The LA crisis is bigger than the fires — insurance is the next burning issue

The Los Angeles wildfires have spread across tens of thousands of acres of land, burning everything in their path. Homes have been destroyed and lives upended as families begin the process of rebuilding — not only their homes, but their lives.

While a story like this draws the entire nation’s attention, an added dimension is the fact that many properties that have been destroyed are homes to the wealthy and the well-known, as well as some historical landmarks. For the latter, the costs are immeasurable.

For many, insurance will provide the necessary resources to help with certain financial costs. Yet insurance will likely only cover the hard assets that are destroyed, not the memories nor the keepsakes, that no amount of money could ever replace or restore.

The cost to the insurance companies will be easily measured in the tens of billions of dollars. Yet insurance companies are not charitable organizations, giving away money.

By design, insurance is pooled risk. By selling insurance policies across a wide swath of diverse events, the premiums collected (what people pay to be insured) are used to cover damages for covered events. This means that for large insurers that cover events across the country, premiums collected to cover damages from hurricanes in the Southeast, tornados in the Midwest and earthquakes on the West Coast all contribute to cover damage payouts.

The worst-case scenario for insurers is when several events occur across multiple locations, requiring damage payouts that exceed gross premiums collected. Of course, insurers also maintain investment reserves to buffer against such simultaneous events.

The risk assessment of insured events takes numerous factors into account. A problem occurs when insurable events occur at a higher rate and with higher damage payouts than forecast. This means that the premiums collected may not account for all such unanticipated risk.

Insuring events is a gamble, with the insurance companies positioning themselves as the “house.” Much like casinos operate in Las Vegas, the house always comes out ahead, over time. On any given day, a gambler may win a large jackpot, but a long stream of losing bettors effectively paid for that jackpot, with the casinos skimming off their share of profit over time.

With insurance, people are happy to lose their “bets” by paying their premiums and having no losses. In such cases, the premium buys peace of mind against the unlikely event of a major loss.

The mass destruction of the Los Angeles wildfire could not have been forecast or planned for. Otherwise, insurance premiums would have been set much higher to cover the losses being accrued with each acre of land and property being destroyed.

That is why many insurers are pulling out of California, citing high costs and excessive risk exposure.

To remain in this market, the risk analysis of providing coverage would demand such high premiums that many would be unable to afford insurance at all, effectively suppressing some of the pooled risk benefits that insurers use for profit and risk management. That is why California created the FAIR Plan, an insurance program for those unable to secure coverage from private insurers. This, in and of itself, is a red flag for the state, with California subsidizing insurance and willing to assume losses that private insurers are unable — or unwilling — to absorb.

Without coverage, some people may decide to forgo home ownership and become renters. This effectively reduces their personal risk, shifting it to those who own the properties that they may rent. Of course, this would also increase rental rates, adding to the already strained home affordability issue that plagues southern California.

Those who can afford to do so may opt to go “naked” and self-insure. This can work for those with high incomes and whose assets are not concentrated in their homes. For others, going “naked” is a risk beyond their means.

The endgame for the Los Angeles wildfires is not just about putting out the flames. It is about assessing future risks and how current and future residents assume the risk for their homes and property. If insurers are unwilling to offer coverage at rates that residents can afford, some be forced to live elsewhere.

There will always be those who want insurance companies to step up to fill the insurance coverage need. Yet the limitations of pooled risk may make it impossible for companies to do so and retain their financial solvency. Do not be surprised if people in other parts of the country see their homeowner insurance rates rise over the next few years to cover the Los Angeles wildfire losses.

That is how insurance works, and why the best advice for everyone when purchasing insurance is to cover only what you absolutely must, at the minimal level. Indeed, such a strategy means that you will be contributing the smallest amount possible to the house's profit.

Sheldon H. Jacobson, Ph.D., is a professor in computer science in the Grainger College of Engineering at the University of Illinois Urbana-Champaign. He used his expertise in risk-based analytics to address problems in public policy.

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