California Wildfires: A Deep Dive into the Crisis with Tom Mercer

E53 CALIFORNIA WILDFIRES_ A DEEP DIVE INTO THE CRISIS WITH TOM MERCER

Transcript

Dalton Anderson (00:00.724) Welcome to Venture Step podcast where we discuss entrepreneurship, industry trends, and the occasional book review. Today we are going to be discussing California. California, as you know, has been burning and has been burning for some time. A lot of the fires are not controlled. The most notable fires are Palisades and the Eaton fire. The Eaton fire, I think has 0 % containment and the Palisades has 6 % containment. Over the course of the last couple of weeks and years, there's been quite a bit of discourse on

Who is to blame with these California fires and the mismanagement of insurance in general? Is it the insurance companies? Is it the political party or the government mismanagement or is it a multitude of things? Well, I'm pretty sure it's a multitude of things and we do have a guest on the show, Tom Mercer. Tom Mercer was a previous supervisor. He was my boss and he has since moved on and starting a new program. But

The reason why I might be so smart and commercial insurance is because Tom has nurtured me over the last couple of years. And I'd known him previously at a different company and he'd always been very intelligent and thoughtful with the words and ideas he distributed to others. So really excited to have him on the show and his free time. He likes to boat, right? You're a big boater and just, just likes to have a good time. Mountain biking, sailing, and he had to, didn't you grow up?

Tom Mercer (01:07.714) Thank

Tom Mercer (01:19.736) Yeah, like to boat, ski, mountain bike. Yep, pro slings, pro sailing.

Dalton Anderson (01:26.064) in California or spent substantial amount of time in California, correct?

Tom Mercer (01:30.242) I have, yeah. I in the Navy there in San Diego and then went to business school at UCLA. So very near to where the current fires are. I've hiked in those hills that got burned up when I was at UCLA and then was working in West Los Angeles for a while.

Dalton Anderson (01:50.612) That being said, we're glad that Tom is on the show, but this is not financial advice or legal advice. If you're looking for that, speak to a licensed professional in your respective state. Okay, so we'll just jump right into it. The topics today we're gonna be discussing is California, the wildfire, the state of the market, and just in general, how does that influence commercial insurance or insurance in general? How does this all intertwine with

insurance, like with the fires, what went on, how did things fall apart over the last coming years, maybe the last seven years, 10 years? Because it's not just one day things fall apart, it's a slowly deteriorating foundation of what's been going on and what you're seeing and what's coming to light now. And then we'll be discussing just in general, some lag and regulation changes that need to be done with California for it to be a little bit more competitive.

And then the last thing we'll talk about is commercial lines in general or commercial insurance. What are some key problems that need to be solved by technology? And that will allow me to bring in some guests on the show related to those areas that will provide interesting information. But the first topic that we'll be talking about is the California wildfires. So I'll just start off real quick and kind of level set the Eaton fires and the Palisade fires.

both of which I mentioned earlier don't have that much containment at the moment. Why are the fires not contained? Well, when a wildfire starts and the wind is over 40 miles an hour, there is nothing that can stop the wind. The wildfire is in general wild and can't be tamed until the wind dies down. So the firefighters need to be on standby and wait for the wind to die down and then they can attack.

fire. But as soon as those winds get to those dangerous levels where you can't predict where the fire will go and the fire is burning at a rate that isn't controllable or sustainable for the firefighters to be nearby, they have to pull out and come back when the winds are died down again. the issue is now the last couple weeks, there's been some sustained gusts over a hundred miles an hour. it's three acts potentially of what we could almost three acts.

Dalton Anderson (04:16.788) Not, not quite, but definitely, definitely two. Yeah. No, three. Yeah. 40 times. Yeah. That makes sense. Once again, this is live anyway. So three X of what would normally be considered dangerous. So just to put that in perspective, that's why the fires can't be controlled. And the current damage done so far is about 5,000 buildings in the Easton fire and then 5,000 buildings in the Palisades fire.

And then with general math, the median building value for the Eaton, I think is 350,000. And that came out to, you know, a couple billion. And then the. Palisades fire was the median household value of 3.5, but most of those houses are on the fair plan. I assume that they all were. And the max coverage for the fair plan is 3 million for residential buildings. That being said, the risk.

Tom Mercer (04:59.818) you

Dalton Anderson (05:16.062) for both all in is about $25 billion in losses potentially if they were all total losses. Tom, do you want to include anything that I missed there?

Tom Mercer (05:27.318) No, I think you covered it. We can spend some more time about the fair plan and what that means. That's a state market of last resort and that's grown in wildfire exposed areas and we'll touch why that has happened. It's because of really what's been going on with the private market and the regulation challenges that exist in the state. Yeah, I don't have the latest estimates on the fire.

And I'm not certainly not a fire expert, but as Dalton says, when the winds are blowing this strongly, very hard to contain, basically impossible to contain a fire. a fire, know, fire becomes extremely dangerous for firefighters to be around. They can just be quickly overtaken by the fire. There was a fire that occurred near my house when I lived in Colorado. And it was not too far from Boulder, Colorado.

between Boulder and Denver in an area called Aurora slash Superior. And it's not really, even it wasn't an area that was particularly prone to fire. had, it was a sub suburban area. But again, like, you know, like the fires we're seeing here, the winds were very, very strong and it burned up a substantial share of this neighborhood, you know, very, very quickly. So a combination, a combination of really any fire and high winds is truly deadly. As things burn, as houses burn, embers come off.

and those embers can ignite. And what we had going on in the Palisades and all of really Southern California is they've had very light, rains, my understanding since last spring, well below normal range. And so you had a very dry environment coupled with the winds. And then as far as the source of ignition, that's be determined, but there's all kinds of things that can be doing that.

person careless with a cigarette butt or the car, you know, could conceivably cause this. A homeless person potentially cooking a meal somewhere. you know, or what's happened before is the power lines can actually cause and spread fires as well. And so there's been people pointing at that. But at this point, we don't really know the causes of these things. And I think it's somewhat immaterial, you know, unless it's truly an arson situation, there's just so many ways that these things can be caused.

Tom Mercer (07:49.47) and under the right conditions of high winds and very dry conditions, they're gonna spread.

Dalton Anderson (07:57.652) No, I it's fair. One thing I like to point out, my math was wrong. I think I said 350,000 is 3.5 million for Palisades and then 2.1 for Eaton Eaton. And so that, brings it around, you know, 25, $25 billion. But yeah, as Tom said, the main thing here is the winds are high. The winds also contribute to embers flying. Embers are one of the leading causes of a fire. A lot of times fire spread.

not home to home, with a ember, multiple embers latching onto a home and then that home burning over time with the winds hitting the ember and the ember causing fire to the home.

Correct, right? think 70 % or something like that. So definitely over 50 % of the time an ember is what's causing the fire. It's not a fire. Your home is directly impacted by the fire and it in your, in your home catches fire because it's engulfed in fire and flame. It's that's typically not how it goes down.

Tom Mercer (09:02.134) And the other interesting thing there, my understanding is in both of these areas, there are still older homes that had wood shake roofs. that's basically the most standard roof you see on most homes is a composite shingle roof. You know, those have some fire resistance. They're not as strong as metal roofs, but these wood shake roofs are literally made of slabs of wood. And you can imagine a place like California, those wood shake roofs will dry out. And so an emerald lands on those.

and can start a fire. And so those have been banned now over 50 years, but they've allowed grandfathering of existing structures. And as long as they keep those roofs repaired, so that's a problem. And it speaks broadly to a problem, which we'll talk about later on, or we'll talk about it as far as, we're not really, but today, other than some small measures, we're not really building buildings to be.

to be fire resistance from wildfire exposure.

Dalton Anderson (10:06.92) Yeah, I think that's a good, good place for us to move on. think we provided some background on what's going on in California. The next thing is to talk about the regulation lag or not only just the lag of regulation, but the over tightening of regulations within California related to wildfire risk. And in general, the sense is like one of the main things that we couldn't do as an insurer in a midded market, there's two markets.

there's admitted lines, is a insurance company that is registered and accepted by the state. And they have to follow what the department of insurance does. So if the department insurance has an exact rule, then the admitted insurance carrier needs to do that. There's a lot of requirements regarding rate changes. They need to be approved by the DOI forms. Form changes need to be approved by the DOI and they need to be scheduled.

There is another section of insurance called not admitted, which is what has been serving California in a greater, more prominent stance than it normally would because of the lack of supply in the admitted market, simply because there isn't the ability for these admitted companies to provide the right premium to the higher risk areas, thus making it one, unprofitable, two,

not very competitive because you can't segment the risk. And that's the good thing about insurance is that typically if it's done correctly, everyone would pay their fair share and you're getting charged what your actual risk is. But if you can't segment the risk, then you're charging everybody the risk, which is unfair to you. And if the admitted market can't do what the surplus lines market is doing, then they're not competitive in that regard.

Tom Mercer (11:54.798) Yeah, yeah, if you want to expand on that a bit, Alton.

Dalton Anderson (12:00.506) Yeah, so one thing that omitted lines, one thing omitted lines can't do that a surplus lines carrier could do or MGA is that they can include their reinsurance costs. And this has been a recent change as of December, early December, California did change the rules where you could include your reinsurance costs.

But the caveat was it needs to be within what they deem to be industry standard. And the issue with that is reinsurance is very customized, very complex, and overall there is no standard. Everything is a customized contract, given your portfolio, what you want to do, the notional portfolio, which is your example portfolio that you send to the reinsurance market or you go to market with. And that's how you raise capital to get

people to sign on to your program and they think it's a good idea. But there is no industry standard of, okay, this is what you have and this is what the industry standard is. It's $2 per foot for this. it's not a piece of wood. It's a very complex and complicated international contract that is not by any means standard. So that being said, go ahead. You want to take it off?

Tom Mercer (13:20.91) Yeah, yeah, let me elaborate on this a bit. know, and explain what we say reinsurance, what's that means. And so what insurance companies will do is they buy protection for large events and they go to these global capital providers for that. you know, whether it's a major wildfire, whether it's a major hurricane, whether it's a tornado, at some point the losses,

for these large events are more than an individual insurance company wants to bear. And so they then buy protection for those larger losses from these global reinsurance companies. And these companies are covering these sorts of risks around the world. yeah, those costs have been rising and they've been rising across all lines of coverage because of the higher climate activity. we've had

We've had an impressive number of cat for hurricanes make landfall in the last year. What I saw this together, they, we've had more in the last seven, more than the last eight years than we had in the 41 years or 46 years prior to those eight years in terms of cat for above land falling hurricanes. Uh, we've had, um, some pretty bad tornadoes as well that, um, you know, Joplin is the most famous, but you know, there's, there's the massive, massive hail events and tornado events, uh, that are, that are costing.

costing it quite a bit. Because this is the global reinsurance market, there's events around the world, events in Japan, events in Asia. They're all drawing and events in Europe, a big flood in Europe last year. All these events are drawing on this capital, so as this capital has to pay out, they need to charge higher and higher rates to compensate for these losses.

And so an insurance company has to pay those and those vary every year. That's a new contract every year. We've seen rates on reinsurance going up 20, 30, 40 % a year in recent years. But until just literally weeks ago, as Dalton said, insurers in the state of California could not pass on these costs to consumers. They couldn't include these costs in their rate filings to the state.

Tom Mercer (15:43.02) They had to, and so they were getting very much squeezed for profit. The other thing that was going on is the state would typically would limit, California would limit rate increases to 7 % per year. That was sort of a long term max that they were not willing to breach. Well, these costs were simply outpacing, cost of this reinsurance was outpacing the amount that they could get in an additional rate.

And so in turn, companies were because up against this hardware, they couldn't get more rate. The state wouldn't approve more rate. And yet their reinsurance costs were going up. They had to take active measures to lower the reinsurance bill. the way you have to, in California, your big natural peril risks are wildfire and earthquake. The earthquake exposure in most of the market is offloaded to a state

private public partnership called the California Earthquake Authority. a lot of that exposure is already outside of insurance companies. But wildfire has been borne by the carriers. these laws... Where was I going with this? Yeah, so wildfire becomes your major catastrophic risk.

And so the way you have to get your reinsurance cost down if you're insurance companies, you've got to shed, you've got to get rid of risk that are in these highly wildfire exposed areas. so that's, ever since the large, there was a series of very large wildfires in California. Like you said, what, the Camp Fire Dalton in 2018? Is that right? Yeah. And then I was looking at, and then the other big ones in 20 and 21, I don't have the names those, but these.

Since they had these large wildfires, and while we had a bit of a reprieve in 22, 23, obviously here in 24 and 25 things have come back with a vengeance with these big fires. These latest fires will probably be the largest fires, certainly in California and perhaps the entire country in terms of damage. But anyway, so, but before this,

Tom Mercer (18:03.406) Companies had been non-renewing policies in the most exposed areas, areas like the Palisades, areas like where the Eaton Fire is, areas where the old Camp Fire was, areas around Lake Tahoe and so forth. Because they simply had to get their reinsurance costs down so they wouldn't be losing money. And so now that we can, now as of these recent regulations, now that those reinsurance costs can be passed on,

Hopefully the market can start to be healthy again, but the state's going to also have to allow more reasonable rate increases to cover these costs. the other thing that happens in this market, unfortunately, is because companies have not been able to get the rates they need to cover their exposure in wildfire areas, they've had to raise rates across the board. So everybody, even in areas that aren't wildfire exposed,

have been you know have been in california have been subject to much, you know much higher rates. so It's it creates it's been creating some real challenges for this market and we'll have to see You know where where it goes where it goes from from here. maybe maybe talk should I talk about the fair plan for a minute? Dalton?

Dalton Anderson (19:20.454) Yeah, yeah, I think that would be good.

Tom Mercer (19:22.562) Yeah, so what's been happening is in every state there are called insurance markets of last resort. And they really, there's state entities that are designed to step in and provide critical insurance when the market won't. in California, that's called the fair plan. And in these wild, as these companies have said, have needed to flee the wildfire areas to preserve profitability or to even make money.

the huge number of homes have been coming onto the fair plan. And I think as we looked, I guess I'll figure that something like over 70 % of the homes in the Palisades were on the fair plan. The private market had abandoned that much of the market. so that fair plan runs like an insurance company. They buy reinsurance themselves, but they can only have enough premium to afford to buy so much reinsurance.

And as I said, reinsurance is expensive these days. And so it's highly likely or likely, somewhat likely that the fair plan through these most recent events will actually, they will lose, you they will exhaust their reserves and they will exhaust their reinsurance and, you know, will need to replenish. Now, the way they do have a mechanism that they can replenish and the way that, what they will do is they'll initially will ask

ask all these other, all the companies in the market to contribute to pay off, pay off, to pay, to pay claims. And then they, those insurance companies will in turn be allowed to raise their rates through special assessments and their policies. So again, all of California is going to have to, all of the California policy orders are going to have to step up and pay, you know, pay higher rates for years to, you know, restore the balance, if you will, you know, on the fair plan. and,

That's gonna create even more pain for the insurance customers of California.

Dalton Anderson (21:27.88) No, I agree. Well said by the way, with the reinsurance piece and illustrating to people that are listening that okay, insurance companies needed to pull stuff out of their portfolio to reduce their reinsurance costs. And the best way to do that is to take risk that is in the highest, most fire prone areas. Take that off the book and hopefully someone else picks it up like the fair plan. The fair plan.

has about $458 billion in risk and total exposure. So it's quite a bit. I don't know what the total market is for home insurance, because I'm not in home insurance anymore, but I'm sure that's a substantial part of high risk areas. So it's 458 billion in high risk areas. And coupled with the fact that a lot of the homes in California are quite expensive in those areas.

there might be a higher concentration like the East and in the palace sides that they're quite expensive homes and they're all multi-million dollar homes. But that being said, very good point. Another good point that you made Tom was about the reinsurance. have read that there's two things that I found that was pretty interesting. One that a lot of times the reinsurance will have a clause for the wildfire where if it's within a certain amount of hours and they have like one 56 and two 56 hours,

and within a certain amount of distance, they'll classify that as one event or two events, which is very important because if it's one event or two events, it changes what needs to get paid out. Do you want to potentially illustrate a little bit about that? The one event or two events? Like if you had a hurricane, that's normally classified as one event because it's a named storm, but with wildfires, could have, you get events going on throughout the state. How do you classify what's one event or two events?

If it's one event or two events, how does that change?

Tom Mercer (23:26.414) Yeah, let's just use an example where a company buys a small insurance company buys a relatively small insurance company buys a reinsurance cover that kicks in for losses above $20 million. And so once a loss exceeds $20 million, they can go access their reinsurance to pay losses up until they exhaust their reinsurance.

If an event is classified or if there's another event, they have to pay another $20 million. A third event, they have to pay a third $20 million retention. so, I mean, I guess fortunately or unfortunately, thing is at least these two fires, the Palisades and the Eden fires, because they are within that timeframe, those will be classified as one event. And the insurance companies will have to, won't

will only bear a single retention, if you will. That being said, the reinsurance companies will bear more of the loss and it'll impact them more. Now, as people look at this event from a reinsurance standpoint, they're going to be fine. mean, there's enough pools of capital. There's really little threat of insolvency among the broader reinsurance sector, but it just contributes to

these global trends we've been seeing, which I think at this point it's hard to deny climate change as being a driver of cost, but it's not the only driver of cost. But we are certainly seeing a higher frequency of high intensity hurricanes and a higher frequency of high intensity hail events across the Midwest and in Colorado and elsewhere.

and then wildfires as well. But it's not the only thing that's going on. The other thing that's going on is general inflation. Inflation post-COVID peaked around 9 % overall and in some sectors it was higher. So that's increased building costs and those building costs have remained high. The other thing is what's called social inflation. And what that is, is there are litigation trends.

Tom Mercer (25:50.318) There are trends among in certain areas, particularly in hail areas where roofers have been very, very aggressive in marketing and marketing their products or marketing roof replacements where they go into a neighbor and just go house to house to house and say, well, your neighbor's getting into a roof. You know, should we get you a new roof? And people are not even realized they have damage in many cases, you know, they have probably have some roof damage, but it's not enough roof damage to where the roof is leaking or anything. Anything's visible on the inside, but yet.

because there's been some loss of granules and loss of resistance in their composite roof, composite shingle roof, they've been able to get a new roof. so those sorts of trends, aggressive litigation trends and sometimes fraud, aggressive roofing trends, overall inflation have really been pushing the cost of property insurance upward and really squeezing the market.

countrywide.

Dalton Anderson (26:49.172) The roof thing with social inflation, that example, that's a huge, huge issue in Florida until Florida eventually cracked down. But in general, the perspective of insurance carriers or MGA is that there is a, especially in Florida, because that's where majority of my perspective is, like before roofs, was sinkhole. And then before sinkhole, it's something else. so everyone sees this as the cash cow event.

And so we're all in on sinkhole and we're, filing claims and escalating things and we're, filing lawsuits. And in Florida, they had a multiplier effect for attorneys. So if you won a case against an insurance company, even if it was a dollar, you would get two and a half to three times what you would normally would have gotten. So there was an incentive to take insurance companies to court and hopefully win. And if you won a dollar, then you get your multiple.

that over a long period of time, and this whole industries are built over this thing that where you're just squeezing out billions of dollars from insurance companies. the sad thing about it is the free roof that you're getting or this free claim that's being expedited for you. One, the claim amounts are typically inflated to you're the one that gets the free roof, but everyone else has to pay for your roof that you've gotten.

and you multiply that by thousands of people, adds up quickly. And I'm not to say that insurance companies never do anything bad, but for the most part in the world, there's a lot of good things going on. And especially insurance, how regulated it is, it's very difficult to do bad things. And if you're doing bad things, you're going to get caught. And there's a lot of clauses that if an insurance company goes insolvent or if there's mismanagement, one, they should be pursued criminally to

other insurance companies will have to pick up the tab. Correct?

Tom Mercer (28:50.277) Yes, that's correct. And the way insurance is priced is you cover a large pool of risk, you expect a small percentage of those to have a loss. And so,

people pay people for insurance will pay a fraction of their home value. And the expectation is that the percentage of losses is much more than the percentage of people that are paying in. Typically one less than, certainly less than 1 % of exposed risk gets subject to a complete loss. And then even the partial losses.

sets that you don't need to collect that much premium from everybody because you're able to spread it. Well, when you have litigation that's greatly increasing the number of claims and the cost of those claims, that becomes a problem. It unbalances the pricing models. When you have these CAD events that simultaneously affect multiple properties, that can also unbalance the cost. The other thing I didn't mention about, when you see areas like pallet, when you see

areas, large areas like the Pacific Palisades. I think there's over over 5,000 homes there. When you see when you see earthquakes comes ash comes ashore. We had Ian a few years ago was a was a major cat for hurricane came in south of south of Tampa. This this last last fall we had hurricanes of Helene and Milton. Helene was a major flood event here and here in the west coast of Florida. And then as it got up in North Carolina and other areas, it caused it caused more damage.

But in those areas where you have damage, lot of damage, you get a phenomenon called demand surge. what this is, there's only, know, contracts will flood, contractors will flood in to do these repairs, but there's so much demand, there's so much demand to repair homes. In the Palisades, there'll be so much demand to rebuild homes once the permits start to get approved and so forth. And they've promised to expedite those permits that you run out of people that can really, they can do it. And so,

Tom Mercer (30:58.636) they can start to charge whatever the market will bear and whatever to do things. so that's another thing that drives up the cost above just standard inflation, that trend of demands.

Dalton Anderson (31:15.732) Yeah, good point about that. And one thing that we missed maybe was with surplus lines insurance, it is the free market. if, it's just a different perspective for people listening is that surplus lines is free market. basically the state is kind of hands off. There is some things that you have to follow that the state says, like there's some laws and regulations that apply to surplus lines.

most notably like how you go about cancellations and renewals and non-renewals. can't just not renew somebody whenever you want. You've got to give proper notice and allow them to find insurance cover somewhere else. But for the most part, you can change rates. can include things in your rates when you want, but I couldn't change somebody's premium midterm 40%. That would have to be a conditional renewal. But that being said, the state,

isn't as hands-on as they are with omitted as we were talking about earlier. And so what happens there is it is what the market will bear. So say that California is a very hard market, which means that the rates are high and it's difficult to get cover.

you might have high deductibles or whatever is going on. It's whatever the market accepts at that time. So if everyone is offering these independent groups are all offering X and the agents are asking, Hey, can you get to this price? I can win this. When we, when we market it to the insured, then that is what the market will allow. But if you go to a different state and it's a softening market or soft, soft market,

The market determines what the price is. It doesn't necessarily mean that you have to play in that space if you don't like the price, but the market is what determines what it requires. And if you don't like it, then you don't have to offer any insurance in that area.

Tom Mercer (33:14.67) Yeah, I mean, this is a market that has grown in recent years, this non-emitted market. It's not unregulated, but it's certainly lightly regulated. And generally, in the non-emitted markets, there's full freedom of premiums, there's full freedom of forms and coverages. And so, what companies can do is they can tailor their coverage to help mitigate their risk.

And it's a market that can step in to provide coverage, albeit oftentimes more expensive, but market that can step in to provide coverage when the regular markets aren't there or pulling out. And so it is a solution somewhat, I mean, it's a solution, it's not a large enough solution to be the entire market. And it does have some limitations. mean, one of the key limitations of

the admitted markets or the non-admitted markets is lack of access to a state guarantee fund. so, know, insurance has been around a while and what used to happen, you know, what used to happen, you know, the wild west days, if you will, of insurance is companies would overexpose themselves, go out of business and, you know, would leave policyholders holding the bag. And so, you know, people are out of luck. And so states...

A, that's triggered a lot of the regulation initially, a lot of the regulation we see in insurance today. But in addition to regulation, they also created what's called a state guarantee fund. And this is a fund that every insurance company pays into. It's a share of premiums. And that fund exists to provide support for policyholders when a company goes insoluble, when a company goes out of business. That's only accessible to the admitted market. So the non-admitted companies...

they don't have that protection and if the non-emitted company goes insolvent, there is no protection. Now that being said, on the non-emitted side, and that's one of the things you do see, you do see high ratings, high financial ratings, generally rated by AMBEST in the non-emitted market. So there's protections in place somewhat, and people are buying reinsurance typically to...

Tom Mercer (35:35.458) a level at or above a 250 year probable maximum loss event. We can talk more about that. So it's not as wild west as perhaps it used to be, but again, there's not the full range of protections in the non-admitted market, but it's a market that has flexed in California and has flexed in other areas to continue to allow coverage in these challenging conditions.

Dalton Anderson (36:04.434) No, I agree. Do you want to just touch a little bit about your 250 statement and then we could talk about what potentially do we need to solve or not we, but California needs to solve in that area to allow the market to open up and flourish.

Tom Mercer (36:13.144) Yeah, so...

Tom Mercer (36:19.182) Sure, yeah. So we talked about these reinsurers and how they've had to increase their pricing because of losses. Well, what these reinsurance use, all these reinsurances use these industry standard catastrophic risk models and or they have proprietary in-house models, each of them do.

And what these catastrophic risk models do, the big names in that are Varisk, the Varisk Touchstone product, used to be called AAR, and Moody's RMS model are the two largest players in the space, but there's Equicat and there's a few others. But these models run thousands of years of simulations. Most of the standard is 10,000 years of simulations. And in that 10,000 simulations, they've come up with what they would expect for

hurricanes over those 10,000 years, what they would expect for earthquakes over those 10,000 years, wildfires, there's wildfire models now, and there's convective storm models as well. insurers and reinsurers will run these models against their portfolio of exposures. And that will produce estimates of loss across those 10,000 simulation years.

You and from those you get estimate of an average loss per year. You take all the losses, you divide by 10,000, but you also get to see what are the largest loss simulation loss years. so if there's a... So the 100 year, a 100 year probable maximum loss really is odds that what the models is telling you in the 100 years is there's a 1 % probability per year that the loss will be...

you know, this high, at this level or greater. The 250 year problem maximum losses, there's a 0.4 % probability per year that the loss will be that much or greater. And so it allows insurers to sort of quantify, know, insurers to quantify the risk. Obviously, you can have the kind of major, major event that we've really never seen before that can exhaust.

Tom Mercer (38:40.526) But the idea is that by buying to that 250 year level, which is quite common in the space, you've bought enough protection so that in most viable scenarios, companies aren't going to go insolvent. The other thing they're doing is when people buy reinsurance, they don't buy from one reinsurance companies. They typically buy from a panel of reinsurance companies. And that can be as little as three to as many as 10 or 12 and even 20.

different reinsurers are taking parts of that risk. So that helps spread the risk around and helps reduce the risk of if one or more reinsurers were to go and solve it. that's, know, and that's what, but in turn, you know, as we talked about, these people needing to get their reinsurance, their prices down, well, these cap models, the brush fire cap models that exist now, you know, they're obviously gonna,

suggests there's going to be more wildfire damage in mountainous regions and scrub regions than in the middle of the urban cores. So that was driving their probable maximum loss, which in turn was driving how much more insurance they needed to buy. And so those are the risks that needed to be shed. Right now, State Farm, for example, is getting a lot of heat because just in the last six months, they non-renewed a lot of

a lot of the Pacific Palisades policies. They were trying to work with the state, trying to get the rates they needed when they were getting rebuffed by the state and weren't able to get the rates they needed to pay their reinsurance bill. They ultimately decided, hey, we have to start exiting the state, particularly in these high risk areas. Not just State Farm, but others did as well. And so they were in a bit of between a rock and a hard place. And I know they're facing bad press right now, but I can tell you being a professional in this space, you get to the point.

where there's nothing you can do. mean, you can't, you can't, as a private company, and all these are private companies, they can't lose money. They can't be losing money year after year because the cost of outstripped their ability to charge appropriate premiums.

Dalton Anderson (40:55.092) It's a good point about State Farm State Farm from what I read, requested a 30 % rate increase for homeowners, personalized homeowners, and then a 50 plus rate increase for renters. And as you mentioned, it's 7 % is the max. So if you go over a certain amount, it's special approval. I think you have to have a video conference call and it's recorded and it's public where you have to

explain your reasoning and respond to exhibits with state legislature, right? With from the DUI is how it worked in Florida. Previously, when I had experience with it, with the, with the exhibits that it respond to when I worked in the pricing department.

Tom Mercer (41:39.766) Yeah, the other thing that in California, there's legislation that actually funds these public watchdog groups. there's these organizations and the name of the most popular in California escapes me, but they can go to those rate hearings and they can protest the increase. They can challenge the increase and they oftentimes are successful in preventing the amount of desired increase.

I mean, it's not necessarily bad to have an adversarial party in these things. There's some good rationale behind it in terms of protecting the consumer. But unfortunately, the way things have trended over the years is that they've won more often than they've lost. They've also been able to hold on to that 7 % cap for far too long. as the cost rose, again, companies were short.

companies were stuck and had to find ways, have had to find ways to get themselves back to profitability through reductions of exposure in the most vulnerable areas.

Dalton Anderson (42:50.964) And I did see something recently on social media where people were complaining about State Farm and they're like, okay, well we have the State Farm arena, we've got all this stuff and why don't you just take this advertising budget and put it over into our California market and offer policies and then you should be able to afford it. And then there was someone in the, like I guess the comment section that was like, okay, well State Farm is a mutual so

policyholders are the owners and then the advertisement is 2 % to 4 % of the revenue. And that revenue is, that revenue spend is to allow State Farm to broaden their policy distribution so they're less correlated with each other. So basically it improves your ownership of the State Farm shares that you have because you are a policyholder.

But yeah, there's just a fundamental misunderstanding of why insurance companies are making these decisions. And it's easy to point fingers, but it's a multitude of things, mismanagement with the state, the watchdog groups, just the capital environment of reinsurance, squeezing the insurance companies as they can or should because it's costing them too much money. so the insurer or the insured, sorry, the insurer is seeing

one piece of the puzzle, but there's many moving parts that they're getting squeezed at the end when their price increased 40%. It's not necessarily that the insurance company is like, Oh yeah, like Tom, I can get Tom here. He doesn't know where to go. I'm going to give him another 40 % raise. That's not how it works, but it's just in general, it's a complicated topic. And I don't think that there's a lot of discourse on the just different parties involved. think a lot of times you see a perspective, Oh, it's,

the it's because it's a Democrat state and it's mismanaged and all sorts of other stuff. Like look at LA and then they're talking about, well insurance companies are, are super bad and they're evil and they just try to take your money and don't pay claims. And so there's these, these different segmented groups that have one maybe misunderstood part of the problem, but it does contribute to the core issues that the insurance market in California is necessarily falling apart.

Dalton Anderson (45:15.102) And this is a good transition to what could change. And I think one thing that they are opening up to is more advanced AI models to recognize and price risk. so Zesty is currently the only wildfire vendor authorized in the emitted market. But Zesty is a good example because they are an advanced AI company, although that they're

their product is advanced. is expensive for insurance to use, but it does allocate costs to the wildfire risk with frequency of a wildfire to happen and the severity of a wildfire occurring. That being said, they're the only ones available to use in the emitted market. And I think that California potentially is opening up their horizons and perspective of being able to allow other vendors.

Tom Mercer (45:43.598) Okay.

Dalton Anderson (46:11.922) with advanced models to enter the state and help spread.

the, I guess, additional information intelligence with related to wildfires and provide a different perspective because one vendor doesn't have all the answers. One reinsurer doesn't have all the answers. I don't have all the answers. It's when you combine everyone's perspectives, you get a leveled set view. I think wildfire vendors and enabling the emitted market to price and use these advanced AI vendors also

being able to include wildfire costs and within their pricing, which they couldn't do until recently with the reinsurance, but they also couldn't include certain wildfire factors. Being able to do that would be a big help in segmenting the pricing. In addition, I think that they just need to be a little bit more level headed on, on where they're at in the current market, right? Like the market is very hard. It's very hard to get insurance in those areas. They need to take risk off their fair plan to afford to be sustainable.

Tom Mercer (47:00.682) you

Dalton Anderson (47:15.57) And one thing that they could do is not require insurers to enter the state. If they enter the state and they want to include their reinsurance costs, there's a clause in there that they have to have a share within these high risk wildfire areas. So you required, if you want to write business and include your reinsurance costs within California, you need to write in these high wildfire prone areas, but forcing people's hands on things that they,

may or may not do might be good, but I think if we're in the state that they were in in California, it's better to work with the insurers and see like, Hey, what do you really need for us to be able to write here? Like we need, we need private companies writing in these wildfire prone areas. What would you need from us for you to feel comfortable writing here? And then let them, let them tell you. And maybe what they say is so far away from what you want and you meet somewhere in the middle.

But I don't think that there's enough conjuncture between the two groups because they had a third party advisory group that they paid for to let them know that it's essential to include reinsurance costs in their pricing, which I think is abysmal because it's pretty clear that you need to be able to do that.

Tom Mercer (48:34.269) Yeah, you know, I think another thing they can bring the cost down over time or at least control the cost increases is more mitigation. There's an interesting case study with Florida. Florida, after Hurricane Andrew, I think Andrew was 2005, it was a massively devastating hurricane.

to the state in the broader Miami area. And you saw whole neighborhoods that were just reduced to sticks. They just were not built to withstand large hurricane winds. guess that was prior to 90s, that was something in the early 90s, like 92. But anyway, so the first real estate of hard Florida.

Florida building codes came in in 93 and they've continued to be strengthened. And what these, you know, these impose for, you know, for the high risk, high risk parts of Florida, the beach, the beach areas, the ones that are most exposed to hurricanes, have, they have wind design parameters. And so a roof has to be able to meet a hundred, you know, withstand 130 mile sustained, sustained winds and the highest things. That roof has to be held down by.

by what's called hurricane straps. The shingles have to be attached with a certain number of nails. The windows need to have a certain amount of impact protection. So as a storm kicks up, kicks up debris, the windows are penetrated. All these things help make buildings more resistant to hurricanes. And had Florida not had those things, guarantee you,

these recent storms would have been far worse than they actually were. Florida's been the leader in that sort of building buildings better to withstand natural perils. Other coastal states have lagged, but they've gotten religion in this over time. In the wildfire regions, maybe because it's relatively new, maybe because we're seeing really massive wildfires in recent years that we haven't seen in the past.

Tom Mercer (50:46.05) Maybe because we built more, we continue to, as cities grow, they naturally will grow in, they naturally grow into more of the wildland interface, they call it, where, know, so they're more naturally exposed to existing trees, brush, and so forth. But there hasn't been robust practices in terms of building codes or management codes to prevent losses.

There are some regulations in California around clearing nearby brush from a property. Those aren't enforced as well as they can be. But frankly, they also get a lot of pushback. mean, people like trees. like, you know, we've seen some stories in the Pippix of Palisades. People like their privacy. They like hedges. They like the trees. And they don't like to see that stuff taken down or removed for fire protection.

We absolutely, and there's already a long time ago, there was the wood shake roofs, but there's more we can do with roofs and there's more we can do with the way we structure eaves and so forth to make buildings more fire resistant and better job of clearing brush. And I think that's just gonna have to happen over time. Ultimately, you can't avoid these market impacts. You can't avoid...

the climate change effects and some of these other effects that are raising the risk of large wildfires and the cost of large wildfires. And so, you over time, and hopefully it happens sooner rather than later, you know, we start to have more mitigation, we start to have more resilient buildings so that, you know, so that these costs don't continue to continue to run away from us and we can get back to more well-performing insurance markets where

where people are getting increases that are more in line with inflation and not many multiples of inflation.

Dalton Anderson (52:46.132) No, well said. One thing I think is a little different in Florida is Florida really only has to worry about their flood now. mean, hurricanes are still an issue, but with the regulations they put in place, the building codes, it's clearly reduced the issue. Really when you see something devastating, it's like the floods that come in from the storm surge or some random freak one in 10,000 rainstorm like you saw in Fort Lauderdale when it just flooded all of the airport and a lot of the surrounding areas and FAU campus.

With California, they have the fire and then they have earthquakes, but they kind of counter each other because concrete doesn't do that well with earthquakes. Wood does better with earthquakes, but doesn't do so well in fires. There is, yeah, there is things that you could do covering it up, but I think that's one of the core issues that might be little harder problem for the building materials piece. I know that there is some stuff that you can do with like special types of concrete or special foundation things, but that's a complete rebuild.

for you to enable to have this earthquake fire, earthquake proof and fireproof structure. In Florida, my Nana was able to be part of the wind hardening mitigation program. And so that was a program that allowed us to spend, say we spent 10,000, we were, or if you spent 20,000 on the house for wind mitigation things, you could potentially qualify for $10,000 in credits.

So if you replace the roof and you put in hurricane proof windows, that substantially hardens your roof or not your roof, your, your roof, cause it's new, but your structure of your building. But if you did something similar, where you had a wood building and then you put down defensible space, it does harden your space where it doesn't allow as much wildfire in that area, but it still makes it, it's still a difficult problem to solve unless it's a complete rebuild. Right.

Tom Mercer (54:44.213) Yes, yeah, no, it's a hard problem to solve I mean one of things we talked about these models the zesty model and some other models out there, but they're using they're using imagery and You know lidar radars and other things to like Assess assess the vegetation how close it is. How close does the house? Assess the surrounding vegetation the slope of the hills and so forth. So there you know

they're providing individual scores on buildings as to how vulnerable they are to wildfire. that in turn allows insurers to price the most exposed properties the highest as they should and the less exposed properties less, but it also pushes the market into a low exposure mode as risks become very difficult to ensure. But when you have...

When you have the kind of regulation California had where you couldn't use these models, where you couldn't pass long the insurance cost, it was inhibiting those natural market forces that can promote better buildings, better fire management practices, and so forth. Simply to keep costs down, people will do those things, but there has to be financial incentives.

Dalton Anderson (56:01.182) Yeah. If you close your eyes, it's not there apparently sometimes, right? But the rule of innovation. So we talked about a little bit of Zesty in AI, but what about some, some other things that need to be solved in just, would say mainly in the commercial space, I have seen some interesting wildfire vendors in the inter tech conference I went to that are instead of having it the perspective of partnering with the insurer, they're more of partnering with the insured where

Tom Mercer (56:03.786) No.

Dalton Anderson (56:31.112) they're more of a partner with the homeowner. That's for personal lines. But what do you see on your perspective as something that needs to be solved in commercial lines? One thing would probably be like the manual processes could be automated.

Tom Mercer (56:46.604) Yeah, more manual processes can be automated and work and you know with these with these AI to these AI tools allow us allow us to you know handle handle paperwork. There's still a lot of offload of paperwork that's coming in in the insurance things and so we to the extent we can we can machine read that paper that machine read that paperwork interpret it and then put in our data. You know we need we need fewer fewer people. I mean anyway slice it. There's a lot of people that are there are a lot of people that are part of part of insurance companies and.

That's great for jobs, but that raises the cost on the end customers. So insurers are able to get more efficient using these tools and the market will dictate them that they will then pass on those, they'll have to pass on those savings. Because what's interesting about the insurance market and what people don't often realize is there are so many companies in nearly all lines of insurance that will provide the insurance. So we have a very robust competitive market. And so if there are cost advantages to be had.

those will result in lower prices. The other thing that's going on with called the Internet of Things or Internet enabled devices and sensors can be very helpful in this space. We've been talking today primarily about wildfires, but another huge loss category for the industry is water damage from

from an overflow toilet, from a broken water pipe, cause huge amounts of damages to the interiors of homes, interiors of businesses. modern structures and retrofitting, they're putting in water sensors. if there's a constantly running situation, water's running constantly, the line gets shut off. There's already those things that exist. One of the challenges that there's been with earthquake

with earthquake is when an earthquake can sever gas lines. And when it severed gas lines, it can create fires. Well, more advanced homes are built with automatic shutoff to gas lines. When the gas line breaks, it detects the leak and the line is shut off. I think people, particularly after these recent fires, people are gonna be exploring a number of things. Some people are quite successful out there.

Tom Mercer (59:13.912) you know, out there with a garden hose, know, spraying around at the last moment, putting their lives in danger, but did protect some homes. Well, you you could see sprinkler systems designed to, you know, to come on when needed to provide that protection in an automated way. So that's, you know, that's another potential area, you know, for improvement. All these things cost money and some they don't pencil out, but as we're seeing here,

Replacing a home is very replacing a home is very expensive insurance insurance. Even insurance is very expensive And so, you know as these other as it these other costs rise these minute these mitigation member measures You know can be can and becoming more cost-effective, you know The other thing we're seeing in it applies to it applies to wildfire It also applies to win is more and more use of standing seam metal roofs But the facts the metal are is that composite roofs the standards composite shingle roof?

Doesn't last that long doesn't last that long under under high temperature conditions Doesn't last that long under regular rain rain and hail a metal roof on the other hand performs much better Today metal roofs are two two to four times more than a composite single roof But you know more and more more and more businesses and more homeowners are making that choice and and they're making that choice You know because you know because you know that they know they know it helps their insurance bill

and they know it also means better for protecting their home. you know, it's a, in government, you know, sometimes it's individual decisions, sometimes government regulations play a small role. Certainly in Florida, as we talked about the building codes, the change we saw in Florida wouldn't have happened, you know, without robust government regulation on building codes. there's places, you know,

between private individuals, industries and innovators. There's a lot of opportunity here to make ourselves better equipped to handle these higher natural perils or higher frequency of natural perils.

Dalton Anderson (01:01:23.196) No, I couldn't agree more. Tom, is there anything that you want to share before we go the end of episode about yourself? Maybe if people want to connect with you on LinkedIn or something like that, if you're willing.

Tom Mercer (01:01:36.45) Yeah, sure. I don't know exactly what my LinkedIn, but name's Thomas Mercer. currently work at Safe Lease and working on a commercial property program for them. That's where I developed a specialty, is in bringing new commercial property programs to market. And I've been at Safe Lease now a few months and there's been some exciting work.

Dalton Anderson (01:02:00.252) And how many times have you done that? So one time at my company, MSI, another time coming soon-ish, whenever. I don't want to disclose what you've got going on privately, but with Safe Lease. then there is what? You did that two other times again? So this is like your fourth time?

Tom Mercer (01:02:06.253) Yep.

Tom Mercer (01:02:11.906) Yeah.

Tom Mercer (01:02:20.438) Yeah, so I got started in Catastrophe Earthspace with ICAT, an NGA in Boulder, Colorado. And while I was there, I put together a new residential earthquake program for us to cover homes in California for the peril of earthquake. After that, moved to Velocity Risk, which is an NGA that just recently announced their sale to Ryan's specialty group and was responsible for setting up.

I was one of the founding members there, you know, in setting up our data cap modeling team and our data analytics team and help pull together our small commercial program and get our initial large commercial programs going. And then more recently, as Dalton says, at MSI with a commercial property program and now at Safe Place. So it's been, it's been fun to be at the forefront of this and seeing the, you know, seeing these cap models evolve and these internet tools evolve and it keeps the job very interesting.

Dalton Anderson (01:03:16.146) Yeah. Tom is a serial starter. So if you're seeing new insurance company pop up, it's, it's probably cause of Tom, but I really appreciate you on the show. Tom insightful as always wealth of knowledge for sure. If you guys listen or watch this podcast on YouTube, let me know what you think. Share your comments below and contribute. And as always hope you listen in next month or sorry, next week and have a good day.

Tom Mercer (01:03:22.606) Maybe.

Dalton Anderson (01:03:45.652) Good afternoon, good evening, wherever you are in this world. See ya, until next time.

Tom Mercer (01:03:51.022) Thanks, Alton, enjoyed it.