Investor Bets Against Big Quake for 4 Years

Multibillionaire investor Warren Buffett is betting that no big earthquake will devastate California before March 31, 2001.

And that, according to a principal advisor for the new California Earthquake Authority, seems like a very good bet.

Buffett’s Berkshire Hathaway Inc. has agreed to sell the state-run earthquake insurance agency $1.5 billion of reinsurance for four years, in return for a premium of $590 million, it was disclosed over the weekend.

The earthquake authority’s actuary, John Drennan, said Sunday that calculations of annual quake probabilities indicate that there is only one chance in 20 that Buffett would have to pay out so much as a penny in return for that premium. Terms for paying the premium were not revealed, but reinsurance premiums routinely are paid early on in the agreement.

Reinsurance means that an insurer--the newly created state earthquake authority--pays a premium in exchange for a commitment that the reinsurer--in this case, Buffett’s firm--will pay damage claims above a certain amount, or, alternately, a percentage of the claims above that amount.

According to the terms of the agreement reached Friday between the earthquake authority and the Buffett firm, if damage from any quake in the next four years exceeds $7 billion in homeowners claims, then Buffett’s Omaha-based firm would pay the next $1.5 billion in claims.

Richard Wiebe, spokesman for Insurance Commissioner Chuck Quackenbush, said Sunday that the $590-million premium might seem high. But Wiebe said state officials calculate that it will still be cheaper than paying interest on bonds, which the earthquake authority had originally planned to sell to buttress its resources.

Buffett, whose $15-billion fortune ranks him just behind Microsoft’s Bill Gates as the nation’s richest man, could not be reached for comment Sunday.

If a huge quake were to occur and claims were to surpass $7 billion, Buffett’s firm would have to pay out up to $910 million, on top of the $590-million premium, which would have to be returned.

But Drennan, a retired Allstate actuary from Libertyville, Ill., said Sunday that this is not at all likely.

According to the quake probabilities calculated for the earthquake authority by the quake-modeling firm of EQE, International, Drennan said, the annual probability of so substantial a California quake is only 1.27%.

“In an 80-year period, you would expect to have one year where the losses exceeded $7 billion,” Drennan said.

So, in four years, those chances translate to 1 in 20--although, of course, the next big quake could occur tomorrow.

The reinsurance takes full effect by April 1, 1997.

Drennan stressed that the $7-billion figure refers only to damage that would have to be paid by the quake authority.

In the 1994 Northridge earthquake, private insurance companies paid out $8.5 billion in residential damage claims.

But under the new law, the state coverage--while costing policyholders more than such insurance did before the Northridge quake--covers less than half of what it had before.

By raising the deductible to 15%, by exempting garages, pools, fences, landscaping and outbuildings from coverage altogether, and by limiting coverage of a home’s contents to $5,000 and extra living expenses to $1,500, the state authority’s payout in a quake the size of the Northridge temblor would be only $4 billion.

In the Northridge quake, where the total of all damage to public and private facilities reached $27 billion, a little more than half the total relief came from private insurers, and a little less than half from the federal government.

After that quake, though, private insurers launched a major lobbying effort to reduce their exposure by creating the state agency for homeowners insurance.

With the reduced coverage, a new quake would mean that either the government relief share for homeowners would have to rise dramatically, or much more of the burden for repairs would fall directly on the homeowners.

Reinsurance is generally calculated in such a way that the reinsurers seldom have to pay, and it is usually very profitable to its sellers.

But when reinsurers are called upon to pay, the impact can be severe, as it would be for Buffett in this case.

In that context, it is worth recalling that selling earthquake insurance was profitable for the companies in every California quake but one. But damage claims in that one--Northridge--far exceeded all the earthquake premiums ever paid.

Buffett, now in his mid-60s, is widely regarded as the most successful investor in America in the last 30 years.

Single shares in Berkshire Hathaway now sell for $33,000, and an investor who gave Buffett $10,000 to invest in 1956, and kept that investment intact, could realize $120 million today.