A Beverly Hills Bailout?

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.

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.

It’s much more likely, however, that a federal program would underprice its coverage and leave all taxpayers holding the bag. The results could resemble those of the most similar existing federal effort, the National Flood Insurance Program, which promised to break even in the long run when it started over 40 years ago but currently owes the Treasury over $17 billion and has no practical way to ever pay it back. Because of California’s ongoing financial crisis, it’s quite plausible that in the event disaster struck, it would be able to slough its obligations off on federal taxpayers. Even if California met the bill itself, the need to fund repairs from tax revenues could send people fleeing the state. And none of this takes into account the need for another bailout of Fannie, Freddie, and the many banks that would suddenly be in trouble if enormous numbers of California borrowers walked away from mortgages following a quake.

Earthquake coverage today is not remotely unaffordable. In early July 2011, CEA quoted a premium of $71.67 a month for a 20-year-old, two-story wood-frame Beverly Hills (90210) house with a structure value of $500,000 (land value would almost certainly put the sale price of such a house over $1 million). CEA’s deductibles, 15 percent in the above example, are much higher than those typical from wholly private insurers but not unmanageable since low-interest, everyone-qualifies Small Business Administration disaster loans could cover uninsured costs.

The solution, therefore, isn’t a new federal liability but measures that would encourage homeowners to take responsibility, rather than assume an eventual taxpayer bailout. If Congress wants to do something constructive, it should protect taxpayers around the country by having Fannie and Freddie require privately backed earthquake insurance for all mortgages in seismically active areas, just as they now require homeowners’ insurance everywhere else. It’s true that any measure that raises housing costs will cause further turmoil in California’s housing market. But the benefits of having private insurance available to pay the costs of “the Big One” far exceed the damage to housing values that might result.

Whatever happens, however, members of Congress, even those from California, should realize that proposals to have the federal government take over the earthquake insurance market will not work as advertised.

Eli Lehrer is vice president of the Heartland Institute.

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