Our review of the California Earthquake Authority's (authority) reinsurance costs and State Assistance for Earthquake Retrofitting (SAFER) program disclosed:
RESULTS IN BRIEF
In 1996, following a residential property insurance crisis precipitated by the Northridge earthquake, the Legislature created the California Earthquake Authority (authority) to provide California homeowners with earthquake insurance. Working through 18 member companies, the authority insures more than 830,000 homes against earthquake damage, accounting for nearly two-thirds of the residential earthquake insurance market in California. By law, the authority was intended to depend highly on outside sources such as reinsurance (insurance that an insurance company purchases to cover a portion of its potential losses) and assessments on its member companies, giving it a direct source of payments to its policyholders in the event of a loss. Because an earthquake can cause extensive losses, its reinsurance coverage is costly, but without it the authority might not have the resources to pay for the losses arising from a major earthquake. The authority's reinsurance costs are high but not unreasonable, and the authority has succeeded in reducing those costs while maintaining a level of coverage that it believes is prudent.
The authority maintains roughly $2.5 billion in reinsurance coverage, which makes up about one-third of its capacity to pay policyholders in the event of an earthquake. Because catastrophe reinsurance is more expensive than other types of reinsurance, and because the authority must offer earthquake insurance to all qualified homeowners throughout the State, the reinsurance it purchases is costly. The authority's reinsurance costs are higher than other insurance companies because of its unique restrictions. By law, it must offer earthquake coverage statewide, so it cannot reduce its exposure to loss by limiting coverage in geographic areas that are highly prone to earthquake damage.
In 1998 the authority's rate (the percentage of policyholder premiums it spent for reinsurance) was 90 percent, according to its audited financial statements. This was due primarily to reinsurance costs that were not allocated evenly over the life of its original two-year contract for the first $1.4 billion of reinsurance coverage. The authority's member companies had existing earthquake policies that would be converted to authority policies over the course of its first year of operation. During that year, the authority's exposure level gradually increased until it reached its full amount when the conversion was complete. Therefore, the payment schedule was set up to reflect the fact that the authority would have considerably more risk to cover in 1998 than it had in 1997. Additionally, the contract for the remaining $1.1 billion of reinsurance coverage required the authority to pay for two years of coverage in calendar year 1998. Therefore, although the authority's 1998 rate seems alarmingly high, this rate is due primarily to a high reinsurance premium split unevenly over a two-year contract and a required up-front premium in the second contract.
Nevertheless, the authority has taken steps to reduce its reinsurance costs while maintaining the required amount of reinsurance coverage. For example, it negotiated with its reinsurers to reimburse a portion of the premiums on the first layer of reinsurance if they sustained no losses under the contract for calendar years 1997 through 1999. This, coupled with a reinsurance premium adjustment due to the authority's exposure falling below 90 percent of $203.6 billion, resulted in a reinsurance refund of nearly $82 million for its first three calendar years. Moreover, according to its lead reinsurance intermediary, hired by the authority to negotiate its reinsurance contracts, the rate-on-line (the amount of compensation the authority currently pays to reinsurance companies to assume part of its risk) is not unreasonable compared to what other companies are paying.
The authority is also attempting to lessen its reliance on reinsurance by following the advice of its consultant to reduce the amount of coverage it buys and by testing its ability to transfer some of its earthquake risk into the capital market. Specifically, the authority's governing board has recently approved the authority's proposal to elect a contract option that reduces the amount of reinsurance coverage it purchases under one of its contracts by half, beginning April 1, 2001. In addition, the authority has recently contracted with one of its reinsurers to sell insurance-linked securities to selected institutional investors, who risk losing their investment if insurance industry-wide losses exceed a specified amount. However, the authority faces challenges in maintaining its claims-paying capacity because its reinsurance contracts will expire in the next two years and its authority to assess its member companies up to $2.2 billion when losses exceed its capital will expire in December 2008.
In addition to providing residential earthquake insurance, the authority administers an earthquake mitigation pilot program, which is currently in its second phase, called State Assistance for Earthquake Retrofitting (SAFER). Under its SAFER program, which is intended to reduce earthquake-related personal and business economic losses in the State, the authority uses some of the interest earned on premiums from its policyholders to provide free seismic assessments to all homeowners in the pilot counties whose homes meet certain eligibility criteria. Among other requirements, a home must have been built before 1979 to be eligible for the SAFER program. The authority believes that it must offer its earthquake mitigation program to all owners of eligible homes even if the home is not covered by a policy issued by the authority to maintain its current federal tax status. Between October and December 1999, after a great deal of media attention, the SAFER program received nearly 17,000 telephone calls from interested consumers, resulting in 8,304 qualified homeowners interested in receiving a seismic assessment of their homes. To meet this unexpected demand and the resulting backlog of inspections, the authority increased the number of engineering firms that conduct the inspections and prepare assessment reports. As of early December 2000, the authority had spent about $3.5 million for its earthquake mitigation program, had completed roughly 68 percent of the home inspections, and had sent 86 percent of these homeowners their assessment reports. According to the authority, the remaining inspections and assessment reports should be complete and mailed to homeowners by mid-May 2001.
However, the authority has not yet found an effective mix of incentives to encourage homeowners to retrofit their homes, and the number of homes that have been retrofitted is low. Thus, although the authority has spent approximately $3.5 million for the SAFER program, it cannot demonstrate it has achieved its ultimate goal of reducing the State's risk of personal and business economic loss from earthquakes. As of December 8, 2000, only 31, or 0.9 percent, of 3,576 homeowners whose homes needed structural retrofit improvements had completed the needed improvements through the SAFER program. Another 54 homeowners had begun the retrofitting process, but the work was not complete. A telephone survey in January 2001 of 300 homeowners who participated in the SAFER program needs more analysis before the authority can use it to estimate how many other homeowners who received seismic assessments through the SAFER program made some or all of the necessary improvements but did not report them.
To ensure that it maintains its claims-paying capacity, the authority should continue to monitor the reinsurance market and research alternative financing to reduce its dependence on reinsurance.
To ensure that the goal of the mitigation program is achieved, the authority should establish a system for determining how many homeowners who participate in the SAFER program complete the recommended retrofit improvements. The authority should also establish a target number of homes to be made seismically secure so it can demonstrate that the goal of the program has been achieved. Until these elements are in place, the authority should delay expanding the program.
To further encourage homeowners to protect their homes from the peril of earthquakes, the authority should continue to research why more homeowners who received assessment reports have not followed through with retrofitting their homes. Once the authority identifies the reasons, it should make appropriate changes before expanding the program.
The authority generally concurs with our conclusions and recommendations. In particular, it agrees with the factors we identified as contributing to high reinsurance costs and that it is too early to determine the full level of success of the SAFER program. However, the authority believes the SAFER program is an emerging success, in part, because a large number of the homeowners responding to its survey have made or plan to make retrofit improvements. In addition, the authority believes that the SAFER program is successful because it has made a large number of homeowners aware of the steps required to retrofit their homes.