Major Quake Could Level Insurers

Question: I live in an area where a major earthquake is forecast. Since my house is my major investment, I have been contemplating earthquake insurance. Then I had a sudden fear that if, indeed, Southern California had a major quake, the insurance company’s purse strings would burst with the sudden drain. My question is: What would happen if the company went bust?--S.D.S

Answer: There is something uncanny, almost eerie, in the timing of all this. Your question arrived a good two or three weeks ago, and I was in the process of researching it on the very day that Mexico City was struck. Certainly, no one living in California could view the destruction there on television--the piles of rubble reaching to the sky--without shuddering at the realization that “there, but for the grace of God. . . .”

In the event of a comparable shake hitting Los Angeles, would there be fatalities among the insurance carriers serving the state in the backlash of such horrendous losses? You’d better believe it!

Although it rarely receives a lot of public notice, insurance companies rather routinely go belly up in the state even without catastrophic losses.

“We had four insolvencies last year alone, and in ‘85, so far, we’ve had two, with one more going under next week,” according to John Gates, executive director here of the California Insurance Guarantee Assn.

And, in the event of a major quake, there is little doubt in anyone’s mind that they would drop like flies.

“It’s a matter of very widespread concern. I’ll bet we’ve had 50 phone calls on it already this year--ever since the mandatory earthquake insurance law went into effect,” says John McCann, regional vice president of the Insurance Information Institute in San Francisco.

“Back in 1906 at the time of the San Francisco earthquake, there was no such thing as earthquake insurance, of course,” McCann adds, “but the fire losses that followed wiped out 18 insurance companies. The surviving companies passed the hat, some paid off in stocks and things like that, but a lot of policyholders simply didn’t get paid at all.”

Actual quake damage in San Francisco came to about $24 million, but the fire damage added another $350 million in losses. And this, of course, came at a time when a good house might cost $500 to $1,000, and a rather imposing commercial building might cost as much as $10,000 to $15,000.

Not Disturbed

Why neither McCann, as a representative of the insurance industry, nor Gates, as a representative of the state, appears particularly disturbed by the prospect of insurance companies being unable to pay off their losses in the case of a major quake is because of the existence of Gates’ agency--the California Insurance Guarantee Assn.

Under state law, Gates explains, every insurance carrier in the state writing property or casualty insurance (not life or health) must maintain a “policyholder surplus,” which is a stiff ratio of liquid reserves to its premium writings.

“Customarily, this is either 3 to 1 or 2 to 1,” he adds. In a 2-to-1 ratio, for instance, 50 cents of every premium dollar collected must be invested in some asset that can be quickly liquidated.

“And once an insurance company’s reserves drop below this figure--no matter whether it’s from heavy earthquake losses or anything else--it’s simply declared insolvent,” Gates adds. “At that point the state insurance commissioner steps in as liquidator. An inventory of all unpaid claims is drawn up, and then the Insurance Guarantee Assn. moves in to administer the payoff of those claims by assessing all 525 insurance companies in the state their prorated share of the claims. If you’ve got one large company writing, say, 8% of all the policies of this type in the state, then that company is assessed 8% of the losses.”

Admittedly, Gates concedes, the homeowner can take more comfort in this process than the owner of a high-rise.

“Under California law, we’ve got a top limit of $500,000 on any single claim, and that’s one of the highest in the country.

“Most have ceilings of anywhere from $50,000 to $300,000, and only two states--Rhode Island and New York--have a higher ceiling of $1 million. The state law, quite clearly, was designed to protect the little guy and came about to pay off policyholders in Marin County about 15 years ago when an automobile insurer went belly up and left them high and dry.”

And what about the owners of large buildings for whom a $500,000 payoff wouldn’t offset the loss of their first-floor window glass?

“They stick with the big, sound companies that can ride out almost anything,” Gates explains.

Reinsurance, the Insurance Information Institute’s McCann adds, has always been a major hedge used by large insurers to cut their losses on really big policies--buying their own insurance on a portion of their potential loss.

“This reinsurance field is a worldwide market, of which Lloyd’s of London is probably the best-known reinsurer,” McCann adds.

“But, unfortunately, reinsurance has become increasingly harder to get because they’ve had a rough time themselves. Because of heavy price competition, a few years ago all of the reinsurers started cutting their premiums--sometimes to as low as a fifth of the known losses. As a result, last year they were paying out $1.18 in claims for every dollar in premiums they were collecting. So, this year, the premiums have skyrocketed.”

As horrendous as earthquake losses can be, McCann adds, actual damages (so far, at least) rarely measure up to the potential losses.

“In the San Fernando earthquake of ‘71,” he continues, “about 12,000 homes were damaged, but the average damage came to just 5.7% of the value, and because most of the policies had a 5% deductible, the average pay-out came to about one-half of 1% of the individual home’s value. A good 75% of the homes damaged had losses of less than 10% of their value.

“But the average homeowner doesn’t buy earthquake insurance in order to get a $500 check from the insurance company, anyway. He’s buying it to get that $90,000 check.”

Behind all earthquake insurance thinking, McCann adds, is a sort of mystical figure known as the “probable maximum loss”--a worst-scenario piece of guesswork.

“For Los Angeles,” he continues, “this PML in ’83 was put at $5.5 billion, but for ’84 it was scaled down to $4.7 billion--largely because of higher deductibles for commercial buildings. About $597 million of that represents the probable maximum loss for residential structures. At any rate, it’s interesting that the total PML is only about half the $9 billion representing the industry’s policyholder surplus.”

Pinch of Salt

Gates, however, takes any PML figure with a liberal pinch of salt.

“Who knows what the real loss would be in a major earthquake? It’s anybody’s guess,” he says. “Under California law, though, we can assess insurance companies up to a maximum of 1% of their premium income in any one year, but in a real disaster, we can carry this forward for eight or 10 years, or whatever is necessary, until all claims have been paid. We’ve had a lot of big insurance companies go broke in the last 16 years, and we’ve collected assessments of about $132 million to pay off their losses, but, so far, total assessments have only amounted to about one-tenth of 1% of premium income.”

While on the surface it might seem like a time-consuming procedure to collect on a claim filed with an insurance company that has gone belly up (waiting, that is, until all 525 companies have been billed and ante up for their share of the loss), it’s actually pretty speedy, Gates promises.

“We’ve got the authority,” he says of the California Insurance Guarantee Assn., “to borrow whatever money is necessary to pay off the claims and then repay it as the assessments come in.”

So, there you have it: As a homeowner you should have no fears about your earthquake insurance carrier going broke in the aftermath of a major quake here.

Unless, of course, your home is valued in excess of $500,000, the maximum.