California's Sustainable Insurance Strategy: Balancing Innovation with Industry Challenges

In the fall of 2023, California's Department of Insurance unveiled the Sustainable Insurance Strategy, a comprehensive initiative aimed at reforming the state’s insurance market. The impetus for this strategy was driven by a confluence of factors, primarily the increasing frequency and severity of climate change-related disasters in the state and the resulting strain on its insurance market. California, like many other states, has been significantly impacted by climate change, experiencing severe wildfires, prolonged droughts, and extreme weather events such as heatwaves, heavy rainfall, and flooding with greater frequency and intensity. These environmental challenges can cause substantial property damage and economic losses, which are often exacerbated by inflation and rising rebuilding costs. The financial burden on insurance companies to cover these damages is immense, leading to higher premiums and reduced availability of coverage in high-risk areas. Many insurers have stopped providing coverage to California homeowners and businesses altogether. As noted in a recent article by the New York Times, this can have a devasting ripple effect – “Without insurance, banks won’t issue a mortgage; without a mortgage, most people can’t buy a home. With fewer buyers, real estate values are likely to decline, along with property tax revenues, leaving communities with less money for schools, police and other basic services. And without sufficient insurance, people struggle to rebuild after disasters.”¹

According to its proponents, California's Sustainable Insurance Strategy will stabilize the insurance market in California by making it more attractive for insurers to return to the market, protect consumers by providing more coverage options, and ensure resilience and sustainability in the face of escalating climate risks.

Key components of the strategy and regulatory reforms include:

• Efforts to streamline and expedite the rate filing process by updating and clarifying what information must initially be included in a complete rate application prior to any rates taking effect, hiring additional Department of Insurance staff to review rate applications and inform regulatory changes, and enacting reforms to increase transparency and public participation in the process.
• Integration of advanced catastrophe models into the rate approval process to better predict and prepare for the impact of climate change. The Department of Insurance unveiled its catastrophe modeling regulation in March of this year. The proposed regulation expands the allowable use of catastrophe models to include wildfire, terrorism, and flood lines for homeowners and commercial insurance lines. Currently, the use of catastrophe models is only permissible for earthquake losses and fire following earthquake. The proposed regulation also provides that any catastrophe model must incorporate “the best available scientific information on risk mitigation at the property, community, and landscape scales, including risk mitigation initiated by local and regional utility companies.”² The stated goal of these proposed changes to the current regulations is to ensure that insurance rates reflect the benefits of investments in wildfire safety and mitigation.
• Changes to the California FAIR Plan, including further expansion of its coverage limits and ensuring that it has sufficient reserves and financial safeguards to prevent bankruptcy during extraordinary catastrophic events. The California FAIR Plan, originally intended as an insurer of last resort, is fast becoming the primary option for many homeowners and businesses in high-risk areas due to the inability to find coverage elsewhere.
• Giving FAIR Plan policyholders who comply with California’s Safer from Wildfires regulation first priority for transition to the traditional insurance market. The Safer from Wildfires regulation, enacted in 2022, mandates that insurers recognize and reward homeowners and businesses for implementing wildfire mitigation measures, such as upgraded roofs, defensible space, and participation in community-wide programs aimed at reducing wildfire risks.
• Mandating that insurers write a minimum of 85% of their statewide market share in high wildfire risk areas. This measure is designed to transfer homeowners and businesses out of the FAIR Plan and into the traditional insurance market.
• Holding public meetings exploring rules that would allow insurance companies to recover the expenses they incur for reinsurance related to their California policies.  This change aims to encourage insurers to re-enter the California market by enabling them to set rates that more accurately reflect the true cost of doing business in the state.

The Department of Insurance is aiming to implement the reforms by December 2024. The Sustainable Insurance Strategy is expected to have a profound impact on the insurance industry in California. In theory, by enhancing climate risk assessment and promoting sustainable practices, insurers will be in a better position to predict and manage their exposure to climate-related risks. Thus, they may be able to offer more innovative and tailored products and services. Furthermore, the emphasis on mitigation and adaptation efforts should help reduce the overall risk of property damage, potentially leading to lower premiums and more affordable coverage for policyholders. Additionally, by expanding coverage under the FAIR Plan, those in high-risk areas will have access to necessary insurance coverage, thereby protecting homeowners and businesses from catastrophic financial losses.

However, the strategy presents significant challenges for insurers. Among other things, insurers must invest in new technologies and practices to be able to predict climate-related risks more accurately and comply with the enhanced reporting requirements. They will also need to ensure that their models and practices comply with eventual new regulations and potentially face legal challenges to their interpretation of those regulations. One of the biggest challenges is the financial feasibility of the requirement that insurers write a significant portion of their statewide market share in high wildfire-risk areas.

California's Sustainable Insurance Strategy has been recognized as a necessary and ambitious attempt to address the insurance crisis in California and may prove to be a model for other states facing similar challenges. For now, however, the impact and effectiveness of the proposed measures, and whether they will lead to a competitive admitted market remains to be seen.

¹ Christopher Flavelle, Mira Rojanasakul, As Insurers Around the U.S. Bleed Cash From Climate Shocks, Homeowners Lose, New York Times, May 13, 2024.
² Draft text of catastrophe modeling regulation. See https://www.insurance.ca.gov/0400-news/0100-press-releases/2024/release011-2024.cfm#:~:text=The%20proposed%20regulation%20expands%20the,passed%20by%20voters%20in%201988.