An Overview of the California Earthquake Authority

The California Earthquake Authority (CEA) is a one-off, public catastrophe-insurance organizations often seem to be that—formed to replace dysfunctional private insurance markets—but each unique to its own political and economic setting. The CEA owes its existence to a single earthquake over 20 years ago and a 1980s-era state law: Without the 1994 Northridge earthquake and the 1985 law requiring sellers of home insurance in California to offer earthquake insurance, there would be no CEA. And without appreciating its primary legal columns of support, the CEA cannot be fully understood (See Figures 1 and 2). Because CEA's organizing genome is so particular, to California and to the insurance-market aftermath of a damaging earthquake in a crowded California urban belt—and because this article is offered to help form a map to explore future reform and improvement of national catastrophe-insurance programs—the following observations aim to explain CEA as an entity, to help potential “explorers” both form specific insights and draw broad lessons. In that vein, the background of CEA is the first key: What happened, who did what, what alternatives were on the table, and why did the choosers choose the CEA model, and what did they expect (? ). Without depth in those matters, there can be no useful or creative comparison of CEA to present or future states of other organizations. As well, after more than 20 years of operation CEA is no longer just a bright idea—it is a mature insurance provider with a broad portfolio of ideas: market-leading insurance products, unique loss-mitigation programs, and innovative financing techniques. CEA is the largest and by far most active California player in addressing and mitigating both structural and financial residential earthquake risks, and its CEA experience is instructive. After the 1994 Northridge earthquake caused massive, unexpected, and wholly unprecedented insured losses to residential properties in Southern California, the losses led to an ever-worsening home-insurance crisis and market failure—and after 2 years of frustrating efforts to address the crisis and people's mounting concerns—the State of California in 1995 moved to solve the crisis when it created a first-of-its kind public instrumentality. It was 1996 when the final enabling legislation, passed with declared urgency, took effect, and the California Earthquake Authority (CEA) set off on its journey of—so far—21 years. Although CEA as public instrumentality provides basic residential earthquake insurance throughout California in a voluntary insurance market, its principal (and statutorily declared) function was to restore California's homeowners’ insurance market. Often termed “fire insurance” in home-mortgage-document requirements, homeowners insurance (unlike earthquake insurance) is typically required as a condition of obtaining and maintaining a home mortgage. Indeed, the title of principal CEA-enabling legislation was the Homeowners Insurance Availability Act of 1996. But to imply that the California Legislature acted in 1995 and 1996 solely to save the homeowners-insurance market (anticipating impacts from home-insurance unavailability on California's massive residential real estate market) would be to imply that government cared little about earthquake coverage or did not mind leaving Californians to fend for themselves the next time the Earth shook. That was not the case: The reason there was a homeowners-insurance availability crisis was the effective refusal by the Legislature in 1995–1996 to even consider removing California's statutory “mandatory offer” of residential earthquake insurance, which had been in place since 19851 and can be seen as an unusual way to form an insurance contract. In their attempts to advance their vision of how to fix the paralyzed market caused by their refusal to sell new home-insurance policies freely, insurers strongly advocated repealing this mandatory-offer arrangement. But the Legislature, as strongly, insisted the earthquake offer continue, hoping to assure market availability. That standoff over the mandatory-offer set the stage for CEA. These factors demonstrate that CEA is a product, in significant part, of California's mandatory residential-earthquake-insurance offer scheme. And the offer mechanism is also why CEA enjoys a unique market posture, since not a day goes by that California home insureds up and down the state are not offered CEA quake coverage by their CEA-participating home insurers—which together represent about 80 percent of the California homeowners market. So, with the biannual mandatory-offer continuously blanketing the state, within the span of just 2 years effectively all such home insureds are presented with the opportunity and power to insure through CEA. After some administrative adjustments to rates and rating territories in its first year or two of operations, and accounting for its unique operating attributes, including its public mission, CEA has generally acted in the manner of a private-market participant in California's voluntary (but well regulated) market for residential earthquake insurance. Created with an unusually high degree of independence and autonomy for a government-associated entity, 3 CEA—when transacting its residential-earthquake-insurance business according to its express statutory authority—does not operate as the government: It achieves its mission and purpose by operating for the government, and it does so without acquiring, consuming, or relying on any state money. Indeed, this unusual status has proved a major factor in the CEA's improving its products far beyond minimum insurance attributes the law requires, raising available policy limits to levels meeting more customers’ needs, and efficiently working concepts of earthquake-loss mitigation (retrofitting) into both stand-alone outreach and grant programs and significantly lower CEA-insurance premiums. This self-sufficiency, made express in the CEA law, has two macroeconomic-cum-legal effects of interest here, both intended: (1) It provides a plausible basis to the legal immunity of the State of California from responsibility for CEA's insured liabilities from earthquake damage to residences, and (2) it permits the CEA to operate without restraint as a competitive-market player and nonprofit insurance provider, whose customers select and contract freely with it. Residential earthquake insurance in California is offered and written, with direct reference to an unconventional statutory definition (described below), for California's version of personal lines property risks. These risks have in common an express “residential” component, but at least one defined coverage (residential structures of up to four dwelling units) is often written in California as a commercial coverage. Commercial earthquake insurance in California—effectively, those policies not defined in law as “residential”—has no similar mandatory-offer scheme, and commercial earthquake insurance rates are not regulated. Customer take-up, on a statewide-average basis, is slightly lower than for its residential counterpart: under 10 percent of commercial properties insured for fire are also insured for earthquake. Originally, CEA-policy sales arose from private insurers’4 legally mandated offers of earthquake insurance to their residential-property-insurance customers, accomplished during the brief statutory-offer window. But for the past several years, because of CEA's unilateral directive, any participating-insurer customer—at any time, regardless of whether there is a current quake offer from their insurer on the table—can request CEA earthquake insurance and be written a CEA policy. Such a “mid-term” request, historically, would have been turned down by insurers writing their own earthquake policies, for administrative convenience, perhaps, but also as a means of exposure control. There are a handful of state-sponsored, public catastrophe-insurance providers in the United States, but other than FAIR Plans existing in many states (which provide high-risk residential coverages), the public catastrophe-insurance entities formed under state law only cover wind exposures—in California, only earthquakes are covered. CEA is also unlike its counterparts around the world, virtually all of which outside the U. S. are created by federal governments that, typically, assist outright or financially backstop their public insurers. Various countries around the globe, other than New Zealand, also have public programs that respond to and compensate for catastrophes, some operating as reinsurers (e. g. , Japan, Taiwan), some operating as multiperil primary insurers (e. g. , Spain, France), and some operating as single-peril primary insurers (e. g. , Turkey, U. K. ). CEA shares some traits and purposes with all the foregoing, but it is essentially different from those entities, too, as this article attempts to illustrate. This article will explain that CEA's existence and operational direction stem from a unique-in-the-U. S. , only-in-California, insurance-market characteristic: imposed by law, the mandatory offer of residential earthquake insurance. CEA—then and now the sole public, nonprofit provider of residential earthquake insurance in the United States—is by far the dominant California-market player operating under that 32-year-old regulatory regime. The granularity provided for source material here is offered both for the public record and to facilitate its use by those who wish to leverage and use an in-depth look at CEA, and its back story and legal and historical underpinnings, to inform future models of public catastrophe-insurance organizations. If California were a sovereign country, it would be the sixth-largest national economy in the world. 7 Newsweek magazine in 2015 said that California would be “France. ”8 (See Figure 4). At its current (and growing9) population of over 39 million, California would be the 35th most populous nation. And those 39+ million people live in over nine million households in the Golden State. California also has two-thirds of the U. S. ’s earthquake risk—and despite the ever-present threat of serious and damaging ground-shaking (Alaska has the most earthquakes per year in the U. S. by sheer numbers, but California has the highest number of damaging earthquakes in the U. S. 10), only about 1. 15 million of those owned or rented California households have any earthquake insurance. 11 By the numbers, clearly, California householders simply are not well earthquake-protected, at least in a financial sense through the mechanism of earthquake insurance. In view of the more than 11. 2 million home-insurance policies in force in California in 2015, and the 1. 15 million residential earthquake policies in force, at December 31, 2015, there was a statewide take-up rate of 10. 23 percent. 12 Even considering that the 10. 23-percent number is an average across lower- and higher-risk areas of the state, and that by the same token people in certain high-risk California regions buy earthquake insurance at differing rates of take-up, many Californians clearly have chosen to self-insure. Or, if self-insuring is by its true nature an act that requires combining prudential financial planning and either substantial savings or substantial wealth with the choice not to buy insurance, it might be more reasonable to conclude that many Californians have simply chosen not to insure and therefore not to prepare, financially, for the next damaging earthquake by purchasing applicable insurance. Residential earthquake insurance13 has been available in California for many years, but since the mid 1980s California law has required insurers that sell residential property insurance14 to make what is commonly known as a “mandatory offer” of earthquake insurance to new and existing customers. 15 As a condition to selling (or, biannually, renewing) a policy of residential-property insurance (as defined) in California, the insurer must offer earthquake insurance on the insured property. 16 The offer must state the proposed dwelling, contents, and additional living expense limits; the deductible, and the estimated annual premium. 17 Besides California, only one U. S. state imposes any sort of requirement that insurers offer earthquake insurance to residential customers: Besides California's regulated scheme, Kentucky has a regulatory “preference” that an earthquake-insurance offer be made regularly18 in connection with the sale of homeowners insurance (but has no statutory requirement so providing). There are no state-law mandates of which the CEA is aware, including in California, that require an offer of a policy of earthquake insurance to commercial risks. 19 It is CEA's understanding, however, that some lenders financing commercial construction or purchase in seismically active areas may require some level of earthquake insurance, possibly limited to periods when a building is in a construction phase during which it may be more susceptible to damage from ground movement. Under California's residential-property-insurance mandatory-offer system, consumers are not required to buy earthquake insurance, but they must be offered the opportunity to do so. In other words, the legal mandate applies solely to the offer of a policy—not to the acceptance of that offer. So what sort of effect has this evident public policy—which periodically shines a light on the ability of a householder to buy earthquake insurance to provide financial security and family protection—had on consumers’ market behavior? Observers have expressed anecdotally to CEA from their observations at the time that insurers historically—that is, pre-Northridge—did not well understand how to price the residential earthquake policies they sold, even in the face of a mandatory-offer system that virtually guaranteed insurers would have earthquake risk in their insured portfolios. In other words, despite facing forced acceptance of catastrophe risk they could not rid themselves of merely through careful or restrictive underwriting, 24 they were unsuccessful in risk-based pricing. 25 Years of (in effect) inattention and “competitive” rating (in which pricing goes down when market appetite of sellers goes up, and underwriting is relegated) resulted arguably in insufficient premium being charged and collected for the risks insured. On January 17, 1994, at 4: 31 a. m. Pacific time, a magnitude 6. 7 earthquake26 struck broad swaths of Southern California—the epicenter was in California's San Fernando Valley, 20 miles northwest of downtown Los Angeles. While the strong ground-shaking lasted only 20 seconds, the earthquake produced enormous ground acceleration, which set in motion ground and structural effects that resulted in loss of life and severe damage to public and private property. From this devastating event, 33 lives were lost, 8, 700 persons were injured, and residential insured losses exceeded 12 billion, making it one of the costliest natural disasters in U. S. history. Over ensuing weeks and months, as insurers scrambled to assess their unprecedented, huge Northridge insured losses, their representatives in Sacramento lobbied intensely, seeking to repeal the mandatory-offer law. Insurers told lawmakers and the regulator they wanted to stay in the California homeowners-insurance market, which was mostly profitable and whose risks were well understood, but California earthquake risk was too high and too poorly understood, they said. Continued earthquake writing threatened company profitability, ratings, and (in extreme cases) solvency. While a minority of lawmakers acted in sympathy and support of those concerns, most legislators were concerned that a flat repeal of the mandatory offer could quickly end residential-earthquake-insurance availability in the state, at least until the voluntary market for it returned. Insurers’ selling restrictions, including refusals to sell, eventually reached some 94 percent of the home-insurance market. Insurers representing 70 percent of the residential-property-insurance market in California would have to irrevocably commit to CEA participation. That participation level would bring CEA at least 700 million in start-up operating capital, according to the original statutory funding formula, which is still in law. 33 The Internal Revenue Service would have to rule that the CEA was not required to pay federal income tax. 34 To help achieve its initial, estimated insuring capacity, CEA was obligated to obtain committed commercial reinsurance cover in an amount twice the (at least 700 million) initial (aggregate) insurer contributions. This 1. 4 billion (or more) limit to be secured in initial reinsurance contracts would require a then-unprecedented reinsurance buy for a one entity writing a single catastrophe risk. (Because discussions with reinsurers were started long before the date on which CEA was statutorily authorized to operate, long before CEA had acquired risks to insure, and long before CEA had employees or an office, the reinsurers had to be persuaded not only to consider the huge and unprecedented placement, but to reserve reinsurance capacity without payment—that is, they “warehoused” the cover, solely on an expectation that the CEA would meet the goals imposed as its operational pre-conditions. Without that cooperation, secured through efforts of reinsurance intermediaries and California Department of Insurance (CDI) staff, CEA would not have been able to commence operations as and when it did: About 60 days after then-Governor Pete Wilson signed the final enabling legislation, the CEA opened its doors with a skeleton staff and began accepting existing earthquake risks, and issuing new insurance policies, through its participating insurers. 35) When all three benchmarks were duly met, the insurance commissioner formally authorized CEA to commence operations as a provider of basic residential earthquake insurance, not as a licensed insurer but pursuant to an express statutory grant of authority. 36 It is important to bear in mind that the State of California did not establish CEA as an insurance company per se—an insurance company, absent special sanction in the Insurance Code, must be a corporation. 37 To the contrary, CEA is by law termed a “public instrumentality of the State of California, ” and its business form is not additionally described in law. 38 CEA accepted its first insurance risks as of December 1, 1996. From that day, CEA has served a statewide, voluntary residential-earthquake-insurance market that most of the private insurance market had effectively abandoned, while making it possible for those same private insurers to operate in a manner they prefer—and to continue to insure the home/property risks they better understand and can from now for 20 years, the CEA through its legal participating insurance operating under a contract with the CEA and the California insurance catastrophe insurance policy of residential earthquake CEA insurance contracts and insurance rates are by CEA and are to regulatory by the of the California Insurance By law, CEA is the provider of the earthquake insurance that participating insurers offer by law to their home-insurance There is a statutory that CEA participating insurers are not to with the CEA by selling any similar insurers on the other authorized to residential earthquake insurance products that or the basic residential earthquake insurance provided by the These might be or limits that the CEA's basic policy. But in only one CEA participating insurer has offered a product, and that was This operational was in the to what insurance products CEA would sell, since legislators it important that California's residential earthquake insurance market, be similar to that market, But participating home-insurance customers who wish to insure earthquake loss must CEA earthquake products, which both to the of those products as well as to CEA rating and pricing The was that the California residential earthquake-insurance market did not look the same CEA began And insurance with the new CEA and its and the CEA's new required by law to be and therefore than what the private market had quickly began to Because the market from CEA's participating insurers had in the CEA began to offer additional limits in a which was financially, per CEA of both reinsurance and a The to CEA coverage was by no means without as participating insurers strongly expressed about the CEA just 2 years after its important to CEA's of additional insured At least one participating insurer so far as to at a meeting of the CEA but the to with the which was what CEA offers by way of limits and new That act of a the way for the CEA's earthquake products, and the products were eventually into the CEA's portfolio without or The California insurance commissioner also has a with or is a of CEA's At the same time, CEA is regulated (in the manner by of by the not as a private and CEA rates are regulated according to most of California's and Because the insurance commissioner has that and is the of the commissioner to a when the up CEA rate and regulatory matters, such as In to the CEA operations regulatory The CEA's are by of the California insurance according to a statutory The CEA has CEA policies are available for or of any property described in Insurance property by a of residential property The CEA homeowners’ are to insure and current CEA policy are available in their as on the CEA January 1, significant additional limit and coverage as well as premium for (See Figure Although it does not sell its products to the public CEA products are by participating the CEA has a but on its available to the public, and which is with who are to CEA no commercial whether for risks or The CEA does not residential earthquake insurance take-up relying on the and its (See Figure The were on and residential property insurance and residential earthquake insurance policy as of December 31, the The of why so many households buy earthquake insurance years after Northridge is and there are several or The of the and any one are (See Figure CEA earthquake insurance take-up is on the The in the rate of take-up through 31, and as of this writing (in the more even CEA is making a to clearly and why this effect is (See Figure CEA is the sole public by or in connection with a provider of residential earthquake insurance in In it is the only public earthquake-insurance provider in the United There is no public provider of earthquake insurance in California for commercial risks. By the same there are a number of private providers of earthquake insurance in California in the for about 20 percent of the home-insurance market, by premium But CEA is of or efforts by any of those a provider of earthquake products or an insurer writing earthquake insurance pursuant to its own legal requirement to make a mandatory to consumers to or sell any of its earthquake CEA participating operating in legal but as private the of the California FAIR an of do not insure residential earthquake risks in California as under their own insurance under which a participating insurer would insured quake risk. however, have had and still have over 20 years of CEA statutorily of CEA's earthquake-insurance a cover provided to CEA without as a sort of under and and the in CEA's financial CEA are as a which is by CEA all the according to their CEA's participating-insurer have however, during the CEA's 20 Originally, by law, there were two lower in the financial and therefore more to CEA earthquake losses, and one After years, the largest and most according to the original CEA the At the time of a new was in the than the Figure the original in its amount only by the level of insurer participation in CEA it has And the new to 10 years of by its statutory The new will to in leaving only the original which will to by law, CEA's available and at the of the (described the California Legislature took to the CEA with of financial security and mandatory participating-insurer a for CEA to purchase reinsurance and other in their private and on the legal to into on its own and the legal to and (and the ability not to do and the legal ability and statutory to under of availability. In the Legislature authorized and CEA to and its in a way that is wholly of in however, with and other on CEA operating under from CEA's has on the working with to assure CEA's and financial are known and understood, and So from a it is to that all of the of the CEA law have the that those planning the CEA might not have fully (but would have CEA's over 20 years, with a of damaging earthquakes in the same has CEA to the loss of substantial participating-insurer by but capital, purchasing