Legislation to create a new federal earthquake insurance backstop is currently being considered in Congress. The Earthquake Insurance Affordability Act, a bill from California Senators Dianne Feinstein (D-CA) and Barbara Boxer (D-CA), proposes limited backing from the federal government for the privately financed but publicly run California Earthquake Authority (CEA), California’s dominant seller of earthquake insurance. Although CEA isn’t specified in the measure by name, no other state has an entity that would qualify.
Proponents of the legislation say it would allow CEA to cut its premiums and thereby increase the number of people with quake insurance, and that doing so can be done at little or no cost to federal taxpayers. With more people buying earthquake insurance, they say, the federal government will achieve a reduction in disaster assistance dollars provided after an earthquake.
Opponents of the federal earthquake backstop say it would displace private companies and place much of the financial burden for a major earthquake on taxpayers because, rather than spreading risk around the world as is currently the case, a backstop would concentrate risk in the United States. In addition, opponents of the measure say it would undermine the CEA’s currently stable structure. Finally, they question that any legislation benefitting one state alone should become law.
Matthew Glans of Out of the Storm News recently conducted a Q&A with Dennis Burke, Vice President of the Reinsurance Association of America, who opposes the backstop. Mr. Burke’s comments provide good insight into how the insurance and reinsurance markets are reacting to the bill and its possible effects on the market.
Glans: Is there a need for a federal backstop for earthquake insurance? Is access to earthquake insurance a significant national problem?
Burke: No. The private insurance and reinsurance markets have the ability to and are providing coverage for earthquake insurance. The private market is willing and able to provide such coverage efficiently, if it is allowed to work. In most states, insurers directly provide such coverage to willing purchasers. The insurers transfer some of that risk to private reinsurers. In California, in addition to a few insurers who directly offer earthquake insurance, much of the earthquake insurance is written by the California Earthquake Authority, a quasi-governmental body that is financed by private capital. The CEA aggregates earthquake risk and transfers it to willing private market capital providers, including reinsurers.
Access to earthquake insurance is not a significant problem. Earthquake insurance is supported by private capital in all 50 states. The issue, in our view, is that consumers do not appreciate the risk they face from earthquake. Because of that, they do not consider purchasing earthquake cover or are unwilling to pay the rational economic price to transfer their risk of financial loss.
Glans: What effect could the backstop have on the private insurance and reinsurance markets? Can the private market cover earthquake policies on its own?
Burke: As noted, the insurance and reinsurance markets can and do provide insurance for natural catastrophes. History demonstrates time and again that the private markets are willing to underwrite and pay for ever larger natural disaster risks. The capital markets have provided additional capital, efficiently, when needed to support an increased demand for insurance and reinsurance. Despite dire warnings from scientists and public officials, consumers do not purchase earthquake insurance commensurate with their risk. If consumer demand increases, the capital markets can and will expand as necessary to provide the desired coverage.
The implementation of a federal backstop for earthquake insurance could have adverse consequences for consumers and private insurance and reinsurance market participants. To the extent such a government backstop were established, the California Earthquake Authority, the only qualifying entity, intends to increase its earthquake exposure and retain more risk than is prudent. The private reinsurers who presently provide coverage to the CEA would obviously lose some premium revenue, but the significance is much greater than that.
Taken simplistically, insurance is based upon the premise that catastrophes in all areas of the globe will not happen at the same time. Insurance and reinsurance operates most efficiently when insurers are able to diversify, that is write coverage and collect premium for a variety of risks in different geographic areas, balance the amount of risk taken in one area against risks in other areas, and using the total amount of premium collected worldwide to pay for the inevitable losses when and where they occur. In doing so, the private markets are able to reduce the cost of insurance to consumers. A government backstop for earthquake would interfere with this process by removing one of the diversifying risks from the global pool of risk. The result would be a less efficient insurance market, which rational economic theory suggests could lead to higher prices in other areas.
Glans: Will the backstop lead to additional costs for the states or individual policyholders?
Burke: Yes. The losses caused by a catastrophe will have to be paid (or repaid) by someone. A government earthquake backstop will result in cost shifting – frequently for political and not economic purposes, with taxpayers not at risk paying for those who are unwilling to pay their fair share.
First, only California has a qualifying entity. Because the California Earthquake Authority intends to reduce the amount of reinsurance it purchases if there is a backstop, it is probable that the CEA will need to borrow significant sums of money from the government. That has a cost to all federal taxpayers, not just those in California. In addition, after an event the CEA would be required to pay the borrowed funds back – at least in theory. That will result in additional costs for CEA policyholders and other Californians.
Second, despite the fact that the proposal suggests that the backstop will be self funding, history has taught us that government entities require a taxpayer bailout at some point. For example, despite a requirement to be self-funded, the National Flood Insurance Program is over $19 billion in debt to the federal government and it has no viable means of repaying that debt. The government sponsored entities, Fannie Mae and Freddie Mac, are similarly situated. They were not supposed to be backed by the federal treasury. In reality, they were and taxpayers will pay their losses for decades to come. In addition, there is always political pressure to cancel such debts after catastrophes – as some have called for in the context of the flood program. Finally, government programs tend to experience “mission creep”, where the original focused objectives are supplanted overtime with less prudent, more costly objectives.
Ultimately, the theory behind a federal earthquake backstop will fail in practice and the taxpayers across the nation would be called upon to bail out California.
The private insurance and reinsurance markets avoid these cost shifting problems. First, by efficiently balancing earthquake with other risks worldwide and charging an efficient, yet adequate premium up front, private markets provide the best pricing when permitted to do so. Second, when losses occur, only the insurers, their reinsurers and other willing capital markets participants are responsible for paying the losses.
The private market can handle natural catastrophe risks and a government program is simply not needed.