California’s recent “Winequake” brought the public’s focus back to the state’s significant vulnerability to seismic events. Fortunately, the tremors, while costly, did not tally a high human score. For every image of a cracked street or a toppled building, there was another of a broken bottle or a toppled cask. Thus, media emphasis on emergency response was able to quickly turn to analysis.

Some commentators were surprised to find that California’s earthquake risk is dramatically underinsured. The California Earthquake Authority (CEA), the state’s largest writer of earthquake insurance, has a current take-up rate of 10%. That number, while far too low, still leaves the CEA with a large amount of risk to finance. In 2013, CEA’s total exposure was $320.5 billion.

A different and underappreciated element of earthquake risk is the cost of workers’ compensation payouts. Consider that the purpose of workers’ comp insurance is to cover the cost of work-related injuries. If an earthquake were to occur during the work day, employers would be on the hook.

To cover that risk, the California State Compensation Insurance Fund – the nation’s largest state-operated workers’ comp insurer – recently turned to the capital markets to provide catastrophe bonds for earthquake-related workers comp losses.

What are catastrophe bonds? The prevailing technical definition states:

Catastrophe bonds are risk-based securities that pay high interest rates and provide insurance companies with a form of reinsurance to pay losses from a catastrophe such as those caused by a major hurricane. They allow insurance risk to be sold to institutional investors in the form of bonds, thus spreading the risk.

In other words, if a specified catastrophe occurs, the money spent on the bonds will be used to satisfy claims. If no catastrophe occurs, investors will be returned their capital plus interest.

Catastrophe bonds are a desirable way of spreading risk for any number of reasons, but principally because:

  1. They provide an alternative to the reinsurance market when its capacity has been exhausted;
  2. Relatedly, catastrophe bonds provide casual participants with opportunities to engage with risk-transfer markets. In doing so, they help furnish greater overall insurance capacity;
  3. Catastrophe bonds maintain a high payout certainty because the bonds are fully collateralized, by their very nature;
  4. Most importantly from a free-market perspective, in the case of state entities like SCIF, catastrophe bonds can abrogate the need for a taxpayer backstop.

While the catastrophe bond market is relatively new, California has been a leader in its willingness to embrace this new pool with potentially huge capacity. In fact, the CEA was the first residual market entity to avail itself of the catastrophe bond market. SCIF, for its part, recently decided to undertake a second catastrophe bond issuance.

The new catastrophe bonds will be issued by “Golden State Re II.” This entity will be a Bermuda-domiciled special purpose insurer with much the same purpose and organization as Golden State Re I. Reports suggest that the deal is sized at roughly $200 million, similar to the first issuance, and will expire in 2019. Coverage is to be triggered on a “per-occurrence” basis, which takes into account a dizzying array of factors. In less dizzying terms, to trigger the catastrophe bond, it is estimated that a 5.5 magnitude earthquake would be required.

Though each catastrophe bond deal will be different, and some will be better than others, it is encouraging that other states with residual insurers are choosing to embrace the use of catastrophe bonds. To date, Louisiana, Florida, North Carolina, Massachusetts and (most recently) Texas, have all chosen to offset some of their property insurance risk with catastrophe bonds. What is driving those states to do so, whether a result of sour experiences with taxpayer-backed models or attractive pricing in the capital markets or perhaps embryonic libertarianism, matters less than the fact that they are doing so.

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