Shake, Rattle, and...Insure?

For our California clients, whether to acquire earthquake coverage or to “self-insure” is a gnawing concern. Unlike most other insurance decisions, the decision whether to purchase earthquake insurance is, for a variety of reasons, not straightforward and frequently involves an emotional component that overshadows the pure financial analysis. There is no universally applicable rule about whether a family should carry earthquake insurance (or for that matter, any kind of insurance). Rather, when deciding whether to carry earthquake insurance, we find it helpful to employ the same framework used for other insurance decisions; that is:

• quantify the magnitude of the potential loss,

• determine the impact of that potential loss on clients’ ability to achieve their long-term objectives,

• decide, in light of one’s own perception of risk and unique circumstances, whether to insure or self-insure the risk of loss,

• acknowledge that insurance decisions have an emotional component that sometimes overrides the pure financial analysis and, finally,

• if insuring, select a carrier able to bear the burden if the loss does occur.

To buy, or not to buy

Most risks are relatively easy to quantify. Decades of data enable actuaries to almost precisely determine how many people will die, how many houses will burn down, and how many car accidents will occur in any given year. The wide availability of this data and the contained nature of any individual loss have created a robust, highly competitive industry that enables families to efficiently insure many risks. Generally, clients choose to obtain homeowner’s insurance even if they could comfortably afford to self-insure their home burning down. This is not only because mortgage lenders require it and because it is very conventional, but also because this kind of coverage is very efficiently priced.

The market for earthquake insurance, in contrast, is far less efficient. Unlike most other risks, it is impossible to predict the magnitude, frequency, or location of earthquakes with any accuracy. Moreover, a single earthquake has the potential for creating massive localized destruction, unlike the more isolated risk of a single individual dying or a home burning down. These two factors cause the “law of large numbers,” which guides underwriting for most other insurance contracts, to break down, leading to much less efficient pricing on earthquake insurance policies.

Of course, “less efficient” doesn’t necessarily mean that the price is too high; indeed, if a catastrophic earthquake destroys your home tomorrow, having purchased earthquake insurance today will look like a good deal. Less efficient pricing simply means that there is less certainty that the price is “correct” (i.e., that it reflects the actual underlying risks). In such an environment of uncertainty, insurers are likely to estimate the risks as being high, leading to high costs to insure that risk. Indeed, as any California homeowner knows, earthquake insurance is expensive.

So, does the high price of earthquake insurance make it an unwise purchase? Not necessarily. The decision whether to carry any type of insurance requires an analysis of each client’s unique circumstances and comfort with bearing risk. For example, clients whose home equity represents a large percentage of their assets are more likely to view a loss as truly catastrophic than clients for whom home equity is a relatively small portion of their wealth. So, anyone who cannot comfortably self-insure the loss of their home equity should, at a minimum, consider the option of insuring that risk. Thus, you should consider factors that impact the risk to your particular property (e.g., is the property built on bedrock or sand?; has it been earthquake retrofitted? how close is it to a known fault?). Fortunately, skilled insurance professionals are able to assist with evaluating some of these more technical considerations, which help clients determine their homes’ vulnerability to earthquake damage. Moreover, clients also need to observe earthquake policies’ limitations, including very limited coverage for personal property (often just $5,000) and a very high 15% deductible. For example, a policy with $1.5 million in dwelling coverage would not pay out until the insured has met a steep $225,000 deductible. Finally, clients should recognize that uninsured casualty losses from earthquakes are deductible for income tax purposes. Even though subject to substantial deductibility thresholds, the tax savings from such a deduction could significantly reduce the overall financial burden.

In light of the very low probability of an earthquake causing more than a 15% deductible’s damage to any single property and the availability of the tax subsidy if a loss actually does occur, the premium, which can run $5,000 or more for many properties, can seem very costly. This causes many people to make the decision to self-insure, even if suffering a loss would require making a substantial adjustment to their long-range objectives. Other clients, many of whom could comfortably self-insure the risk, arrive at a decision to purchase earthquake coverage for the peace of mind that it provides. Different clients, faced with identical situations, will often arrive at different conclusions about whether to insure earthquake risk. From our perspective, regardless of the decision, we want clients to be informed about the risks and to make decisions that are appropriate and comfortable for them.

Selecting an insurer

If, for whatever reason, you decide to purchase an earthquake policy, selecting the right policy is crucial because earthquakes carry the potential to cause massive localized destruction that can severely tax an undercapitalized insurer’s reserves. So, how should clients who want to obtain earthquake insurance coverage proceed? Below we provide some answers, in Q&A format.

Q: What are the most important factors in choosing an earthquake insurance provider?

A: If a major earthquake occurs, the big concern will be whether earthquake insurance carriers can pay all of their claims and how long it will take to process claims. Financial stability of the insurance company becomes the most important factor in choosing a carrier.

A number of less well-capitalized carriers became insolvent after the 1994 Northridge and 1989 Loma Prieta earthquakes. In these situations, claims were paid in full for some customers and, when the money ran out, claims were not paid. Carriers with financial woes took 6-18 months before checks were cleared and, in the case of insolvency, the claims payments took 18-24 months and many were settled for less than the full claim.

Q: Who are the major players today, and how do they compare?

A: Any company selling homeowner’s insurance in California must offer earthquake insurance to its policyholders at the policy inception and then every two years thereafter. However, few insurers directly underwrite insurance policies; rather, most companies offer clients an opportunity to purchase earthquake coverage through the California Earthquake Authority (CEA). The CEA, however, is an unmanaged risk pool that anyone can join, regardless of the risk characteristics of their property; therefore, it invites moral hazard (i.e., the highest risk properties will choose to insure). The CEA’s resources have not yet been heavily taxed but, in the event of a particularly large earthquake or multiple destructive earthquakes over a short period, many insurance professionals suspect that the CEA could have trouble paying claims. Moreover, the CEA is not backed by any governmental agency, so policyholders could receive reduced settlements if the CEA is in financial trouble.

In contrast to most homeowner’s insurance companies, which rely on the CEA for providing earthquake solutions for their policyholders, Chubb, AIG and Fireman’s Fund all underwrite their own earthquake policies and are the preferred providers for personal earthquake insurance because of their higher standards in underwriting, financial stability, and expanded coverage options.

One example of a potentially meaningful difference in coverage terms is “loss of use” coverage. Chubb offers loss of use coverage that allows the insured to move into a “like and kind” home while their home is being rebuilt, regardless of the cost of the temporary residence and how long it takes to rebuild. Many other insurers offer loss of use coverage for only up to 12 months and provide “fair rental value” coverage only which we suspect would be inadequate for many families.

Q: What are the financial ratings of the major earthquake insurance carriers?

A: The financial strength of property insurance companies is rated by A.M. Best, whose rating system is to provide an overall opinion of an insurance company’s ability to meet its obligations to policyholders. AIG and Chubb have the highest A.M. Best ratings: A++ XV. Chubb and AIG are the only two carriers to have held this rating for 50+ consecutive years.

Q: How can one estimate the size of an insurance company’s potential liabilities?

A: Carriers use 2 models for determining their potential liabilities. The first model is the total amount of face value policies. This assumes every client would be paid policy limits. The second model is called “Probable Maximum Loss”. With this model, each carrier has its own way of calculating the probability of X% of their clients having losses of $Y. Most companies use the second model and share their calculation with rating agencies such as A.M. Best. Chubb and AIG use a more conservative method for determining potential liabilities than other carriers contributing to their higher overall ratings.

Q: What is the State Guarantee Fund, and how does it work?

A: The California Insurance Guarantee Association (CIGA) provides a mechanism for the payment of covered insurance claims by insolvent insurance companies. For claims other than claims for workers compensation, CIGA can pay only up to a maximum of $500,000 per claim. For example, a client suffers a $2 million loss with a 15% deductible ($300,000), but the carrier only pays $1 million of the $1.7 million net loss. State Guarantee Fund will step in and pay up to $500,000 of the remaining $700,000. Importantly, the State Guarantee Fund does not cover claims in the event of insolvency of CEA.

Q: What about insuring personal property and collections?

A: High quality underlying homeowners insurance and collections (jewelry, fine art, etc.) policies, such as those offered by Chubb, AIG and Fireman’s Fund, will provide earthquake coverage for contents damaged during an earthquake.

Q: What’s the bottom line?

A: Chubb, AIG, and Fireman’s Fund underlying homeowner policies offer articles and fine arts coverage which would include losses to those items due to earthquakes, with no deductible. Many clients will decide to stop there; however, if clients decide to purchase an additional earthquake insurance policy, obtaining it through a company with superior capitalization and financial ratings, and comprehensive coverage features, is the best approach for truly insuring the earthquake risk.

As always, your Kochis Fitz client service team is prepared to help you put these general comments into the context of your particular situation.

Karen Blodgett, Greg Schick,and
Leigh Shimamoto