Climate Risks Series, Part 4: California Wildfires – Insurance Insights

Fenchurch Law firmly believes that an outstanding approach to claims payment is fundamental to the health of any insurance market. In fact, Lloyd’s of London’s modern reputation for excellence owes much to its response to the San Francisco earthquake in 1906, when leading underwriter Cuthbert Heath famously instructed his local agent to “pay all of our policyholders in full, irrespective of the terms of their policies”.

With extreme weather events including earthquakes, hurricanes and storms on the rise, the most recent wildfires in Los Angeles present a number of challenges, and also opportunities, for California’s insurance market.

Background

The fires originated in the canyons above the Hollywood Hills and were swept into residential areas by notoriously strong Santa Ana winds. Although the areas affected are known to be at risk of wildfires, it is unusual for them to occur in the winter months. This year, however, a combination of drought and abundant vegetation (the result of above average rainfall in the previous two years) resulted in there being ample fuel for the fires to spread.

Evidently, climate change is increasing the risk of wildfires in the area, with a study from Stanford University predicting that the frequency and potency of these fires will only continue to escalate in the future.

Now contained, the most significant fires were located in the Pacific Palisades and Eaton, primarily upscale residential areas surrounding the Hollywood Hills. The Pacific Palisades, in particular, is home to a wealth of high-value residential property, with average sale prices above $3 million. The impact of this is that insured losses are set to be the highest in California’s wildfire history, with JP Morgan’s most recent estimates at $20 billion. For context, California’s most expensive wildfire to date, the 2018 Camp Fire, resulted in insured losses of around $10 billion.

Beyond their initial response to claims payment, insurers will need to reconsider their approach to wildfire risk and implement resilience measures in order to continue to do business in the area, while maintaining adequate capital reserves and managing cumulative exposures.

A fragile home insurance market

In recent years, several leading insurers, including AIG and Chubb, have stopped issuing new home insurance policies in the state of California due to persistent losses against a backdrop of rising construction costs and property prices, with one deciding to reduce cover for 72,000 homes in the Pacific Palisades area. Underinsurance is a widespread problem.

At the end of last year, the California Department of Insurance sought to entice insurers back into the market by allowing them to use sophisticated catastrophe modelling and artificial intelligence to evaluate risk in fire-prone areas. That risk, together with the cost of any reinsurance, could then be factored into premiums. Unfortunately, the effect was that premiums soared, and it became increasingly difficult to obtain adequate cover at an affordable price.

In response, many homeowners opted to take out policies with the State-backed insurer of last resort, Fair Plan. Fair Plan distributes losses among a number of insurers based on their respective market share. If insufficient funds are available to cover its losses, Fair Plan can issue assessments requiring insurers in the voluntary market to contribute. If that happens, the Plan will impose a special assessment on home insurance policyholders across the State.

It is estimated that Fair Plan’s exposure in the Pacific Palisades alone is almost $6 billion, with luxury property specialists Allstate, Travelers and Chubb the most exposed. Post-Covid-19 construction prices could further increase final payouts, in addition to living expenses claims, typically capped at 30% of a property’s value. It has already been reported that regulators are allowing Fair Plan to collect $1 billion from private insurers to cover its recent losses.

The future

Following initial focus on the safe evacuation of residents, the State’s Insurance Commissioner has taken steps to mitigate the impact on California’s already fragile home insurance landscape, by issuing a moratorium preventing insurance companies from cancelling or not renewing policies in the affected areas for the next year. The Commissioner has also issued a notice to insurers urging them to go beyond their legal obligation and pay policyholders 100% of their personal property coverage limits without requiring them to itemize everything that has been lost.

The insurance industry has, historically, supported risk management in the aftermath of catastrophic events. It was the London market that established the first organised firefighting services when insurers hired their own firefighters to protect policyholder properties during the Great Fire of London in 1666, and it was Hurricane Andrew that changed the way insurers looked at hurricanes, and at natural catastrophes in general.

Following the 2018 Camp Fire, the Californian town of Paradise implemented a number of measures to build resilience to future fires, such as burying all power lines underground to reduce the risk of electrical sparks causing fires, requiring residents to remove vegetation in close proximity to their homes, and making grants available to homeowners willing to use fire-resistant materials in their rebuilding efforts.

At a property resilience level, the Insurance Institute for Business & Home Safety (IBHS) provides science-backed mitigation measures for homeowners to reduce the risk of wildfires igniting in their homes. The IBHS is an independent body, supported by the insurance industry to advance building science in order to reduce risk from natural hazards.

It remains to be seen whether the local insurance market will step up to deliver on the Commissioner’s request to pay out full policy limits without requiring proof of loss for every individual item, and how far mitigation measures will be implemented to respond to the difficulties that policyholders are likely to face in the coming months.

Given the impact of climate change, losses resulting from wildfires and other natural perils are likely to increase in severity in the future, highlighting the critical importance of a strategic approach to consumer protection and insurance market sustainability.

Abigail Smith is an Associate at Fenchurch Law

Climate Risk Series:

Part 1: Climate litigation and severe weather fuelling insurance coverage disputes

Part 2: Flood and Storm Risk – Keeping Policyholders Afloat

Part 3: Aloha v AIG – Liability Cover for Reckless Environmental Harm