Two decades since its formation, the West’s only regional catastrophe pool, the California Earthquake Authority, faces financial and management changes that could have significant implications for its future. Those in turn could have implications beyond California, as other states consider forming their own pools and Congress debates the creation of a national natural disaster insurance program.
At issue are recent management changes and impending reductions in funding. Two of the three voting seats on CEA’s governing board turned over in November, with the election of Steve Poizner as insurance commissioner and Bill Lockyer as treasurer. CEA also is looking for a leader after its CEO for five years, Elaine Bush, departed in March, putting Chief Financial Officer Tim Richison at its helm until a successor is named.
If management turnover isn’t enough to destabilize CEA’s foundation, lack of funding could. On Dec. 1, 2008, CEA will lose a large portion of its financial “layer cake” that as of Jan. 1, 2007, gave it claims paying capacity of $8.3 billion. On that date, two-thirds of CEA’s capacity to assess member insurers up to $3.6 billion to pay claims expires under its authorizing legislation.
California homeowners insurers have been required to offer seismic endorsements since 1985. Yet CEA didn’t begin operations until Dec. 1, 1996, under legislation that set up the insurer funded, state-run residential seismic risk pool.
The Authority was formed amid market volatility after a spike in demand for earthquake coverage following the 1994 Northridge Earthquake led some insurers to stop writing new coverage. Insurers representing 70 percent of the state’s homeowners market provided CEA’s initial $1 billion of capitalization.
Member homeowners insurers sell CEA coverage. The program is designed as catastrophic coverage, kicking in only when seismic damage to a home exceeds 10 or 15 percent of the dwelling’s replacement value. The CEA basic 15 percent policy provides limited contents ($5,000), additional living expense ($1,500) and excludes outbuildings.
While a jump in demand for coverage led to CEA’s formation, the passage of time since the Northridge Earthquake, which was the most costly quake in U.S. history causing an estimated $20 billion in total property damage including $12.5 billion in insured losses, has had the opposite effect. Lackluster demand for earthquake insurance and more expansive coverages offered by stand-alone insurers prompted CEA to offer lower deductibles and higher supplemental policy limits in 1999. In 2003, CEA was losing about 1,000 policyholders per week.
Then in July 2006, CEA said more detailed local information on potential seismic damage allowed it to reduce rates for basic coverage by an average of 22 percent for the 85 percent of CEA policyholders living outside of the state’s riskiest seismic areas. The Authority also enhanced supplemental coverages up to $15,000 in additional living expense, contents limits of up to $100,000 and building code upgrade coverage.
At the time, the California Department of Insurance estimated slightly more than 12 percent of California households had earthquake insurance — a number that remained unchanged in 2005 based on the most recent CDI data.
“A decrease in this already low penetration rate would reduce the number of Californians able to afford to rebuild after a devastating earthquake,” CDI said, warning that if the higher limits were unavailable, CEA would lose a significant number of policyholders. In 2005, CEA wrote 70 percent of the $699 million in premiums paid for residential earthquake coverage, CDI said.
The dilemma for CEA is the supplemental coverages are underwritten by reinsurance, which has grown volatile and costlier amid a market hardening following hurricane losses in 2004 and 2005. As of Jan. 1, 2007, reinsurance comprised $593 million of CEA’s $643 million in claims paying capacity under its supplemental limits program.
Terms also have become more stringent, requiring CEA to purchase a greater proportion of excess rather than quota share reinsurance to back supplemental coverages. Both developments forced CEA to seek emergency authorization last year from CDI to boost rates for supplemental coverages by 32.5 percent in 2007 and 2008 and to authorize the transfer of $8.9 million in 2007 from the basic to supplemental limits program. Also, the Authority authorized $50 million of $315 million in revenue bond proceeds from 2006 be applied to supplemental coverages.
Raising rates for supplemental coverages could make them less attractive to homeowners and renters, defeating the initial purpose of getting more Californians covered for earthquake losses. Not only that, base policy rates could increase if CEA is forced to purchase additional reinsurance to replace $2.6 billion in post-event industry assessments when authorizing legislation expires in 2008. CEA projects, reinsurance would account for more than half ($5.2 billion) of total claims paying capacity of $9.9 billion as of Dec. 1, 2008.
In the near term, reinsurance is expected to become less expensive because 2006 was relatively catastrophe free. In March, CEA analyzed the cost and availability of reinsurance and concluded it could cover a 1-in-600 year earthquake or series of earthquakes in 2008 instead of the current 1-in-800 year standard.
Future finances and coverage
Representatives of personal lines trade associations say discussions have been underway between member insurers, the CEA advisory committee and CEA staff regarding how the the Authority should deal with the expiration of part of the post-event industry assessments. Also on the table is the possibility of merging basic and supplemental coverages into a single policy, said Sam Sorich, president of the Association of California Insurance Companies. “It is hoped that some consensus will be reached” on these issues prior to a CEA governing board meeting set for late April, he said.
Rex Frazier, president of the Personal Insurance Federation of California, is concerned supplemental coverages are not growing base capital and require subsidization from premium dollars paid by policyholders electing for the minimum coverages of a CEA basic policy. “Certainly we are committed to figuring out how to move forward,” Frazier said, adding there have been “extensive discussions” on CEA’s future financial structures.
During its first decade, CEA was spared a major test of its financial strength. It paid only $3.5 million in claims since Dec. 1996, of which $2.5 million resulted from a 6.4 magnitude temblor near San Simeon in 2003.
Last April, on the 100th anniversary of the 1906 San Francisco earthquake, Standard and Poor’s Ratings Services predicted CEA would be bankrupted by major quake. “If the ‘Big One’ comes and claims are higher than the authority’s total claims paying ability, policyholders might have to accept a prorated percentage of their expected coverage, which could call into doubt the credibility and value of such policies,” said S&P credit analyst Michael Gross. “California’s homeowners are unprotected from the financial consequences of a major quake to a disturbing degree.”
CEA staff disagreed, noting models of maximum probable losses from potential seismic events are within CEA’s claims paying capacity.
For the fifth consecutive year, A.M. Best assigned CEA an “A-” rating in July 2006. However, the rating house assigned a negative outlook, citing the possibility of adverse risk selection and inadequate pricing on some policies. “Studies by CEA and consulting actuaries have, however, identified no adverse selection,” A.M. Best added.
Yet all the coverage in the world won’t help if no one is buying it. Newly installed Commissioner Poizner said he’s concerned that relatively few Californians purchase coverage. He predicts a major temblor would produce “a lot of angry people” who don’t realize their CEA coverage comes with a steep deductible and far more limited coverages than standard homeowners policies.
Poizner said he’s forming a CDI task force to address what he sees as the state’s deficiencies in preparing for natural disasters. “We’re not prepared for the big one,” he declared.
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