Japan Quake Reveals Cracks in Insurance System

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Michael Korn, managing principal at Integro Insurance Brokers, is a popular person these days, which is perhaps not too surprising considering he is an insurance broker in earthquake-prone San Francisco.

“We’re pretty busy,” he said of the period since Japan’s devastating earthquake on March 11.

More than 28,000 people are dead or missing in Japan’s magnitude 9.0 earthquake and subsequent tsunami, and researchers estimate some 143,000 buildings were in some way damaged. Depending on whom you ask, the insurance industry may be on the hook for anywhere from $12 billion to $42 billion in claims – a fraction of the more than $160 billion capital insurance brokers say is available in the reinsurance sector, but a huge number nonetheless.

If only it had been a hurricane instead.From Sacramento to Sendai, everyone is better prepared for big storms than earthquakes. Insurance companies have more data and more experience; customers have more and better coverage; and the disaster researchers who support the industry have more science on their side.

While insurers can literally see a hurricane coming a mile away (and then some), every earthquake is an educated guess.

The sophisticated modeling systems the insurance industry uses to predict where disasters will happen and how much they will cost never factored in an earthquake the size of Japan’s. At most, programs suggested a magnitude-8.4 earthquake might hit that part of Japan in the next few centuries. But the 9.0 quake was some five times or so more powerful than even the finest scientific minds in Japan thought possible.

Despite the fact that three of the six strongest earthquakes in history have struck since late 2004, relatively few people carry insurance for them, and the industry has for the most part ignored them.

“We’ve now had three of these earthquakes close to magnitude 9 in the space of seven years. That is sort of interesting. It doesn’t look like random behavior,” said Robert Muir-Wood, chief research officer of catastrophe modeling company RMS.

No Insurance, No Problem

Earthquake insurance is so rare in San Francisco and other places where tectonic plates slip that even insurers are shocked.

“Frankly all of these facts have been on the table for a long, long time,” said Jacob Rosengarten, chief risk officer for reinsurer XL Group.

Scientists say California will suffer a severe earthquake in the next 30 years – in the middle of the desert or under downtown Los Angeles, no one knows. Only one in 10 California homeowners has earthquake insurance, athough California law requires anyone selling homeowners policies to also offer earthquake coverage.

“In California, the insurance industry is better prepared for the next earthquake than Californians because for the most part they don’t cover it,” said Glenn Pomeroy, CEO of the California Earthquake Authority.

Of the few people in California who have an earthquake policy, 70 percent get it from the CEA, paying huge premiums for the privilege and facing a 15 percent deductible if their home is actually lost in a quake.

“If anybody ought to be able to make earthquake insurance affordable, it’s us, and yet we still struggle because of the nature of the risk,” Pomeroy said.

The problem is more acute in Missouri, which sits on the fault that caused the New Madrid earthquake in 1812. Were that temblor to happen now, it would cause an estimated $100 billion in insured losses.

In February the state identified eight at-risk regions, and found that in each case coverage had declined sharply as premiums in some instances doubled. The disparity is a hot-button issue for John Huff, director of the Missouri Department of Insurance who holds the insurance commissioner’s seat on the Financial Stability Oversight Council. That makes Huff an important player in the ongoing debate about how insurance will be regulated in years to come. He said all options are open – including a regional compact or CEA-like partnership, following on discussions he is holding with insurance commissioners in neighboring states.

“It’s an issue we should not take off the table and we should not dismiss without discussing,” he said. “The amount of deductible on these products would put folks out of reach of having adequate coverage if an event occurred.”

The question is, if people cannot or do not buy coverage, what happens when the worst happens? In Japan and New Zealand, government reinsurance pools protect most homeowners from quake risk. In the United States, insurers say there is an assumption – the belief, right or not, that if a really bad disaster devastated a truly important region of the country, the U.S. government would somehow step in to help.

Short-Handed Science

Financial assumptions are not the only problem; scientific assumptions are an issue too. Earthquake science is still catching up to wind science. Insurers do not focus on earthquakes the way they do on hurricanes. This is partly because by an accident of geography, richer, more heavily-insured parts of the world are hit far less often by earthquakes than by windstorms.

“You have greater competence in the response for hurricanes because you have a much greater frequency,” said Tom Larsen, the product architect for EQECAT, another risk modeling company.

“No event is the same. Every single event, whether it is large or small, has its own unique characteristics,” said Jay Guin, senior vice president of research and modeling for AIR Worldwide, another risk modeler. “Most people would agree that earthquakes have more uncertainty. … An earthquake happens with no forewarning so that adds to the psychological effect.”

One consequence of earthquakes’ relative rarity is that models used to predict their impact on insurers are less developed. This greater uncertainty makes insurers more wary of earthquake risk.

“We believe we are less exposed to earthquakes than wind, and that’s partly driven by the fact that there’s more modeling uncertainty,” said Paul Martin, head of enterprise risk management at Bermuda-based insurer Catlin. “Quake models have been less tested. This is a massive test for the Japanese quake model. The modeling companies will undoubtedly learn a lot from this.”

Price Pressure

A natural human response to a catastrophe is to buy insurance in case it recurs. Rising demand in the aftermath of an earthquake or hurricane allows the industry to push up prices. Often, those hikes are helped by an easing of competitive pressure as some insurers, hit by gigantic claims, withdraw from the market because they no longer have the capital to write new business.

However, with insurance stocks still mostly hovering below their pre-March 11 levels, investors appear to be betting against a transformation in the industry’s pricing power, according to Andy Broadfield, an analyst at Barclays Capital in London.

“The market’s telling us there isn’t a big enough impact to change prices. It’s pricing in the losses, and perhaps a very, very small improvement in the outlook,” he said.

The European insurance share index, home to the world’s top reinsurers, fell nearly 9 percent in the five days after the March 11 quake. In the United States, the Standard & Poor’s insurance index also has struggled.

That is in contrast to the aftermath of Hurricane Katrina in 2005, when most insurance stocks rose strongly in the expectation that the industry would be able to deliver bumper shareholder returns on the back of a steady increase in prices.

But what investors did not foresee was that the prospect of strong returns would also encourage cut-throat competition. That, coupled with a relative dearth of major insured losses, has resulted in flat or falling prices across most categories of global insurance and reinsurance for the past four years.

Reinsurer Swiss Re reckons the industry has absorbed some $43 billion in losses from earthquakes in Chile and New Zealand and floods in Australia last year, and some analysts and brokers say the impact of the Japanese quake could yet firm up prices.

Most in the industry agree that whatever happens to the broader market, the price of pure earthquake coverage will probably rise strongly as insurers reconsider their appetite for risk in the light of the Japanese disaster.

“[It might] cause some insurers to reassess the pricing they have in place for earthquake cover,” said Luke Savage, chief financial officer of Lloyd’s of London. “In places like Chile and New Zealand, earthquake cover was with hindsight fairly reasonably priced and I don’t think insurers can continue to offer cover in those areas at such reasonable prices going forward,” he said.

Considering Options

Senate Bill 637, introduced by California’s two senators a week after the Japan quake, would create a system of federal guarantees for up to $5 billion in bonds issued post-catastrophe by public/private partnerships that meet a strict set of financial criteria.

Pomeroy said he has spoken to five national insurers about whether they would take part in such a partnership in other states, and all have said yes. He estimated quake-insured California homeowners would save $100 million a year if the bill passed. He said such a guarantee would “give us the certainty that private debt markets would lend to us after an event, which would let us cut back on some of our reinsurance.” He predicted premiums for CEA policies would fall by at least one-third if SB 637 became law.

Yet big insurers are adamant that in the normal course of events, the industry is better equipped than any government to provide affordable earthquake coverage in high-risk areas, given its superior expertise in risk management.

“I don’t think the government could provide quake insurance any cheaper than the insurance industry,” said Andreas Schraft, head of catastrophe perils at Swiss Re. “An insurer with a global spread in its portfolio would have much better diversification and would have a lower cost of capital than a government that only covers earthquake risk in a small area.”