The $20 Billion Problem

I am sure that we have all been following the current tragedy going on in Los Angeles with the large fires burning there.  One of my friends in the insurance industry told me that he had heard from someone in the reinsurance business that the total insured losses from these fires will be more than Twenty Billion Dollars.  

So, I have been thinking about how a catastrophe of this magnitude could be financed.  In insurance, everything depends on the pool of risks that are to be covered by the insurance.  Let us consider who should be in this pool.  How about using all the homes in the LA Basin?  This is a pretty big geographic area including all of LA and Orange counties.  There are about 1.39 million homes in the basin.  Certainly, this is a large enough number of  homes for the law of large numbers to work if we had a loss history which would allow an actuary to set rates.  

Suppose these homes are currently paying an average annual premium of $2500 each.  This would produce a total annual premium of $3,475,000.000.  The $2500 premium has been enough in our hypothetical pool to cover all the losses and expenses of running our pool for each of the past 5 years.  

I think that you can begin to see the nature of this problem.  The $20B loss represents 5.45 times the total annual premium the pool has been collecting each year. And, our pool does not have $20B laying around.  So, perhaps we could borrow the money using the future premiums as collateral and increase the premiums enough to pay back the loan.  We would have to double the premiums, plus add another $800 per home to cover the interest for the each of the next 5 years.  So instead of paying $2500 a year, policies would cost $5800 per year.  (Note: this is essentially how catastrophic reinsurance works)

Alternatively, we could perhaps have a special assessment on the pool members and collect the $20B right away.  This would mean an assessment of $14,870 for each home in our pool.  I am not sure that would be well received.

Perhaps we just need a bigger pool.  Maybe we need to have all the homes in CA in our pool rather than just those in the LA Basin….With a larger pool we could spread this loss over a larger number of homes with a lower amount from each home.  Hold on, I hear a voice in the back….yes those NorCal folk are already paying for their own large fire losses from past years.  

So, how do you feel?  Do you want houses in your city to be in a nationwide pool?  Do you want to share losses with folks in Florida, or hail prone states like those in the Midwest and Texas?  Do you want to help pay for fire losses in California?  Or, do you think that this is a California  problem?   Remember, that some day it might be your state on the wrong side of this issue.