Floods and Earthquakes and Hurricanes, Oh My
The insurance industry has for decades considered issues of other natural disasters and exposures, whether flood, earthquake, wind and hail, or other natural disasters. The primary means of addressing the issues of insurance availability and coverages has been at the state level, with one main exception - floods. For example, many of the southern states, including Texas and Florida, have established wind associations.[14]
In 1968, the National Flood Insurance Act (“NFIA”) became law. It established the National Flood Insurance Program (“NFIP”). Congress stated its purposes in the NFIA:
“The Congress finds that (1) from time to time flood disasters have created personal hardships and economic distress which have required unforeseen disaster relief measures and have placed an increasing burden on the Nation's resources; (2) despite the installation of preventive and protective works and the adoption of other public programs designed to reduce losses caused by flood damage, these methods have not been sufficient to protect adequately against growing exposure to future flood losses; (3) as a matter of national policy, a reasonable method of sharing the risk of flood losses is through a program of flood insurance which can complement and encourage preventive and protective measures; and (4) if such a program is initiated and carried out gradually, it can be expanded as knowledge is gained and experience is appraised, thus eventually making flood insurance coverage available on reasonable terms and conditions to persons who have need for such protection.”[15]
Other weather issues have not resulted in similar national programs.[16]
The recent extreme weather has not been the first time that California had to address the shortage or unavailability of insurance coverage for its residents. Following the 1994 Northridge earthquake, many insurers in the state stopped writing new policies, leading to the establishment of the California Earthquake Authority (CEA), which “is one of the world's largest providers of residential earthquake insurance, with more than 1 million California households placing their confidence in us.”[17] The CEA has “about $19 billion in claim-paying capacity.”[18]
It remains to be seen whether and to what extent California might consider a framework similar to the CEA for climate issues, although the FAIR Plan is one model that potentially might be expanded and modified.
The Current Coverage for Natural Disaster and Extreme Weather
One of the primary reasons for the concerns of Allstate and State Farm is that the current policies generally have language that covers first and smoke. For example, the Homeowners 3- Special Form[19] provides protection for losses caused by various losses, including “Fire Or Lightning,” “Windstorm Or Hail,” and “Smoke.”[20]
To date, both State Farm and Allstate have committed to renewing existing homeowner policyholders, even in highly vulnerable areas.[21]
The exposure caused by climate change is significant. For example:
“Physical risks arise from the increasing frequency, severity, and volatility of acute events, such as hurricanes, floods, and wildfires, as well as chronic shifts in weather patterns, such as droughts disrupting agriculture production. These risks directly affect property/casualty insurers’ liabilities and the long-term viability of certain business lines. Climate-related natural disasters can also cause business disruption, destruction of capital, increase in costs to recover from disasters, reduction in revenue, and migration. In turn, these can lead to lower residential and commercial property values, lower household wealth, and lower corporate profitability, translating into financial and credit market losses that affect insurers’ assets.”[22]
The New York Department of Financial Services issued a circular letter to all financial institutions, which includes insurers, noting that insurers must “start integrating the financial risks from climate change into their governance frameworks, risk management processes, and business strategies.”[23]
The numbers presented in the surveys and in various industry publications suggest that, eventually, many insurers in various jurisdictions either will exclude some natural disasters or refuse to write policies. Time will tell where the industry lands, but for now most existing policy language for homeowners includes coverage for wildfires.
The NAIC Response
Some insurance companies have been focusing on climate change and impact for some time. For example, “’Swiss Re and Munich RE, the two big re-insurers, started attending early global-warming meetings.’”[24]
The NAIC has long considered how climate risk impacts the industry. In 2010, the NAIC adopted the Insurer Climate Risk Disclosure Survey,[25] an insurer reporting mechanism that provides regulators with information about how insurers are assessing and managing risks related to climate change. At first the survey was a simple eight-question survey requesting insurers provide a description of whether and how they incorporate climate risks into their mitigation, risk-management and investment plans. The Climate Risk Disclosure Survey has several purposes:
- “Enhance transparency about how insurers manage climate-related risks and opportunities.
- “Identify good practices and vulnerabilities.
- “Provide a baseline supervisory tool to assess how climate-related risks may affect the insurance industry
- “Promote insurer strategic management and encourage shared learning for continual improvement.
- “Enable better-informed collaboration and engagement on climate-related issues among regulators and interested parties.
- “Align with international climate risk disclosure frameworks to reduce redundancy in reporting requirements.”[26]
The Climate Risk Disclosure Survey has expanded since 2010:
All the states were to administer the survey to their domestic insurance companies that write more than $500 million in direct premium. Approximately two dozen states surveyed their companies, and the data was aggregated. In 2011, the threshold was lowered to all companies writing $300 million in premium, however, California was the only state to continue to survey its insurance market. In 2012, California, along with New York and the state of Washington, began administering the Survey to all insurance companies licensed in these states, and that write at least $300 million, making the survey mandatory and the results public. In 2013, the threshold was lowered to $100 million, and the multi-state group was expanded to include Connecticut, Minnesota, and New Mexico.
In 2021, the disclosure survey initiative was joined by nine more states/jurisdictions, reaching 15 members: California, Connecticut, Delaware, District of Columbia, Maine, Maryland, Massachusetts, Minnesota, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Vermont, and Washington. That year, more than 1,400 companies responded, capturing nearly 80% of the entire U.S. insurance market, allowing regulators, insurance companies and interested members of the public the ability to identify trends, vulnerabilities, and best practices by the insurance industry with respect to climate change.[27]
Recently, the NAIC adopted a new reporting standard for insurers to report their climate-related risks.[28] The new standard is:
“in alignment with the international Task Force on Climate-Related Financial Disclosures (TCFD). The TCFD standard is the international benchmark for climate risk disclosure and will help insurance regulators and the public to better understand the climate-related risks to the U.S. insurance market. The NAIC Climate Risk & Resiliency Task Force determined that implementing a TCFD-aligned disclosure framework would enhance transparency about how insurance companies manage climate-related risks and opportunities and incorporate international best practices, among other benefits.”[29]
In light of continued concerns and need to address climate change and its impact on the insurance industry, the NAIC in 2020 formed the Climate and Resiliency (EX) Task Force, which serves as the coordinating body for discussion and engagement on climate-related risk and resiliency issues, including dialogue among state insurance regulators, industry and other stakeholders.[30]
One important element of the work of the task force is to address ways to mitigate the exposures. One of the task force’s charges is:
“Consider innovative insurer solutions to climate risk and resiliency, including:
- Evaluation of how to apply technology and innovation to the mitigation of storm, wildfire, other climate risks, and earthquake.
- Evaluation of insurance product innovation directed at reducing, managing, and mitigating climate risk, as well as closing protection gaps.”[31]
The numbers are large, climate risks are likely to become more severe, and markets change as California’s has with two of its top four homeowners’ insurers withdrawing from the state. Innovative solutions are called for to address this emerging crisis.
California Regulatory Regime
California has been a leader when it comes to climate change and natural disasters. In addition to its leadership with the Climate Risk Disclosure Survey, it has established the CEA and also the Fair Plan. However, one issue facing California and the insurance market is the oversight and pressures imposed by the California Department of Insurance on rates.[32] The issues were outlined well in a recent Los Angeles Times article:
Those reps painted a picture of an insurance market threatened not just by wildfire but also by California’s regulatory apparatus, headed by Insurance Commissioner Ricardo Lara, keeping insurance premiums too low.
Since 1988, when California voters approved Proposition 103, insurance companies have had to submit all requests for premium increases to the state insurance commissioner’s office, along with evidence justifying their need to raise rates. That process can be slow, and even slower if companies want to boost rates by 7% or more, at which point the approval process can turn into a full-on trial.
Companies aren’t allowed to pass along the costs of their own reinsurance premiums — the policies they rely on to cover their own losses in the case of catastrophe. The reinsurance market is global and unregulated, and firms have been raising rates, especially for fire coverage, in recent years.
The last major sticking point that industry reps point to is the use of fire models. Insurance companies are allowed to use only historical losses to justify their increases to the insurance commissioner, rather than using forward-looking fire models. This rule, the companies say, makes for mismatches between price and risk in an evolving climate.[33]
It remains unclear if and to what extent California might revisit its regulatory approach to homeowners, if the withdrawal by Allstate and State Farm, along with continued wildfires, has a major negative impact on the insurance market in California.
Conclusion
The withdrawal by Allstate and State Farm in California may only be the tip of the (melting?) iceberg for the insurance industry addressing wildfires and extreme weather. Whether Californians will be able to weather this insurance storm is yet to be seen. The question is a complicated one with more analysis and discussion to come. But in the meantime, while this issue is being sorted out, the wildfires and extreme weather incidents are growing, and the California Department of Insurance, insurers, and other interested parties must focus on the issue and how best to handle going forward, or we likely will see insurance crises such as those we have seen in South Carolina and other coastal areas due to extreme weather, primarily storms. An abiding question presciently raised in a book addressing the 2016 Fort McMurray wildfire and the “devastation wrought by modern forest fires” is, “Who will insure [the major losses caused by the fires] may be the more pressing question.”[34]