Quake agency grapples with critical financing

Thirteen years after the Northridge earthquake shook Southern California, the state still is wrestling with how to best protect homeowners in the event of another quake–and what obligation the insurance industry has to provide quake insurance to consumers.

It’s no academic question.

Next year, the obligation for insurers to pay $2.2 billion in the event of a quake, a key component in the complex financial structure of the California Earthquake Authority (CEA), goes out of existence. It will disappear under the contract in the law that created the CEA in 1996. Some replacement is likely to be negotiated–the CEA’s governing board decided two weeks ago to get the ball rolling–but how much and in what form is uncertain. Insurers, regulators and consumers are watching closely. Negotiations are under way.

“Our main concern is to keep the CEA viable and effective. We’re in the same hunt for options here as everybody else,” noted spokesman Bill Sirola of State Farm, one of CEA’s 17 participating insurance companies. Ken Gibson, vice president of the American Insurance Association, agreed. “It’s vital. It’s in everyone’s best interest.”

At issue is the CEA’s “layer cake” financial structure, in which each layer of money kicks in when the one below it is tapped in the event of a quake. If the $2.2 billion layer is removed–perhaps a fourth of CEA’s capacity–would that force up rates or limit the CEA’s ability to cover claims?

The lowest layer, the money on first call, holds the insurers’ original assessments and the investment income they generate, now about $2.6 billion. The second layer, the one under scrutiny, is the $2.2 billion that CEA’s insurers have promised to pay, if needed, to satisfy claims. This $2.2 billion obligation expires on December 1, 2008.

The levels higher up in the 11-layer cake are largely reinsurance purchased by the CEA, except for the top level–another obligation for insurers to pay, this one for nearly $1.5 billion, if the lower layers are exhausted. The total: $8.4 billion.

That is more than enough to handle two Northridge-like quakes back-to-back, in part because CEA-issued policies provide basic coverage to replace the principal structure and few frills. Insured home losses totaled $12.5 billion in 1994 because those policies often included sheds, out buildings, landscaping structures, swimming pools and fencing.

CEA policies, which target residences and carry deductibles of 10 percent or 15 percent, cover only the principal structure, although enhanced coverage can be purchased for contents and temporary rental housing beyond what the basic CEA policy provides. A Northridge-style event in 2007 would cost CEA about $3.5 billion in claims, according to the CEA’s own estimate. A handful of private insurers, not participants in CEA, sell earthquake insurance on the private market. Their policies generally are more comprehensive, and costly, than the CEA.

The idea for the basic CEA policy, originally dubbed a “mini-policy,” came from consumer groups, who sought low-cost coverage for large numbers of homeowners. The consumers’ role was noted in the law that created the CEA.

Nearly from the day CEA came into being, insurers have longed for the $2.2 billion obligation to expire and have chafed at attempts to prolong it. Politics plays a role, too: Former Democratic state Treasurer Phil Angelides, a member of the CEA’s three-member governing board and a candidate last year for governor, sought political mileage in attacking the program and seeking an extension of the insurers’ obligation.

But now, insurers are seeking negotiations that would continue their obligation–in some form. None of the participants are publicly discussing the negotiations. But there are at least two key points, according to Capitol sources and comments made publicly at an April 26 CEA board meeting. The impetus to renegotiate came from insurers.

First, insurers want the obligation raised to a higher level in the layer cake, which means it would be tapped later than it would be if it was lower down. Second, they want some form of compensation for agreeing to continue the obligation.

“We want an opportunity to establish new contract terms,” Mike Paiva of the Personal Insurance Federation of California told the CEA governing board.
Consumer activists were not pleased.

“The insurers want to go two steps up the ladder, where there is an infinitesimal chance that they would bear any responsibility to pay out,” said Carmen Balber of the Foundation for Taxpayer and Consumer Rights. Balber’s colleague, Douglas Heller, agreed.

“They want to move up the ladder to the least-needed part, and they want to charge us for it. The insurers’ obligation should be in the first layer, not higher up. When we do have the next Loma Prieta or Northridge, [insurers] need to be there,” Heller said.

Board member Bill Lockyer, the Democratic state treasurer and also a critic of the CEA, replaced Angelides on the board. The second board member is Insurance Commissioner Steve Poizner, a Republican who, like Lockyer, is all but certain to run for governor in 2010. The third member, designated by the governor, is Clark Kelso, a Democrat and veteran government trouble-shooter. With Poizner and Lockyer on the board–both appear disinclined to send surrogates but attend the meetings themselves–confrontations between the two are likely. Neither is considered knowledgeable about earthquake insurance. Kelso, however, temporarily ran the Insurance Department in the aftermath of the scandals that forced the resignation of Republican Chuck Quackenbush in the summer of 2000.

Reconfiguring the layer cake is likely to require new legislation, which means the issue will be debated in the Legislature. That, in turn, will give the issue a high political profile. Until now, the debate has largely been the purview of industry insiders.

The CEA is unique in the nation, a purveyor of quake coverage to 757,000 policyholders who pay an average of $700 annually for protection. In effect, the CEA is a pool of money, mostly investors and insurers, spawned by the 1994 Northridge earthquake. That quake roiled the homeowners insurance market and pushed some insurers to insolvency as they faced enormous losses and struggled with the California law that requires homeowners’ insurers to offer quake coverage. Indeed, protecting the homeowners’ insurance market is a fundamental goal of the CEA.

Quake coverage costs are determined by a policyholder’s location in one of 19, risk-defined territories, by the number of stories in the house, by construction type, by soil issues and a number of other factors. They also depend on evolving technology: As seismic studies improve, structural risks are redefined. For example, older homes were once considered the most quake prone, but now homes built between 1960 and 1979 are often considered high risk, with suburban “big-box” tract homes among the riskiest in such regions as Riverside County and the Inland Empire, according to the CEA.

The basic nature of the CEA’s policies has drawn fire from consumer groups, who believe the policies are inadequate. Too, the CEA is not a state agency but a private entity that acts on behalf of the state’s goals.

“We’re the first to say that this is not a product for everyone,” says CEA spokeswoman Nancy Kincaid. “The question is, ‘How should you manage your risk?’ It is the absolute belief of some consumers that the government will bail them out in the event of a quake. And the government does that every single time. But the government doesn’t bail everyone out. That’s the mistake that people make.”

Contact John Howard at

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