What Will Happen When the Big One Strikes?

By Bill Churney

The recent magnitude 5.1 earthquake struck Southern California, rattling several counties, including Los Angeles, San Bernardino, Orange, Ventura, and Riverside. Minor damage was reported, mainly near the epicenter in northern Orange County. The tremor instigated an immediate debate as to whether this might be a foreshock of something bigger. It also brought to mind the last truly significant earthquake to strike the region, 20 years ago.

On January 17, 1994, the magnitude 6.7 Northridge earthquake struck Southern California. The epicenter was just 20 miles northwest of downtown Los Angeles, and the quake produced the largest ground motions ever recorded in an urban environment in the United States. More than 40,000 buildings were heavily damaged, and insurance companies paid out a record USD 12.5 billion in claims (in 1994 dollars) — substantially more than the total amount of earthquake insurance premiums collected during the previous several decades. The obvious implication was that the industry had significantly underestimated the risk, and a shortfall in availability of earthquake insurance ensued.

After several attempts at a remedy, the state passed legislation to create the privately funded, publicly managed, not-for-profit California Earthquake Authority (CEA) in September 1996. Residential insurers can either write policies on behalf of the CEA at predetermined rates or offer private earthquake coverage in accordance with minimum state requirements. Intended as a permanent solution to California’s earthquake insurance coverage issues, the CEA currently bears just over two-thirds of earthquake-insured residential property risk. However, only 12 percent of homeowners opt for earthquake coverage across the state — down from roughly 25 percent statewide when Northridge struck. (The take-up rate is higher in major cities such as Los Angeles and San Francisco.) Millions of California homeowners are more vulnerable than they were 20 years ago.

No earthquake in the past 20 years has come close to the level of damage the Northridge quake caused, but in 2007, the United States Geological Survey estimated that was a 94 percent probability that an M7.0 or greater earthquake will strike California before 2037.

What would losses from the “Big One” look like if it were to strike today? While it’s impossible to predict the exact scenario, we took one entirely plausible simulated event from AIR Worldwide’s U.S. Earthquake Model similar to the 2008 ShakeOut scenario, which was overseen by the Southern California Earthquake Center.

Our simulated earthquake measures magnitude 7.9 and ruptures 22 segments of the San Andreas fault. Properties across 13 counties of Southern California are damaged. Total replacement value affected is more than USD 4 trillion, about 40 percent of which is in Los Angeles County. AIR estimates that such a quake would cause USD 202 billion in total residential and commercial losses — about 85 percent of which is uninsured.

Who Pays?

Insurance payouts (including from the CEA) would cover just USD 30 billion — about 15 percent — of the total loss. The uninsured portion is the responsibility of homeowners, landlords, and businesses — and there’s a price beyond that. The cost of repairs decreases savings, increases debt, and affects profit margins for businesses. Some businesses may file for bankruptcy, and homeowners may walk away from their mortgages. Thus, a large portion of the uninsured loss may shift to other stakeholders, such as lending institutions and — ultimately — taxpayers.

Source: AIR Worldwide

Large disasters can reduce overall real estate and economic activity in an area for many decades. Homeowners may negotiate for lower payments or moratoriums, and mortgage defaults will force lending institutions to sell foreclosed properties at a loss. In this scenario, a USD 1 billion loss to the mortgage industry represents only 1.5 percent of the insured residential loss.

Finally, after a major disaster strikes, federal agencies such as FEMA and state entities provide short-term emergency relief funding and longer-term aid. In January 2013, Congress passed a USD 50 billion federal aid bill for Hurricane Sandy relief, a portion of which goes toward loans and grants to help repair homes and businesses.

Better Understanding of Risk, Better Preparedness

Given the far-reaching consequences outlined in AIR’s simulated scenario, a catastrophic earthquake in today’s insurance environment will likely result in a new set of regulations and laws that once again will transform the landscape of earthquake insurance in California and the role of private insurers. But it’s not a foregone conclusion.

The understanding of earthquakes (seismicity, ground motion, and engineering) has improved greatly since the Northridge event. Probabilistic modeling, still in its infancy 20 years ago, can now provide insight into compelling ways to improve the value proposition of insurance while keeping short- and long-term financial objectives in mind.

Insurance companies are thus better equipped to develop viable insurance products by assessing different policy conditions, underwriting guidelines, and the impact of mitigation options. They’re also able to make better portfolio optimization and reinsurance purchasing decisions. Twenty years after the Northridge earthquake and before the Big One strikes, it’s time for the industry to rethink a better future for earthquake insurance in California.

Bill Churney is chief operating officer at AIR Worldwide, a provider of risk modeling software and consulting services.