Who Should Bear the Cost? Socialized versus Market-Based Risk Management
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 508. It's titled, Who Should Bear the Cost? Socialized vs. Market-Based Risk Management.

As I record this on January 21st, 2025, there are still wildfires burning in California. The Palisades fire has burned almost 24,000 acres. It's only 63% contained. The Eaton fire at 14,000 acres, 89% contained. And there's some other smaller wildfires that have started that have less than 10% containment.

27 people have died in these fires. Over 12,000 structures destroyed or damaged. J.P. Morgan estimates that these fires around Los Angeles have close to $50 billion in losses, of which only $20 billion are insured. 60% of the losses are uninsured. I can't imagine having that type of

exposure. Obviously, some people are wealthy enough to self-insure, maybe some businesses, but I suspect many individual homeowners are underinsured, which will make rebuilding especially challenging. Munich Re in 2024 estimates that natural disasters caused losses of $320 billion.

billion, 56% of which were uninsured. That is the fifth most cost

costly year since 1980. Of those natural disasters, 93% of the losses were weather-related, which means about 7% were due to earthquakes. Insurance companies segment natural disaster losses into what are called non-peak perils, such as floods, wildfires, and severe thunderstorms. Those losses were $136 billion in 2024.

Peak perils would be earthquakes and hurricanes. They tend to be unpredictable, and when they come, the losses are very large. In their annual report, Munich Re says, it is striking that from a long-term perspective, non-peak perils are increasingly fueling the trend of

of rising losses, while peak risk, like tropical cyclones and earthquakes, continue to be a source of loss volatility. So more spikes when it comes to earthquakes, cyclones, and hurricanes, whereas floods, wildfires, and severe thunderstorms are becoming more regular, even though where it might hit can shift from

from year to year. Munigree continues, the impact of man-made climate change on weather disasters has been proven many times over by research in many regions. Severe thunderstorms and heavy rainfall are becoming more frequent and more extreme. And they point out that even though cyclones and hurricanes are not increasing in number, their severity is increasing. Chief climate scientist Tobias Grimm at

Munich Re says the physics are clear. The higher the temperature, the more water vapor, and therefore the more energy is released into the atmosphere. Our planet's weather machine is shifting to a higher gear. Everyone pays the price for worsening weather extremes, but especially the people in countries with little insurance protection or publicly funded support to help with recovery.

Most of the costs of natural disasters are uninsured. And in that report, they link to a number of studies

that looked at different natural disasters like the Hurricanes Helene and Milton in the U.S. in 2024, the flash floods in the Valencia region of Spain, flooding in Brazil, and they ran the numbers and determined that these events were more severe than they would be with an event in a hypothetical world without climate change. Now, we protect against disasters

disasters primarily through insurance, even though many were uninsured. Insurance works by insurance companies

Assessing the risks, actuaries do that, climate risk analysts, and they determine the potential loss over time. And then they set the premium to where the loss ratio is about 70%. So the actual losses is 70% of the premiums received. That's what they're trying to do. The other 30% covers premiums.

And so those two combine the losses plus expenses divided by the premium that's known as the combined ratio. And so a insurance company that has 100% combined ratio basically has covered losses for that year plus expenses. Now, they still might be profitable because they have earnings.

earnings on their investments. When we looked in at the loss ratios in California, just the losses, so not the combined ratio. Again, the target 70% for a typical insurance company. In California,

Over the last decade, the losses have been 108%. So they're paying out $1.08 in losses for every dollar of premium earned, and that's on $70 billion of insured losses from 40 major wildfires in California, and that's not including what's occurring in 2025. Now, the insurance market in California, home insurance market,

It's complex. In 1988, Proposition 103 was passed to try to limit the increase in home insurance premiums. Any rate increase over 7% triggers a public hearing that can prolong process before insurance company can raise the premiums. In order to calculate the premiums, the insurance company's

have to use historical claims data from the previous 20 years. But with climate change, those losses are increasing. And so that 20-year time horizon has made it more difficult to cover the losses, hence the 108% loss ratio over the past decade. Another interesting element of Proposition 103 is that insurers, home insurers, couldn't include the

the cost of reinsurance and setting insurance premiums for homeowners. Reinsurance is insurance that first-line property insurers buy to cap their exposure.

Ricardo Lara, who is the commissioner of insurance in California, in a press release announcing new home insurance rules that went into effect January 1st, 2025. One of those changes is to allow insurance companies to...

to include reinsurance costs in pricing home insurance premiums. Now, there's some constraints on that, but in that press release, they describe what reinsurance is. It's a financial tool. They write, that is part of how insurance companies manage their risk portfolios associated with the policies they write to homeowners and business owners. Its roots date back to the 14th century when merchants and traders sought ways to spread the risk of perilous ocean voyages

often relying on multiple insurers to cover their ventures. Lara continues, in the press release today, as climate risks escalate across the nation, reinsurance has become an even more imperative component of insurance companies operating in high-risk and distressed areas.

One of those areas is California, which had eight of the 10 costliest U.S. wildfires in 2023, and I believe that includes 2024. Because of Proposition 103, the inability for insurers to factor in reinsurance costs and setting rates, and reinsurance costs have been jumping significantly,

Because their loss ratios are losing money because of the losses, a number of insurance companies took action to stop selling new policies, including State Farm and Allstate. State Farm, for example, dropped 30,000 policies in California, and 69% of those were in the Pacific Palisades area that is burning now.

Now, reinsurance is an interesting business because they're, in some regards, the insurer of last resort, not counting the government. So they're very attuned to the

the cost of natural disasters and what their premiums should be. And after suffering big losses in 2017 and 2018, they've been raising rates meaningfully 30, 40, 50% per year. And they're actually reducing their exposure to these non-peak perils, wildfires, flooding. In fact, city analysts...

estimates that reinsurers would absorb less than 3% of the insured losses from the Los Angeles wildfires. And that over the past 25 years, Bay had modeled about 46% of catastrophic risk related to natural disasters. And now their exposure is down to 33%. Andrew Engler, who's co-founder of

a firm called Kettle, they're a wildfire-focused insurance technology business in California, said reinsurers backed away from taking on a lot of that catastrophe risk. So the insurers naturally said, we want to step away too.

Primary home insurers, Allstate, State Farm, and others, not only were they not allowed up until this year to include the cost of reinsurance in setting premiums, but even now the reinsurers have been raising premium rates and in some cases reducing their risk.

I've always been interested in reinsurance as an investment. Berkshire Hathaway, Warren Buffett has been very involved in that over the years. I was on a call the other day and a financial advisor mentioned that he's been very happy with his reinsurance investment in the Stone Ridge High Yield Reinsurance Risk Premium Fund. We talked about this last year.

on one of our premium podcast episodes, Money for the Restless Plus. This is our premium membership community. And we looked at it because I was interested in what the returns would be. So this is a fund. It has very high minimum. I'm not invested, 250,000 minimum. Expense ratio is super high, 1.85%. But they are purchasing products that reinsurance companies sell.

Event-linked bonds, sometimes called catastrophic bonds, bonds that have exposures to certain events and where if something happens, they have to pay out. But beyond that, they earn some very attractive yields.

They're high yield or non-investment grade. But here's a fund that is purely exposed to reinsurance risk. And the returns have just been, they've been okay. Five and a half percent annualized over the past decade. Better over the past three years because reinsurers have been able to raise rates. I guess they're paying higher yields on catastrophic bonds. But three-year return of 10.6% annualized.

It's different risk, though. It's not equity market risk. It isn't necessarily bond market risk or interest rate risk. It's catastrophe risk. And that's what this reinsurance fund is taking on. But it's telling that reinsurers are reducing their exposure to climate risk as it relates to natural disasters. Before we continue, let me pause and share some words from this week's sponsors.

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When we think about purchasing insurance, the reinsurance market, this is risk pooling, this risk diversification. It's market-based. It's setting a homeowner premium based on what's expected to happen, the potential losses. And the changes that California has made with respect to setting those premiums, one, prop

property and casualty insurance companies can factor in the cost of reinsurance, but they can also use predictive models. Instead of rates being based on what happened over the past 20 years, they can use models based on what could happen as wildfire risk increase in California. Now, they can't

Use different models. So use one model to set the homeowner's rates with certain potential losses and then use a different model for reinsurance. It has to be the same model, but they're changing the way the premiums are being set, modeling it out. It was a fascinating article last week by Greg Ip in the Wall Street Journal, and he talked about this risk pooling and contrasted it with socialized risk.

Socialized risk is where a household can no longer afford insurance. It could be homeowner's insurance, it could be health insurance, and then the government steps in to spread the cost of the premiums or the losses across society as opposed to a purely market-based approach.

It writes that with private insurance, actuarial rate making, the premiums are set based on customer risk and it prevents adverse selection in which only the riskiest people buy insurance and moral hazard, which is the tendency, as he writes, to encourage risk by undercharging for it. If the premiums don't reflect the risk, then what?

Maybe we take on more risk. I thought about this when it comes to the Affordable Care Act. This is the insurance program in the U.S., government subsidized. LaPril and I get our health insurance through an Affordable Care Act plan. And one of the elements of this program is no preexisting conditions. They can only set prerequisites.

premiums based on your age and whether you smoke or not. But your health history doesn't impact it. And I have known individuals who have said, and they've been on health share plans, which we used to be on, where this is a private plan where you pay a certain amount into a pool and that pool is used to cover the hospital and other health-related costs of those in the pool. But health share plans often cap the

the amount of exposure. The one we were on, it was capped at $100,000. And that's one reason I dropped it, because you can quickly generate cost of greater than $100,000 if you get sick. And I've known individuals on these health share plans, because of the adverse selection embedded in the Affordable Care Act, that said, well, if they actually got sick and got cancer, they would just sign up for an affordable care plan where there isn't

And that's one of the challenges with socialized risk, because then the price of the premium isn't based on the actual individual risk.

In the U.S., Medicare, the insurance program for seniors, this is socialized risks. Now, it's muddled because there's all these different aspects of it, and it's incredibly difficult to do well, but it's because the premiums are unaffordable for somebody that's 85 because they get sick. And so the U.S. has chosen to socialize that risk, as have many other countries.

Carolyn Kowski, she's an economist that specializes in risk, the founder of the nonprofit Insurance for Good, says, what we are seeing is a real disconnect. There are opposing views on insurance. Is it a private market good or is it social protection to make sure everyone has the resources to cover from disaster? When we think about socializing risk, it's trying to ensure financial

fairness so that people that can't afford to pay or bear the cost of a disaster, they don't have to. It's shared among everyone. But that can undermine personal accountability. Greg Ip writes, socializing risk weakens one of the main benefits of insurance, encouraging the insured to mitigate their risk so as to reduce premiums. Without that price signal, it usually takes direct intervention to modify behavior. And he gives the example of the

the banks that took way too much risk during the great financial crisis. The government came in and bailed them out. And then the government passed more stringent capital rules where banks had to have much less leverage and more capital or more of a buffer in case of losses. Now, there's always pressure to reduce that. Did the government overstep?

In California, we've seen the private insurers drop thousands of homeowners from their policies. And in their case, in the case of California and other states, those they can't afford or get homeowners insurance will often go to what are known as residual market plans. This is insurance offered by the state. California is called the California Fairgrounds.

Fair Plan. There's the Florida Citizens Plan. There's the Louisiana Citizens Plan. The growth in these plans over five years or so has been 200 to 400 percent compound annual growth. As more people have gone into these plans, there are sources of funding to cover the losses. It comes from premiums. It can be assessments. So these state plans will assess the

the private insurers operating in the state, often to cover losses if there's a catastrophic event, such as a wildfire we're seeing, and those losses, if the state doesn't have enough money in the plan, and in the case of California's fair plan, they don't. They have

underwritten almost $500 billion in potential loss exposure, but have only $200 billion in cash and $2.5 billion in reinsurance coverage. And so while the California Fair Plan hasn't said what the potential losses are, it doesn't sound like there's enough money there. And so they will go to the private insurers to recover those funds. And one of the changes is

California's insurance laws that took effect beginning of 2025 is that these private insurers can now go to their customers to recoup the assessments that they're getting from the state plan. They can add to their customers' bills 50% of the first billion dollars of their assessment and 100% for any amounts over the

the billion dollars. So again, this is a type of socialized risk in that the premiums charged for these residual market plans like California Fair weren't high enough. The five-year combined ratio, which again is the losses plus cost for the California Fair plan was about 108%, as we pointed out, but in Louisiana was 414%. So four times as many losses than premiums

In Florida, it was about 200% combined ratio over five years. And so the losses were more than what was being charged. Assessments were made, and that impacts other customers. And the growth in these plans, 400% five-year growth in Louisiana in terms of number of individuals,

joining the plans, again, because in the case of California, private insurers were dropping coverage, canceling policies, not renewing policies, because in their minds, they couldn't charge enough or weren't able to charge enough because of the restrictions. Now that's going to be fixed. We'll see. But this is a huge challenge when it comes to health insurance, when it comes to homeowners insurance. There's an ongoing debate. Who should pay? This article by Greg Ip, it was

It was titled, The World is Getting Riskier, Americans Don't Want to Pay for It. And I don't know what the right answer is in terms of there are negatives to socializing risk, but it's something we're going to, as nations, as peoples, just decide and figure out and try to avoid some of the adverse selection effects of socializing risk, decide

how much should be socialized. And obviously there's other reforms. California has made some reforms to help...

their insurance market. But obviously, there's tort reform trying to reduce legal liability. There's bureaucracies, red tape. It's muddled, but it's real. And I have said for years, if climate change is real, it'll show up in the numbers. It'll show up in premiums for insurance. It'll show up in what those on the front line...

with exposure, including reinsurance companies, what they do because they're the ones with the money at stake. They have skin in the game. And so they're going to make market-based decisions to the extent that they can. And then we as consumers have to make decisions. As these homes in California get rebuilt, what will the standards be to hopefully reduce fire risk in the future as well as earthquake risk?

So it's a constant dance between who should bear the risk and making sure that insurance is fair, market-based to the extent possible. But when the costs get too high to where people just can't afford insurance, how do we structure socializing that risk so other parties have to pay for it? See how that evolves? That's episode 508. Thanks for listening.

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