Can’t win, can’t break even, can’t get out of the game. Once used to illustrate the three laws of thermodynamics, that saying also describes where many California home insurers find themselves today.

December 7, 2019
Copyright 2019 Tony Lima. All rights reserved.
(A downloadable pdf version is available at the bottom of this article.)

California insurance regulators are now forcing insurance companies to continue to offer homeowners insurance in high-risk areas. For some of these policies, the premiums will not be sufficient to cover the risk. That means the insurers face three choices.

1. They can continue to underwrite those policies, reducing profits and exposing the company to increased risk.
2. They can try to raise rates. To do that they will have to make their case to the same insurance regulators that just told them to continue offering coverage.
3. They can stop offering any homeowners coverage in the state.

Background

On December 5, State Insurance Commissioner Ricardo Lara announced a one-year moratorium that prohibits insurers from dropping policies for homeowners in areas deemed at high risk of wildfires.^[1] Insurance companies are understandably nervous about fire risk in light of their recent experience.

The largest insurers – State Farm, Hartford, Liberty Mutual – will undoubtedly continue to offer coverage. They can afford the profit hit. Some smaller companies may decide to leave the market. That will leave all their policyholders scrambling to get coverage. And those in fire-prone areas may find that no company is willing to write a policy for them.

How Insurance Works

All insurance is based on risk-pooling. Consumers are risk averse. Businesses are risk averse with respect to some types of uncertainty. Both are willing to pay to reduce or eliminate some risks. That is the basis for insurance. Auto, fire, liability, and all other forms of insurance work this way.

Risk-pooling means the company writes a large number of policies. The insurance company can be risk-neutral because they hold a diversified portfolio of policies they have written. As is always the case, diversification can reduce risk without reducing expected return.

But the real issue here is price. Risk pooling only works if the policy holders are charged a price commensurate with the risk they are insuring. Higher risk activities should carry higher premiums.

Applying this to California wildfires means those who live in or near fire-prone areas should pay higher premiums. But those premiums must be approved by the state insurance commission.

Why Are Some Industries Regulated?

Economists know the fundamental reason industries are regulated is lack of competition. A monopoly is a market in which a single firm produces all the output. In oligopolies, several firms produce the output. A subset of monopolies are firms operating as natural monopolies. These firms have economies of scale large enough that a single firm can supply the entire market at the lowest per-unit cost. These economies of scale are often created by some form of network.

Consider trash collection. In most communities a single firm picks up the trash (and, often, the recycling, too). A simple example will reveal why this happens. Suppose there are two companies making the rounds. One company collects from odd-numbered houses. The second only stops at houses with even street numbers. I hope the inefficiency here is obvious. What’s less well understood is this same logic applies to cable television (except inroads being made by satellite providers), internet services, natural gas, water, as well as police and fire protection.

Now let’s apply this to the California insurance market. Luckily, the California Department of Insurance provides market share information. Figure 1 shows this information for 2018.^[2]

One does not need a Ph.D. in economics to see that this market is not a monopoly or an oligopoly.

Measuring Market Power

But we can go even further and calculate the extent of market power. Economists and anti-trust regulators use the Herfindahl-Hirschman Index (HHI) to measure industry concentration. The HHI is the sum of the squared market shares of the firms in the industry. Two examples will illustrate how this works.

Suppose an industry is a pure monopoly. The monopoly, by definition, has a 100 percent market share. The HHI is 100² + 100² =20,000. This is, in fact, the maximum value for the HHI.

Now assume two identical firms share the market equally. Their market shares are 50 percent. The HHI is 50² + 50² = 5,000. This indicates some market power.

A rule of thumb used by the Antitrust Division at the Justice Department consider any industry with an HHI greater than 1,800 to be concentrated. If the HHI is between 1,000 and 1,800 Justice will challenge any proposed merger that would increase the value by 100 points or more. Below 1,000 is considered fairly competitive.^[3]

The HHI for the largest 25 firms in the California property and casualty insurance market is 347.16.^[4] This market is not concentrated.

Why Does California Regulate Insurance?

So why does California regulate insurance? The answer is found on the Department’s website:^[5]

In 1988, California voters passed Proposition 103, a citizen-led initiative. Proposition 103 expanded CDI’s authority as well as changed the Insurance Commissioner from an appointee of the Governor to an independent statewide officer elected by popular vote. Proposition 103 also required prior approvals of property and casualty rates, including personal auto and homeowners insurance.

Short version: California voters decided to do this.

It’s theoretically possible to regulate a monopoly in ways that improve economic welfare. But regulation is a blunt instrument. It usually takes considerable time to put together an application for a rate increase, go through the hearings, and get the result. The rate increase application form is an Excel workbook with 11 worksheets (only 9 if you make the right choices on worksheet 2). Figure 2 shows the first worksheet and the tabs for the other 10.

But sometimes events can outpace this process.

Wildfires Happen Fast

Wildfires are not inclined to wait for regulators to make rate decisions. In fact, insurers in California are hurting. Figure 3 and Figure 4 tell the sad tale.^[6]

In Figure 4 note the sharp decline in the number of companies in the California market. There were more than 190 in 1991. Today that figure is around 110. But even that number indicates a robust, competitive market. And, of course, the losses in 2017 and 2018 are in marked contrast to the previous decades.

This cannot continue. The largest insurer in the state, State Farm Group, has an 8.6% market share. Their loss ratio in 2018 was 71.56%. They will likely survive for at least a few more years. But the second largest, Farmers Insurance Group, had a loss ratio of 95.95%. That firm is in a precarious position. Of the 25 largest insurers, five have loss ratios above 90% with one exceeding 100%.

Those five firms and probably several others are a couple of natural disasters away from exiting the California market. Who will write the high-risk policies formerly issued by those outfits?

Conclusion

Our families’ houses are not in high-risk areas. And we both have long histories with our insurance companies. But if you once thought of retiring to a nice place in the Sierra foothills or near Sacramento, you may want to check the homeowners insurance situation first.

One of two things must happen. Either premiums will rise for houses in high risk areas or there will be no companies willing to write policies on those locations. The Insurance Department’s decision to impose a one-year moratorium on cancellations combined with their resistance to letting premiums rise does not bode well for this market.

1. Serna, Joseph (December 5, 2019). “California bans insurers from dropping policies in fire-ravaged areas.” Los Angeles Times. Available at https://www.latimes.com/california/story/2019-12-05/california-bans-insurers-from-pulling-policies-in-fire-ravaged-areas. Accessed December 6, 2019. ↑
2. California Department of Insurance (2019). “2018 CA Property and Casualty Market Share.” Available at http://www.insurance.ca.gov/01-consumers/120-company/04-mrktshare/2018/index.cfm. Accessed December 7, 2019. ↑
3. Karl Case, Ray Fair, and Sharon Oster (2019). Principles of Microeconomics (13e) Chapter 14 p.305. Prentice-Hall Publishing, Upper Saddle River, NJ, 2019 ↑
4. Author’s calculation based on “2018 CA Property and Casualty Market Share.” op.cit. ↑
5. California Department of Insurance (2019). “About the Department.” Available at http://www.insurance.ca.gov/0500-about-us/02-department/index.cfm. Accessed December 7, 2019. ↑
6. California Department of Insurance (2019). “2018 CA Property and Casualty Market Share.” op.cit. ↑