The Southern California Wildfires and Problems in the Insurance Industry 

Fire damage in the Pacific Palisades. (Photo from Reuters via the Wall Street Journal)

As of January 15, the series of devastating wildfires in Southern California have killed at least 25 people and destroyed billions of dollars’ worth of homes and businesses. Adding to the tragedy is the fact that many homeowners aren’t fully insured against the damage. As a result, they lack the necessary funds to rebuild their homes. Unfortunately for these people, the market for fire insurance in California hasn’t been working well. 

In the United States, regulation of property and casualty insurance occurs at the state level with regulations differing substantially across states. In California, insurance companies face an unusually long regulatory process to receive permission to increase the premiums they charge. The delays in raising premiums have contributed to companies not renewing property insurance policies in some areas, such as those prone to wildfires. In these areas, the payouts the companies expect to make have been higher than the premiums that California regulators have allowed companies to charge policyholders.

The wildfires have ravaged the Pacific Palisades neighborhood of Los Angeles . Although housing prices in the neighborhood are among the highest in the country, an analysis by the Reuters news agency showed that: “Measured against home values, insurance costs are cheaper in the Palisades than in 97% of U.S. postal codes …” For example, the median insurance premium in the Pacific Palisades was “less than residents paid in Glencoe, Illinois, an upscale suburb of Chicago where homes are two-thirds cheaper and the risk of wildfire is minimal.”

Catastrophe modeling is a way of statistically forecasting the probability of events—such as floods or wildfires—occurring that would sharply increase claims by policyholders. Regulations had barred insurance companies from using catastrophe modeling to justify increases in premiums. (State regulators lifted the prohibition on the use of catastrophe modeling shortly before the fires.) These restrictions made it more difficult for companies to charge risk-based premiums, which are based on the probability that a policyholder will file a claim.

Insurance markets can experience adverse selection problems because the people most eager to buy insurance are those with highest probability of requiring an insurance payout. Insurance companies attempt to reduce adverse selection problems by, among other things, charging risk-based premiums. Limiting the ability of insurance companies to charge risk-based premiums increased the adverse selection problems the companies face. To cope with the problem of companies not renewing policies, regulators began requiring companies to renew policies in some Zip codes, particularly those that were in or near areas that had experienced wildfires. This policy further increased adverse selection.

By 2023, some insurers, including State Farm and Allstate—which are two of the largest property insurers in the United States—had decided that they were unlikely to be able cover their costs from offering property insurance policies in California and stopped writing policies in the state. Policyholders who are unable to obtain a policy from a private insurance company typically buy a policy offered through the Fair Access to Insurance Requirements (FAIR) Plan. The FAIR Plan is sponsored by the state government, although operated by private insurance companies. The premiums charged for a FAIR Plan policy are significantly higher than the premiums charged for a traditional policy. Despite the higher premiums, the number of FAIR Plan policies doubled between 2020 and 2025, reaching nearly 500,000. 

The FAIR Plan lacks sufficient funds to pay the claims from policyholders who had lost their homes or businesses in the Southern California wildfires. To cover the deficit, the FAIR Plan will assess private insurance companies, who, in turn, will raise premiums charged to their other policyholders. In this way, some of the costs from the wildfires will be borne by all property insurance policyholders in California, even if they live far from the areas affected by the wildfires.

We discuss moral hazard in insurance markets in Microeconomics and Economics, Chapter 7 (and in Money, Banking, and the Financial System, Chapter 11). In general, moral hazard refers to actions people take after they have entered into a transaction that make the other party to the transaction worse off. Moral hazard in insurance markets occurs when people change their behavior after becoming insured. The way that the insurance market is regulated in California and, in particular, the way that the FAIR Plan is administered increases moral hazard because people who own homes or businesses in areas with a greater risk of damage from wildfires don’t pay premiums that fully reflect that greater risk. In other words, more people live in fire prone areas in California than would do so if the premiums on their insurance policies fully reflected the probability of their making a claim.

Whether, following the wildfires, the California legislature will change the regulations governing the insurance market is unclear at this point. As an insurance agent quoted by the Wall Street Journal put it: “We are in uncharted territory.”