Shaking up the earthquake insurance market

by R.J. Lehmann on October 5, 2011

Does Glenn Pomeroy know something the rest of us don’t?

Pomeroy, a former North Dakota insurance commissioner and brother to former U.S. Rep. Earl Pomeroy, currently serves as CEO of the California Earthquake Authority, the quasi-public residual market entity that underwrites 70% of California’s residential earthquake policies. Created by the state legislature in the wake of 1994′s devastating Northridge quake in the San Fernando Valley, and the subsequent decision by many carriers to restrict their underwriting of earthquake risks, the CEA is publicly managed, but financed by private member insurers, who combine to write about two-thirds of the state’s residential property insurance.

But CEA has a long-standing problem. Despite obvious public awareness of the threat of earthquakes in California, only about 12% of the state’s homeowners elect to buy the coverage. Looking to broaden take-up rates significantly, the CEA recently announced it would embark on a new agent marketing campaign and the authority plans to cut its rates, required by law to be actuarially sound, by 12% effective Jan. 1, 2012.

The authority also is overhauling its capital structure, notably with the sale of $150 million of three-year catastrophe bonds that will pay investors 660 basis points above returns on one-year U.S. Treasury money-market funds. While the offering is relatively small in the scheme of the CEA’s $9.4 billion claims-paying capacity, which includes $3.1 billion of reinsurance, Pomeroy was quoted by Insurance Journal as saying the deal was key to the authority’s plan to “diversify and expand its claim-paying resources.”

“A diverse set of risk-transfer tools, which includes not only reinsurance and catastrophe bonds but also post-earthquake federal loan guarantees, will help us make earthquake insurance more affordable and more widely used.”

Hold the phone: What was that bit about post-earthquake federal loan guarantees? There is no such federal program currently, but Pomeroy sounds here as if he’s already taking for granted that they will be a part of CEA’s financing in the future.

Over the past year, the CEA has been the most vocal supporter of legislation introduced by Sen. Dianne Feinstein, D-Calif., called the Earthquake Insurance Affordability Act. The bill, which is cosponsored by Sen. Barbara Boxer, D-Calif., would authorize the U.S. Treasury to guarantee up to $5 billion in loans to “eligible state programs” (the CEA is the only existing program that would presumably be eligible) to finance claims payments following significant earthquakes.

The guarantees against loss of principal and interest would serve to make the loans risk-free, and thus much cheaper than what the authority would face in the private sector. Moreover, because the bill’s language stipulates that it would “not require insurers to pool resources to provide property insurance coverage for earthquakes,” the predictable effect is that states would be encouraged to bypass the private insurance market altogether, and instead establish government-run insurers to take on earthquake risk.

What is perhaps most notable about the earthquake bill, from a political perspective, is that it marks a separation of West Coast states, and particularly California, from the broader effort for a federal insurance backstop for natural catastrophes, which was seen by many as conferring outsized benefits on Florida and the other Gulf Coast states. One doesn’t need to be expert in political alliances to see why California might want to go its own way. Whereas subsidized flood and windstorm insurance encourages development in environmentally sensitive wetlands and coastal barrier islands, this is less of an issue with earthquake risk.

But a more focused lobbying appeal is a double-edged sword. While it might make fewer enemies among environmentalists, California’s push for an earthquake-only backstop also has fewer natural allies. That’s why you saw Pomeroy and the CEA redouble their efforts following August’s East Coast earthquake, suggesting that the temblor, centered in Virginia, served as “a reminder for all Americans that the time has come for our national leaders to address the affordability of recovery for families and communities after the next damaging earthquake strikes.”

While it is true that earthquake risk is not limited to California — some of the largest earthquakes in American history have been seen in locales as far flung as Alaska and the Midwest’s New Madrid fault line — given its population and the extent of the risk it faces, the benefits of a federal loan guarantee facility would disproportionately accrue to the Golden State. And there simply isn’t any compelling public policy rationale for property owners in states like Mississippi or even Pomeroy’s home state of North Dakota — which are relatively poor and face relatively little earthquake risk — to subsidize the risks taken by property owners in one of the nation’s wealthiest markets.

Moreover, the CEA’s recent cat bond placement would seem to amply demonstrate that there is no market failure to address here. The authority had to turn away investors who were interested in the $150 million placement and rating agency Moody’s commented that the capital markets “have pent-up demand for cat bonds, particularly those that diversify away from U.S. hurricane exposure, the underlying risk in the majority of cat bonds.”

In fact, the authority’s move to catastrophe bonds could even pressure reinsurers, Moody’s noted. The authority itself reported that it has paid $2.8 billion to reinsurers over the past 14 years, representing more than 40% of its $6 billion in total premium revenue. While the CEA isn’t the first residual market entity to include cat bonds in its capital structure — many observers were left wondering whether the strike of Hurricane Irene would be significant enough to trigger any of the four cat bonds North Carolina’s underwriting associations have issued — Moody’s noted that this marked the first time the authority completely bypassed private reinsurers, going to the capital markets with a deal led by Deutsche Bank and forming an indentured trust for the Embarcadero Re Ltd. transaction that will be managed by Citigroup.

What all this means is that the private market — including reinsurers, investors and big investment banks — is hungry for earthquake risk. Big banks and investment funds haven’t needed any inducement from the federal government to take on these risks. Federal loan guarantees would mark a preemptive bailout of these same sorts of institutions, who would still reap profits, but with any and all risk of loss transferred to the taxpayers.

The problem, from the CEA’s perspective, is that most California property owners would rather self-insure their earthquake risk, rather than pay to transfer it. That may or may not be wise risk management, but it’s a decision every individual property owner must make for themselves. If the CEA, or any other insurer, wants to change that dynamic, the answer is for them to come to market with products the public actually wants to buy.

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