The Insurance Apocalypse

Fire, money, and who gets burned.

On the Secret pod today Sarah and I talked about loneliness and technology and isolation and modern life—it’s off-topic, but interesting.

The show is here. Only for members of Bulwark+.

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A tree remains intact on January 8, 2025 in the Pacific Palisades community of Los Angeles. (Jay L. Clendenin/Getty Images)

1. The Fires

The Los Angeles fires are terrible, obviously. And the median political discourse about them is beyond depressing.

So I want to take a beat to talk about one of the non-obvious, systemic reasons we got to this point, a subject absolutely no one will be interested in: insurance.

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When California is finally able to start rebuilding from this disaster, it will probably require a wholesale reinvention of its current approach to property insurance. Here’s Noah Smith explaining the state’s recent evolution:

In 1988, California voters passed a ballot proposition called Proposition 103, which says that if insurers want to raise their premiums, they have to get the raise approved by the government first. This means that if premiums go up, California voters will blame the insurance commissioner, who is democratically elected. So naturally, the commissioner tries to keep voters happy by forbidding insurance companies from charging higher premiums. In recent years, insurance companies have been begging California Insurance Commissioner Ricardo Lara to let them charge higher premiums in order to account for the increased risk of large fires, and for the reinsurance premiums they now have to pay. But Lara forbid them from doing so.

What happened? Predictably, the insurance companies couldn’t afford to insure a lot of the people they used to insure. So insurers like State Farm started dropping tons of people in high-risk areas, including lots of the people who lived in the Pacific Palisades neighborhood of Los Angeles—which just burned to the ground.

California’s solution to this problem was to cover uninsurable people with a state plan called FAIR. FAIR can pay for big claims—like the ones about to come out of the L.A. fires—by charging insurance companies a surcharge based on their market share in the state of California. But this creates an incentive for insurers to just leave California entirely—or shrink their coverage in the state by a lot—in order to avoid getting charged by FAIR when there’s a huge disaster. So California homes are becoming increasingly uninsurable.

This fire is going to stress-test FAIR. In order for the program to pass the test, it will have to (a) raise enough money to pay for the claims and (b) not burden insurance companies to such a degree that more of them leave the state. Because every time an insurer pulls out, it makes FAIR more vulnerable down the line.

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Everyone hates insurance because it’s like betting on the Don’t Pass line. Insurance is, at heart, speculating about terrible things happening to people.¹

The inherent weakness in the system is scale: The bigger the pool of insurees, the more stable the system—but also, the less efficient. The smaller the risk pool, the more efficient the system can be—but also more vulnerable to tipping over following a catastrophic event.

Massaging these weaknesses is the business of the government. Government sets rules for insurers. These rules are meant to protect both the customers and the businesses by making sure that the people paying into the system are getting what they pay for and making sure that the insurer holds enough assets to meet its potential obligations.

As you might imagine: Such regulation is a highly imprecise business. It is impossible for anyone to completely understand the risk environment; events do not always conform to actuarial probabilities; and the process of regulation itself is subject to all manner of externalities.²

One of the ways individual insurers typically mitigate their own risk is by purchasing reinsurance.

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Reinsurance is exactly what it sounds like: Let’s say you are a customer-facing insurance company like State Farm. You sell insurance policies to individual customers. But State Farm then turns around and buys insurance policies for itself from a larger reinsurer, such as Lloyd’s of London.

But even reinsurance can only cover so much loss. If a catastrophe is big enough, it can leave the front-line insurer exposed to failure.

One way to think about the modern history of the insurance industry is as an attempt to create enough financial instruments to extend the umbrella of reinsurance so that a catastrophe has to be really large in order to kill a front-line insurer.

One of these instruments is the Catastrophe Bond.

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The Catastrophe bond market (CAT) emerged after Hurricane Andrew in 1992. At the time, Andrew was the most expensive hurricane in U.S. history. The extent of the damage was so great that it toppled eight insurance companies.³

In the wake of Andrew, insurers realized that they needed to find a way to get more capital into the hands of reinsurers. So they created the CAT: A bond that pays out when disaster strikes:

A CAT bond is a security that pays the issuer when a predefined disaster risk is realized, such as a hurricane causing $500 million in insured losses or an earthquake reaching a magnitude of 7.0 (on the Richter scale). The first CAT bonds were issued in 1997, giving insurers access to broader financial markets and offering institutional investors, such as hedge funds, pension funds, and mutual funds, the opportunity to earn an attractive return on investment uncorrelated with the returns of other financial market instruments in exchange for assuming catastrophe insurance risks.

The CAT is a complicated instrument but it serves a very simple purpose: Expanding the risk pool. By giving more actors exposure to the insurance market the CAT spreads out the risk, thus adding more money to the insurance pool, and, finally, making insurance companies more resilient following disasters.

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2. Socialism?

By now you can probably see what’s going on.

We’ve been talking about private insurance, but what private insurers have been trying to do is build a system to mimic social insurance.

Social insurance is what you have when the risk pool is everybody.⁴

At the level of social insurance, the government mandates that everyone under its authority participates in the market, which usually means that the government itself becomes at least the insurer of last resort. (And sometimes becomes the front-line insurer, too.)

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What’s weird here is that in most industrialized societies, private insurance is de facto social insurance, even if everyone pretends otherwise.

For instance, when Japan was rocked by the 2011 earthquake, the front-line insurers had reinsurance policies—but . . .

About 90 percent of the property and casualty business in Japan is written by three big domestic insurance groups, the MS&AD Insurance Group, the Tokio Marine Group and the NKSJ Group.

The Japanese insurers jointly own a reinsurer, the Japan Earthquake Reinsurance Company, which in turn is backstopped by the Japanese government.

This hybrid approach tries to get the efficiency benefits of a private insurance market while retaining the resiliency of social insurance. Which sounds nice, except that you can imagine how murky, complex, and vulnerable to corruption these arrangements can be.

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There aren’t any easy lessons here. Insurance isn’t a typical good/service. It functions according to incentives and externalities that are peculiar. It has to be highly regulated—but the business is always a moving target and even the best, smartest regulatory environment may result in failures from time to time.

At the end of the day, my own view is that at scale, all insurance eventually winds up as social insurance.

I assume that’s what will happen in Los Angeles. Private insurers will pay what they can but they will not be made whole by their reinsurance—the scale of the destruction is just too big. The private insurers will also get hit by FAIR levies. Maybe some of these insurance companies will fail. Maybe FAIR itself will fail.

At the end of the day, both the state and federal government will come in and backstop the system. Because that’s what government does.

Afterwards, we’ll try to come up with a new regime that balances efficiency with stability. This new regime might be better, or it might be worse. And eventually it, too, will fail and need to be backstopped.

Because that’s the entire nature of insurance. There are no solutions; only temporary fixes.

I understand that this is depressing. We want to believe that there’s some platonic ideal of policy by which, if we just did X, Y, and Z, then we wouldn’t have these problems. But the world is messy; life is messy. And as Walter Sobchak once said, “We live in a society.”

Which means that we rarely “solve” our challenges. We just muddle through them, together.

You can give to World Central Kitchen here.

Or the American Red Cross here.

Sonny also recommends the Global Empowerment Mission and the California Community Foundation.

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3. The Santa Ana

I haven’t been able to get Joan Didion’s essay about the wind out of my head.

The Santa Ana, which is named for one of the canyons it rushers through, is foehn wind, like the foehn of Austria and Switzerland and the hamsin of Israel. There are a number of persistent malevolent winds, perhaps the best know of which are the mistral of France and the Mediterranean sirocco, but a foehn wind has distinct characteristics: it occurs on the leeward slope of a mountain range and, although the air begins as a cold mass, it is warmed as it comes down the mountain and appears finally as a hot dry wind. Whenever and wherever foehn blows, doctors hear about headaches and nausea and allergies, about “nervousness,” about “depression.”. . .

It is hard for people who have not lived in Los Angeles to realize how radically the Santa Ana figures in the local imagination. The city burning is Los Angeles’s deepest image of itself. Nathaniel West perceived that, in The Day of the Locust, and at the time of the 1965 Watts riots what struck the imagination most indelibly were the fires. For days one could drive the Harbor Freeway and see the city on fire, just as we had always known it would be in the end. Los Angeles weather is the weather of catastrophe, of apocalypse, and, just as the reliably long and bitter winters of New England determine the way life is lived there, so the violence and the unpredictability of the Santa Ana affect the entire quality of life in Los Angeles, accentuate its impermanence, its unreliability. The winds shows us how close to the edge we are.

Read the whole thing. I miss living in a world with Didion’s voice. Part of me wishes she was here to write about these fires and help us process the tragedy. Another part of me is glad that she did not have to witness it.

1. That’s actually the origin of the industry: Men sitting around a London coffee shop betting on which ships would be lost at sea. This betting market eventually became an insurance market.

2. Like politics.

3. Remember: The fewer insurance companies there are, the more unstable the market becomes.

4. Or at least everybody within a defined boundary of governance, i.e., a state or a nation.