LA Fire survivors got a rude surprise that could hit more Americans

(Bloomberg) --A year after the Los Angeles wildfires, many survivors face the same problem: Their insurance policies aren't paying out enough to cover the cost of rebuilding. 

It's a tragic predicament. And it will happen again when the next disaster hits. 

Read More: One Year After LA Fires, Recovery Is a Battleground

Since the 1990s, American homes have been systematically underinsured in the event that they are completely destroyed. Study after study shows that, counter to the public's understanding, many home insurance policies are not required to cover total replacement of homes.

The trend, though decades old, has been somewhat hidden. But climate-driven events that cause massive destruction, especially wildfires, are revealing just how pervasive and severe the problem has become.

"Climate change did not cause underinsurance, but it does expose it and amplify it," said Kenneth Klein, a professor at the California Western School of Law specializing in the topic.

Global warming is creating a hotter and drier world. Combined with more construction in areas with lots of flammable vegetation — the wildland-urban interface — it's led to a rise in damaging fires in the US. Researchers at the University of Colorado Boulder in 2023 found that wildfires in Western states destroyed 243% more buildings in the decade between 2010 and 2020 than in the previous decade. The fires in LA claimed in excess of 15,000 structures. 

United Policyholders, an advocacy group, was formed in part to help homeowners not being adequately covered for rebuilding costs after the Oakland firestorm of 1991. The group began sending surveys to wildfire survivors in 2007, and since then, an average of two-thirds of respondents said they had found themselves underinsured, by an average amount of $200,000 or more. 

Studies have confirmed what the surveys indicated. For example, researchers analyzed data from the Marshall Fire in Colorado, which consumed more than 1,000 homes in suburban Boulder County on Dec. 30, 2021, and found 74% of affected homeowners were underinsured.

The Insurance Information Institute, a research center funded by insurance companies, estimates that two-thirds of American homeowners are underinsured for wildfires, typically by about 20% and in some cases by as much as 60%.

Loretta Worters, the institute's vice president for media relations, said there is a "structural challenge in aligning dwelling coverage with actual replacement costs, particularly when reconstruction costs spike after a catastrophic event." 

In other words, acute demand for labor and materials can send prices soaring after a disaster, and it's hard for the insurance industry to know before an event occurs how much costs will go up. 

That wouldn't have been a problem before the 1990s, according to Klein, because until then most US home insurance policies included a guaranteed replacement clause. That is what it sounds like: a promise to replace no matter the cost. But as American houses got bigger and more expensive, the guarantee lost ground to replacement-cost-value coverage, which sets an upper limit on how much the insurance company will pay out. 

Rising construction costs and natural disasters made the guarantee unsustainable, said Worters, while capping payouts helps insurers remain solvent and keep rates down.

Most major insurers use third-party estimator tools to determine the upper limit. Consumer advocates and plaintiffs' attorneys have charged that such tools routinely underestimate rebuilding costs, which in turn helps insurers keep premiums low and sales strong on the front end. 

One of the commonly used tools is 360Value, which the insurance analytics firm Verisk Analytics Inc. introduced in 2007. In a written response to questions, Alberto Canal, vice president of corporate communications at Verisk, said 360Value can consider up to 13 million data points and that when the same subset of data points are considered before and after a loss, the "360Value estimate is consistent with claims data." 

Nicole Ganley, a spokesperson for the American Property Casualty Insurance Association, said insurers work "directly with policyholders to help them understand, and when needed, increase their coverage limits to keep pace with changing reconstruction costs." The trade group encourages consumers to do an annual insurance check-up that includes updates after home improvements.

Homeowners sometimes sue insurers for allegedly misrepresenting the extent of their coverage. But according to Amy Bach, executive director of United Policyholders, courts often find that determining what level of coverage is needed is the obligation of the homeowner, not the insurer. Bach calls this a "fiction" and says there is an easy fix: Insurers should go back to guaranteed replacement coverage.

"If any state legislature were to pass a law" that made it the insurer's responsibility to fully restore a fire-damaged home, Bach said, "the problem would be solved because to avoid litigation liability, insurers would figure out how to get it right."

A disaster-recovery reform bill recently introduced in the California state senate would require insurance companies to at least offer guaranteed replacement cost policies.

Colorado Insurance Commissioner Michael Conway said his state considered a similar measure but decided "it would destroy our market." Most big insurers don't even write guaranteed replacement cost policies anymore, he said, and aren't interested in doing so, at least for Colorado customers.

He also thinks it wouldn't solve the problem, given the insurance affordability crisis. "If people can't afford the products on the market now, forcing more expensive products isn't going to help," he said. 

Driven by a combination of inflation, increased development, disasters juiced by climate change and tariffs, home insurance prices have been soaring around the US. Conway says he receives steady complaints from homeowners telling him they have to either cut back on what is covered or agree to a higher deductible to afford insurance. Getting a policy with more coverage — the full amount needed to rebuild — would only add to their costs. 

Conway has other ideas for how to cut rates, for example, by getting insurance companies to credit homeowners for steps taken to reduce their risk of wildfire. In the meantime, he worries, "the next big hailstorm, we are going to see a wave of underinsurance there, too."

To contact the author of this story:
Leslie Kaufman in New York at lkaufman27@bloomberg.net