California Fire Insurance

The market is broken

Photo by Joanne Francis on Unsplash

The scenes from California these last few weeks have been apocalyptic. Entire neighborhoods razed to the ground. Tens of thousands of acres torched. As of this writing the death toll is luckily only in the dozens, but that will surely rise. There has already been a lot written about the tragedy, and undoubtedly, there will be a lot more. The blame game has begun, with some leveling criticisms at the local government, others at the state, and others with the feds. How much “blame” will likely never be known with certainty, as California has always, and will continue to have, a natural risk for wildfires. How much damage could have been prevented, and at what cost, is a bit of a fool’s errand to calculate. Fires are going to happen - where the act of God ends and government responsibility begins is often not a question with an objective answer.

Regardless of this, going forward, one thing is clear: California needs to think carefully about its home insurance market.

Home insurance is a simple enough business. Homeowners generally don’t have the finances to rebuild their home should it be destroyed. Instead, they purchase an insurance policy, whereby they pay a small fraction of their property’s value every year to an insurance company. If nothing ever happens, the insurer gets to keep every cent the homeowner pays. Should the property be damaged or destroyed, then the insurer pays out the value of the policy so that the homeowner can rebuild. From the insurer’s standpoint, things are a bit more complicated. To stay in business, the insurer has to have a large enough pool of undamaged properties every year that it can afford to pay out all claims for properties that are damaged. An insurance company also needs to be able to set rates so that the firm is paid more money than it has to pay out. Both these conditions are difficult for insurers in California.

The problem with wildfires, unlike tornados or electric fires, is that they can affect a large number of properties at the same time. An insurance company would never issue fire insurance policies for homes only near the Sierra Madre Mountains of Southwest California. Even if most years there are no fires, every once in a while there will be a big fire that will destroy hundreds of homes. One event like that could bankrupt a company. Instead, insurers try to spread their risk out as much as possible, issuing fire insurance policies to homes in a wide geographic area, so that even in a year with a bad fire, the vast majority of insured properties are unharmed. One fire in Southern California results in billions worth of claims, but if there were no fires in Northern California, the insurance company can still balance their books. The 2025 fires haven’t followed that script. They are so large, and have consumed so many properties, that most insurers would have difficulty coming up with the money required to pay out all the claims.

Second, insurers in California are heavily restricted in how much they can charge homeowners for policies. In the 1980s, both car insurance and home insurance policies were increasing in cost at a rapid clip. The voters of California, in their infinite wisdom, voted in favor of a ballot initiative named Proposition 103 in 1988. The new law required that companies submit any rate increases to a government official for approval. This is quintessential California. The law sounds great - who doesn’t want to stick it to those greedy insurance companies? Of course, insurers don’t just raise prices willy-nilly. They do so when the risk to the property increases. Prop 103 wound up having a large distortionary effect on the insurance market. Companies were forced to set their rates lower than they wanted to. They were also prevented from using modeling to forecast how risk might increase in the future.

The initial results were good. Rates went down. Californians paid significantly less in insurance premiums than they should have. People in other states effectively subsidized Californian’s home insurance policies. Slowly but surely, however, sand gummed up the system. Government officials continued to restrict how much insurers could charge in premiums. Even when the government agreed with insurers they could raise rates, they acted slowly, often approving rate increase requests after months of delay. At the same time, the risk of wildfires in California increased. Less precipitation in recent years has dried the area. Environmental groups have quixotically fought prescribed burns. The value of real estate has exploded, leaving insurers on the hook for more.

So they left. State Farm canceled 72,000 policies in 2024. They’ve gotten a lot of grief for that online, all of which is grossly misplaced. State Farm is a for-profit company. If they deem properties too risky to insure, especially when the government is preventing them from charging the price they want, the firm should exit the market. It's absurd to force a company to provide a product that will lose money. This is all entirely predictable. If you don’t allow insurers to set their rates where they would like, eventually the government is going to become too strict and force policies to be too cheap. Private insurers will exit the market, leaving homeowners will few options.

Of course, the one option remaining for insurance is the state itself. The state of California has established an “insurer of last resort” for properties that are not covered by the private market. The government option, known as the FAIR Plan, now insures almost half a million properties, and only has $377 million on hand to deal with what will be billions of dollars worth of claims. What is going to happen is clear: the California taxpayer is going to bail out homeowners who lost their homes in the fires.

This is not a good outcome. Most of those homeowners were millionaires - perhaps only because the house they bought in 1993 is now worth $4.3 million, but millionaires nonetheless. Having other California residents cover losses to disproportionally wealthy homeowners is far from optimal. California needs a massive rethink of its policies. Proposition 103 needs to be repealed immediately. Insurers should be given a much freer hand to set rates. Most importantly, California needs to figure out a long-term answer to what is going to be a growing problem: how to insure homes in areas that are prone to wildfires.

Insurance doesn’t work without a large pool of undamaged homes every year. If fires are going to frequently destroy a non-trivial portion of housing stock, the state government needs a massive overhaul of how they operate. Homes should be required to cut back burnable plants. The state needs to clear undergrowth in undeveloped areas. Prescribed burns should increase. Insurers need to be allowed to charge market-based premiums. Greater resources need to be put into firefighting infrastructure. Wildfires are here to stay. If people want to stay as well, California needs to plan accordingly.