Higher fire insurance rates for everyone

by Zain Jaffer

Mainstream media in late January 2025 reported that fire insurance rates for most Americans will increase as a means to pay for the catastrophic Los Angeles (and other parts of Southern California) fires [https://edition.cnn.com/2025/01/22/homes/la-fires-homeowners-insurance/index.html]. Instead of a few homes that were destroyed, entire communities burned to the ground. A late January 2025 Harvard Business Review (HBR) article [https://hbr.org/2025/01/the-la-fires-could-change-the-insurance-industry] estimates that the total cost could run up to $250bn or higher.

The HBR article said something about what insurers call “parametric insurance.” Instead of the normal exclusions that do not cover certain types of event normally lumped under Acts of God clauses, if a policy is parametric, it pays out a certain fixed amount in the event of certain calamities if you have sustained some damage. It is called parametric because the actual predetermined amount depends on the severity of the event.

For example, instead of excluding people in wildfire prone areas from getting full coverage to replace their destroyed assets, parametric insurance instead gives policy holders a certain sum if an event occurs. While they receive something instead of nothing, the amount they will get will not often be enough to replace say a burned home.

Insurance is a business. The reason it has worked well in the past is that the risk to reward ratio is great. Insurers collect policy premiums from holders, and their profit is based on an assumption that the likelihood of a disastrous event is low. However if the likelihood of the disastrous event goes higher to the point where it becomes significant to impact the actuarial calculations of the insurer, then either they charge higher premiums, spread the risk across a wider base, or pull out from covering that category or area. They also need to deal with state and federal authorities like insurance commissions who determine what they can charge.

While insurers like State Farm intended to drop (or actually dropped) certain policy holders living in what they considered high risk areas, it now becomes politically untenable for them to do that. State Farm has stated that they will renew coverage in those areas that they deemed high risk [https://www.latimes.com/business/story/2025-01-15/state-farm-palisades-fire-non-renewals-la-fires-eaton-insurance-cancellations-altadena]. However do expect that they will probably recoup the potential cost of taking on added risk from a wider policy holder base across the state, if not the entire US. Spreading the risk across a wide base also ensures that premiums do not rise as much as compared to raising it for only the residents in limited particular areas. Otherwise, as we see in certain areas, coverage becomes too expensive to afford for most people.

The December 2024 assassination of United Healthcare CEO Brian Thompson and the subsequent public support in certain sectors for the murder suspect [https://apnews.com/article/unitedhealthcare-suspect-ceo-assassin-shooter-eaee0b7d31b319f42e0cf7f2f7badfb1] has again reiterated the public’s perception of how they think the insurance industry works. Right now we are seeing the impact of that on how insurers like State Farm have shown empathy towards the policy holders who were not renewed.

Insurance is a business with shareholders and investors. These companies need to make money and are not a public charity, and their work has now become more challenging given their need to operate in a riskier environmental environment driven by climate change and other factors.

However they also have public service responsibilities. Hopefully they can navigate this tricky situation and strike the right balance between profitability and public service.

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