Executive Summary

• Insurance of last resort is a program meant to cover individuals living in high-risk areas prone to natural disasters. 
• These programs are meant to supplement the private market, but overregulation of the private insurance market has prompted them to grow at an unsustainable rate.
• Many insurers of last resort are bleeding money at both the state and federal level from the combination of actuarily unsound premiums and a heightened number of policies in force (PIF). 

Introduction

The purpose of insurance is to mitigate the risks of a probable loss for consumers. Some consumers are inherently riskier to insure than others simply based off where they choose to live. This causes many property and casualty (P&C) insurers to demand higher rates or forego plans completely. In the instance a consumer cannot obtain a plan by a private company, many states have created programs called insurance of last resort. 

Insurers of last resort are a part of the residual insurance market and meant to supplement available private insurance. The purpose of these programs is to provide insurance directly to the consumer. These plans are not meant to be long term solutions, as prices are typically higher than the competitive rate. Insurers of last resort require a consumer be denied coverage by a private insurer to qualify for the state-backed coverage. In most cases this type of insurance is to protect against natural disasters like floods, hurricanes, wildfires, and convective storms. Currently, 32 states have an insurance of last resort program. 

Insurers of last resort run by government entities have historically underpriced the risk associated with certain properties. Many states are also developing communities in higher risk areas or neglecting preventative maintenance, causing private insurers to deny coverage to individual property owners. This has increased policies in force (PIF) of state backed insurers past the socially optimal point. Overdevelopment, along with undervaluing risk and an increased prevalence of natural disasters has forced state backed insurers of last resort to have massive debt. 

A California Case Study

California remains the most prominent state backed insurer, especially in the wake of the tragic Palisades fire. Their program is entitled the Fair Access to Insurance Requirement (FAIR), and to qualify for the program a property owner must show proof of being denied coverage by a private insurer. California’s PIF has almost tripled in the last five years, from 160 thousand to 450 thousand. This comes in the wake of insurance regulations inside the state. California imposed Proposition 103 in 1988 which required a hearing and prior approval for insurance companies to change premium rates inside the state. This caused an asymmetry in the pricing market, disallowing insurance companies to appropriately respond to changes in risk inside the state. Slowing down the approval process only hurt consumers. By promoting artificially deflated premiums, California understated the risk associated properties. Insurance companies had less incentive to operate inside of the state because of the potential for greater losses. The unfavorable regulatory conditions and higher risk caused many companies to stop providing new plans or leave the state all together. Lower premiums are good for the consumer in the short term, but in years with a catastrophe event companies struggle to pay the entirety of claims made.

Source: Key Statistics and Data – The California FAIR Plan

That was not the only regulatory hurdle. California did not allow insurance companies to consider the costs of reinsurance as a ratemaking factor for consumer premiums. Reinsurance is insurance for insurers: The ability to purchase reinsurance gives insurance companies the power to expand into riskier markets. It also allows them to maintain profitability in the instance of a major climactic event. This is because the overall risk and cost burden is not concentrated on one company or in one geography. The inability to factor in reinsurance rates into premiums kept them at an actuarily unsound, lower rate as well. Economic theory suggests capping the price of insurance rates below the competitive rate creates an artificial shortage in the market. 

The state of regulation in California is what has driven many consumers to the state-backed plan. The FAIR plan is funded through private insurers. Insurers in the state of California pay into the FAIR program based on percentage of market share. It is evident that the funding of this program has decreased as well because of tighter regulations forcing private insurers to leave. This has left the state of California with a higher burden. In the most recent year records were available, the FAIR plan posted a year end loss of $330 million and a liabilities to liquid asset ratio of 276 percent. Similar programs in Texas, Louisiana, and North Carolina had an average ratio of only 76 percent. The FAIR plan is bleeding millions of dollars a year because of an overregulated insurance market. 

Hopeful Reforms

As of late 2024, California’s Department of Insurance (CDI) has implemented a Sustainable Insurance Strategy (SIS). This is an attempt to right the wrongs of the previous decades and incentivize insurance companies to reenter the California market. Although not touching Proposition 103, the SIS now allows for the cost of reinsurance to be a ratemaking factor. This would allow insurance companies to accurately price their risk through premiums. It is likely that premiums will increase in high-risk areas because they now account for potential risk more precisely. It also promises to streamline the approval process, which would allow for more complete information for consumers to make rational decisions in the insurance market. The SIS shows promising first steps for reform in the state of California. 

An Unfortunate Reality

Economic and environmental trends have also contributed to rising insurance costs. Underwriters at insurance companies have kept a watchful eye on climate news. The reality is there has been an increase in damages related to climate events since the start of the 21^st century. Rapid inflation in the cost of building supplies has made construction and repair costs skyrocket. Also, many communities are overexposed to risks because they are developed in high climate activity areas or lack preventative maintenance plans required to reduce risks. Insurance costs in these areas will always be higher, but insurance premiums across the board will increase because of high building costs and overdevelopment. This is a grim but true reality homeowners need to account for when moving to new locations. 

Reminiscent of the NFIP?

The National Flood Insurance Program (NFIP) is supposed to be an insurer of last resort but has morphed into a widely used program that sits at $20.5 Billion in debt. AAF’s Thomas Kingsley has written extensively on this topic, and his most recent arguments can be found here. The NFIP is not used for its original purposes, which was to be an insurer of last resort for flooding. The same is happening to the California FAIR but with wildfires. What was meant to be a part of the residual market is now a major provider. The NFIP uses outdated methods and is not priced at the true risk rate. The FAIR plan undertakes the burden of the regulatory consequences inside the state. Both government plans cannot fully support their constituents in the event of a natural disaster. It is evident that government entities cannot operate insurance as effectively as private markets can. 

Conclusion

Insurers of last resort meant for the residual market have evolved because of an overreach into the private market. Private premiums have been artificially suppressed which has caused insurance companies to stop administering programs or leave states completely. States with these programs are now stuck with the financial burden of paying claims greater than their premiums. Since state backed programs don’t have the financial leverages of private companies, the debt is then transferred to the consumer. State backed insurance programs along with tight regulations, while having good intentions, do not allow for the private insurance markets to function properly. This inefficiency ultimately burdens taxpayers and distorts market incentives. States should promote the efficiency of the free market to achieve a competitive and reasonably priced insurance market.