How To Fix California's Self-Inflicted Homeowner's Insurance Crisis

A recent policy report points to much-needed market-based reforms.

According to a recent news story, California's raging home insurance woes are a result of climate change. That's certainly true if the climate we're talking about is the state's regulatory climate. Like many of California's problems, the insurance crisis is a self-inflicted wound—in this case, one suffered when residents and regulators turned a once-competitive market for insurance into a command economy in which insurers are increasingly unwilling to operate. Fortunately, the market for home insurance can be improved if Californians are willing to address their (regulatory) climate problems.

A Self-Inflicted Insurance Crisis

"Just months after fires devastated parts of Los Angeles, one of the leading home insurers in California, State Farm, is temporarily raising rates 17 percent," The New York Times' David Gelles wrote May 15. He cited this rate hike, which follows on an even larger one last year, as "just the latest example of the indirect but increasingly costly ways that climate change is affecting the American economy."

But the "insurance crisis" that Gelles points to in California and sees "spreading across the country" isn't just the result of temperature fluctuations or shifts in humidity. It's a foreseeable outcome of state residents voting themselves discounts at the expense of insurance companies, and of politicians catering to the public's desire to pay what they want rather than market rates.

"This insurance market crisis is downstream of California's cumbersome, voter-approved insurance regulations that limit the ability of insurers to raise rates to cope with increased wildfire risks," Reason's Christian Britschgi noted in February after the Los Angeles wildfires made a bad situation even worse.

In 1988, Californians passed Proposition 103 which, according to the state's summary of the measure, "required that every insurer reduce its rates to at least 20% less than the rates that were in effect on November 8, 1987 unless such rollback would lead to a company's insolvency." The California Supreme Court modified this to allow for what state officials considered "a fair rate of return," but there are more voters paying premiums than working for insurance companies, with predictable results.

The Problem With Voting Yourself Discounts at Others' Expense

According to a 2023 paper from the International Center for Law and Economics, as of 2020, despite sky-high property values and well-known wildfire risks, Californians "paid an annual average of $1,285 in homeowners insurance premiums across all policy types—less than the national average of $1,319." When insurers need to raise rates to reflect risks and costs, they can only do so after extended hearings and a government review process designed to please voters, not to reflect economic reality. Unsurprisingly, well before the Los Angeles fires, insurers were limiting coverage and leaving the state.

Even Insurance Commissioner Ricardo Lara admits insurers "don't have to be here, and when we try to overregulate, we'll see what happened after the Northridge earthquake, when the legislature came in and tried to overregulate, and they no longer write earthquake insurance in California."

To avoid further destroying the market for insurance, California needs regulatory reform. To get reform, more state officials and residents will have to admit that they created the problem.

Unleash the Market To Address Risk

"The root cause of California's current crisis lies in a combination of increasingly destructive wildfires and a regulatory framework that is both inefficient and inadequate in addressing the growing risks," comments the Independent Institute's Kristian Fors in a recent policy report proposing reforms for California's homeowners' insurance market.

Kors points out that a functioning insurance market hedges against low probability but expensive events by spreading the costs across a pool of people paying premiums. The market works best when people are sorted by "risk classes" that more or less reflect different likelihoods that they'll ever collect on that bet over a low-probability event. All else being equal, homeowners living on a well-cleared island in the middle of a lake should probably pay lower premiums than those living amid dry brush.

As mentioned above, California interferes in the market in crowd-pleasing ways, lowering costs for the insured and reducing the chance that insurers will make a profit or even break even if they participate in the market. As Kors notes, "prohibitions on using forward-looking 'catastrophe models' for assessing wildfire risks have further compounded the exposure faced by insurance companies." The state finally backed off that prohibition in December 2024.

Allowing catastrophe modeling is a step in the right direction, according to Kors, "but the prior-approval process still hinders the efficient pricing mechanisms of free markets to operate." That is, California needs to get out of the business of regulating insurance rates and allow the market to operate. "Insurance companies should be able to raise and lower their prices freely, in accordance with changing market conditions, and they should also be free to incorporate any variables associated with risk in their actuarial assessments." To do that, Proposition 103 will have to be repealed.

Bring Reality to Forest Management, and Free Home Construction

The growing severity of wildfires also needs to be addressed through better land management. "One of the most critical errors made by Cal Fire and other agencies was to focus on fire suppression rather than prevention," Kors notes. That will require forest thinning and prescribed burns to reduce the risk of uncontrollable fires. As it is, California committed in 2020 to treating 500,000 acres of forest land per year, but it has only met about a fifth of that goal (the federal government also lags in its land-management obligations).

Kors adds that "a well-functioning insurance market would also minimize wildfire risk by properly incentivizing home hardening and fire mitigation practices." It would also discourage building in high-risk areas without taking steps to reduce fire danger.

While a big part of the reason so many homes are built in high-risk wildland-urban interface (WUI) areas is regulatory restriction on market rates that would reflect risk, Kors adds that the state's expensive restrictions and delays on constructing new homes in desirable areas push settlement into higher-risk areas: "Eliminating the restrictions that prevent housing development would alleviate the pressure that people from all socioeconomic backgrounds, but especially those of lower incomes, experience that push them into fire-prone WUIs." That will require reform not just of insurance rules, but of zoning laws, permitting, urban growth boundaries, and other red tape that obstructs housing construction.

Climate may change and risks can rise and fall, but insurance markets are capable of adjusting—if they're allowed to do so. If Californians want insurance to deal with their wildfire problems, they're going to have to undo a lot of bad policy choices.