7.1.1: Some Philosophical Issues
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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 a hazard, 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 bushes 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?