through 2022, wildfires burned an average of 1 million acres a year in California, according to an E&E News analysis of data from the state Department of Forestry and Fire Protection.
But in the six years from 2017 through 2022, California wildfires burned an average of 1.8 million acres a year and destroyed or damaged nearly 51,000 structures in total.
“The problem in California is that the risk is changing pretty quickly, especially if you think over two decades. Two decades is just not fit for the problem,” Wara said.
Nancy Watkins, a California-based principal at Milliman insurance consultants, said the retrospective method “is an extremely simple rate-making model that in practice has totally failed to anticipate the growing risk in California due to factors like housing growth in high-risk areas, vegetation build up, the effect of climate change on longer fire seasons, hotter temperatures, drier air.”
“None of that is factored into a backward-looking formula,” Watkins added.
Michael Soller, a spokesperson for the California Department of Insurance, said State Farm’s announcement “can create uncertainty and anxiety” among people seeking homeowners’ insurance and noted that 115 other companies are writing property coverage in the state.
“Our immediate focus is on helping consumers navigate their options,” Soller said.
California Insurance Commissioner Ricardo Lara is forcing insurers to give discounts to policyholders who make properties more wildfire-resilient, which Soller said encourages insurance companies “to invest in wildfire mitigation measures.”
Unable to account fully for wildfire risk, insurers instead have canceled or declined to renew policies in wildfire-prone areas. In 2019, after two consecutive years of massive wildfires in California, the number of insurer cancellations or nonrenewals shot up to 235,000 from 165,000 in 2018, state figures show.
At the same time, the number of policies written by the California FAIR Plan, which insures property owners who cannot buy coverage from an insurance company, jumped from 140,000 in 2018 to 190,000 in 2019. The number hit 268,000 in 2021, the most recent year for which records are publicly available.
The growing number of FAIR Plan policies is one reason the nonprofit organization has accumulated a $332 million debt and made it increasingly likely the plan will be forced to charge insurance companies in California a special assessment to pay its claims. Insurers cannot pass the cost of the assessment to policyholders, Watkins said.
“When companies leave the market or when there’s more FAIR Plan coverage, the level of the exposure of concentrated risk in FAIR Plan gets higher,” Watkins said. “The likelihood of a large event goes up, the number of companies around to pay the bill goes down.”
The 6.9% solution
Another problem created by Prop 103 is that if an insurer seeks a premium increase of 7 percent or more, consumer advocates are allowed to become intervenors and challenge the proposed rates. A rate-setting process involving an intervenor can take several years and turn costly for insurers, which often are required to pay the intervenors’ costs.
The result is that many property insurers have sought rate increases of 6.9 percent. That avoids the involvement of an intervenor but also generates insufficient premiums, said Wara of Stanford.
“That worked OK when the real inflation rate was 2 percent or less,” Wara said, noting that a 6.9 percent rate increase would generate a post-inflation increase of up to 4.9 percent. “Now inflation is 5 percent, so insurers are getting a 1 percent to 2 percent real increase.
“We’re still stuck in the 6.9 [percent] world, which doesn’t contemplate high inflation,” Wara added.
Prop 103 also has made California the only state that bars insurers from incorporating reinsurance costs into their premiums, said Sektnan of the insurance association. Reinsurance is coverage that insurers buy to pay excessive claims they incur.
The theory behind the prohibition is that because reinsurers operate on a global scale, their rates potentially reflect risks across the United States and the world — not just in a state where insurers are seeking rate increases.
But Sektnan says that theory is misleading because reinsurance companies can determine their costs in individual states. “It’s possible to only include California risk in the [reinsurance] rate,” Sektnan said.
California lawmakers are considering legislation that would address some concerns expressed by property insurers.
“They are taking it very seriously,” said Janet Ruiz, California spokesperson for the industry-funded Insurance Information Institute, referring to a recent hearing by the California Senate Insurance Committee.
“The committee has done their homework and are bringing the right people to speak at the hearing. That was very hopeful,” Ruiz said.
Carly Fabian, policy advocate for the climate program at Public Citizen, a consumer advocacy group, said in a statement to E&E News that State Farm’s decision “is both alarming and predictable. The company’s decision should be seen as a warning sign to regulators across the country.”
Fabian added that State Farm “has some responsibility for causing this problem” because it holds investments in fossil fuel companies.
Wara of Stanford said the officials need to “go much further in terms of helping and also forcing people to make their homes less prone to ignition and fires.” He suggested adopting policies that require a house to meet wildfire safety standards in order for it to be sold.
“If we want to preserve the insurance market, we need to be decisive,” Wara said.