Earthquake Cover: To Buy or Not to Buy?
In high-hazard earthquake zones such as California, Japan, China, Australia and others, earthquake insurance is both tightly underwritten and high-priced.
The decision to buy or not to buy coverage can be a difficult one with varied approaches that range from buying as much as possible to not buying any at all. Specific approaches include:
- Buy as much as possible: A number of firms consider the probability and severity of a seismic event to be so potentially devastating to their livelihood that they purchase as much coverage as is available to them, be it from the traditional earthquake insurance market and/or from the growing capital market via Insurance Linked Securities – such as Cat Bonds and the evolving Parametric Trigger products.
- Set a budget and buy to that: Some firms set a specific premium budget and stick to it. In a soft-market, a premium of $500,000 may buy $50 million of coverage for a specific risk, while that same $500,000 buys only $30 million in a hard-market. A number of firms only purchase earthquake insurance where they are required to per lease agreements containing such stipulations.
Lease requirements can vary from referencing “modeled PML” to “what is reasonably available” and anywhere in between.
- Buy to the modeled PML: Ubiquitous in the industry now, models are utilized by individual buyers, brokers, insurers, reinsurers, banks and rating agencies. These models factor characteristics such as fault location, release of energy, soil type, building height, construction type, and local codes. Based these geographic and site-specific factors, models estimate the Probable Maximum Loss (PML) for an entire portfolio, as well as (though less statistically accurate) a single location. Many Risk Managers use the PML to set the limit they will purchase. These models represent the best technological estimate of the probability and damageability of seismic events.
- Only buy what’s required per leases: A number of firms only purchase earthquake insurance where they are required to per lease agreements containing such stipulations. Lease requirements can vary from referencing “modeled PML” to “what is reasonably available” and anywhere in between.
- Engineer out the risk: Some firms approach seismic risk through a combination of physical and operational strengthening, rather than, or in conjunction with, purchasing insurance. Instead of paying an annual premium, this approach invests would-be premium dollars into seismic retrofitting. They may also invest in business resiliency measures like having alternate facilities remote from the seismically exposed locations, or contingent contracts to strengthen their supply chain.
- Don’t buy any: There are firms that either due to price, confidence in their physical and operational resilience, or their ability to financially assume the risk, do not purchase any earthquake insurance. They may assume the risk through a captive; special financial instrument designated for seismic recovery; or reliance on cash or loans at the time of loss.
While there are other philosophical approaches regarding whether or not to purchase earthquake insurance, the considerations noted above are the most common. Matching your company’s physical and operational ability to survive an earthquake along with coverage price and availability will help shape your approach to buying seismic coverage.