7.1.4: Government Intervention
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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, monitor the financial strength of a company, and determine its ability to pay its claims. An admitted insurance 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 through surplus line brokers.
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 policyholders) 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 an 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 the 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 suffer 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. 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.