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A Look at the Economic Impact of the California Wildfires

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California is currently experiencing devastating wildfires in both the Northern and Southern regions of the state that have collectively been called the worst fire season ever. As of this writing, the death toll stands at 42 – with hundreds more people still unaccounted for.

At least 7,000 homes have been completely lost and over 300,000 people have been evacuated - and many of them fully expect to return to homes that have been damaged or destroyed.

An unfortunate combination of weather conditions including low humidity and high winds has moved the fires far and fast and there’s no end in sight with the two biggest fires both less than 25% contained.

In addition to the horrifying human toll extracted by these fires, once they are over, there will be a significant economic impact on the state of California and elsewhere.

Insurance Companies

The insurance industry might seem to be the most obviously affected group of businesses after a natural disaster. In normal times, insurers use actuarial data to predict the likelihood of any given loss and then charge appropriate premiums to be able to withstand those losses after investment gains on the premiums they’ve held and the administrative costs of their operation.

Natural disaster events complicate that process because they are more difficult to predict than, for instance, the number of homes that will be damaged by fires caused by faulty wiring or unattended stoves, but also because disasters cause a large number of insured losses to occur simultaneously, rather than being spread out over many months or years during which insurers collected premiums and invested the proceeds.

Although they are more difficult to predict, insurers are certainly aware of the inevitability of occasional large losses from natural events and they do their best to manage reserves accordingly and also make use of the reinsurance markets to diversify their risks as much as possible.

According to BusinessInsurance.com, the insurance companies with the most exposure to the current situation in California – based on net written premium in the affected areas - are State Farm with 11.7%, Farmers with 11.5% and Liberty Mutual with 6.2%.

State Farm and Liberty Mutual are both mutual organizations, owned by the policyholders who pay premiums rather than traditional shareholders in public markets. Farmers is a subsidiary of the Zurich Insurance Group, an enormous Swiss firm that trades publicly on the SIX Swiss exchange.

US-based insurance companies Allstate (ALL - Free Report) and American International Group (AIG - Free Report) are expected to have considerably less exposure to the California fires, as well as extensive reinsurance in place that will help mitigate losses.

Based on share price performance since the fires started a week ago, it appears that investors are not significantly concerned about outsized losses at these publicly-traded firms.

Utilities

Utility companies operating in California now appear to be about to bear the brunt of the most significant losses. Shares of Pacific Gas and Electric (PCG - Free Report) and Edison International (EIX - Free Report) – parent company of So Cal Edison - have both tumbled over the past few days with each falling more than 25% at their lows. Though EIX has rebounded somewhat, PCG shares continue to fall.

In addition to the anticipated costs of replacing vast amounts of utility infrastructure to restore service to the affected areas, California law allows utilities to be held liable for damages if their equipment is deemed responsible for starting fires, even if they were operating within the appropriate regulatory guidelines.

PG&E in particular has already been facing liability issues associated with the wildfires in wine country in October of 2017 that caused in excess of $16B in damage. The company recorded a charge of $2.5B in the final quarter of 2017, “in connection with the Northern California wildfires.”

Prior to the most recent fires, PG&E had already suffered credit downgrades from Fitch and Moody’s because of their liability for the 2017 fires and had retained the services of a debt restructuring consulting firm. While regulators usually seek to avoid the bankruptcy of public utilities and often allow rate increases as an alternative, PG&E could hardly afford another potentially huge liability event.

The final tally on the utility companies exposure to wildfire damage will likely not be known for months or longer, but it seems unlikely that they will emerge unscathed.

Construction

Once the fires have been extinguished, a massive rebuilding effort will get underway to replace the lost homes, businesses and other structures.

Most of the rebuilding will be performed by privately held specialty firms rather than large homebuilders in California like KB Homes (KBH - Free Report) , Pulte Group (PHM - Free Report) and Lennar (LEN - Free Report) – who concentrate on big development projects on land they already control – but all of that construction will likely have effects on the entire industry.

Increased demand for labor and materials like lumber and copper is expected to send prices higher. The homebuilders have already had an extremely tough year in 2018, partly due to the costs associated with historically tight labor markets in skilled construction trades and the situation in California can only make that worse.

Obviously, it’s important not to underestimate or ignore the enormous suffering these events have caused thousands of California families, but as investors, it’s important to also understand the potential economic effects on businesses.

Right now it looks as though the aftermath of the fires will reverberate through the California economy - and beyond - for the foreseeable future.

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