Investors Check the Label on Retail

Summary

Motley Fool Money: Investors Check the Label on Retail – Detailed Summary

Release Date: January 15, 2025

In this episode of Motley Fool Money, hosts Dylan Lewis, Ricky Mulvey, and Mary Long delve into the dynamic landscape of the retail sector. Focusing on key players such as Abercrombie & Fitch, Lululemon, and Aritzia, the discussion navigates through their recent financial performances, strategic initiatives, and the broader implications for investors. Additionally, the episode transitions into a critical conversation about the evolving challenges in the home insurance industry, exacerbated by increasing natural disasters.

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Abercrombie & Fitch: Navigating Expectations and Valuation

The episode kicks off with an in-depth analysis of Abercrombie & Fitch's recent financial updates. Host Dylan Lewis highlights the seemingly paradoxical situation where strong quarterly results coexist with a significant stock price decline.

Dylan Lewis [00:05]:
"Strong holiday for retailers, but is it a fit? Motley Fool money starts now."

Abercrombie's Q4 outlook was recently boosted, and full-year expectations were raised. Despite these positive indicators, the stock experienced a sharp 20% drop from its previous close. Analyst Nick Seiple provides insight into this phenomenon:

Nick Seiple [01:17]:
"What have you done for me lately? I thought you were going to put up numbers even better than what you reported."

Seiple attributes the stock decline to the guidance possibly falling short of analysts' heightened expectations. While headline numbers appear robust—with fourth-quarter net sales growth projected between 7-8% and full-year operating margins affirmed at 15-16%—the market's reaction suggests that investors had anticipated even stronger performance, likely fueled by Abercrombie's impressive past growth, including a five-bagger performance earlier in the year.

Dylan Lewis [02:11]:
"From my personal firsthand interaction with the brand, I see Abercrombie boxes coming to my house because my fiance orders it. They seem to be hitting the basics. They seem to be hitting the denim categories particularly well right now."

Despite the stock's current valuation at around 13 times earnings—the lowest in the past year—Abercrombie remains well-positioned, thanks to strategic leadership under CEO Fran Horowitz. Horowitz's focus on merchandising responsiveness and demographic repositioning from teens to adults in their early 20s up to mid-40s has revitalized the brand's appeal.

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Lululemon: Growth Drivers and Market Positioning

The conversation transitions to Lululemon, another retail heavyweight that has recently provided an optimistic glimpse into its holiday quarter by raising its guidance. However, similar to Abercrombie, Lululemon's positive reports have been met with a tempered market response.

Dylan Lewis [04:12]:
"Lululemon also giving investors an early glimpse at the holiday quarter this week and raising their guidance. Also being met with a bit of, you're wearing that from the market. Is it a similar story here?"

Lululemon forecasts an 11-12% increase in sales to approximately $3.5 billion and raises its fourth-quarter earnings per share forecast to between $5.81 and $5.85. Despite these encouraging numbers, recent quarterly performance in the Americas showed a 2% decline in comparable sales, signaling that the company has room for improvement in execution.

Nick Seiple identifies three primary growth levers for Lululemon:

1. Product Innovation: Expanding into menswear, with plans to double sales in this segment by 2026.
2. Digital Sales: Doubling revenue generated from e-commerce platforms.
3. International Expansion: Particularly focusing on markets outside North America, with significant growth anticipated in China.

Nick Seiple [05:35]:
"The real story for Lululemon today is can we continue opening stores outside of the US. If the brand can continue to resonate in those markets the way it has here, then there's lots of growth ahead of the business."

These strategies aim to stabilize and enhance Lululemon’s market position amidst fluctuating domestic sales.

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Aritzia: Capitalizing on International Expansion and Brand Loyalty

Shifting focus to Aritzia, the discussion highlights the company's stellar performance without recent guidance updates. Aritzia's shares surged by approximately 15%, reflecting investor confidence driven by robust earnings and strategic expansion efforts.

Dylan Lewis [06:34]:
"The street is cheering. What we saw from Aritzia, shares up were about 15%."

Nick Seiple elaborates on Aritzia's growth trajectory, emphasizing its vigorous expansion into the U.S. market. With about half of its revenue now stemming from the U.S., the company reported a 12% year-over-year increase in net revenue for the third quarter, including a remarkable 24% rise in U.S. sales. Successful store openings, particularly in high-profile locations like New York, have significantly contributed to this upward momentum.

Nick Seiple [07:00]:
"This is a company that I think has lots of room to continue expanding in the US if they can do that. Lots of room for growth for the stock."

Aritzia's ability to create a "cult following" is evident through high-demand events such as their annual warehouse sales, drawing massive crowds eager to purchase limited-edition items. Additionally, the company's strategic focus on maximizing per square foot revenue and maintaining brand exclusivity positions it favorably against competitors.

Dylan Lewis [09:41]:
"They may not have a lot of products for men to buy, but they do know the male shopping experience in these stores and have tried to make it as convenient as possible."

Looking ahead, Aritzia plans to expand its menswear segment, signaling further growth opportunities akin to Lululemon's strategy.

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Leadership in Retail: The Shift from Finance to Merchandising Expertise

A pivotal theme in the episode is the importance of leadership with a strong merchandising focus in the retail sector. The discussion references an article from Bloomberg titled "The era of Finance CEOs running retailers is Over," highlighting the success of leaders like Fran Horowitz at Abercrombie & Fitch.

Dylan Lewis [12:52]:
"It seems like that trend is back and companies are being rewarded for that focus on the customer."

Nick Seiple concurs, emphasizing that retail success hinges more on trend responsiveness and customer-centric strategies than traditional financial optimization. Companies like TJX have historically thrived by adeptly managing inventory and market trends, underscoring the value of merchandising expertise in sustaining long-term growth.

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Transition to Home Insurance: Challenges Amidst Natural Disasters

The episode takes a significant turn towards the pressing issue of home insurance in the context of escalating natural disasters, particularly wildfires in Southern California. Introducing Senior Full Analyst Asa Sharma, the hosts explore the complexities facing the insurance industry today.

Mary Long [15:13]:
"We're talking today about insurance, but what spurred this conversation is largely the fires that are happening in Southern California right now."

As wildfires devastate large areas, insurers like State Farm and Allstate have begun withdrawing coverage from high-risk regions, citing the unsustainable financial burdens posed by frequent and severe disasters.

Mary Long [20:24]:
"State Farm said, we can't charge you a high enough premium to make this a financially viable business model... Allstate also announced in 2023 that it had stopped writing new home policies in California after years of losses."

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The Viability of Insuring Homes in Disaster-Prone Areas

Asa Sharma addresses the multifaceted challenges in maintaining a viable home insurance market amid rising natural disasters:

Asa Sharma [20:24]:
"There's really four parties that are involved in making such a thing happen... The insurance company, the reinsurer, the homeowners, and the governmental entities."

Sharma outlines the necessary collaboration between insurers, reinsurers, homeowners, and government bodies to create a sustainable insurance ecosystem. He underscores the difficulty of balancing increased premiums, enhanced loss reserves, proactive disaster-proofing by homeowners, and government-funded infrastructure to mitigate risks.

Mary Long [23:39]:
"California's insurer of last resort, it's called the Fair Plan... exposed to nearly $458 billion in potential damages."

The Fair Plan in California exemplifies the daunting financial gaps insurers face, struggling to cover colossal potential damages resulting from frequent disasters.

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Consumer Perspective: Ensuring Adequate Home Insurance Coverage

Concluding the insurance segment, the conversation shifts to the consumer's role in navigating insurance complexities. With an alarming 80% of Americans lacking adequate home insurance, Sharma emphasizes the importance of understanding one's policy details to ensure sufficient coverage.

Mary Long [25:09]:
"If you are a homeowner, especially if you live in a disaster-prone area, how can you be sure that you are fully insured should disaster strike?"

Asa Sharma [25:37]:
"The value of maybe having an insurance agent... to understand what's in your policy is the best way to make sure you're fully covered should a disaster strike."

Sharma advocates for homeowners to engage with insurance professionals to demystify policy terms and secure comprehensive coverage, highlighting the critical need for informed decision-making in increasingly volatile environments.

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Closing Remarks

The episode wraps up with acknowledgments of the profound challenges facing both the retail and insurance industries. Hosts and analysts underscore the importance of strategic adaptability and informed investing in these turbulent sectors.

Dylan Lewis [27:00]:
"Thanks for listening. We'll be back tomorrow."

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Notable Quotes with Timestamps:

• Dylan Lewis [00:05]:
  "Strong holiday for retailers, but is it a fit?"

• Nick Seiple [01:17]:
  "What have you done for me lately? I thought you were going to put up numbers even better than what you reported."

• Dylan Lewis [02:11]:
  "From my personal firsthand interaction with the brand, I see Abercrombie boxes coming to my house because my fiance orders it."

• Nick Seiple [05:35]:
  "The real story for Lululemon today is can we continue opening stores outside of the US."

• Dylan Lewis [09:41]:
  "They may not have a lot of products for men to buy, but they do know the male shopping experience in these stores."

• South Martin Sharma [25:37]:
  "The value of maybe having an insurance agent... to understand what's in your policy is the best way to make sure you're fully covered."

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This comprehensive discussion on Motley Fool Money offers investors valuable insights into the current state and future prospects of major retail firms, while also shining a light on the pressing issues within the home insurance market. By dissecting company performances and industry trends, the episode equips listeners with the knowledge to make informed investment decisions in these pivotal sectors.

Transcript

[Dylan Lewis]

Strong holiday for retailers, but is it a fit? Motley fool money starts now. I'm Dylan Lewis and I'm joined over the airwaves by Motley fool analyst Nick Seiple. Nick, thanks for joining me today.

[Nick Seiple]

Great to be back here with you, Dylan.

[Dylan Lewis]

We've got a bit of a retail rundown on today's show. Reminds me of our old industry focus days digging into one specific sector. We've got updated numbers from Abercrombie and Fitch, Aritzia and Lululemon to dive into. I think it's funny because one of the themes that we're going to be talking about today is on the surface, a lot of strong numbers coming out from the retailers market. Not necessarily agreeing though.

[Nick Seiple]

That's right. Really strong results from these mall retailers. However, as the market often is. What have you done for me lately? I thought you were going to put up numbers even better than what you reported. I think you're seeing that a little bit with the retailers this week.

[Dylan Lewis]

So first up, Abercrombie boosted outlook for calendar Q4 and also their full year expectations earlier this week and the stock is down about 20% from where it closed last week. So yeah, help me wade through this one a little bit because on the surface, some strong reports here.

[Nick Seiple]

Yeah, for me, I think it's mostly an expectation story here. You've got an increase in guidance for fourth quarter net sales growth to a range of 7 to 8% from the priority 5% to 7% guidance. For the full year net sales growth around 15% up from the 14 to 15% previously guided for and affirmed prior fourth year operating margin outlook of 16% and the full year operating margin outlook about 15%. That means let those numbers flow through. Operating income expected to be up 50% year over year. Really strong numbers. But I think what you're seeing here is the guidance maybe came in a little bit lighter than the analysts had expected. You've seen some accelerating trends during the quarter. It could be that they just sandbagged a little bit on the guidance and didn't give the analysts exactly what they were looking for. If you look at the headline numbers, not a lot to complain about. Maybe it's just over excitement about Abercrombie and Fitch. This is a stock that's performed very well over the past few years.

[Dylan Lewis]

Yeah, I could understand some high expectations here. If you go back to the beginning of 2023, Abercrombie is something on the order of a five bagger. There's been a lot of growth built into this company and Some high expectations alongside that. It's interesting to check in, though, because as we look at valuation for this company right now, shares are at the cheapest that they've been in the past year. I think they're currently around 13 times earnings. We have seen this story before with Abercrombie. It's become incredibly popular, been one of the leading brands for a while, and then gone through a period where it was not. It was out of favor. That is the cyclicality that we run into on the apparel side. From my personal firsthand interaction with the brand, I see Abercrombie boxes coming to my house because my fiance orders it. They seem to be hitting the basics. They seem to be hitting the denim categories particularly well right now. How do you feel like the company's positioned?

[Nick Seiple]

Yeah, if you just look at the numbers, I think they're in a great spot. You mentioned being on target when it comes to merchandising. That really goes back to leadership. CEO Fran Horowitz took over the company in 2007, really brought a merchandising focus to the business. Have been able to be more responsive to trends and get those products to customers when they're interested in them. Also, you think about how Abercrombie has changed from maybe we were kids, the business approach has changed. They announced just a couple years ago they're going to change their target demographic from teens to folks in their early 20s up to their mid-40s, which I think is the demographic your fiance is in. Really having success in that demographic, has got their merchandising back online and really repositioned the brand in a way that when folks say, hey, I went to go buy something at Abercrombie, folks don't look at you with a side eye anymore. So I think the business is in a great spot. But as you mentioned, in retail, in apparel, you're really only as good as your last clothing line. So we'll see if they can continue to deliver on that. But I think the culture is good and the positioning of the brand is great.

[Dylan Lewis]

Nick, we have come a long way from the T shirts with A and F emblazoned on the chest from our childhood, haven't we?

[Nick Seiple]

That's right. I certainly have. Dylan.

[Dylan Lewis]

Lululemon also giving investors an early glimpse at the holiday quarter this week and raising their guidance. Also being met with a bit of, you're wearing that from the market. Is it a similar story here? Is this an expectations game?

[Nick Seiple]

Yeah, I think so. Lululemon again, increased guidance, expecting sales to grow 11% to 12% to about $3.5 billion. That's up from prior estimates. Also now forecasting fourth quarter earnings per share to be between $5.81 and $5.85, up from previous guidance from $5.56 to $5.64. I think when you see some of these numbers, the increase on guidance, it's hopefully a sign that Lululemon is turning the corner on the performance of the business. We've seen some disappointing results in 2024 in the Americas region, which is really the bulk of Lulu's business, had a 2% decline in comparable sales in the most recent quarter. Perhaps this release gives some optimism that the business has turned a corner. The stock has found its bottom, but still execution ahead of the company.

[Dylan Lewis]

In addition to what we got in terms of holiday numbers and the drop there, we also heard from Lulu CEO Calvin McDonald this week. He was at the NRF Big show. I'm going to go straight to the CEO here. Lululemon is aiming to double sales and pass 1,000 stores in the coming years. What are the levers there? How do they get there?

[Nick Seiple]

Yeah, the company talks about three big levers for the business. First off, product innovation. How can we sell to more customers? The big growth opportunity there is in men. They think they can double sales of menswear products by 2026. Today it's just about a quarter of sales for the business. Also is aiming to double the revenue it generates from digital sales. You see this focus in a lot of folks in the retail business. Not only driving sales at the physical store, but also opportunity to grow digitally. Then the big opportunity is outside the US I mentioned the struggles in the US Market. Tepid same store sales growth, the big opportunities to grow revenue outside the US they have a goal to quadruple revenue outside North America with a large proportion of that coming from China. The real story for Lululemon today is can we continue opening stores outside of the US Outside of North America? If the brand can continue to resonate in those markets the way it has here, then there's lots of growth ahead of the business.

[Dylan Lewis]

Last retailer I wanted to bring into the conversation for today was Aritzia. No preview from them. We got the real deal results, not a guidance update unlike what we saw from the market with Abercrombie and from Lululemon. The street is cheering. What we saw from Aritzia, shares up were about 15%. I know that this is one that you follow relatively closely as part of your work with Full Canada. Where do you want to Start with their earnings.

[Nick Seiple]

Aritzia is a recommendation in multiple full Canada services. Like Lululemon is an apparel retailer coming out of Vancouver. Like Lululemon, the story for Aritzia is international expansion. Lululemon has already squeezed the juice they can out of expanding from Canada and the U.S. but Aritzia today is really about a U.S. expansion story. You've got about half of their revenue coming from the US today and that's expected to grow quite rapidly. Just to give you some numbers, from the third quarter delivered 12% increase in net revenue compared to the prior year. If you drill further into that US net revenue up 24% year over year. Seeing accelerated momentum in E commerce. One thing to call out too is lots of success opening stores in the US they're paying back in 12 to 18 months. The big highlights in stores 2024 was repositioning several flagship stores in New York. That's really pulled through into the performance for Aritzia. Look at their guidance. They updated their guidance for the full year 2024, calling for 15% revenue growth year over year margin expansion of 450 basis points in gross margin. The business really performing quite well. Also last thing to mention on the earnings call that the guidance that they have for the fourth quarter is really just projecting the trends they had in place during the third quarter. They called out that we've seen an acceleration in performance in the fourth quarter. Reading through that they've sandbagged guidance here. You had a really strong guidance release and management's telling you they're likely to beat that. This is a company that I think has lots and lots of room to continue expanding in the US if they can do that. Lots of room for growth for the stock.

[Dylan Lewis]

If you're unfamiliar with Aritzia like me, prior to some of my conversations with you and our colleague Jim Gillies, you, you'd be forgiven if you're a US listener of Motley Fool Money, because they are still very much in their early days in that expansion. To give you a feel for this company and where they sit, they say everyday luxury. That's kind of the theme for them. I see some headlines that are interesting with this business that seem to get at a mix of a cult following for the brand and what they are able to establish. And also a little bit of the drop culture of fashion. I'm just going to rattle up a couple here. These Aritzia sale finds will be the backbone of my 2025 wardrobe. Another one, how these $150 Aritzia pants took over the young working woman's closet. It feels like they are tapping into a pretty direct relationship with customers and are kind of very quickly becoming one of the go to spots for that really coveted 20 to 40 demo. Nick.

[Nick Seiple]

That's right. If you look at the squares for self per square foot of the brand, they're higher than Lululemon. Lots of other really attractive retailers they've been able to. They're a brand of brands. They've got lots of sub brands that are unique to them that they sell in the Aritzia stores. They've been really responsive to trends in merchandising, been able to stay on top of what folks are looking for. Part of why you've seen the stock, the stock's more than doubled in the past year. Part of that is they got got into some trouble on their inventory back in 22 and 2023. Many retailers did during the pandemic when they had issues getting supply to customers. They ordered lots of inventory ahead of demand and the market ended up being a little bit over inventoried. Over the past year they've been able to get their merchandising a lot more under control, be a lot more responsive to customers. And I really think it's showing in performance. You talk about the popularity of the brand, one thing I would just look up is just pull up Aritzia warehouse sale. Every year they have it in Vancouver and Canada and the line stretches for miles and miles of young women showing up at the crack of dawn. So they can get one or two sales opportunities a year that Aritzia offers. These are stores that pay back again in 12 to 18 months. They have performed as well in Austin, Texas as they have in Vancouver, Canada and Montreal. This is a brand that's traveled quite well and I think they're going to continue to do so as we proceed forward in 2025.

[Dylan Lewis]

Unfortunately for you and me, I think the pickings are a bit slim for fellas over at Aritzia. I think looking through what they make available online, I see that they have jackets available for men. They have some cool outerwear stuff, not very much else. Is the menswear segment kind of an opportunity for them similar to Lululemon, but maybe a little bit earlier on in the story.

[Nick Seiple]

That's right. I think long term you will see Aritzia expand into menswear. In 2021, they bought 75% which is a Vancouver based men's athletic wear brand. They're able to buy the remaining 25% of that in 2026 to get up to 100% growth. That's an opportunity to expand the brand and I think you will see expansion and men. One thing that is attractive to you though, Dylan, even if there aren't products for you, they do have the boyfriend area at the Aritzia store set aside where you can go get coffee and have a drink and entertain yourself while your significant other has a good time shopping. So they may not have a lot of products for men to buy, but they do know the male shopping experience in these stores and have tried to make it as convenient as possible. I think that's kind of helped them.

[Dylan Lewis]

That's smart. And it actually, it kind of accidentally dovetails with something that I did want to talk about. There was a piece out in Bloomberg this week with the headline the era of Finance CEOs running retailers is Over. The gist of the article was pointing to Abercrombie's success with Fran Horowitz. You mentioned her earlier at the helm of that company. Her background being in merchandising and them really nailing the in store experience and focusing on what customers want rather than having a more dollars and cents bean counter approach to retail. It seems like that trend is back and companies are being rewarded for that focus on the customer.

[Nick Seiple]

Yeah, I think so. That's really the part and parcel of retail is being able to follow the fickle interest that retail customers have. You think about the companies that have had success historically, tjx. Their whole business is just being able to purchase stuff and get it out to market. I think apparel retail is a business that really defies financial optimization. It's really about staying on top of the trend quarter to quarter, making the right bets. The companies that remain focused on that are the companies that are going to continue to show success over the long term.

[Dylan Lewis]

I think we see some surprise in that. While we would expect the younger shoppers out there in retail to be a little bit more digitally oriented, in fact that is something that goes from Gen X to Millennial to Gen Z. There is a desire, there's a willingness to be in store and to be touching things, to kind of have these places to go to to shop. It's not just an E commerce experience that people are looking for.

[Nick Seiple]

If you look at surveys out there today, there's a higher propensity for Gen Z to shop in person than you see among the Millennial and the Gen X demographic. Maybe you're seeing the early signs of this with the mall retailers that are probably going to over index to the Gen Z demographic. More than you see in other segments of the retail market. Seeing how well these mall retailers have performed maybe says something about Gen Z's willingness to go shop in person. Again, part and parcel of retail is being responsive to those customers and being where the customers wants you to be. And the companies who have success in this market are going to be the ones who do that.

[Dylan Lewis]

Nick Seiple, thanks for joining me today to talk all things fashion. You're my go to correspondent when we're talking fits.

[Nick Seiple]

Appreciate you anytime, Dylan. Just don't come to me for fashion advice.

[Dylan Lewis]

Coming up to get a mortgage, most lenders require you to have home insurance. But insurers are fleeing places like Florida and California that are facing increasingly common natural disasters. Up next, my colleague Mary Long talks to Senior Full Analyst Asa Sharma about the changing reality of home insurance in the United States.

[Ricky]

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[Asa Sharma]

Asit.

[Mary Long]

We're talking today about insurance, but what spurred this conversation is largely the fires that are happening in Southern California right now. And just kind of before we dig in, I want to make a note that of course our hearts go out to everybody who is directly and indirectly affected by these catastrophes. We're recording this on Tuesday, but as of Monday, around 40,000 acres in Southern California are ablaze. 150,000 people are under evacuation orders. 24 people have died. Hundreds of thousands are without power. Water is tough to come by. All water storage tanks in the Pacific Palisades area specifically will have been dry for a week by the time this conversation airs on Wednesday. There are a lot of stories wrapped up in this. A lot of policy stories, a lot of climate change stories, and of course, human stories Today though, we're going to focus on the business angle because there's a larger conversation to be had about insurance and home insurance. Particularly in prepping for this asit, you brought up the history of the insurance industry. The very basic idea of spreading risk among a number of people, a large number of people, that's been around for a long time. But insurance as a business as we know it today, that's only really been around for a few hundred years. Fire insurance came to be after the Great Fire of London destroyed 13,000 homes in 1666. Why did you flag that for me? Why is the history and the recency of insurance as a business relevant to a conversation about insurance today?

[Asa Sharma]

Mary, Insurance is something that's a little esoteric and it changes at a glacial pace. So if you think about it, we really don't know what the long term types of insurance will actually evolve into because this industry changes very slowly. I have a theory that if we fast forwarded 100 years from today, I could still tell you what a candy business would be like. I am certain I would bet my house that candy bars will still be an item in grocery stores 100 years from today. But what will insurance look like? That's hard to tell. I really like that you brought up the Great Fire of London. Before that, there weren't a lot of enforceable codes that had to do with housing in the city of London. They banned timber construction after the fire. They standardized the use of bricks. They had a lot of urban planning after the Great Fire of London. And this all impacted what was then a nascent industry. But you know, as you point out, insurance in some form or another has been around for hundreds and hundreds of years. I note that reinsurance, the idea that one insurer cedes some of their revenue stream to another insurer, was in existence in the 1400s. I think the first recorded contract is from 1370, but it really only became standardized around the 18th century. So this sort of gives us an idea that the world changes, insurance changes slowly and the timescale is hard for us to understand. But things do evolve and they're not like they were before. And I think this will be pertinent to the rest of our conversation because, you know, climate change has something to do with the changing nature of insurance today.

[Mary Long]

Well, and in these especially high risk areas, you're seeing a lot of insurance companies just begin to not offer service at all. Because in California in particular, you're seeing this happen. It's also happening in Florida. Last summer, State Farm canceled hundreds of homeowner policies in the Pacific Palisades. This is one of the wealthiest zip codes in the US and effectively State Farm said, we can't charge you a high enough premium to make this a financially viable business model. Now, that's in part because of regulations in California that limit how much insurers can charge for premiums. But you have this larger problem of companies deciding that it's too financially risky to insure houses in certain areas. This again, has happened in Florida as well. Allstate also announced in 2023 that it had stopped writing new home policies in California after years of losses. Austin, is there a financially viable way to insure homes in disaster prone areas, especially in light of seeing so many insurance companies saying, no, it's not.

[Asa Sharma]

I mean, theoretically there is, Mary, it doesn't happen overnight. But there are really four parties that are involved in making such a thing happen. The first is, okay, the insurance company, they will, over time take in more premiums and they'll also increase their loss reserves. So they'll take more revenue in, but account for more losses and understand that it's not going to be the most profitable business in their book. That's contingent on a reinsurer agreeing to buy more of the insured interest. So a reinsurer, again just to define this once more, is a party that will buy some of the risk from an insurance company. They'll get the revenue, they'll buy that revenue, and they'll be responsible for the associated claims that may arise in the future. So the language of insurance is interesting because when you sell your stream of premium to a reinsurer, it's known as ceding your income. So you're giving up some of your income, but you're also taking a little bit of risk as an insurer off of your table and letting what's often a very much bigger company take some of that risk. So that's the second party, the reinsurer, they're going to agree to buy more of that interest. And the third party is us, the homeowners. Right? We have to agree to pay a higher premium. We will get incentives for disaster proofing features. So we take a hit both ways. We pay more for insurance and we have to invest more in our houses if we live in these disaster prone areas. And the fourth party are the governmental entities. So the municipalities, state and local governments, they have to fund better disaster infrastructure if we're not going to be able to change climate overnight. So they may do this by any number of value added taxes, think property taxes. They may come up with some other innovative solutions. Or they may create pools to subsidize insurance in order to avoid greater economic disaster. What disaster would that be is people leaving an area, migrating out of an area. So there's an incentive for that fourth party to go ahead and put some of their capital at play to preserve this whole equation. But short of this complicated interrelation among these four parties, it's getting really tough to find a viable path forward.

[Mary Long]

I'm going to put some numbers behind what we're seeing specifically play out in California right now. So California's insurer of last resort, it's called the Fair Plan, this was established in the 60s, but it's grown big over the past four years. The state, through that Fair Plan, is now exposed to nearly $458 billion in potential damages. And that's a figure that has tripled since 2020. So just in the past four full years, fair policies are exposed to $6 billion. In the Pacific Palisades neighborhood alone, Fair itself only has about $700 million in cash. That is a really long way from $6 billion, not even to mention $458 billion. How does any insurer, whether it's a state program like FAIR or a private company, how do they fill that massive, massive gap when a catastrophe strikes?

[Asa Sharma]

I'm not sure they can. Look at Mercury General. This is a small, publicly traded company. About 80% of their insurance premium revenue is concentrated in California, with decent exposure to homeowners policies. Their stock is down about 27% since these wildfires started. And that if you know nothing else about the company, that indicates a kind of risk that is faced by a smaller, concentrated insurer? So my question is, why would a larger, diversified insurer even want to participate in a scheme where the probability of large claims is rising each year, continuously rising, and the frequency of occurrence is also rising? So insurance itself is based on an insurer's ability to predict statistically the frequency of events. If you've heard of terms like the hundred year floodplain for flood insurance, you sort of get a sense of how this is thought of by insurers. You can predict the magnitude of events. That's not hard to do. But if you can't really call the frequency of them, you may not be able to figure out a way in which you're charging even a price or premium to your insured parties, but build up enough of reserve and profits that you can pay out those claims. So I don't know, given the government stepping in with some incentives with Some capital how any entity, even a public entity that hasn't been funded enough like the fair Plan, as you mentioned, can cover these risks.

[Mary Long]

I'm going to attack this from a consumer angle kind of as we close up because in prepping for this, I came across what is, I think it's an, it's an understatement to call this a pretty jarring number. The Connecticut Insurance Law Journal has estimated that 80% of Americans do not have adequate home insurance. If you are a homeowner, especially if you live in a disaster prone area, how can you be sure that you are fully insured should disaster strike and you need to take advantage of your insurance plan?

[Asa Sharma]

Yeah. My apologies to dentists in advance because I'm going to say this is maybe second only to having to go get a tooth extracted. But this shows the value of maybe having an insurance agent. Being able to understand what's in your policy is the best way to make sure you're fully covered should a disaster strike. And I know that's hard. I mean, if you get a hard copy version in the mail of your insurance policy, it's a tome to read. And even if you get a PDF version, who wants to thumb through that? Who wants to read through that? But it's one exercise where it really pays to drill down to understand where you're covered, where you're not, where you are insured, maybe at a percentage of the replacement value of your house, where you might be excluded because of something that happened when your roof was installed. There are so many details. If we don't specialize in this, I think this really begs that we go to the experts, in many cases, the people who sold us the policies and get a clear understanding of what to say stake so that we know what we'll be on the hook for and what we won't be should the worst happen.

[Mary Long]

Asa Sharma, thanks as always for the insight, for the information and for spending time with us here on Motley Fool Money.

[Asa Sharma]

Thanks a lot, Mary.

[Dylan Lewis]

As always. People on the program may have interest in the stocks they talk about and the Motley fool may have formal recommendations for or against. So if I sell anything based solely on what you hear, all personal finance content follows Motley fool editorial standards and is not approved by advertisers. Motley fool only picks products that personally recommend friends like you. For Nick Seiple, Mary Long and Austin Sharma, I'm Dylan Lewis. Thanks for listening. We'll be back tomorrow.