2016-03-02 - By Henrik Sjöholm

The next “Big One” earthquake illustrates the need for cat bonds

The ”Big One”, is a potential earthquake along the San Andreas Fault in California with a magnitude greater than 7.0 on the moment magnitude scale, could cost more than $200 billion and is an illustrative example of the case for cat bonds.

Golden State Freeway vid Gavin Canyon efter Nortridge-jordbävningen 1994. Foto: Robert A Eplett /FEMA | public domain

Golden State Freeway at Gavin Canyon after the 1994 Nortridge earthquake. Photo by Robert A Eplett /FEMA | public domain

The ”Big One”, is a potential earthquake along the San Andreas Fault in California with a magnitude greater than 7.0 on the moment magnitude scale, could cost more than $200 billion and is an illustrative example of the case for cat bonds.

Experts cannot predict when this “Big One” will occur, but they agree that the southern part of the San Andreas Fault is the most likely to be affected. Therefore there is no surprise that the study of the expected economic and human impact of the “Big One” has been intense. One such study was performed in 2008 by the US Geological Survey (USGS) and published in the report “The ShakeOut Scenario”. The scenario is a magnitude 7.8 earthquake on the southernmost 300 km of the San Andreas Fault, chosen with regard to the recurrence intervals of serious earthquakes.

Due to numerous mitigation efforts in the last decades by state agencies, utilities and private owners, the vulnerability of California has been greatly reduced. Thus, the total financial impact of the scenario is “only” estimated at $200 billion, with approximately 1,800 fatalities. As the report point out, though, these are still big numbers.

The total losses are distributed as follows:

Building Damage 32.7
Related Content Damage 10.6
High-Rise Building Damage  2.2
Related Content Damage 0.7
Fire Damage 40.0
Related Content Damage 25.0
Highway Damage 0.4
Pipeline (water, sewer, gas) Damage 1.1
Sub-total Property Damage   112.7
Business Interruption 96.2
Relocation Costs  0.1
Traffic Delay Costs 4.3
Sub-total Additional Costs   4.4
Total 213.3
$ billion

Effects on the insurance industry

However, only a small fraction of all losses would be insured. The study estimates that only 6% ($1.3 Bn) of the total residential losses of $22 billion would be insured. The risk modelling firm RMS states that only 10% of residential buildings have earthquake insurance coverage.

One obvious conclusion of this is that mortgage owners face a serious financial risk exposure to earthquakes in California. With only a small fraction of insured losses, the alternative for many home owners will simply be to turn the key into the bank.

Bill Churney, AIR Worldwide, estimated in an article that the total insurance payout for a similar event would cover just $30 billion, or about 15%, of an estimated loss of $202 billion.

Though the insured amount is well within the capacity of the insurance industry, a single catastrophic event of this magnitude would could still cause disruptions of the normal functioning of the insurance market. It is worth noting that hurricane Andrew, which cost the insurance industry about $17 billion forced 11 insurance companies into default.  (Can insurers pay for the “big one”? Measuring the capacity of the insurance market to respond to catastrophic losses by J David Cummins, Neil Doherty and Anita Lo).

As properties and businesses are underinsured against a major earthquake in California, not only mortgage owners would face severe effects, but ultimately the Federal government would be expected to relieve the economic effects of the event, such as the $50 billion federal aid bill after hurricane Sandy, which was partly used for reconstruction purposes.

While it is obvious there is a case for increased earthquake insurance penetration in California, this would immediately also scale the costs for the insurance industry of a major earthquake and widen the gap between capacity and risk.

The case for insurance risk securitization

An illustrative example would be to compare the total simulated losses with the actual capacity of the US insurance industry. $213 billion corresponds to almost 1/3 (31%) of the total surplus capital for all property and casualty insurers in the US (Property/Casualty Insurance Results: First-Half 2015, ISO/PCI). Put another way: it corresponds to more than 40% of the premiums in one year, or roughly to the net after-tax income for almost four (3.8) years. As surplus and income are not evenly distributed, it is easy to realize the difficulties of the industry to absorb a shock of this magnitude.

This also illustrates the cat bond case. The market capitalization of the New York Stock Exchange was on Feb 26, 2015, $16 613 billion, or roughly 25 times the property/casualty insurance market surplus. If we were to add the Nasdaq capitalization of $8.500 million, the relation between the stock markets and the insurance surplus would be 37:1.

the big one vs market cap en

 

Part of a global solution to the insurance puzzle

While the example above concerns the effects of the “Big One” in the US, it also illustrates the case for securitization of catastrophe risk in other countries, not least developing countries. Globally, the roughly (as there is no agreed standard on measurement) $294 trillion capital market is about 3,700 times larger than annual property and casualty premiums worldwide, or more than 200 times the global insurance coverage ($78 billion and $1,440 billion, respectively).

As more people globally move out of poverty, the demand for insurance will increase. Urbanization increases the costs of a catastrophe hitting major population centers and the climate change will also increase the number of extreme weather events. It may seem like an impossible equation to solve, but transferring risks to the capital markets is certainly one important piece in the puzzle.

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Henrik Sjöholm

Henrik Sjöholm

Director of Communications and Responsible Investment

Henrik has 20 years’ of communications experience, as a speech writer for former minister of industry, Maud Olofsson, and as a PR consultant. He has successfully worked together with Brummer & Partners to influence the issue of pension savings transferability in Sweden. Prior to joining Entropics, he was head of the policy department at the Swedish Federation of Business Owners.

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