The California Earthquake Authority: A confused success story
The fact is that Californians are overexposed and underinsured. The desire to live in a beautiful environment outweighs the certainty of earthquake loss, as the state’s population continues to concentrate itself along the coast in two of the most seismically active areas of the world. The likely impact of a significant earthquake increases apace.
Modeling done in contemplation of the 100th anniversary of the 1906 San Francisco earthquake estimated that, were an identical event to occur today, the total economic loss to the region would be $260 billion. In that event, California would not be facing an insurance crisis. Instead, it would be facing a massive depression.
Leaving aside commonsense questions about any individual’s wisdom or responsibility in moving to dangerous locations, or government’s baffling public policy support of such foolish decisions, we must accept as a reality that people willingly put their lives and property in the path of certain disaster. Is sympathy wasted on the person bemoaning her flood loss after she built her castle on the banks of the certain-to-flood Mississippi?
The California Earthquake Authority – a publicly managed, privately funded, state residual market entity – was established in the wake of the 1994 Northridge earthquake. That earthquake measured 6.7 on the Richter scale, killed 60 people, destroyed thousands of homes, businesses and apartment complexes, and is, to date, still the costliest quake that California has experienced.
Insurers had dramatically underestimated their exposure to a Northridge-like earthquake. The insured loss in Northridge was more than four times the $3.5 billion in earthquake premiums collected by all earthquake insurers in California from 1969 through 1994.
Because California law requires insurers that sell homeowners insurance to also offer earthquake insurance, insurance companies’ response to Northridge was to attempt to reduce their earthquake exposure by restricting the sale of new homeowners policies. Insurers representing more than 93 percent of the homeowners market either reduced their sales of new policies or stopped writing entirely. Lenders, builders and realtors started to howl in economic pain. A state residual market entity, though controversial, was deemed necessary because of the problems caused by Northridge’s effect on the homeowners insurance industry.
Over time, the animating rationale undergirding the genesis of the CEA has changed. Just what was “the problem” that policymakers were seeking to address?
It is often assumed that the CEA was created to increase earthquake coverage, which is a reasonable assumption, given that the Northridge quake preceded the CEA’s creation. However reasonable, that assumption is wrong. Floor analysis from the time makes clear that the CEA was created in an effort to ensure that homeowners insurance remained available, in spite of the specter of seismic catastrophe.
To wit, the CEA’s primary function is not as a guarantor against earthquakes, but rather as a stabilization mechanism in the homeowners insurance market. Expanding the number of Californians with earthquake coverage is an ancillary benefit.
In each of this year’s hearings, a consensus developed that the CEA has been at once a success and a failure. The success was that the CEA has ushered in a new era of stability to the residential homeowners insurance market. The purported failure is that availability has not resulted in most homeowners being protected against earthquake risk.
It is odd that the CEA is indicted for failing to achieve what its creation did not anticipate. In fact, though financially robust, the CEA’s inability to cover a large proportion of Californians should surprise nobody. As far as take-up rate is concerned, one problem is affordability. As far as affordability is concerned, the problem is a high risk and a small pool of insured. For people willing to move into the jaws of disaster, insurance to cover such risks will be costly.
To solve the problem of affordability, both of California’s U.S. senators, with support from the CEA, have tried to put everyone else in the nation on the hook for California’s earthquake coverage. Their proposal would establish a system by which California would pay fees to the federal government in exchange for loan guarantees to the CEA, allowing it to reduce its premium rates and increase its take-up rates. As one would expect, the California Senate has seen fit to endorse just such a proposal. Senate Joint Resolution No. 28 urges the federal government to implement the “Earthquake Insurance Affordability Act.”
Eli Lehrer soundly dispatched the viability of such a federal approach back in 2011. In primis, a loan-based approach does not spread risk adequately to sustain the rates necessary to make the CEA policies practicable to purchase.
Are there other solutions to expanding the number of Californians covered by earthquake policies? Some might say a more desirable alternative would be to require, as a condition of securing financing for real property, earthquake insurance coverage in earthquake-prone areas. Such a mandate is comfortably within existing precedent. For example, federally backed mortgage securitizers Freddie Mac and Fannie Mae already require homeowners’ insurance and, in flood prone areas, flood coverage. As long as homeowners policies are linked by law to an earthquake offer, as a matter of long-term strategy, such an approach could be brought to bear.
But given the status quo, and aside from their market distorting infirmities, such insurance mandates are likely to lead to technical complications. For instance, mandating earthquake coverage could cause problems in California since the CEA is statutorily required to stop issuing policies within 180 days of exceeding its financial capacity. The CEA maintains that mandatory coverage would push the agency over the statutory limit. If so, it is clear that mandatory coverage would require a sizable increase of insurance capacity.
With regard to capacity, one school of thought holds that the scale of California’s earthquake risk is simply too big for capital markets to cover and that there is no way of “insuring our way out” of the present situation. R.J. Lehmann makes a compelling case that there is currently no such deficiency and that, even now, the private market is willing and able to take-on more earthquake risk. If Lehmann is correct, increasing CEA capacity is not a question of ability, but is, rather, a question of will.
More importantly, the private market could be induced to take-on more earthquake risk. A more straightforward approach to expanding coverage while maintaining the homeowners insurance marketplace could be pursued by simply “de-linking” homeowners policies from mandatory earthquake policy offers. This free-market approach would allow smaller insurers to enter the homeowners market, while simultaneously freeing up other insurers to more aggressively approach the earthquake insurance market.
Regardless of how the earthquake coverage problem is resolved, the CEA should be considered a success. It alleviated a dire situation in which insurers were forced to refuse to sell even basic homeowners policies. And yet, the existence of the CEA should also serve as a reminder that California’s penchant for micro-managing insurance practice has had profoundly dangerous, unexpected and distortionary consequences.