When the hole swallows the donut

California's FAIR plan and the future

I called a friend of mine who lives in a hillside home in Los Angeles yesterday. "I've been thinking about property insurance in California all morning," I said to him. "That's funny," he replied, "I've been doing the same thing." Our chats usually meander through career and family topics, but he's an on-trend kind of guy—and now he's wondering how he can protect his investment in his house.

Here's the news from California (and from Louisiana, Florida, and several other states): Loud noises of climate-driven risk, great trumpet blasts of warnings, are finally about to reach the intertwined banking/insurance/real estate/muni bond markets. A realignment, the matching of risk to valuation, is coming.

One current kerfuffle is focused on the extraordinary exposure of the California insurer of last resort, the FAIR (Fair Access to Insurance Requirements) plan, to an estimated 404,000 policies covering $320 billion in assets. The FAIR Plan, growing at a rate of about 27 percent a year, has only about $250 million in cash on hand. One major fire near Lake Arrowhead, where the Plan holds $8 billion in policies, would plunge the whole scheme into insolvency. 

As California Assemblymember Jim Wood said to Victoria Roach, president of California's FAIR plan, during a hearing earlier this month: 

Quite frankly, if this were on Wall Street, I'm not sure you'd be able to get away with this.

The FAIR plan's fate has major implications for both Wall Street and Main Street: a legal structure established to keep a relatively small number of difficult-to-insure properties going (the hole), within an otherwise healthy and thriving context of credit and finance (the donut) has grossly ballooned. The donut is vanishing. As Roach said during the hearing, "There's not a lot of options out there for people" to buy insurance. What happens next is uncertain. 

History of the Hole. The original idea behind FAIR plans was that they would remedy redlining by providing an option for properties that insurers were systematically refusing to insure—particularly in urban cores across America. Following the 1968 riots, and with the encouragement of the insurance industry, Congress passed the Urban Property Insurance and Reinsurance Act of 1968 authorizing state FAIR plans. (The insurance industry was not necessarily being altruistic in supporting the idea. They wanted to avoid government interference.)

The plans are set up to be run by associations of the insurers that are authorized to do business in the state. A key incentive for insurers at the outset was that federal reinsurance (sharing risk) was going to be available for riots or civil disorders. In exchange, insurers would share in profits and losses for policies sold by FAIR plans in high-risk markets. 

The idea was that those FAIR policies wouldn't cannibalize existing markets that insurers were actually interested in picking to serve, because FAIR policies would be more expensive—three times as expensive, traditionally—and offer less coverage. There was plenty of "good" business to go around.

At the time the FAIR plan idea was adopted by Congress, all the talk was about riots and racial discrimination. It seemed unfair to classify a property as high-risk just because it was located within the inner city. To take advantage of that riot reinsurance these FAIR associations were supposed to make last-resort insurance available without regard to "environmental hazards," meaning "any hazardous condition that might give rise to loss under an insurance contract, but which is beyond the control of the property owner." Everyone understood that this was about FAIR policies keeping inner cities limping along, as insurers continued to do direct business elsewhere within the state.

Well, times have changed. Environmental hazards mean something different now, and they're widespread. In particular, wildfires in California caused substantial losses in 2017, 2018, 2020, and 2021. Insurers in California have felt they can't raise rates sufficiently to match the risks, and seven of California's 12 largest property insurers have cut back coverage or left the state. The California FAIR plan is struggling to keep up with demand and added 15,000 policies last month alone.

Interestingly, 40 percent of the FAIR plan business late last year came from *outside* wildfire areas. People buying houses are being told by their lenders or realtors to just go to the FAIR plan to secure their loans. They're no longer the insurer of last resort. They're the first stop.

What's about to happen. California has had a couple of years of small catastrophes, which has allowed the FAIR plan to build up its nugget of $250 million to pay claims. What if large catastrophes strike this summer and several billion dollars are owed to policyholders?

The FAIR plan will then assess the insurers who did business in the state over the last two years to pay their share of claims. Insurers have 30 days to send the money in. The burden of those assessments will probably be passed through to other policyholders, to the tune of thousands of dollars in additional premiums. Kim Stone, a consumer advocate, told the California Insurance Standing Committee last week that a complete loss for FAIR plan policies in Lake Arrowhead "could amount to a $975 surcharge on every other insurance policy." More insurers will probably leave the state. In the meantime, even if the FAIR policyholders are paid, they'll be surprised at the narrowness of the coverage and the caps on claims. 

Naming the crisis. Is this an insurance crisis or a housing crisis? Insurers in California say it's a problem of accurately pricing risk. They want to be able to charge higher rates, and are asking their regulator to allow them to reflect reinsurance costs in their pricing and include forward-looking risk models when rates are set. California Insurance Commissioner Ricardo Lara is working on this. Someday, the thinking goes, accurately-priced "voluntary" insurance can relieve the pressure on the FAIR plan. The FAIR plan also wants to more accurately set its premiums, but the process is slow. And all of this will lead to sharply-increased costs of owning a home. 

For homeowners, like my friend in California, it's increasingly a personal crisis. The hole, the properties that aren't attractive to the insurance industry, is growing so large that everyone will eventually feel its effects. Credit will begin to tighten as banks worry about the instability of insurance in California. Houses will sit on the market as buyers evaporate. There will be, in short, a meltdown at some point. 

California accounts for 12 percent of the country's population, and often leads the way for the rest of us. The whole point of insurance is to spread unrelated losses across a pool of contributors while making a profit. But notice those policyholders in non-wildfire areas in California going right to the FAIR plan: it may be that the insurance industry is sending the signal that risks spread across the state are becoming unattractive. Every risk is insurable at some price, and they'd like those prices to be higher. That will inevitably raise housing costs and impose an indirect tax on everyone involved. The signal of climate change, muted until now in real estate markets, is being heard.

What's the answer? There is no one answer. But the entire discussion about "fixing" insurance markets may be covering over the larger issue: You can reduce a risk by insuring against that risk, or you can reduce it by reducing it. Where we live, and how we live there, will be changing. Whether those changes are a scramble or a planned, dignified evolution is up to us.