A major quake is coming, but when? And what about insurance?

The Northridge earthquake in 1994 killed people and damaged property. That is not all. That disaster also created the California Earthquake Authority, a public entity that provides earthquake insurance coverage and helps make it available to those who want it.

The multibillion-dollar CEA is privately funded and publicly managed, and is backed by reinsurance that it buys to help cover losses in the event of a catastrophic temblor. The not-for-profit CEA does not sell coverage directly to consumers, but its participating insurers do, currently 25 firms. Other companies also offer coverage, but the bulk of California quake insurance — about two-thirds of it — comes through CEA.

“The effect of the Board’s changing the range gives CEA the flexibility to purchase less reinsurance when market conditions are unfavorable.” — CEA

Its board meetings do not receive much public attention, but they are closely watched by the insurance industry and Wall Street.

In March, the CEA board met in part to consider its risk assessments and its current capacity of $19.6 billion to pay claims, and approved some changes.

The board approved a new claim-paying capacity range for CEA moving from 1-in-400 to 1-in-550 to 1-in-350 to 1-in-500.  The expression of claim-paying capacity in terms of 1-in-X is simply an alternate way to express an annual probability.

For example, a 1-in-400 chance is a 0.25% annual probability (1/400) of occurring, and a 1-in-350 chance is a 0.29% annual probability.

“The effect of the Board’s changing the range gives CEA the flexibility to purchase less reinsurance when market conditions are unfavorable,” CEA noted.

Fitch Ratings, the Wall Street credit rating agency, downgraded the CEA’s  “Issuer Default Rating (IDR) and revenue bond ratings to ‘A-‘ from ‘A’. The Rating Outlook is Stable.

“The rating action follows the vote of the CEA’s Governing Board to reduce the target claims paying capacity (CPC) to a return period of 1-in-350 years, from the previous target of 1-in-400 years, as part of a review of the company’s strategic plan,” Fitch noted.

The average annual cost of a California earthquake policy in 2020 was $738, according to data compiled by the state Department of Insuranc

But Fitch also noted that the CEA’s “financial flexibility is much stronger than similarly rated private insurers that cover catastrophe risk, which allows its final rating to be elevated a full category above the risk assessment of claims-paying resources to ‘A-‘.

“The State of California, the insurance industry in California and policyholders in California all have an interest in the CEA’s continuance as an organization,” Fitch added.

Earthquake insurance is computed by such factors as ZIP code, age and size of the dwelling, the materials used to construct the home, the cost of rebuilding, soil type and proximity to fault lines, among other factors. Typically, deductibles range from 5% to 25%, but unlike other forms of deductibles — such as in auto insurance, for example — the quake deductible is not paid in advance, but is subtracted from the rebuilding coverage.

Nobody knows, of course, when a major quake will hit. Experts believe a magnitude 7 earthquake may hit the San Francisco Bay Area within the next 30 years.

“The real threat to the San Francisco Bay region over the next 30 years comes not from a 1906-type earthquake, but from smaller (magnitude about 7) earthquakes occurring on the Hayward fault, the Peninsula segment of the San Andreas fault, or the Rodgers Creek fault,” according to the U.S. Geological Survey.

The average annual cost of a California earthquake policy in 2020 was $738, according to data compiled by the state Department of Insurance.

The Consumer Federation of America advocated going to a 1-in-250-year event.

We turn to a saying on Wall Street. Never predict anything, especially the future.  Much of what happens on Wall Street reflects wagers on future prices going up or down, with the Great Recession and its genesis in mortgage-backed securities that crashed when homeowners were unable to afford balloon payments a case in point.

Rex Frazier is the president of the Personal Insurance Federation of California. The PIFC’s missive to the CEA board before its March meeting reads thusly: “There should be no approach adopted that only seeks to alleviate short-term financial pressures at the expense of long-term sustainability. The highest priority should, therefore, be to restructure the CEA to fund not only the next ‘Big One,’ but also ensure ‘day after’ funding to support CEA’s continued operations following the ‘Big One.’”

The Consumer Federation of America advocated going to a 1-in-250-year event. “We think that consumers, homeowners, renters, condo owners who buy earthquake insurance would prefer affordable policies with some slight risk,” according to Doug Heller, the CFA’s insurance specialist.

Buying higher-priced reinsurance for reserves correspondingly increases what policyholders pay for coverage

But that scenario is a balancing act with possible losses that are not covered.

In the meantime, a prospect of rising prices for earthquake insurance policies is the impetus for the CEA’s proposed changes.

Inflation (rising prices and wages) is perhaps the most persistent problem for the economy now. The CEA’s reliance on the unregulated global reinsurance market to shore up its capital reserves is driving earthquake policy price hikes, says Heller.

“There is a long history of the CEA using the reinsurance market as a financial backstop,” he added, “without considering alternative approaches. One is creating a public backstop, not necessarily taxpayer-funded, but one that is created for the people of California.”

In terms of the latter option, the state of Florida offers an example. Its name is the Florida Hurricane Catastrophe Fund. The FHCF’s public financing helps to cut the costs of future payouts from reserves. In addition, claims not paid from reserves strengthen the FHCF, according to Heller.

Buying higher-priced reinsurance for reserves correspondingly increases what policyholders pay for coverage. Apparently, this is a “whatever the market will bear” scenario. That scenario can benefit sellers over buyers.

Accordingly, global reinsurers bear a wide array of risk. In essence, the CEA is paying for reinsurance that reflects risk around the world.

It is noteworthy that the international reinsurance market is unregulated. That means reinsurance is not subject to regulation from the state’s Department of Insurance to determine that rates are not excessive, as are auto, business and homeowners’ insurance. Regulation, of course, is not a magic wand for lower prices in the marketplace, as historical examples in airline and trucking industries suggests.

However, for most consumers most of the time, buying unregulated goods or services means that they pay higher prices. That reduces their buying power in the marketplace. We see that dynamic playing out now in rising prices for food and fuel.

The global reinsurance market covers risk worldwide, such as climate disasters and terror attacks. Accordingly, global reinsurers bear a wide array of risk. In essence, the CEA is paying for reinsurance that reflects risk around the world.

The bottom line for Californians is that earthquake insurance is expensive. The following slow growth numbers for California indicate that trend. In 2019, there were 1,657,850 policies statewide (a total for CEA and non-CEA policies) versus 1,687,712 in 2020. The California Department of Insurance will update the data for 2021 this July.

The CEA’s governing board consists of the state’s governor, treasurer and insurance commissioner. The CEA’s next board meeting is June 30.

—
Editor’s Note:c Corrects 2nd graf to show CEA is privately funded,