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Inside in Full: State Farm: The end of California Dreamin’

Last week in America, President Joe Biden and Speaker of the House Kevin McCarthy managed to find some common ground for the greater good of the economy and agreed to a deal on the debt ceiling.

The agreement came after weeks of back and forth, with both parties hesitant to give ground.

A similar struggle is playing out in California, where the state government and insurance companies cannot find common ground concerning the best course for the marketplace.

On May 26, State Farm announced a halt on new homeowners’ business (among other lines) in California. As P&C analysts, the reasons the company gave for the moratorium came as no surprise to us: cat risk, inflation, reinsurance costs and an antiquated rate approval mechanism.

Before we get to State Farm and the implications of the announcement, it makes sense to revisit how we got here in the first place.

In 1988, California voters approved Proposition 103, intended to alleviate the premium increases in the state borne by common citizens. Apart from rolling back rates by 20% at that time, this proposition also created an intervenor process that required “prior approval” for rate filings.

In any capitalist enterprise, state intervention can lead to problems, including causing companies to find ingenious ways to limit coverage through language, or slow walking top-line growth. This, in turn, can cause issues such as allowing lower-quality companies to grow, letting business overflow into backstops or even, ultimately, stopping new business.

Unfortunately, our decades of experience watching this market tell us that this boils down to an attempt to score political points by framing consumers and insurance companies as an “us vs. them” situation.

As a result, we have often seen state regulators parlay their time and effort at these bodies into launching pads for political careers. Maybe the intent of Prop 103 genuinely was to alleviate the burden on policyholders, but over the years this attempt to keep a lid on the appropriate rates has weakened the marketplace as it impacts the ability to achieve true rate adequacy.

This brings us to State Farm’s decision, which likely was the culmination of a combination of internal and external forces at play.

Firstly, as our note will show, State Farm’s recent results in the state have been more volatile than the long-term trend, which begs the question of what other trends are in play. It is worth noting that State Farm is the California’s largest homeowners’ provider, so it was particularly exposed to this market.

Secondly, as we have seen over the past few years, an uptick in catastrophe and non-catastrophe losses has been plaguing the industry. This also includes an increase in the frequency of wildfires and severe weather storms throwing a wrench into mid- and long-term planning for insurers.

Lastly, can the industry course-correct with rate filings? Our analysis will show that getting these approvals can often be a drawn-out process fraught with uncertainty. The best course is often to stop writing business, as we have seen with State Farm.

Moving back to the bigger picture and the potential implications for the market, when the largest player talks about a pause in new business, it will likely have a domino effect, and embolden others to take similar steps.

Will it fix the marketplace? It’s too early to tell. We have seen a different variation of state intervention play out in Florida, where the biggest carriers left only to be replaced by smaller companies with shakier balance sheets.

Below, we cover these points in greater detail:

 

Firstly, State Farm’s California results have been volatile vs. rest of the country.

As mentioned in recent previous notes, personal lines have been under extreme pressure, manifesting in historically bad results. Personal auto has been the bigger driver of the poor performance over the past two years or so, but homeowners’ insurers have been dealing with increasing catastrophe and non-catastrophe weather losses too.

Although 2017 can be seen as an outlier for California homeowners’ results, the historically bad year was relatively recent, and is likely still on the minds of State Farm and other California homeowners’ insurers and, consequently, their reinsurers. Since then, unease over whether the industry is pricing correctly for cat risk has only amplified.

The chart below shows State Farm’s California results vs. their overall US book from 2000 to 2022. The 2017 spike was from the Tubbs Fire and other losses. Results in subsequent years were also under pressure but recall, the company won a multibillion subrogation settlement against PG&E in 2019.

  

As State Farm’s California loss ratio picked up (while the company’s overall US book trended down), the company, as you would expect, was filing for sizeable rate increases.

The following table shows two pending California homeowners’ filings from State Farm, with significant overall rate changes, aiming to increase written premium by more than $700mn on the current book.

 

  

On the reinsurance front, our news team covered some of the changes coming out at the 6.1 renewals where the market appeared to be holding the line.

As Insurance Insider reported back in September, State Farm was aiming to purchase $1bn more in reinsurance limit at its June renewal, to account for increased loss costs and inflation.

It is not clear whether it secured that extra limit, given the contraction in reinsurance capacity since September. But regardless, with continued reinsurance rate hardening, State Farm will have been faced with worse economics vs. paying out more for protection but unable to pass this through to insureds due to the regulatory environment.

 

Secondly, California is getting riskier to insure as frequency/severity ticks up.

Inflation and wildfire events in California are increasing in frequency and severity, leading insurers to attempt to raise rates and, in the case of State Farm, even pause new business to maintain financial strength.

If we examine wildfires, we see the spikes in 2017 and 2018 which largely drove the loss ratios shown above. The following chart shows the number of wildfires along with the number of structures destroyed in California from 2016 to May of this year, demonstrating persistent volatility.

It’s too early to blame climate change, weather patterns, shifts in residential patterns or poor risk selection in the short term. But longer-term, this is turning out to be a concern, making it difficult to trust prior underwriting trends when setting pricing.

  

State Farm also cited spiking construction costs as a reason for the company’s halt of new policies. One of the issues after every loss is the challenge of demand surge, which drives up reconstruction costs and, in turn, the severity of the loss.

The chart below shows the impact of demand surge using the construction backlog indicator (CBI) as a proxy. So, for example, after the 2017 California wildfires, there were two months of additional time for reconstruction, whereas the rest of the country only saw an increase of 0.2 months.

  

 

The impact of wildfires prolonged the time it would take contractors to finish reconstruction, and hence will have meaningfully extended the cost vs. projections made at the time of writing these policies.

If insurers are unable to adjust pricing to reflect the near-term shifts, pausing new business is logical.

 

Thirdly, California’s regulatory approach has been exacerbating problems for a long time.

Ideally, insurance regulators are playing referee and providing accountability to both insurers and insureds. However, as we have seen in a few states, insurance regulation can become quite political, with insurers and insureds paying the price for politically fueled decision making.

When looking at the rate approvals for departments of insurance across the country vs. California, we see major volatility in rate approvals.

  

  

As we see above, the steady rate-taking seen across the country is in stark contrast with the tumultuous ups and downs coming out of the California Department of Insurance.

California’s regulators also impede the insurance market with an extremely slow pace of rate approval. And remember from the Prop 103 discussion above, California is a prior-approval state, already prone to slowness.

The chart below shows the top 25 homeowners’ states by direct premium written. For each state, the height of the vertical bar indicates the average number of days the regulator takes to approve a rate filing.

The bars are also color-coded to specify that state’s filing process. The most insurer-friendly are the purple bars, which are “use and file” states. The yellow bars indicate “file and use”, and the gray bars are states which require “prior approval”. (In our chart, “other” means that state offers a mix of flexible rating, prior approval, and file and use). Lastly, the teal points indicate the overall rate change level of that state over the past 15 years.

  

 

In addition to having one of the longest regulatory turn-around periods and one of the lowest rate approval levels, California is also in the bottom four states for number of approved filings in the past 15 years.

This unique combination of a low number of approved filings, extensive lag in enacting rate changes and an overall low level of rate increase approved likely contributed to State Farm’s decision to push the pause button, and increased the likelihood of similar actions by the industry.

 

In summary, State Farm’s halting of new business in California might prove to be the canary in the coal mine for the P&C industry in the state. State Farm is the California’s largest homeowners’ provider, so it was particularly exposed to this difficult market. However, the company’s moratorium on new business has also been the product of long-term regulatory problems combined with more medium-term market conditions such as increasing frequency of wildfire losses, inflation spikes in construction costs and a hard reinsurance market.

 

 

Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C. 

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