Flirting With Disaster

Like pressure building invisibly along an earthquake fault, a crisis is mounting for homeowners who won’t have enough insurance to cover their losses in a fire, earthquake or other catastrophe.

Major insurance companies have quietly slashed their policyholders’ coverage in recent years, raising deductibles, lowering caps and, perhaps most important, doing away with guaranteed-replacement coverage that promised to rebuild a damaged home regardless of the cost.

At the same time, earthquake insurance has been so radically constricted that today’s typical policy offers tens of thousands of dollars less coverage than what was available before the Northridge earthquake.

It’s a one-two punch that insurance companies say they needed to take to fend off huge risks that could bankrupt them.

But consumer advocates and some analysts of the insurance industry say the changes could deliver a knockout blow to homeowners’ finances, exposing millions of people to the possibility of devastating losses. Because of the high propensity for natural disasters here, California homeowners are more likely to find themselves on the ropes.

“People don’t realize what has been happening,” said Brian Sullivan, editor of Property Insurance Report, a newsletter published in Laguna Niguel that tracks insurance industry trends nationwide. “Consumers have to be savvy about the changes that are happening and recognize that their policy isn’t what it used to be.”

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Not surprisingly, insurance companies and their critics disagree about the magnitude of the potential problem.

A State Farm survey of its customers completed in 1996 found that 30% to 35% had less insurance than the company thought they needed. State Farm says it has worked diligently to boost those customers’ coverage.

The Western Insurance Information Service, a Los Angeles-based industry trade group, says it can’t quantify how many people are underinsured but that insurers are concerned enough about the problem and its legal and financial implications to support education and outreach programs.

“Absolutely there has been a problem, and the insurers acknowledge that,” said spokeswoman Candysse Miller. “That’s why we try and do promotions that help people understand what it means to be properly insured and how important that is.”

Industry critics say the percentage of underinsured policyholders is closer to 65%--possibly as high as 85%--among the nation’s 60 million homeowners. A recent study by Marshall & Swift, a Los Angeles building-cost consultant, estimates that at least 70% of residences nationwide are underinsured by an average of 35%. The company estimated the insurers could be collecting $4.5 billion a year in additional premiums--meaning homeowners could be underinsured by tens of billions of dollars.

“Homeowners are at enormous risk,” said Greg Kaighn, a Sacramento attorney who represents homeowners against insurance companies. “Insurance companies have taken [the risk] and dumped it all back on the consumer.”

Many say the extent of the problem won’t be known until the next major disaster, when policyholders try to make claims and discover they don’t have enough insurance.

Insurers and their opponents agree that the current situation arose from the collision of two trends: a gradual expansion in what insurance companies offered their customers, and an increase in the frequency of major disasters, in California and nationwide.

For years, homeowners insurance was hugely profitable, thanks to benign weather patterns that stretched from the 1960s to the early 1980s. Emboldened by their profits and eager for more business, insurers kept increasing the coverage limits on their policies, lowering deductibles and adding features such as guaranteed-replacement cost, which promised customers their homes would be rebuilt regardless of how much underlying insurance they had bought.

At the same time, consumers figured out that homeowners insurance “could be used not just for disasters, but if you dropped your camera on the garage floor,” industry analyst Sullivan said. That also led to more claims and more exposure to risk.

“They were giving away too much insurance,” Sullivan said. “It became an all-risk policy that covered everything, and that’s bad business.”

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Furthermore, competition induced some agents to calculate low replacement values on homes so they could quote lower premiums and win more business, analysts said. For example, an agent might insure a $300,000 home for only $200,000 in order to lower the premium, then tell the homeowner the guaranteed-replacement clause would pick up the difference. So if the home burned down, the homeowner would indeed get a check for $300,000.

“A lot of times formulas [for replacement values] were winked at in the old times,” Sullivan said. “You don’t often have to replace a whole house, so what was the risk? Well, surprise.”

Since 1989, the industry has been rocked by the 10 largest disasters in insurance history, including Hurricanes Andrew, Hugo and Opal; the Loma Prieta earthquake; massive winter storms in 1993; and the Northridge quake in 1994.

Insurers say the $12.5 billion in insured damages from Northridge alone cost them more in claims than they had ever collected in earthquake premiums.

A fear of future losses led most insurers to stop writing earthquake policies in California until the Legislature created the California Earthquake Authority in 1996 to assume most of the risk.

Most major insurance companies now send their customers to the authority for earthquake coverage. But these policies have higher deductibles and sharply lower coverage limits than what insurance companies offered before the quake. Often, they are much more costly as well.

In 1994, Len and Barbara Vosen of Northridge paid $560 for an earthquake policy that covered most of the $140,000 damage to their home and $60,000 in destroyed furnishings. Today they pay more than $1,800 for a policy that has a 50% higher deductible and provides only $5,000 of “contents coverage” that would replace lost furnishings. Their pool, patio and fences are no longer covered, and the cost of living away from home while damage is fixed--known as “loss of use” coverage--is limited to $1,500, an amount the Vosens say would barely cover a month’s rent.

“I don’t have a problem with paying more, but this coverage is a joke,” Barbara Vosen said.

So much lower is the coverage, so much greater are the restrictions, that, had the current quake insurance conditions been in force in 1994, few Northridge victims would have been able to collect much if anything. For most victims, the 15% deductible would have precluded any claim, Sullivan said.

Even before insurers advocated the creation of the earthquake pool, however, they were starting to limit their coverage.

State Farm was eliminating guaranteed-replacement coverage and capping payouts on some of its earthquake policies as early as 1985. The decision was costly. In June, plaintiffs’ attorneys revealed that the company had paid $100 million to settle claims from 117 policyholders who said they hadn’t been given adequate notice of the change.

The state now requires that all homeowners receive a clear notice of what their policy covers when the policy is renewed. Whether homeowners read the disclosure or understand what it says is another matter.

“Who wants to read their insurance policy on a Saturday night?” the trade group’s Miller asked. “It’s hard to get people to read their policies.”

The trend toward capped payouts continued apace. State Farm, Allstate and Farmers, which together write more than 50% of homeowners policies in California and 40% nationwide, gradually eliminated guaranteed-replacement coverage on homeowners insurance starting in 1992. Many smaller insurers followed suit or added other kinds of restrictions to their coverage.

Instead of guaranteed replacement, Miller said, insurers have instituted policies that limit their payout to 120% or 150% of a home’s insured cost.

The difference in coverage can be huge.

Say a home would cost $250,000 to rebuild but that the homeowner has failed to update the insurance after a remodeling or simply failed to get the right amount of insurance in the first place, and so is 35% underinsured, with coverage of just $162,500.

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Under a guaranteed-replacement policy, the insurer would have paid $250,000. But with a 120% cap, the homeowner would get $195,000 from the insurer. The rest--$55,000 in this example--would come out of the homeowner’s pocket.

Insurers vary dramatically in how they have handled the switch from guaranteed-replacement coverage to coverage with caps.

State Farm, which writes nearly a quarter of the California homeowners business and which caps replacement costs at 120% of insured value, says it reviewed every one of its 6.3 million policies nationwide, sending agents or other company representatives to personally inspect each property and make sure customers had adequate insurance.

Coverage limits were compared with building costs for each area, and polices were adjusted accordingly, said spokesman Bill Sirola. These new policies also come with built-in inflation riders that are supposed to adjust a homeowner’s coverage to keep up with rising building costs, and an additional 10% coverage to pay for bringing older homes up to modern building codes, Sirola said.

Farmers, on the other hand, simply sent notices to its homeowners about the change to a 125% cap and is conducting spot reviews to determine how many homeowners may be underinsured.

“The consumer has the responsibility to determine what their coverage should be,” said Farmers spokeswoman Diane Tasaka. “We can make some estimate about what the replacement cost should be, but if the consumer doesn’t tell us about remodeling, about upgrades, about special features that could increase the house’s worth, there’s no way we’re going to know.”

Industry analyst Sullivan said he believes the insurance companies’ reviews ensure that most homeowners will have adequate coverage. Those most at risk are people with older or unusual homes that may not fit neatly into insurance company formulas, or people who have remodeled their homes and failed to notify their insurers, he said.

But some consumer advocates question the diligence of insurance company reviews and the accuracy of the calculations. Competitive pressures may still be inducing agents to quote too-low replacement values--but now the stakes are higher, because guaranteed-replacement coverage will no longer pick up the difference, the advocates say.

“Some companies are careful and others are sloppy, which puts people at risk,” said Bill Ahern, an insurance expert and onetime consumer advocate with San Francisco-based Consumers Union.

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In addition, coverage designed to pay to rebuild homes to current building codes may be inadequate for homes that are more than 30 years old or that were built in areas that have since radically modified their building codes.

The situation is especially perilous for customers who rarely review their coverage or who don’t compare their agents’ estimates with information from independent sources, such as home appraisers, said Ina De Long, a former State Farm claims agent and supervisor-turned-consumer advocate. Each year they are underinsured, the gap widens between what rebuilding would cost and what their insurance companies would pay.

“The policyholder is placed in the position that the longer they trust the company, the worse position they’re going to be in,” De Long said.

Bert and Pepper Tibbet of Pasadena have firsthand knowledge of what happens when a home is underinsured. The couple say State Farm and the California FAIR plan, an industry-supported pool that covers high-risk properties, in 1992 calculated the cost to rebuild the Tibbets’ home at $204,000. One year later, the 1993 Altadena wildfires burned their home of 25 years to the ground. Contractors estimated the home would cost more than $400,000 to replace, but the FAIR plan refused to pay the difference.

In addition, the Tibbets discovered that any claims they made for money spent on living expenses while their home was being rebuilt would be deducted from their insurance proceeds. They say they were also denied a chance to buy building-code-upgrade coverage, which would have helped them rebuild their home to current safety standards.

“That [building code upgrade] alone would have given us another $30,000,” said Bert Tibbet.

Since the fire, the Tibbets have lived a nomadic existence, staying in friends’ guest houses and borrowed motor homes while they continue to pay the mortgage on their now-razed home. The couple has sued State Farm and the FAIR plan, claiming fraud, misrepresentation and unfair competition.

The threat of future lawsuits from underinsured homeowners also worries the insurance agents who help determine how much insurance customers buy. Although many companies say proper coverage is the consumer’s responsibility, some court decisions have held that the onus was on the agent to determine adequate insurance.

“It’s definitely a concern,” said Jim Armitage, a South Pasadena insurance broker and spokesman for the Independent Brokers and Agents of the West. “We would be at risk [from lawsuits]. That’s why we have errors-and-omissions insurance.”

Although the homeowners insurance market has returned to profitability, industry experts do not expect insurers to begin expanding coverage or lowering premiums significantly any time soon.

“Right now we’re in the very beginning stages” of increased competition, Miller said. Insurers are still leery of potential losses and unwilling to increase their risk, she said.

That means it is more critical than ever for consumers to review their policies and make sure they are adequately covered, experts said. Homeowners should ask their agents to review their coverage at least once a year and after any remodeling or other improvements, Sullivan said. Consumers can also hire a home appraiser for $150 to $300 to conduct an independent review.

“It’s always smart to be responvible for your own needs and to study your own contract,” he said. “It’s your financial well-being, and no one is going to care about that more than you.”

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Know Your Policy: Some points to consider in evaluating coverage. DX

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No Guarantee

Insurance companies have phased out guaranteed-replacement-cost coverage, which paid the full cost of rebuilding a home even if that exceeded the basic coverage amount. Now if a home is destroyed, the maximum coverage is generally 120% to 150% of the insured value--which, for many Californians, is far less than the cost to rebuild, as illustrated in the example below:

1. Home now worth $250,000, insured for $200,000.

2. Ten years later, inflation rider has increased the insurance amount to $297,000.

3. Disaster strikes.

4. Cost to rebuild entire house: $407,000.

5. Insurance company pays $356,400--120% of the home’s insured value--and homeowner pays $50,600. (Under the old guaranteed-replacement coverage, the owner would have paid nothing and the insurer would have picked up the full bill.)

Unless the homeowner wants to share the risk, the solution is to increase the insured amount to cover the full cost of replacement.

Earthquake Benefits Slashed

Earthquake coverage has been radically curtailed in the wake of the 1994 Northridge quake. Most homeowners with earthquake coverage now get their policies from the California Earthquake Authority, a state-run pool. This example compares a typical pre-Northridge earthquake policy on a $250,000 home with current CEA coverage.

Old Policy

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Features Coverage Home (10% deductible) $225,000 50% contents limit* 125,000 10% outbuildings and hardscape** 25,000 20% loss of use*** 50,000 Totals 425,000

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New Policy

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Features Coverage Difference Home (15% deductible) $212,500 --$12,500 $5,000 contents limit* 5,000 --120,000 No outbuildings or hardscape** 0 --25,000 Loss of use*** 1,500 --48,500 Totals 219,000 --206,000

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*Contents includes all furnishings.

**Outbuildings include detached garages and sheds; hardscape includes pools, fences, patios.

***Loss-of-use coverage pays for apartments, hotels or other accommodations while a home is being rebuilt.