Property risk from wildfire is likely to increase over the coming several decades. The increase is due to a combination of climate change and urban development in fire-prone environments. Climate change is expected to cause an increase in temperatures and drier conditions, which will increase the risk of wildfires. Additionally the number of houses in the wildland-urban interface (WUI), where buildings blend with wildland, has increased dramatically in recent decades.
Until last year, the wildfire events of 2017 were generally assumed to be tail events — unlikely to be soon repeated. But now with very similar events having occurred in 2018, the insurance community is rethinking its stance on wildfire risk.
Historically, wildfire underwriting and pricing has either been ignored or done by considering proximity to burnable vegetation, with some insurers using commercial wildfire hazard scores. More sophisticated second-generation wildfire probabilistic models are beginning to emerge, but have yet to gain wide acceptance. While this has been happening, losses from wildfires have increased exponentially, making more sophisticated analytical solutions necessary to confidently underwrite and price wildfire risk.
Faced with rising threats from wildfire, insurers may begin to think about the following when addressing portfolio risk:
- Proactive risk underwriting
- Managing portfolio accumulations to minimize tail loss
The following example outlines a company that has a small amount of total insurable value (TIV) producing a disproportionate amount of the total wildfire loss. This example shows that a wildfire risk score can effectively assist in underwriting and exposure analysis, ultimately maximizing profitability.
Below are some of the takeaways from this changing approach to wildfire risk and how it should be managed. Any insurance company that is exposed directly or indirectly to wildfire risk will need to consider them:
- Understanding individual risk is important. A company may choose to write high premium risks with extreme or high wildfire scores if they do not contribute to the tail loss or are not located in areas with existing concentrations. For insurers exposed to wildfire, combining risk selection with portfolio management can both mitigate claims and save on reinsurance costs.
- Wildfires may not always threaten the primary company’s surplus, but annual earnings are certainly exposed. Reinsurance could manage this volatility.
- Additionally, we expect state lawmakers to be motivated to consider solutions to the rapidly increasing costs of fighting wildfires by using the private market (e.g., insurance, reinsurance, issuing a bond or creating a parametric product).
- Furthermore, private market solutions need to contemplate U.S. Department of Interior requirements prior to utilization.
Managing a portfolio that includes exposure to wildfires, however great or negligible, can therefore be transformed by stepping away from a focus on proximity to vegetated areas and toward a much more nuanced approach. As is often the case with insurance in general and risk management in particular, there are threats to profitability, but opportunities within them.
Partha Sarathi, Ph.D., is part of the Willis Re Catastrophe Analytics team based in New York and is responsible for the analysis of catastrophe exposure, loss and pricing for primary insurers. He is also a part of the model research and evaluation team.