According to news reports, the estimated insured losses from the recent California wildfires stand at $1.6 billion. While the final number won't be known for some time, dynamics in California homeowners insurance will affect the final loss total. What issues are likely to arise as claims are filed during the next several months?

Q: Do California homeowners have the appropriate amount of coverage to protect themselves adequately from these wildfires?

Anderson: Typically, insurance companies use a tool or an application developed by a third-party vendor to estimate the replacement cost of a dwelling. The insurer often provides this estimate to policyholders to help them select an appropriate amount of coverage on their insurance policies. Following the California fires in 2003 there were a number of insurance-to-value issues. The amount of coverage selected by policyholders had not kept pace with the increase in home values, especially on policies that were 10 or more years old. In some cases, the disparity between coverage and actual losses was a big problem. As the claims are settled on the 2007 wildfires, we'll see if policyholders and insurers have made the necessary corrections. In 2003, some of the tools insurers used to help policyholders estimate replacement costs were exposed as being outdated. Since then, companies have updated these tools, especially in California where the home values increase so much.

Meanwhile, there have also been attempts to improve the quality of the inspection process, with inspectors looking out for fire hazards such as brush buildup around homes. Additionally, there has been an increase in the number of inspections, with insurers making a more concerted effort not only to inspect new business but also to perform regularly scheduled inspections as policies are renewed.

Chernick: An inflation cost index also helps keep replacement costs in line. Most companies buy an index like this every year and receive an indicated cost increase by ZIP code. The coverage amount in the homeowner's policy is automatically increased based on that index. As long as policyholders and insurers correctly estimate the replacement cost when the policy is first written, the cost index will reduce future insurance-to-value issues.

Ultimately, though, it is the burden of the insured to review their policy declarations page and make sure they have sufficient coverage. A lot of insurers are clearly spelling out the replacement cost and posing the question of whether there is sufficient insurance. This is an especially important question for homeowners who have remodeled or made additions to their homes. If they didn't update their policies at that time, they may be out of luck.

Anderson: There's one other factor to consider when it comes to replacement costs after a catastrophic event. When there are a large number of homes that are all in need of repair or rebuilding at the same time, it creates a demand surge, which can drive up the cost of materials and labor. Because demand surge usually only occurs after infrequent catastrophes, it is difficult and uncommon to account for demand surge when estimating the replacement cost.

Chernick: It's also worth mentioning that the replacement cost does not equal the total market value of the property. It is only the cost of rebuilding the structure that is insured—it does not include the value of the land. This can be confusing, especially in California, where the cost of land is high.

Q: How will insurers respond to evacuee claims for additional living expenses?

Anderson: In 2005, as Hurricane Rita was headed for Houston, millions of people that were potentially in harm's way evacuated the city. Then the storm shifted course and made landfall about 65 miles east of Houston. Many who evacuated but ended up with no damage to their homes filed claims for additional living expenses, which typically cover increased living costs as a claimant rebuilds. There were several instances of contention over the validity of these claims as some companies did not envision reimbursing evacuee expenses under the provision for additional living expenses.

There's a similar situation brewing with the Southern California fires, since more than half a million people evacuated and, to date, fewer than 2,000 homes were actually destroyed. While it is unclear what will happen for evacuees in California, it seems likely that many companies will cover evacuation expenses for policyholders, as most companies ended up doing after Hurricane Rita.

Longer-term, insurers may look to adopt endorsements similar to what Texas did after Rita. These endorsements specifically provide coverage for mandatory evacuations and fill what previously was a coverage gap. These endorsements can more accurately reflect the difference in risk geographically.

An additional complicating detail goes back to determining what a reasonable expense is. Most policies allow for increased expenses needed to maintain the same standard of living. But what happens when receipts come in from the Ritz Carlton? On the one hand, those kinds of expenses may seem extravagant. But what about someone who was living in a multimillion-dollar home? How is the potential for a demand surge (and a subsequent shortage in hotels) figured into this reimbursement? It's a tricky issue.

Q: In addition to evacuation-related claims, what other types of issues may arise as claims are settled?

Chernick: Many of the homeowner claims will be total losses. Now you would think that a total loss is fairly easy to settle and to adjust, but that is not the case. There's huge potential for fraud on the contents of homes that suffer total losses, because the contents are completely destroyed. The insurance company and the insured have to agree on what was in the house, and then put a value on it. After the Oakland Hills fire in 1991, certain claims for the contents of total-loss homes were quite exaggerated. The insurance companies knew they were exaggerated but it was hard to prove that the insured didn't have those types of contents. The potential for trouble is compounded when you put nonlicensed adjusters in the mix, as has already been announced in California following the recent wildfires.

Q: How will the wildfires affect insurers' future decisions on where to write policies?

Anderson: An estimated 80% of insured losses are expected to occur from the Witch Creek fire. That particular fire burned beyond historical bounds and went into Rancho Bernardo and Rancho Santa Fe. Because of the concentrated damage of the Witch Creek fire, insurance companies may re-evaluate their risk concentration. It's very tempting for agents, when they see a new subdivision being built, to try to sell homeowners policies to half the subdivision. That might not be the best thing to do. After these 2007 wildfires insurers may look to re-underwrite their books to ensure that their exposure and their risk are appropriately spread out in these wildfire-prone areas.

Chernick: Based on the current estimate of $1.6 billion in losses, if a company writes 10% of the market, it will see $160 million in losses. But if for some reason one company wrote a whole subdivision or wrote the majority of risks in certain areas, it could end up with a disproportionate share of the total losses, maybe even as great as $1 billion. That is the kind of impact that most companies can't afford. The lesson for insurers is to watch their concentration levels and avoid this situation.

Q: Will these wildfires result in additional reinsurance costs that may be passed on to consumers?

Anderson: I'm not aware of too many companies that buy reinsurance to specifically cover wildfires. The risk from wildfires is different than the risk from earthquakes and hurricanes. The potential size of losses from earthquakes and hurricanes is greater, which makes them more of a threat to a company's solvency and overall financial viability. While wildfires can be devastating, they generally don't have the same effect on an insurer’s bottom line.

Chernick: Plus, California regulations prohibit insurers from including the additional cost of reinsurance, above and beyond the expected value of loss, in their premiums, except with regard to earthquake coverage and medical malpractice. The reinsurance cost would essentially represent the reinsurers' risk and profit charges. Compare that to Florida, which has a statutory provision that allows the cost of reinsurance to be part of the ratemaking formula.

Especially for areas that are prone to hurricanes and earthquakes, when a company concentrates risk in a natural catastrophe area, it exposes an awful lot of capital to potential loss. From an economic point of view, that company should be allowed to price for the risk of exposing that capital, and for the price of backing up that capital with reinsurance.

Q: Should homeowners expect to see their premiums increase as a result of these wildfires?

Anderson: California is a huge state and the overall homeowners premium volume is substantial. In 2004, 2005, and 2006 the industry netted more than $2.5 billion in homeowners profits each year after paying out losses and expenses. It would appear that the industry could absorb $1.6 billion in losses for this year's wildfires and still end up with an underwriting profit. Even in 2003, after the fires in San Diego and San Bernardino produced $2 billion in claims, the industry ran a 96% combined ratio, which means it actually had some underwriting profits after paying for all those losses. When it comes down to the bottom line for the insurance industry, wildfires can generally be absorbed within a year or two without having to take any additional rate increases. Hurricanes, by comparison, have been known to wipe out 20 or 30 years of profits with a single event.

Chernick: We have already made the comparison with Florida. Let's take it one step further. New legislation in Florida to set up state-financed catastrophe funds would transfer the cost burden of those in high-risk areas of the state to those in low-risk areas of the state. The cost shift is substantial enough to materially affect how much consumers in Florida pay for insurance, especially if there is a big storm. Compare this dynamic to the situation in California. Because the total wildfire loss amount is smaller than the losses incurred by a hurricane and because California is so big, the homeowners market in California can typically absorb these losses.

PAUL ANDERSON and DAVID CHERNICK are actuaries and consultants in the Milwaukee office. Both specialize in personal lines, especially property insurance.