“What would happen if someone discovered how to predict earthquakes? No more earthquake insurance.”
Richard J. Roth, Jr., California Department of Insurance, 1997
1. Some Philosophical Issues
Should you buy earthquake insurance for your house? For your business? Before addressing these questions directly, let’s take a look at insurance in general and then at the particular problems in insuring against earthquakes.
You own a house, and you don’t want to lose it in a fire, a flood, or an earthquake. You might take chances on the little things in life, but not your home; there’s too much at stake. Fortunately, you are contacted by a company that offers to take the risk for you—at a price. The company is gambling that it can assume the risk of the loss of your house, and the houses of a lot of other people, and the price it gets for doing so will allow it to make money. The company is not offering you charity, but a business deal in which it expects to earn a profit. This doesn’t bother you if the insurance is affordable, because you figure that the price you have paid is worth not having to worry about losing your home.
The company that takes on the risk is an insurance company, and the price you have paid is called the premium. The danger you are insuring against—fire, hurricane, or earthquake—is called a peril. An earthquake is often referred to in other contexts as ahazard, but the insurance industry defines “hazard” as something that makes your danger worse, like failing to reinforce your house against an earthquake, or allowing dense brush to grow against your house so that it is more vulnerable to summer wildfires.
The company sells you fire insurance or automobile insurance, betting that your house won’t burn down or you won’t wreck your car so that the company can keep your premium and make money. The company wins its bet when your house doesn’t burn down and you don’t wreck your car. You read about house fires almost every day in the newspaper, and thousands of people die in traffic accidents, but enough people pay fire and auto insurance premiums that the insurance company can cover its losses and still make money.
The insurance company wants to charge you a premium low enough to get your business, but high enough that it can make money after paying off its claims. It can do this because it calculates approximately how many house fires and auto accidents it is likely to have to pay off during the premium period. The larger the number of contracts it writes, the more likely the actual results will follow the predicted results based on an infinite number of contracts—a statistical relationship known as the Law of Large Numbers.
But suppose that an evil spirit casts a spell on automobile drivers so that instead of the usual number of auto accidents, there are hundreds of times more. Or an army of arsonists goes around setting houses on fire. The claims on the insurance company would be many times more costly than the number the company had figured on when it calculated premiums, and it would lose money. It could even go broke.
In a way, this is what an insurance company faces in a large urban earthquake, and indeed in any natural catastrophe, such as Hurricane Andrew in Florida or Tropical Storm Sandy in New York and New Jersey. The difference is that the insurance company is dealing not with claims from a large number of individual automobile accidents or house fires, but from a single gigantic “accident”—an earthquake or a hurricane. The losses from the 1994 Northridge Earthquake were $20 billion, and those caused by the Kobe Earthquake were as high as $200 billion.
A large, destructive earthquake is an extremely rare event in any given place, and most of the time the insurance company collects your earthquake-insurance premium and makes money. But when an earthquake finally strikes a big city, the losses could be so great as to bankrupt the company. If earthquake scientists could finally get it right and make accurate probabilistic forecasts of when, where, and how large an earthquake will be (see Chapter 7), then the company could charge a premium high enough to keep it from bankruptcy, even from a rare catastrophic event. But, unlike the situation with fire and auto insurance, the insurance industry lacks enough reliable information on catastrophic events to estimate its possible losses, and therefore to set a realistic premium. The losses from an earthquake might be so high that the premiums necessary to stay in business would be prohibitively expensive, discouraging homeowners from buying earthquake insurance at all.
Consider the earthquake losses from the great San Francisco Earthquake of 1906. (The dollar figures are small, but so was the size of the insurance industry at that time.) The Fireman’s Fund Insurance Company found that it was unable to meet its loss liabilities of $11,500,000, and it closed down to be reformed as a new company, paying off claims with 56.5 percent cash and 50 percent stock in the new company. Four American and two British companies, including Lloyds of London, paid their liabilities in full, but forty-three American and sixteen foreign companies did not, spending months and years in legal battles to avoid paying off their claims. Four German companies immediately stopped doing business in North America to avoid paying anything. Another offered to pay only a fraction of its losses.
The insurance industry had underestimated its potential losses in a catastrophic earthquake. The premium was not cost-based.
This is why the debate about whether the next Cascadia Subduction Zone earthquake will be a magnitude 8 or 9 is being followed with nervous fascination by the insurance industry. Insurance companies have no problem with a Nisqually Earthquake, not even with several Nisqually Earthquakes. It might even handle a magnitude 7.9 earthquake on the central San Andreas Fault in the thinly populated California Coast Ranges. But a magnitude 9 on the subduction zone, or even a magnitude 7.1 on the Seattle Fault gives insurance underwriters fits. Can the insurance industry survive a magnitude 9 on the Cascadia Subduction Zone and still stay in business and meet its obligations? Can it survive two urban earthquakes, one in Seattle and one in Portland, back to back?
2. A Brief Primer on Insurance
Insurance is our social and economic way of spreading the losses of a few across the greater population. We are pretty sure our house won’t burn down, but we buy fire insurance for the peace of mind that comes from knowing that on the odd chance that it does burn down, our investment would be protected. Our insurance premium is our contribution to setting things right for those few people whose houses do burn down, since the house that burns down could be our own.
Insurance is a business, but it’s also a product. There is a consumer’s market, insurance has value, and the product has a price—called the premium. But insurance differs from other products in that its cost to the company is determined only after it is sold. For this reason, the company tries hard to estimate in advance what that cost is likely to be.
For an insurance company to stay in business, it must be able to (1) predict its potential losses, (2) calculate a price for premiums that will compensate for its losses and allow it to make a profit, (3) collect the premium, and (4) pay off its claims as required in the insurance contract. The company has an executive department that determines overall corporate direction (including the basic decision about whether or not the company wants to be in the earthquake insurance business at all), a department that sends out your statement, a department that settles your claim, and a department that worries about risk so that the price of the premium fits the risk exposure of the company. This last process, called rating, is done by an actuary. To determine a rating for earthquake insurance for your house, the actuary may take into account the quality of construction, its proximity to known active faults, and the ground conditions. Underwriting is the determination of whether to insure you at all. The underwriter uses the rates established by the actuary and accepts the risk by establishing the premium. For example, if you are an alcoholic and have had several moving automobile violations, including accidents that were your fault, the underwriter might refuse you automobile insurance at any price. If a decision is made to insure you, the underwriter would establish the premium and deductible appropriate to the company’s risk exposure.
An insurance company has reserves, money for the payment of claims that have already been presented but have not been settled, probably because the repair work has not yet been completed or the claim is in litigation. Reserves are not available for future losses; these losses show as a liability on the company’s books. A policyholder surplus, or net worth capital, or retained earnings are funds that represent the value of the company after all its liabilities (claims) have been settled. This is the money available to pay for future losses.
It turns out that the insurance company, too, wants to hedge its bets against the future by transferring part of its risk to someone else. To meet this need, there are insurance companies that insure other companies—a process called reinsurance. Let’s say that the original company insures a multimillion-dollar structure but wants to spread the risk. So it finds another company to share that risk, and that company—a reinsurance company—then receives part of the premium. It might well be the reinsurance industry that is most interested in the results of scientists and engineers in earthquake probability forecasting and in assessing ground response to earthquake shaking.
Some say that even the reinsurance industry would be unable to pay all claims arising from a catastrophic M 9 earthquake on the Cascadia Subduction Zone, and only the federal government, with its large cash reserves, can serve as the reinsurer of last resort. I return to this question later in the chapter.
We start with that which insurance does best: insure against noncatastrophic losses such as auto accidents, fires, and death. These are called insurable risks. The loss must be definite, accidental, large, calculable, and affordable. Enough policies need to be written so that the Law of Large Numbers kicks in. The principle of indemnity (which excludes life insurance, of course) is to return the insured person or business to the condition that existed prior to the loss. This means replacing or repairing the property or paying out its value as established in the insurance contract. The contract might include both direct coverage, replacing the property that was damaged or destroyed, and indirect coverage, taking care of the loss of income in a business or loss of use of the property. Protection against liability might be included. The contract commonly contains a deductible clause, which states that the insurance company will pay only those losses exceeding an agreed-upon amount. The higher the deductible, the lower the premium. This reduces the risk exposure for the company and reduces the number and paperwork of small claims submitted.
The underwriter has calculated the exposure risk using the Law of Large Numbers. A lot of historical information about fire and auto accident losses is available, so the risk exposure is calculable; that is, the underwriter can recommend premium levels and types of coverage with considerable confidence that the company will be able to offer affordable coverage and still make a profit. The underwriter also looks for favorable factors that might reduce the risk. For fire insurance, a metal roof and vinyl siding would present less risk than a shake roof and wood siding. Auto insurance might include discounts for non-drinkers or for students with a grade-point average of B or better. The underwriter also looks for general trends, like the effect of a higher speed limit on auto accident risk (increasing risk exposure), or of laws requiring seat belts and child restraints in automobiles (reducing risk exposure).
3. Catastrophe Insurance
Insurance against natural catastrophes is much more complex and much less understood, and a large company might employ engineers, geologists, and seismologists to help it calculate the odds. The insurance market in California changed drastically after the 1989 Loma Prieta Earthquake and the 1994 Northridge Earthquake. If a magnitude 9 earthquake struck the Cascadia Subduction Zone, the devastation would spread across a large geographic area, including many cities and towns. As a result, an insurance company would have a large number of insured customers suffering losses in a single incident, thereby defeating the Law of Large Numbers. Potential insurance losses after a major earthquake determine insurance capacity.
Insurance capacity is in part controlled by the fact that all the insurance companies in a region can write only so much insurance, controlled by their financial ability to pay the claims. (This is not the same as insurance surplus, which is simply assets minus liabilities.) Part of the role of the executive department of an insurance company is to decide how to distribute its surplus among different kinds of losses. For example, an insurance company might be so concerned about the uncertainties in writing earthquake insurance that it is only willing to risk, say, 10 percent of its surplus—which then defines its capacity for earthquake insurance. It could sustain losses in a major urban earthquake but risk a small enough percentage of its total coverage that it would not go out of business.
In making its decision about capacity, the company estimates its probable maximum loss (PML) exposure to earthquakes, meaning the highest loss it is likely to sustain. If the company finds that its estimated PML is too high, it reduces its capacity for earthquake insurance in favor of noncatastrophic insurance, thereby reducing its PML exposure. The company might decide to get out of the earthquake insurance business altogether. Insurance capacity was reduced after the losses following the 1994 Northridge Earthquake; there was too much uncertainty in figuring out the risk.
After a major earthquake, the capacity becomes reduced at the same time the demand increases for earthquake insurance. This creates a seller’s market for the underwriter, who can set conditions more favorable to the company. These conditions might include the stability of the building site, the proximity to active faults, the history of past earthquakes, and the structural upgrading of the building to survive higher earthquake accelerations. If you are a building owner, your attention to these problems can have an economic payoff in lower earthquake insurance rates, just as a good driving record can lower your automobile insurance premium.
Just as health insurers prefer to insure healthy people, earthquake insurers prefer properties that are most likely to survive an earthquake. Your premium will be higher (or you might be uninsurable) if your house is next to the San Andreas Fault. If your building is constructed on soft sediment of the Duwamish River in Seattle or on beach deposits along the coast, which might liquefy or fail by landsliding, your premium might be higher than if you had built on a solid rock foundation. Unfortunately for the insurance company, people living next to the San Andreas Fault or on unstable sediments in an earthquake-prone region such as the San Francisco Bay Area are more likely to buy earthquake insurance than people living in, say, Spokane or Medford, not known for large earthquakes. This is called adverse selection.
The result is that the risk of earthquake damage is not spread over a large enough group of people. This makes earthquake insurance more expensive for everybody and causes people either to refuse to buy earthquake insurance or drop their existing coverage.
Maps of the Portland, Salem, Eugene, and Victoria metropolitan areas showing regions susceptible to liquefaction and landsliding related to earthquakes were designed to highlight those areas where the danger from earthquakes might be much greater than other areas. Liquefaction maps of Seattle and Olympia were a good predictor of areas of liquefaction damage in the Nisqually Earthquake (Fig. 8-16). It’s possible to superimpose on such maps an overlay of building types classified by their vulnerability to earthquakes.
An insurance company asked to insure a large building in one of these areas could use these maps to set the premium, but Proposition 103, passed by California voters in 1988, requires all insurance companies to get their rates approved by the Department of Insurance. Once a rate for a particular class of risk has been filed with and approved by the Department of Insurance, the insurance company may not deviate from this rate. The company would have to request a deviation from the approved rate based on new information contained in a hazard map.
Insurance underwriters are very much aware that the principal damage in an earthquake is to buildings that predate the upgrading of building codes. They know that buildings constructed under higher standards are more likely to ride out the earthquake with minimum damage. Therefore, your premium might be lower (or your building might be insurable) if it’s constructed or retrofitted under the most modern building codes, thereby reducing the risk to the company as well as to yourself.
From an insurance standpoint, building codes are a set of minimum standards, and these standards are designed for life safetyrather than property safety. The building code works if everybody gets out of the building alive, even if the building itself is a total loss. If your structure has been engineered to standards much higher than those required by the code, so that not only the people inside but also the property itself survives, your insurance premium could be significantly lower. You would need to determine whether the reduced premium more than offsets the increased construction costs or the retrofit costs necessary to ensure that your building is usable after the earthquake.
The insurance company can reduce its PML exposure by establishing a high deductible. A common practice is to express the deductible as a percentage of the value of the covered property at the time of loss. For example, your house is insured for $200,000 and your deductible is fifteen percent of the value of the house at the time of loss. An earthquake strikes, and damage is estimated at $50,000. Fifteen percent of $200,000 is $30,000, so the insurance company pays you $20,000, the difference between the deductible and the estimated damage.
Now we get into some gray areas. First, liability insurance. Suppose the owner of the building where you work or rent your apartment has been told that the building is not up to earthquake code but chooses not to retrofit. An earthquake destroys the building, and you are severely injured. Do you have a negligence claim against the building owner that his liability insurance would be required to pay off?
Another gray area is government intervention. A major catastrophe such as the Nisqually Earthquake brings immediate assistance from the Federal Emergency Management Agency (FEMA), including low-interest loans and direct assistance. The high profile of any great natural catastrophe—a hurricane as well as an earthquake—makes it likely that the president of the United States, or at least the director of FEMA, will show up on your doorstep. Billions of dollars of federal assistance might be forthcoming, although this is generally a one-shot deal—aid that is nonrecurring. However, major transportation systems and utilities—called lifelines—will be restored quickly. After the Northridge Earthquake, the highest priority was given by Caltrans to reopen the freeways, and Southern California Gas Company quickly repaired a ruptured gas trunk line on Balboa Boulevard in the San Fernando Valley. After Nisqually, Sea-Tac Airport and Boeing Field were soon placed back into service.
The net effect of this aid is to compensate for the large losses in the affected region, although not necessarily the losses of insurance companies. This aid follows the insurance principle that losses are spread across a larger population—in this case, the citizens of a state and the United States. However, much of this aid focuses on relief rather than recovery. The delivery of aid after Hurricane Sandy was poorly organized in New York and New Jersey in that Congress dithered in funding recovery for several months, and today there are still major legal problems in recovery from that storm, including conflicts between homeowners and government agencies as well as with insurance companies.
4. Government Intervention
State governments have already intervened in the insurance business, thanks to the McCarran Ferguson Act of 1945. The state insurance commissioner must approve the rates charged by an insurance company within the state and must monitor the financial strength of a company and its ability to pay its claims. An admittedinsurance company is licensed by the insurance commissioner to do business in the state. Nonadmitted companies not licensed by the insurance commissioner can do business only throughsurplus line brokers.
The state may be able to help people settle claims against an insurance company that has gone broke, but only against an admitted company. The state of Washington has a guaranty fund made up of payments by all admitted companies based on a percentage of their total premiums. This is administered by a private corporation governed by a board made up of insurance executives. The monetary payment limit is $300,000 with a deductible of $100. Oregon has a similar law covering property losses.
People naturally distrust insurance companies. We see their gleaming downtown office buildings at the same time our premiums are increasing, or we get the runaround when we submit a claim. A state department of insurance might respond to this distrust by developing an adversarial relationship with the insurance industry within the state. Or a state insurance commissioner or state legislators might develop too cozy a relationship with lobbyists for the industry being regulated. The high cost of insurance has become a political issue—first, health insurance costs, with the political debacle over the Affordable Care Act, which prevents insurance companies from denying insurance to people with pre-existing conditions, which is analogous to being forced to offer auto insurance to bad drivers and alcoholics. In California, earthquake insurance has become more expensive under the California Earthquake Authority, which offers less insurance for a higher premium and higher deductible. This has caused many people to drop their earthquake insurance coverage, raising the question of what to do when the earthquake destroys thousands of homes that are no longer insured. This is discussed further below.
This adversarial relationship can be a particular problem in insuring against catastrophes. The insurance industry has developed computer models to estimate its losses in a major catastrophe, models that suggest that premiums are not high enough, are not cost based. But these models are proprietary, meaning that an insurance company might not want to release the details of the model to the insurance commissioner and the public and lose its competitive advantage. Some state departments of insurance might not accept or trust these models, or they might regard them as biased in favor of the industry. However, this is not a problem for the California State Department of Insurance; the California Earthquake Authority, described below, uses its own computer models.
Government intervention could be taken to an extreme: the government could take over catastrophic insurance altogether, rather than merely regulating insurance at the state level. The United States government is already involved in flood insurance; a federal insurance program is administered by the Federal Insurance Administration, part of FEMA. There is also a federal crop insurance program. However, there is no federal program of earthquake insurance.
In 1987, a group of insurance-industry trade associations and some insurance companies organized a study group called the Earthquake Project to consider the effects of a great earthquake on the U.S. economy in general and the insurance industry in particular. This group, renamed the Natural Disaster Coalition after the multibillion-dollar losses from Hurricane Andrew, concluded that the probable maximum losses from a major disaster would far exceed the insurance industry’s capacity to respond, and that a federal insurance partnership was necessary. The study group proposed legislation to establish a primary federal earthquake insurance program for residences and a reinsurance program for commercial properties. However, the proposal was criticized as an insurance-industry bailout, and no action was taken. A revised proposal attracted more congressional support, but the potential federal liability in the event of a great disaster doomed this proposal as well. In 1996, the Natural Disaster Coalition proposed a more modest plan that would reduce federal involvement and establish a national commission to consider ways to reduce the costs of catastrophe insurance. This failed to win sufficient White House support for adoption, but it might be considered by a future Congress.
However, the federal government does respond to disasters, and it did so after the Northridge and Nisqually earthquakes. Disaster relief is sure to be provided, but recovery from the disaster is a political issue and is fraught with uncertainties. Grants might be available from the Federal Emergency Management Agency or the Department of Health and Human Services.
Another proposed solution is to allow insurance companies to accumulate tax-free reserves to be available to pay claims in the event of a catastrophe. Let’s say that a disaster with losses of $100 million will occur once every ten years—far in excess of the premiums expected in the year the catastrophe struck. If the insurance industry collected and accumulated $10 million annually for ten years, then it could meet its claims in the year of the catastrophe. However, under present accounting regulations, the $10 million collected during a year in which no catastrophe occurs must be taxed as income. For this reason, the insurance company must pay off its $100 million losses with the $10 million in premiums that it collected that year plus income collected earlier on which it has already paid taxes. The proposal to accumulate tax-free reserves against a catastrophe has met with enough congressional resistance to prevent it from being passed into law.
Government has become involved in earthquake insurance in California, where the state has orchestrated the establishment of a privately financed earthquake authority, and New Zealand, where the government has gotten into the insurance business directly.
In California, earthquake insurance was offered even before the 1906 San Francisco Earthquake, with major problems paying claims from that disaster, as pointed out above. But since then, earthquake insurance has been profitable for the insurance industry, up until the 1989 Loma Prieta Earthquake, followed by the 1994 Northridge Earthquake. Between 1906 and 1989, claims and payments were far less than premiums, even including three large earthquakes (1971 Sylmar, 1983 Coalinga, 1987 Whittier Narrows), two of which struck densely populated areas. But the claims and payments rose dramatically from less than $3 million for the Sylmar Earthquake to about $1 billion for earthquake shaking damage after the Loma Prieta Earthquake. In 1989, as a result of the Loma Prieta Earthquake, claims and payments exceeded premiums for the first time since 1906.
But the 1994 Northridge Earthquake really broke the bank: about $15.3 billion, with more than $9 billion in insured losses to residential properties—far more than all the earthquake premiums for residences collected for decades. One insurance company severely underestimated its potential for losses from the Northridge Earthquake; it would have gone out of business except for a buyout from another carrier. If a similar size earthquake had struck a major urban area on the heels of the Northridge Earthquake, even some major companies would not have been able to cover their losses. Northridge losses were covered in part by the use of income from investments to pay claims.
Not all of the $15.3 billion paid out was earthquake insurance, which covers damage from shaking. About 20 percent of the loss was paid from other types of insurance, including insurance against fire, property damage and liability, commercial and private vehicle losses, loss of life, disability, medical payments, and so on.
These figures point out another trend in the earthquake insurance market: the sharp rise in insurance premiums and claims after California began to require in 1985 that a company offering homeowners’ insurance must also offer earthquake insurance, although the homeowner was not required to buy it. Because the Northridge Earthquake broke the Law of Large Numbers, the insurance industry was faced with a problem larger than simply earthquake insurance— the much larger market for homeowners’ insurance that had become legally linked to earthquake insurance.
After Northridge, insurance companies asked the state legislature to uncouple homeowners’ insurance from earthquake insurance. The legislature refused for the reason that it would have left millions of homeowners unable to buy earthquake insurance at an affordable price. In response, insurance companies representing 93 percent of the homeowners’ insurance market severely restricted capacity for not only earthquake insurance but homeowners’ insurance as well, with some companies getting out of the homeowners’ insurance business altogether. Demand greatly outstripped supply, and homeowners’ insurance premiums skyrocketed. In response to complaints about the high premiums, companies pointed to studies that suggested that future losses could exceed $100 billion, losses that would bankrupt many companies. Losses of $200 billion from the Kobe Earthquake of 1995 in Japan solidified that view, although only a small fraction of the Kobe Earthquake loss was covered by insurance. Insurance companies and homeowners took their concerns to the California legislature in Sacramento.
The legislature then established a reduced-coverage catastrophic residential earthquake insurance that would cover the dwelling but exclude detached structures. This “mini-policy” included a 15 percent deductible, $5,000 in contents coverage, and $1,500 in emergency living expenses. Despite strong public support, the mini-policy did not lure insurance companies back into the residential insurance market. By mid-1996, the lack of availability of residential insurance was threatening the vitality of the California housing market.
The result was the California Earthquake Authority (CEA), signed into law by Governor Pete Wilson in September 1996. In exchange for pledging $3.5 billion to cover claims after an earthquake, insurers transferred their earthquake risk to the CEA. The CEA then bought $2.5 billion in reinsurance—the largest single reinsurance purchase in history. Premium payments and additional lines of credit raised the amount available to pay claims to more than $7.2 billion, leading the CEA to claim that it can cover losses from at least two Northridge-type earthquakes. This was accomplished without the use of public funds.
Insurance companies representing more than 70 percent of the residential property insurance market agreed to participate by signing a Participating Carrier Agreement to write policies on all eligible categories in the CEA. Insurance premiums have more than doubled, and payouts are expected to be lower. One estimate for residential claims if the CEA had been in operation at the time of the Northridge Earthquake: $4 billion less than the amount actually paid out.
The CEA earthquake insurance is the equivalent of the “mini-earthquake policy” established in 1996. The figures below are based on data soon after the establishment of CEA, with the idea that the insurance philosophy is the same although coverage, deductibles, and rates would change. Structural damage to residences is covered, with a deductible of 15 percent of the value rather than 10 percent. The state requires a minimum coverage of $5,000 for personal property; this turns out to be the maximum coverage offered by CEA. Emergency living expenses up to $1,500 are provided—a token payment if you lost the use of your home for several weeks. Swimming pools, fences, driveways, outbuildings, and landscaping are not covered at all. Claims are processed by individual insurance companies and paid by the state. If the CEA ran out of money, policyholders would get only partial payment of claims, and there could be a surcharge of up to 20 percent on their policy if claims exceeded $6 billion.
Participation by insurance companies is voluntary, but insurers representing two-thirds of the market—including the three largest insurers, State Farm, Allstate, and Farmers—are committed to the CEA. But many smaller carriers have stayed out, in part because they cannot pick and choose among the eligible risks they would cover and risks they would not cover; it’s all or nothing. Using mid-1998 figures, this means that the CEA will be able to pay out only about $7 billion instead of the $10.5 billion estimated with 100 percent participation. Some insurance actuaries believe that the premiums are still too low to protect against catastrophic losses; that is, CEA is still not cost based. The higher cost has been criticized by consumer advocates such as United Policyholders; it has driven many homeowners away from obtaining or renewing earthquake coverage. At present, no more than 12 percent of California homeowners have bought earthquake insurance. Of these, about 70% are insured through CEA. Even so, the CEA is now the largest provider of residential earthquake insurance in the world, with more than eight hundred thousand policyholders (down from 940,000 polycyholders) and $163 billion in insured risk. But the question remains: what will be the impact of a major urban earthquake if fewer than 25% of homeowners are insured? Will they walk away from their damaged homes? Will the state and federal government bail them out? The number of homeowners who walked away from their homes during the recent Great Recession may represent the wave of the future.
Under the CEA, insurance premiums vary from region to region; California is divided into nineteen separate rating territories. Much of the San Fernando Valley, which suffered two damaging earthquakes in less than twenty-five years, is paying 40 percent more than most of the rest of the Los Angeles metropolitan area. But the city of Palmdale, in the Mojave Desert adjacent to that part of the San Andreas Fault that ruptured in 1857 in an earthquake of M 7.9, pays significantly lower rates than much of Los Angeles! San Francisco Bay Area residents are paying rates four-and-a-half times higher than residents of Eureka, opposite the Cascadia Subduction Zone on the northern California coast—an area that has experienced the greatest number of large earthquakes in California, and indeed, in the United States. The north coast was struck by a M 7.1 earthquake in 1992 and is at risk from an earthquake as large as magnitude 9 on the Cascadia Subduction Zone, yet the region has rates that are among California’s lowest. Perhaps the lesson to be learned here is that if your area has recently had an earthquake, earthquake insurance will be very costly, but if not, earthquake insurance could be a bargain.
In other words, the insurance industry is more sensitive to historical earthquakes and instrumental seismicity than it is to geological evidence for prehistoric earthquakes and slip rates on active faults. In terms of establishing insurance rates, the industry’s dependence on previous earthquakes means it tends to look backward rather than forward.
Controversy over the great disparity in earthquake insurance rates from region to region led to a review of the CEA’s probabilistic hazard model by the California Geological Survey under contract to the State Department of Insurance. Revised models will undoubtedly make regional differences in earthquake insurance rates more realistic.
The age and type of home also affect rates. The owner of a $200,000 wood-frame house in Hollywood or Westwood in Los Angeles would pay $540 in earthquake insurance if the house was built in 1979 or later, $660 if the house was built between 1960 and 1978, and $700 if the house was built before 1960—a recognition of higher construction standards in recent years. But if the house was not of wood-frame construction, the premiums would be $960 in Hollywood. The percent damage to homes from the Northridge Earthquake was 35 percent for buildings constructed before 1970 to 20 percent for houses that had just been completed at the time of the earthquake. The differences in insurance rates recognize the value of well-constructed houses in which earthquake risks have been taken into consideration. Rates change; the latest rates for a given area and type and age of building are available online from CEA.
If there were a major earthquake, much of the payments to homeowners would come from reinsurance that CEA has purchased. The CEA claims that its rates, averaging $2.79 per $1,000 of coverage statewide, are competitive with the average rates of non-CEA insurers, $2.92 per $1,000 coverage. CEA rates vary based on assumed risk from $0.95 to $4.70 per $1,000 coverage. A better understanding of earthquake risk has led to two rate reductions; rates are now 15 percent lower than they were when CEA went into operation in 1996.
One factor affecting rates was a decision by the Internal Revenue Service that the CEA is a nonprofit organization so that premiums can accumulate without being taxed as profit in the year they are collected. The IRS ruling is based on the CEA’s commitment to earthquake mitigation programs benefiting all Californians, not just those with CEA policies. In September 1999, the CEA began an earthquake mitigation program in eight Bay Area counties called State Assistance For Earthquake Retrofitting (SAFER), which includes low-cost inspections and assessments of older homes by structural engineers and low-interest loans to pay for seismic retrofits. The CEA worked with Oakland’s KTVU Television to produce a public awareness program on the tenth anniversary of the Loma Prieta Earthquake.
It has been more than two decades since the last major urban earthquake in California, and there will be changes after the next inevitable earthquake. For an example of how an earthquake changed an earthquake-prone region, we turn to New Zealand.
New Zealand, like the Pacific Northwest, is a land of great natural beauty in which the spectacular mountains and volcanoes are related to natural hazards, especially earthquakes and volcanic eruptions. Written records have been kept for less than two hundred years, but during this period, New Zealand suffered damaging earthquakes in 1848, 1855, 1888, 1929, and 1931. The country was thinly populated during most of the historical period, and losses, although locally severe, did not threaten the economy of the nation.
In June and August 1942, the capital city of Wellington and the nearby Wairarapa Valley were struck by earthquakes, the largest of magnitude 7.2, that severely damaged thousands of homes. It was the darkest period of World War II, with the war being waged in Pacific islands not far away to the north. Because of the war, there was little money for reconstruction after the earthquakes, and two years later, much of the rubble in the Wairarapa Valley had not even been cleared. Something had to be done.
In 1944, while the war still raged to the north, Parliament passed the Earthquake and War Damage Act, and in January 1945, the government began collecting a surcharge from all holders of fire insurance policies. The Earthquake and War Damage Commission was established to collect the premiums and accumulate a fund to pay out damage claims from war or earthquakes. Later, coverage against tsunamis, volcanic eruptions, and landslides was added.
In 1988, Parliament changed the commission from a government department with a state insurance commissioner to a corporation responsible both for its own fund, and for paying a fee for a government guarantee to cover its losses in case a great natural disaster exhausted the fund. In 1993, Parliament changed the name of the administering agency to the Earthquake Commission. Under the new law, the insurance automatically covers all residential properties that are insured against fire. It provides full replacement of a dwelling up to a value of $100,000 (in New Zealand dollars, including goods and services tax) and contents up to $22,500. Since 1996, only residential property has been covered, and every property is rated the same, regardless of ground conditions or proximity to an active fault.
The arrangement worked well after 1944, in large part because New Zealand did not suffered a disastrous earthquake in an urban area after the commission was established. Earthquake premiums continued to accumulate at a rate of about $150 million per year in those years when there are few claims, and as of December 1998 the fund had $3.3 billion to cover earthquake losses. The damages paid out as a result of the 1987 Edgecumbe Earthquake (M 6.6) were nearly $136 million, as compared to $2.4 million after the much larger 1968 Inangahua Earthquake (M 7.1) nearly twenty years earlier. (Most of the Edgecumbe damages were to commercial property, no longer covered; residential losses were $22 million in 1987 dollars.) The sharp increase in losses, even after earthquakes of moderate size in rural areas, was an indication that the past would not be the key to the future, especially after a disastrous urban earthquake.
The system was put to the test in September, 2010, when an earthquake of magnitude 7.1 struck in an unexpected place: west of Christchurch, New Zealand’s second largest city, resulting in damages of $2.75 to $3.5 billion, but no deaths. A later earthquake was of magnitude 6.3 and caused 185 deaths and massive destruction within the city of Christchurch with losses of more than $30 billion, equivalent to 15% of New Zealand’s gross national product. Payout for these losses came from several sources: (1) a reinsurance policy of $2.5 billion issued by international insurers, (2) the earthquake fund that had been accumulating for decades through the Earthquake Commission, (3) separate private insurance, especially for commercial buildings, and (4) direct government assistance. As a result, the cost of the Christchurch earthquakes, the most costly natural disaster in New Zealand’s history, was manageable, and claims are being paid through the present system. Because of reinsurance, money actually flowed into the country after the earthquake to pay claims.
Even with the insurance, the New Zealand government will pay about $15 billion of the cost of recovery from the Christchurch earthquakes, and the earthquake fund managed by the Earthquake Commission is now accumulating reserves against the next earthquake, with the hope that the earthquake does not strike before the fund is healthy again. This is in the face of other earthquake threats from a subduction zone and from a strike-slip fault that extends through the capital city of Wellington. One of the factors favoring New Zealand’s recovery is that, in contrast to California, around 80% of New Zealanders are insured against earthquakes. Because of its financial commitment to earthquake recovery, the Earthquake Commission supports earthquake research.
5. The Nisqually Earthquake
At $2 billion, the Nisqually Earthquake was the most costly natural disaster in the history of Washington State. Insured losses were $305 million, about 15 percent of the total. Losses included not only damage to structures but damage to contents and loss of data. Twenty-one percent of businesses had earthquake insurance, but most of their direct losses were less than their deductible, typically 10 percent of the value of the building and contents. For those businesses with losses greater than $10,000, about half received earthquake insurance payments. Most small businesses repaired their damage without insurance payments.
Less than one-third of Washington homeowners have earthquake insurance. Safeco, the second largest issuer of homeowners’ insurance, includes earthquake insurance on only 8.5 percent of its policies, although this figure is 13.5 percent in King County. The average Safeco earthquake insurance policy cost $390 per year before the earthquake.
Immediately after the earthquake, insurance companies placed a moratorium of thirty days on writing new policies. The principal reason was to guard against people who had suffered damage in the earthquake obtaining an earthquake policy after the fact.
In summary, and in contrast to the Loma Prieta and Northridge earthquakes in California, the insurance industry came through the Nisqually Earthquake in good financial shape, even though the urban area affected was about the same. The reasons for this were (1) Nisqually was a deep earthquake, and shaking intensities were lower, and (2) the risk exposure was less than it would have been in urban California; fewer people had earthquake insurance.
6. What to Do if You Have an Earthquake Claim
United Policyholders, founded in 1991, is a 501(c)(3)nonprofit insurance consumer education organization with headquarters in San Francisco. It publishes a newsletter, What’s UP, from which much of the information for this section was obtained. For further information, go to www.unitedpolicyholders.com
The most important thing you can do is before the earthquake: make an inventory. List everything you own, room by room, showing the number of items, their description, age, and cost of replacement. Take photos. Keep all bills and receipts. Keep your inventory and supporting documents someplace other than your house, such as a safe deposit box. Jack Watts of State Farm Insurance Co. told me that “It is difficult to overstate the value of an inventory, photos and receipts. The adjuster is there to work with the claimant in establishing the claim, but it is so much easier when these documents have been kept updated and stored in a separate location from the residence.”
After the earthquake, tell your agent that you have damage and are submitting a claim. Do this even if you are not sure you have an earthquake policy; some losses might still be covered. Review the fine print in your policy, especially the “Declarations” page with categories of coverage and dollar limits. Categories include dwelling, contents, loss of use (or additional living expenses), other structures, etc. Annual inflation factors increase your limits. You might need advice from an independent professional. If your policy and declarations page were destroyed in the earthquake, contact your insurance agent in writing for a duplicate copy.
Don’t give a sworn statement, and don’t sign over a final “Proof of Loss” form to your insurer until you are convinced that you understand your coverage, your rights, and the full extent of your claim. Don’t be rushed into a quick settlement. Documenting a major loss requires comparing cost estimates from at least two or three reputable contractors, including the one you intend to hire for the actual repairs. Contractors might suggest various repair methods, and if your home or foundation is seriously damaged, you should consult a structural engineer. Keep a diary and record the name and phone number of each person you talk to. It is better, of course, to have photos or receipts to claim destroyed property, but it’s recognized that these might have been destroyed during the earthquake. After the earthquake, take photos and keep all receipts.
In rebuilding your home, you’re entitled to “like kind and quality.” If you have “guaranteed” or “extended” replacement-cost coverage, you’re entitled to the same style and quality home even if the replacement exceeds the amount of your policy.
For compensation of additional living expenses or loss of use, keep all receipts for meals, lodging, and purchases from the time of the earthquake until your house is rebuilt. For additional information, contact United Policyholders at firstname.lastname@example.org
Even if your damage was from an earthquake, your coverage might be from other policies. For example, a fire in your home might be covered by fire insurance. Tsunami damage might be covered by flood insurance. On the other hand, landslides are commonly not covered by any type of insurance, whether earthquake-related or not.
7. Summary Statement and Questions for the Future
Earthquake insurance is a high-stakes game involving insurance companies, policyholders, and in some cases, governments. Because earthquakes are so rare at a given location (in a human time frame, at least), consumers tend to underestimate the need for catastrophic coverage. A Tacoma homeowner was quoted in Business Insurance as saying: “My additional premium for earthquake insurance is $768 per year. My earthquake deductible is $43,750. The more I look at this, the more it seems that my chances of having a covered loss are about zero. I’m paying $768 for this?”
The demand for earthquake insurance shoots up after a catastrophic earthquake at the same time the willingness and capacity of insurance companies to offer such insurance sharply decreases. Insurance is, after all, a business, and for the business to succeed, it must make money.
Insurance companies might underestimate the premiums they should charge in a region like the Pacific Northwest, where a catastrophic earthquake (a subduction-zone or Seattle Fault earthquake rather than a Nisqually Earthquake) has not occurred in nearly two hundred years of recordkeeping. But premiums might be priced too high to attract customers in places that have recently suffered major losses, such as the San Fernando Valley or the San Francisco Bay Area. Indeed, the entire state of California might be in this fix. The CEA offers a policy with reduced coverage and higher premiums, which causes many people to drop their earthquake insurance altogether. Yet many underwriters in the insurance industry are still not convinced that the reduced policy is cost based.
The quality of construction, particularly measures taken against earthquake shaking, will have an increasing impact on premium costs. The Institute of Building and Home Safety (IBHS), an association of insurance companies, has an Earthquake Peril Committee whose goal is the reduction of potential losses. This includes discouraging developers from building in areas at risk from earthquakes and other natural disasters. If a project is awarded an IBHS Seal of Approval, it might be eligible for hazard reduction benefits, including lower premiums.
Recently, the legislatures of Oregon and Washington have funded resilience studies to estimate what it would take to reduce the huge risk faced from a subduction-zone earthquake. Much of the analysis concerns hospitals, businesses, command centers, and lifelines, including water lines, fiber-optic cables, and bridges. Among the concerns: what happens if a business on the coast cannot return to profitability because it is unable to get its products to market, in which case the business might relocate to a safer area less at risk from earthquakes. The resilience survey for Oregon examined all major bridges and concluded that many of these bridges are obsolete and would be likely to fail in a subduction-zone earthquake. Despite this evidence, the 2015 legislature failed to pass a transportation bill that would have begun to address this problem.
California has already done similar studies, including its part of the Cascadia Subduction Zone. These results have been presented to the respective legislatures, but state governments have yet to commit sufficient resources to significantly reduce the risk. Were they to do so, the risk exposure to insurance companies would change dramatically. For summaries, see CREW (2013) and summaries for Oregon and Washington in the References.
The federal government still has not determined what its role should be, and the government responses to Hurricanes Katrina and Sandy are not encouraging. What should the general taxpayer be required to contribute? Should FEMA’s efforts include not simply relief but recovery? Aid in reconstruction rather than low-interest loans? Should earthquake insurance be mandatory for properties in which the mortgage is federally guaranteed? Should it be subsidized by the government, particularly for low-income families who are most likely to live in seismically dangerous housing but cannot afford the premiums if they are truly cost based? The unattractiveness of the CEA mini-policy is causing many Californians to drop all earthquake coverage, which raises a new problem for the finance industry. Thousands of uninsured homeowners might simply walk away from their mortgages and declare bankruptcy if their uninsured homes are destroyed by an earthquake.
Problems such as these tend to be ignored by the public and by government except in the time immediately following an earthquake. There is a narrow time window (teachable moment) for the adoption of mitigation measures and the consideration of ways to deal with catastrophic losses, including earthquake insurance. Authorized by their legislatures, both Oregon and Washington have designed resilience plans, but the price of resilience is steep, and thus far the governing bodies have not come up with the money to become resilient. The taxpayer appears to be willing to go along with this lack of action.
The question about earthquake damage is: who pays? This question has not been answered.
Suggestions for Further Reading
California Department of Conservation. 1990. Seismic Hazard Information Needs of the Insurance Industry, Local Government, and Property Owners of California. California Department of Conservation Special Publication 108.
Cascadia Region Earthquake Workgroup (CREW), 2013: Cascadia Subduction Zone Earthquakes: a magnitude 9.0 earthquake scenario, update 2013, 23 p.
Insurance Service Office, Inc. 1996. Homeowners insurance: Threats from without, weakness within. ISO Insurance Issues Series, 62 p.
Kunreuther, H., and R. J. Roth, Sr. 1998. Paying the Price: The Status and Role of Insurance against Natural Disasters in the United States. Washington, D.C.: Joseph Henry Press.
Oregon Seismic Safety Policy Advisory Commission (OSSPAC), 2013, The Oregon Resilience Plan: Reducing Risk and Improving Recovery for the Next Cascadia Earthquake and Tsunami: http://www.oregon.gov/OMD/OEM/Pages/index/aspx, summary 8 p.
Palm, R., and J. Carroll. 1998. Illusions of Safety: Cultural and Earthquake Hazard Response in California and Japan. Boulder, CO, Westview Press.
Roth, R. J., Jr. 1997. Earthquake basics: Insurance: What are the principles of insuring natural disasters? Earthquake Engineering Research Institute publication.
Washington State Seismic Safety Committee, Emergency Management Council, 2012, Resilient Washington State, a framework for minimizing loss and improving statewide recovery after an earthquake: Final report and recommendations: Division of Geology and earth Resources, Information Circular 114, 38 p.