Earthquake Insurance in California
As the water began to drain from New Orleans in 2005, we learned that most of the homeowners in New Orleans did not have flood insurance, since they were supposedly in low risk areas. The over 60% of homeowners will need to depend upon their own savings, and limited federal assistance, to rebuild New Orleans – at an uncalculated cost for homeowners and taxpayers.
Could that level of disaster, especially that level of uninsured disaster, happen in California? Less than 15% of California homeowners currently carry earthquake insurance, due to its high cost, the can't happen to me or my house factor, and mortgage providers not requiring coverage. The next big quake will result in billions of uninsured damage – but is earthquake insurance really worth the high cost?
How Did We Get Here?
The state of California requires that all homeowner's insurance providers to at least offer earthquake insurance (albeit, at a high cost). Until 1994, it was widely available – but the high damage costs of the Northridge earthquake resulted in 97% of homeowner's insurance providers pulling out of the state the California. In response, the California Earthquake Authority was formed by the California legislator to provide earthquake insurance.
What Is the California Earthquake Authority, and How Does It Work?
The California Earthquake Authority provides two-thirds of the earthquake policies in California, sold through their member providers, like Allstate and State Farm. A homeowner purchases the policy through their regular insurance agent, but the policy is actually a CEA policy.
The CEA currently has about $7.2 billion to pay claims, which it states is enough to pay foreseeable damages (Loma Prieta in 1989 had $6 billion in total damages). If the damage claims are more than $7.2 billion, then each claim would be paid a prorated portion of their losses – unlike a regular insurance company, which promises to pay the actual damages under the insurance policy. The state of California cannot help pay the claims out of general funds.
The policies also have a high deductible – usually 15% of the value of the dwelling. In other words, your home must be damaged more than 15% of its value before the insurance starts paying. So, this insurance is not for cracks in the driveway – it is for significant structural damage to your home. The policy also pays for limited contents (starting at $5K) and loss of use (starting at $1500).
Why Is Earthquake Insurance So Expensive?
Insurance policy premiums are calculated based on probabilities – the probability that a house like yours in a neighborhood like yours will catch fire, or a driver like you will have an accident. With data from millions of homes, these probabilities can be calculated with reasonable accuracy. But, no one can reliably predict the probability that there will be an earthquake strong enough to damage your home.
And, as you can imagine, damages from an earthquake, flood, or hurricane, are widespread, over potentially thousands of square miles – instead of one or a few dozen homes, as in a fire. As such, the insurer would have to pay either zero claims, or billions of dollars of claims – too much variance to reasonably plan for or price accurately.
Are We Really At Risk Here in San Jose?
According to the USGS, there is a 62% probability that there will be an earthquake of 6.7 or greater (like the Northridge quake) in the Bay Area in the next 30 years. In my zip code (San Jose 95126), USGS calculates a 80% chance of a 6.0 earthquake and a 20% chance of a 7.0, in the next 30 years. Whether you consider that to be a high risk depends on your risk tolerance for earthquakes – I consider that a high risk of a moderate earthquake and a somewhat low risk of a terrible earthquake, over the next 30 years.
But like any issue involving real estate – it is all local. Where your home is actually located significantly affects your risk – bedrock, reclaimed land from the bay, soil type, nearby streams, actual distance from the epicenter – all can affect potential damage.
But of course, many earthquakes occur where the USGS was not even aware of a fault line – and we never know when or where it will happen, until it happens.
Should I Obtain Earthquake Insurance?
Factors to Consider:
- Could you afford to pay for the rebuilding your home from your own savings & investments?
- Can you afford to pay the high cost of insurance, indefinitely?
- Could make payments on your current mortgage and on a new loan to rebuild?
- Can you mitigate your potential losses by bolting your roof to the walls and the walls to the foundation, for example?
- What is your tolerance for the risk of an earthquake?
- What is the risks of your current home construction (type, age, foundation)?
- What are the risks of your specific location (soil type, distance to known faults)?
Are the Costs Worth It?
Let's assume that you have a home that would cost $250K to rebuild, you will own the home for the next 30 years, and your earthquake premiums are $1200 per year. Over the next 30 years, that would be a total of $36,000 in premiums (assuming your premiums do not increase, to simplify calculations).
Instead of purchasing insurance, you invest the premiums in a diversified mutual fund. With an 8% annual return, you would have $135,000 (pre-tax) in year 30.* But of course, you only have that total in year 30, not in year one – meaning that if the earthquake happens tomorrow, you don't have the money.
The deductible is another big turn off for many homeowners. The insurance pays only for large structural damage, not broken dishes or cracked driveways – meaning that it is less likely you will use it. However, be aware that you will not need to come up with the cash for the deductible – you may either opt to not undertake those repair or rebuilding costs, or you can apply for an SBA loan to pay for the deductible (assuming a federal disaster area is declared).
Why Not Just Get Federal Aid, or Walk Away and Let the Bank Have the Property?
The federal government would probably provide access to SBA loans, if the area is declared a federal disaster area (no small business required). However, the $200K maximum SBA loan may not be enough to rebuild your home – and, it is a loan that you need to pay back (in addition to your current mortgage).
If you have refinanced your mortgage, you have a recourse mortgage – which means that not only can the bank foreclose on the property in case of non-payment, the bank can also come after your personal assets and future income in case of non-payment. So you cannot just walk away, especially if you have a good income and some personal assets. The bank may help out by deferring payments for a few months, but you still must pay back the loan.
We have earthquake insurance on our home. Our home was not yet built in the 1906 earthquake (so who knows if it would stand), it is 75+ years old and is not bolted to the foundation, and we have a refinanced mortgage. For my family, the insurance premiums are worth peace of mind in case of a major earthquake disaster. That's exactly what insurance is for – the you never know.
*calculations ignore inflation