7.1.3: Catastrophe Insurance
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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 landslides, 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 landslides 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 safety rather 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 the 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.