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A Beverly Hills Bailout?

Federal earthquake insurance is an awful idea.

Jul 25, 2011, Vol. 16, No. 42 • By ELI LEHRER
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Residents of California do not have nearly enough insurance to cover rebuilding costs following a big earthquake. One proposal to deal with this problem, a bill before Congress called the Earthquake Insurance Affordability Act, would not make things better and would drain billions from federal coffers. The proposal—a Democratic plan that has received positive attention from California conservatives like Rep. John Campbell—is a new and even worse version of the unworkable, costly, but continually popular idea that the federal government should start writing property insurance for individual homes. It’s a terrible plan that does not even deserve a hearing. 

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At its core, the bill that Democratic senators Barbara Boxer and Dianne Feinstein have proffered would provide federal loan guarantees to the Golden State’s government-run, privately funded California Earthquake Authority (CEA). (Although not mentioned in the legislation as benefiting from it, no entity besides CEA qualifies as eligible under the bill’s language.) These loan guarantees would reduce CEA’s need to buy insurance of its own (reinsurance) on the private market and, in theory, let it cut rates. In return for the guarantees, CEA would supposedly pay fees to the federal government that would cover costs. With lower rates, more Californians would presumably buy earthquake insurance and thus have more money to rebuild following a big quake. 

The problem the bill seeks to confront isn’t trivial, and nobody who has taken a serious look at the issue believes that Californians now buy enough earthquake insurance. Although nearly all seismologists predict that existing stresses along the San Andreas Fault make “the Big One” almost inevitable sometime in the next few decades, the percentage of Californians with earthquake insurance has declined since the last major quake struck in 1994. 

In 2010, only about 12 percent of California home and condominium policies included earthquake coverage; over a quarter had it in the early 1990s. Taxpayer-owned mortgage securitizers Fannie Mae and Freddie Mac don’t require such insurance before they package mortgages, even though they do require general-purpose homeowners’ insurance and, in many places, federally backed flood coverage. As a result, any lender that starts asking its borrowers to secure earthquake policies would face a real competitive disadvantage and, because Fannie and Freddie hold the mortgages anyway, no real benefit to its own bottom line.

The result of this laissez-faire policy towards earthquake insurance would almost certainly guarantee enormous losses following a major quake. The sheer number of borrowers who currently owe more than their houses are worth (58 percent in hard-hit locations like Solano County) could send the already troubled California economy into a terminal tailspin following an earthquake as “underwater” borrowers walked away from their rubble heaps.

Necessary as it is to convince more Californians to buy earthquake insurance, however, the Boxer-Feinstein bill can’t possibly work as advertised since it egregiously violates the risk-pooling principles at the heart of insurance. When they’re underwriting almost any type of large risk, insurers (including CEA) buy reinsurance to spread their risks around the world. Private reinsurance might pool the risks of a quake in California with, for example, the risks of a flood in Germany and an industrial accident in Brazil. Because the events will almost never happen at the same time, reinsurers can make profits off of one type of reinsurance even while paying out big claims on another. 

All other things being equal, the broader the pool, the less a reinsurer has to charge to achieve any given level of profit. The Boxer-Feinstein proposal would concentrate risk in the United States under the aegis of federal guarantees. As a result, for the fees to cover long-term costs, they would have to be higher than the analogous charges now assessed by private reinsurers. If the federal government does its math right, neither the CEA nor anyone else would have any reason to buy what it offers. 

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