Why are insurers leaving California?

 Several insurers have decided to stop insuring property in California. The reason given is fire risk. Is this plausible?

 Roughly, insurance replaces an uncertain and potentially large loss with an insurance premium that approximates the expected loss. That makes sense for risk averse people, for whom losses hurt more than gains feel good – no matter the magnitude of the risk. It also makes sense for an insurer if it can charge a little more than the expected loss and sell enough insurance so that its losses approximate the expected loss.

 So, why would insurers want to leave California? Here are some possible reasons and perspectives.

 1.      There are not enough independent risks to insure for the insurer to be confident that its average loss will approximate the expected loss.

 There are probably enough risks to insure in California, even though fires can cover large areas – after all, not much of California burns every year. Moreover, California fires can be lumped in with, for example, nationwide fires, making possible more accurate risk computations.

 2.      The insurer does not know the expected loss.

 The true expected loss is unknown. It can be approximated if there are enough past events of the same nature so that their frequency distribution can be taken as a good indication of their true probability distribution. This may not be true.

Changes in government regulations and policy, and where property is developed can muddy the future in relation to the past.

 The expected loss is computed from a sample of relevant events.

relevant” may not be “relevant” if the properties actually insured are not a random sample from the same population of events. Consider what might happen once the insurer sets its premium. Property owners who have a reason to think that their expected loss materially exceeds (is materially less than) the insurer’s estimate will buy (not buy) insurance. This gaming of insurers by buyers can cause insurers to lose money.

 3.      The insurer is not able to charge the expected loss plus a premium.

 Governments often regulate insurers in a way that prevents them from setting premiums high enough to be profitable.