Earthquake Risk, Insurance, and Recovery: Issues for Congress

Earthquake Risk, Insurance, and Recovery: Issues for Congress

Earthquake Risk, Insurance, and Recovery:
Issues for Congress
Rawle O. King
Analyst in Financial Economics and Risk Assessment
March 12, 2010
Congressional Research Service
7-5700
www.crs.gov
R41109
CRS Report for Congress
P
repared for Members and Committees of Congress

Earthquake Risk, Insurance, and Recovery: Issues for Congress

Summary
This report examines earthquake catastrophe risk and insurance in the United States in light of
recent developments, particularly the devastating earthquakes in Haiti and Chile. It examines both
traditional and non-traditional approaches for financing recovery from earthquake losses as well
as challenges in financing catastrophe losses with insurance. The report explores the feasibility of
a federal residential earthquake insurance mechanism and assesses policy implications of such a
program.
So far in the 111th Congress, six bills have been introduced that would broaden the federal
government’s role in insuring, mitigating, and financing recovery from natural catastrophes.
Proposals include (1) establishing a national consortium to allow states to aggregate risk from
state-sponsored insurance pools and transfer such risks to the capital markets through catastrophe
bonds (H.R. 2555/S. 505), (2) a provision for a tax-free accumulation of reserves to pay
catastrophe losses (H.R. 998/S. 1486), (3) a Treasury program to guarantee state-issued debt
(H.R. 4014/S. 886), (4) a federal reinsurance backstop (H.R. 83), (5) a provision to establish
individual catastrophe savings accounts (S. 1484), and (6) establishing a bipartisan commission to
examine catastrophe risks and make recommendations for the management and financing of such
risks (S. 1487). On March 10, 2010, the House Subcommittee on Housing and Community
Opportunity and Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises held a joint hearing on H.R. 2555. A mark up on H.R. 2555 is expected in April
2010.This report will be updated as events warrant.

Congressional Research Service

Earthquake Risk, Insurance, and Recovery: Issues for Congress

Contents
Recent Developments.................................................................................................................. 1
Basics of Residential Earthquake Insurance................................................................................. 3
U.S. Exposure to Earthquake Risk...............................................................................................4
Financing Recovery from Earthquake Losses .............................................................................. 5
Challenges in Financing Earthquake Loss ................................................................................... 6
Actuarial and Rate-Setting Difficulties .................................................................................. 7
Adverse Selection and Risk Spreading .................................................................................. 7
Tax, Accounting, and Regulatory Constraints ........................................................................ 8
Low Insurance Participation.................................................................................................. 8
Is Federal Earthquake Insurance Feasible? .................................................................................. 9
Policy Issues and Questions ...................................................................................................... 10
Legislation ................................................................................................................................ 11

Tables
Table 1. Number of Earthquakes in the United States: 2000-2010 ................................................ 5
Table 2. Estimated Insured Loss from the Top 10 Historical Earthquakes Based on
Current Exposure, .................................................................................................................... 5

Appendixes
Appendix. Standard Property Insurance Earthquake and Flood Exclusion Language.................. 13

Contacts
Author Contact Information ...................................................................................................... 13

Congressional Research Service

Earthquake Risk, Insurance, and Recovery: Issues for Congress

his report examines earthquake catastrophe risk and insurance in the United States in light
of recent developments, particularly the devastating earthquakes in Haiti and Chile. It
T examines both traditional and non-traditional approaches for financing recovery from
earthquake losses as well as challenges in financing catastrophe losses with insurance. The report
explores the feasibility of a federal residential earthquake insurance mechanism, and assesses
policy implications of such a program.
Recent Developments
On January 12, 2010, a magnitude 7.0 earthquake struck near Port-au-Prince, Haiti, causing
widespread economic losses from property damage—the worst in the Caribbean region in more
than 200 years. Aftershocks were felt in the Dominican Republic, Cuba, and Jamaica, though
little to no damage occurred outside of Haiti. While smaller earthquakes are relatively common,
the last major earthquake to affect Haiti was in 1842.1 The Haiti earthquake occurred along the
Enriquillo Fault Zone, which runs east-west along Haiti’s southwest peninsula. The islands that
form the Lesser Antilles and Greater Antilles outline the contact zone between the Caribbean and
North American plates. According to the USGS, this region is seismically active due to the
relative motion between the plates, and the Haiti earthquake has generated many aftershocks that
will likely continue for months. The potential for future earthquakes in the surrounding regions
appears to be high, according to the USGS. Earthquakes greater than magnitude 7 have occurred
in Puerto Rico, Jamaica, Dominican Republic, Martinique, and Guadeloupe over the last century.2
The United States Geological Survey (USGS) reported that the geological fault that caused the
Haiti earthquake is part of a seismically active zone between the North American and Caribbean
tectonic plates.3 The proximity of the Haiti earthquake to the New Madrid Seismic Zone (NMSZ)
in the Central United States, and a number of major U.S. population centers with a high level of
economic development, has reminded U.S. policymakers about the earthquake threat to the
interior of the continental United States and the need to have contingency plans in the event of a
mega-catastrophic earthquake.4 A mega-catastrophe is defined as a catastrophic event that causes
losses so large and unpredictable that private insurers either resist offering coverage or charge
premiums so high that significant numbers of customers do not want or cannot afford the
insurance.
Reinsurance broker Holborn Corp. has estimated economic damage to property values in Haiti to
be over $10 billion. Because of the country’s low income rates and limited insurance penetration,
insured losses are expected to be a fraction of economic losses, perhaps in the low-single-digit
billions of dollars.5 The Haiti government received an $8 million payment from the Caribbean

1 Two large earthquakes in the middle of the 18th century occurred close to Port-au-Prince, likely along the same fault
line, and caused widespread devastation. These occurred in 1751 and 1770 and both had an estimated magnitude of 7.5.
2 See United States Geological Survey Issues Assessment of Aftershock Hazards in Haiti, available at
http://www.usgs.gov/newsroom/article_pf.asp?ID=2385.
3 Ibid.
4 Two quakes of 7.0 magnitude or greater have occurred in the United States in the last 125 years: the 1906 San
Francisco earthquake (a 7.7 magnitude quake which killed about 3,000 people) and the 1886 Charleston, SC, quake (a
7.3 quake that killed about 100 people), according to the USGS.
5 London-based Axco Insurance Information Services Ltd. estimates that total non-life insurance premiums in Haiti
amount to less than $20 million annually. See http://www.claimsmag.com/News/2010/1/Pages/Haiti-Lacks-Insurance-
for-Earthquake-Losses.aspx.
Congressional Research Service
1

Earthquake Risk, Insurance, and Recovery: Issues for Congress

Catastrophe Risk Insurance Facility (CCRIF) as a result of insured losses from the recent
earthquake. The funds will serve as a revenue stream for the government to continue operating
after the earthquake. CCRIF is a risk-pooling facility owned, operated, and registered by 16
Caribbean governments in partnership with the World Bank and established to provide economic
stability for the catastrophe-prone region. CCRIF allows Caribbean countries to pool catastrophic
risks, reduces the cost of insurance, and provides Caribbean governments with short-term
liquidity when the policy is triggered after a major hurricane or earthquake. The recent earthquake
was of sufficient magnitude to trigger the full policy limit for the earthquake coverage, effecting
payment after a 14-day waiting period.
Researchers at the USGS, insurance market experts, and computer modeling companies agree that
the potential cost of earthquakes continues to grow due to increasing urbanization in seismically
active areas and the vulnerability of older buildings that have not been upgraded to meet current
building codes. The most recent earthquakes in the United States have been of relatively low
magnitude and did not result in major losses. On February 10, 2010, the USGS reported that a 3.8
magnitude earthquake hit about 50 miles northwest of Chicago with ground shaking felt as far as
Wisconsin, Iowa, and Indiana. There were no reports of injuries or damage. In December 2009,
four small quakes with a 3.1 magnitude were felt in Arkansas, Missouri, Tennessee, and Kentucky
without any economic damages reported. Three months earlier, on September 30, 2009, an 8.0
magnitude underwater earthquake struck 125 miles from the U.S. territory of American Samoa.
Again, there were no reported economic damages.
The 2008 National Seismic Hazard Maps by the USGS have changed the perception of
earthquake risk in the United States.6 Catastrophe modeling firms have updated their models with
research from the latest maps, bringing potentially significant implications for how insurers and
reinsurers manage, underwrite, and price U.S. earthquake risk. Since a 6.7 earthquake shook the
Northridge areas of southern California on January 17, 1994, claiming 60 lives, injuring over
7,000, and leaving 20,000 homeless, Americans have not experienced another major quake in
terms of lost lives and property damages.
A major earthquake could still have catastrophic impact on insurance companies and the insured,
impose significant costs on the U.S. economy, and disrupt U.S. financial markets. Although
individual insurance companies could face massive losses from a major earthquake, the industry
as a whole is not likely to become insolvent for two reasons. First, U.S. earthquake construction
standards are higher than Haiti’s, so the damages would presumably not be as extensive. Second,
there is generally a low purchase rate for earthquake insurance. The relative lack of earthquake
coverage is thought to be due to costly premiums, large deductibles, and limited availability of
coverage, resulting in reliance on government disaster relief in the event of a mega-catastrophe.
Financing economic recovery after a major earthquake is likely to be costly and require both
private and public recovery funds. Currently, money to finance disaster recovery comes from
state and federal disaster aid, private and public insurance, private loans, contingent financing,
and personal savings. Insurance is arguably the most efficient form of pre-disaster risk financing
to mitigate losses and reduce the financial vulnerability of property owners and governments to
earthquake risk exposure.

6 See U.S. Geological Survey, 2008 National Seismic Hazard Maps, located at http://pubs.usgs.gov/fs/2008/3018/pdf/
FS08-3018_508.pdf.
Congressional Research Service
2

Earthquake Risk, Insurance, and Recovery: Issues for Congress

Since the late 1990s, capital markets have entered the reinsurance business through the provision
of alternative risk transfer (ART) and financing instruments that provide excess of loss coverage
at the highest loss levels. ART allows domestic insurers to leverage retained capital to help
increase insurance loss capacity and reduce their sensitivity to extreme events. Catastrophe bonds,
for example, currently offer insurers and reinsurers an innovative approach to financing disaster
risks by transferring some of the catastrophe risk to global financial markets.
The vast majority of businesses and individuals in seismic zones do not purchase earthquake
insurance, preferring to take their chances rather than pay for protection at the cost that may be
considered too expensive for such a remote event. As a result, the government, through taxpayer-
financed federal disaster assistance for disaster victim compensation, has become the de facto
insurer of last resort and source of financial protection after a disaster occurs.
In the 111th Congress, several earthquake catastrophe risk and insurance issues could arise,
including (1) revisiting the nature and extent of earthquake and tsunami hazards in the United
States and (2) addressing the challenges of financing recovery given limited capacity of national
financial markets to absorb the cost and economic burden of a devastating mega-earthquake.
Policymakers are concerned about finding ways to reduce society’s disaster risk to help
homeowners, insurance companies, financial firms, and federal and state governments reduce
future losses from natural hazards. Members of Congress have begun to explore alternative policy
designs and to consider helping the private sector pre-fund and diversify disaster risk by financing
catastrophic losses through insurance, reinsurance, and capital from financial institutions and the
investment community. These approaches are discussed below.
Basics of Residential Earthquake Insurance
Many people assume their residential insurance policy fully protects them, but most standard
homeowners’, mobile-home owners’, condominium, and renters’ insurance policies do not cover
earthquake damage. The Appendix illustrates the earthquake hazard exclusion language in
standard homeowners’ policies. Earthquake coverage must be purchased as an endorsement to an
existing homeowner’s or business owner’s policy or as a separate policy. It includes coverage for
damage to the building structure, contents or personal property, and loss of use of the structure. In
the case of commercial business the policy covers loss of business income. Vehicles are covered
for earthquake damage by the comprehensive insurance policy of an automobile policy.
In general, consumers typically experience multiple challenges concerning residential earthquake
insurance offerings, including the following:
• policy premiums that viewed as unreasonably expensive;
• deductibles that are 15% of the amount of the policy (not the loss);
• lack of knowledge that earthquake coverage is available or misinformation
concerning the terms of such insurance; and
• lack of adequate incentive to take preventive action to reduce shaking losses, fire
losses, and injuries.
California is the only state that requires insurers that sell residential property insurance to offer
earthquake coverage to their policyholders. After the earthquake in Northridge, California, in
1994, most insurers either stopped selling new homeowners’ insurance policies or greatly
Congressional Research Service
3

Earthquake Risk, Insurance, and Recovery: Issues for Congress

restricted the sales of such policies. In 1995, as a result of insurers’ reluctance to offer earthquake
insurance because of the fear of insolvency, the California state legislature created a privately
financed, publicly managed organization—the California Earthquake Authority (CEA)—to offer
primary coverage for property losses arising from a seismic event. In offering earthquake
coverage, insurance companies can become a member of the CEA and offer the CEA’s residential
earthquake policies, or they can manage the risk themselves. To date, companies that sell over
two-thirds of the residential property insurance in the state have opted to become CEA
participating companies. The CEA began providing residential earthquake insurance in December
1996 with a $10.5 billion funding package.
U.S. Exposure to Earthquake Risk
Calculating earthquake risk levels depends upon proximity to earthquake faults, the age and type
of dwellings, and the soil types near those dwellings. Some parts of the country that have not
experienced earthquakes for 200 years or more might be more susceptible to earthquakes than
areas that have experienced recent earthquakes. The reason is that earthquake faults build up
tension over long periods of time, which become earthquakes when that tension is suddenly
released. It is theorized that relatively recent earthquake activity means that faults have released
built-up tension—a lack of earthquake activity can mean that tension is still building and could be
released at any time as an earthquake.
Table 1 shows that on average over 3,000 earthquakes strike the United States each year. Based
on insured loss data provided by the Insurance Services Office, a relatively few earthquakes cause
disastrous accumulation of economic losses because most occur in sparsely populated areas. Most
Americans live in areas considered “seismically active,” although the degree of vulnerability to
earthquake risk varies greatly. The size and geographical location of the quake, and to some
extent its timing, determine the magnitude of economic losses from property damages. According
to the A.M. Best Company, an insurance-rate-making company based in Newark, New Jersey,
earthquakes have caused insured property losses in every U.S. state during the past 100 years, but
potentially damaging earthquakes are more likely to occur along the Pacific coast, the Mississippi
valley around New Madrid in Missouri, Alaska, Utah, South Carolina, and the New England
region around Boston.7
Table 2 shows the estimated impact of historical U.S. earthquakes if they were to happen today.
On August 6, 2009, AIR Worldwide and Risk Management Systems (RMS) announced releases
of new earthquake models for North America.8 The new model versions, based partly on the 2008
USGS National Seismic Hazard Maps, produce significantly reduced loss estimates for most
regions of the United States. While the amount of reduction varies by model, by region, and by
type of business, most companies with significant earthquake exposure saw large reductions in
their model loss estimates. Implemented as is, these changes will affect company risk
management decisions, including earthquake underwriting, pricing, and reinsurance purchasing.

7 A.M. Best Company, Inc., 2006 Annual Earthquake Study, October 16, 2006.
8 Business Insurance, Catastrophe Modellers Update Earthquake Risk Models, August 6, 2009, at
http://www.globalquakemodel.org/node/420.
Congressional Research Service
4

Earthquake Risk, Insurance, and Recovery: Issues for Congress

Table 1. Number of Earthquakes in the United States: 2000-2010
Magnitude 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
8.0
to
9.9 0 0 0 0 0 0 0 0 0 0 0
7.0
to
7.9 0 1 1 2 0 1 0 1 0 0 0
6.0
to
6.9 6 5 4 7 2 4 7 9 9 3 1
5.0
to
5.9 63 41 63 54 25 47 51 72 85 53 1
4.0
to
4.9 281 290 536 541 284 345 346 366 432 290 16
3.0
to
3.9
917 842 1,535 1,303 1,362 1,475 1,213 1,137 1,486 1,449
40
2.0
to
2.9
660 646 1,228 704 1,336 1,738 1,145 1,173 1,573 2,335
39
1.0
to
1.9 0 2 2 2 1 2 7 11 13 25 1
0.1
to
0.9 90 0 0 0 0 0 1 0 0 1 0
Below
0.1
15 434 507 333 540 73 13 22 20 18 0
Total
2,342 2,261 3,876 2,946 3,550 3,685 2,783 2,791 3,618 4,174
98
Source: United States Geological Survey, Earthquake Facts and Statistics, available at http://earthquake.usgs.gov/
earthquakes/eqarchives/year/eqstats.php.
Table 2. Estimated Insured Loss from the Top 10 Historical Earthquakes Based on
Current Exposure,
$ billions
In 2009
Rank Date/Year Location
Magnitude
Dollars
1
February 7, 1812
New Madrid, MO
7.7
$100
2
April 18, 1906
San Francisco, CA
7.8
96
3
August 31, 1886
Charleston, SC
7.3
37
4
June 1, 1838
San Francisco, CA
7.4
27
5
January 17, 1994
Northridge, CA
6.7
21
6
October 21, 1868
Hayward, CA
7.0
21
7
January 9, 1857
Fort Tejon, CA
7.9
8
8
October 17, 1989
Loma Prieta, CA
6.3
6
9
March 10, 1933
Long Beach, CA
6.4
5
10
July 1, 1911
Calaveras, CA
6.4
4
Source: AIR Worldwide Corp., Estimated Insured Loss From the Top 10 Historical Earthquakes Based on Current
Exposure, available at http://www.air-worldwide.com/PublicationsItem.aspx?id=18484.
Financing Recovery from Earthquake Losses
At present, funds to finance earthquake recovery come from several sources: state and federal
disaster aid, insurance, private loans, personal savings, and structured finance securitization.
Insurance is the most common form of financing of recovery from catastrophic disasters, such as
earthquakes and hurricanes. While it is widely agreed among disaster policy experts that
Congressional Research Service
5

Earthquake Risk, Insurance, and Recovery: Issues for Congress

insurance by itself would not mitigate losses from seismic hazards, when combined with options
such as structural and non-structural mitigation, building codes, and land-use planning, insurance
could be used as a financial incentive for action designed to help reduce losses from future
earthquakes.
Insurance involves the collection of premium from pool participants before an event occurs so
that a source for payouts is available to compensate victims following a disaster. Insurance pools
typically purchase reinsurance to diversify catastrophe risk, expand the capacity of the pool to
cover risks, and hedge against the possibility of bankruptcy from catastrophic risks. Insurance
also provides other benefits beyond post-event compensation, namely property loss mitigation.
Commercial insurance may be viewed as a risk-financing tool used to accumulate funds in
preparation for future earthquake disasters, diversify risk among the international capital markets,
and reduce the direct impact of disasters on property owners. As a risk-transfer strategy, insurance
may also be used to help minimize catastrophe losses, reduce the government’s exposure to post-
disaster payouts, and provide a safety net for property owners and communities affected by
natural disasters, such as earthquakes.
A brief review of the financial capacity of the U.S. property and casualty insurance and
reinsurance industry reveals that the insurance industry’s capacity to handle large catastrophic
losses may be substantially less than aggregate figures suggests. A repeat of the 1906 San
Francisco earthquake could cost insurers almost $100 billion in insured property damages.
According to the Insurance Information Institute, the policyholders’ surplus of the entire property
and casualty insurance industry was $490.8 billion as of September 30, 2009.9 Policyholders’
surplus is defined as the “net worth” or “owners’ equity” of a firm. It is a measure of the capacity
of insurers to underwrite policies, and it must increase to meet the demands of a growing U.S.
economy and claims from hurricanes and other natural hazards. Only a fraction of this industry-
wide total surplus amount (e.g., approximately 20%) would be available to compensate victims of
a major earthquake. Furthermore, insurers must rely on this same portion of total surplus to pay
for other potentially catastrophic and unpredictable risks.
Challenges in Financing Earthquake Loss
The 111th Congress may choose to assess whether existing sources of funding of catastrophe
losses will be adequate to finance recovery from a mega-catastrophe earthquake. In the aftermath
of mounting natural disaster losses over the last two decades, property and casualty insurers have
sought to limit their exposure to catastrophe risk while simultaneously exploring new and
innovative sources of capital aimed at financing catastrophe losses. Although insurers are skilled
at handling high-frequency, low-severity “non-catastrophic” events, like auto and home losses,
that follow a predictable claims frequency and magnitude, they face substantially greater
difficulty when attempting to price and insure low-occurrence-probability, high-consequence (LP-
HC) risk. Furthermore, there is a finite amount of protection (capacity) that the insurance industry
can offer to finance a mega-catastrophic earthquake. The amount of catastrophe insurance
coverage is limited by the potential magnitude of possible insured losses, the sporadic and
unpredictable nature of earthquakes, and ability to accurately estimate future losses and price
coverage. Moreover, existing regulatory and accounting systems also result in catastrophe

9 For more information, see Insurance Information Institute, 2009 - First Nine Months Results, available at
http://www.iii.org/Financial_Results/2009-First-Nine-Months-Results.html.
Congressional Research Service
6

Earthquake Risk, Insurance, and Recovery: Issues for Congress

reserves being taxed as profits, discouraging insurers from accumulating loss reserves for
catastrophes. Current tax laws discourage establishment of a reserve for a loss that has not
occurred.
The amount of catastrophic insurance is limited by
• actuarial and rate-setting difficulties;
• industry capacity to meet the payout requirements resulting from a mega-
catastrophic earthquake;
• difficulties in determining both the insurability of properties and the damages
resulting from earthquakes;
• adverse selection and risk-spreading difficulties, including those associated with
reinsurance;
• accounting and Internal Revenue Service constraints on the build-up of insurance
company catastrophe loss reserves; and
• ineffectiveness of current loss-reducing activities (building-code enforcement and
land-use zoning).
A general discussion of these interrelated challenges follows.
Actuarial and Rate-Setting Difficulties
One set of challenges facing private insurers involves actuarial and rate-setting difficulties that
stem from the lack of sufficient data on past losses to estimate the chance of future losses and the
potential for catastrophic losses that can jeopardize insurers’ financial stability. Estimating future
losses is difficult because earthquakes occur infrequently and at any location, and the magnitude
of losses is highly uncertain. Insurers must instead predict losses from technical studies and
computer simulation models, which may arguably be less reliable than actual prior historical loss
data.
Insurers would need to set a premium for each potential customer or class of customers in order
to generate enough revenue to cover both the expected loss and earn a profit. Insurers must be
able to estimate the frequency of specific events occurring and the magnitude of the loss should
the event occur, a condition limited by the low-probability/high-consequence nature of
earthquake risk and the difficulty in identifying what losses may occur. Insurance companies risk
insolvency or being uncompetitive by underpricing or overpricing, respectively.
Adverse Selection and Risk Spreading
Insurers also face adverse selection and risk-spreading difficulties, including access to adequate
reinsurance for earthquake peril. The problem is that risk is not sufficiently spread over a larger
geographical area including areas which are relatively unlikely to suffer a catastrophic
earthquake. Traditional insurance principles for insurability require that there is sufficient demand
to yield appropriate levels of income revenue for insurers to supply the coverage. There is a
tendency for mostly high-risk consumers to purchase policies. This results in a poor spread of risk
and an inadequate premium base. Economists note that this “adverse selection” problem in
insurance markets generally persists for two reasons: (1) the insured possess information on their
Congressional Research Service
7

Earthquake Risk, Insurance, and Recovery: Issues for Congress

particular risk, which is unknown to the insurer; and (2) consumers have short time horizons in
determining the expected benefits relative to the up-front costs (rates and deductibles), or
compare costs with potential benefits and conclude that loss-reduction measures are not good
investments. Insurers may attempt to address or correct this asymmetrical information problem by
creating different risk categories with corresponding price differences to discourage high-risk
consumers from purchasing the low-premium policy.
Tax, Accounting, and Regulatory Constraints
Another set of challenges to financing catastrophe risks involve tax policy and regulatory
constraints on the build-up of insurance company catastrophe loss reserves and the industry’s
ability to raise external capital during times of financial crisis. Under current federal income tax
provisions, premiums collected by insurers and placed in a reserve fund for catastrophes are
treated as excess profits and taxed at the corporate income tax rate. Insurers view this as a major
impediment to marketing of earthquake insurance, and they have supported a longer loss carry-
forward period or tax-free reserves for potential earthquake losses.10 Insurers might consider
offering insurance coverage at a price level high enough to cover the high-end in the range of
expected losses. The rate, however, would be so high that it may not be marketable or regulators
may not approve extremely high catastrophe rates. At this point, insurers typically have opted to
withdraw from lines of insurance in catastrophe-prone areas.
Low Insurance Participation
A high percentage of property owners in areas prone to earthquakes simply do not have
earthquake insurance, relying instead on good fortune or federal emergency disaster relief
assistance to cover uninsured losses. Researchers have found that Americans are reluctant to
purchase earthquake insurance because of the high cost of insurance and low likelihood of a
disaster.11 Moreover, earthquake insurance is not required as a condition for federally secured
mortgages, as is currently the case of flood insurance in federally designated flood zones. Fannie
Mae and Freddie Mac require homeowners with federally backed mortgages to buy insurance for
flood and windstorm damage, but not for earthquakes. Fannie and Freddie have dramatically
changed the landscape for homeowners’ property insurance by not requiring coverage for
earthquakes. The penetration of earthquake insurance has been low, and the government, through
disaster relief assistance, continues to serve as the predominant bearer of earthquake catastrophe
risk.
The lack of insurance or underinsurance against earthquakes could negatively impact bond and
equity markets, the mortgage loan industry, and government budgets at all level. With roughly
12% to 15% of exposed mortgaged properties covered by earthquake insurance nationwide, a
mega-catastrophe could leave a number of mortgages in default with lack of sufficient underlying
market value. In the case of mortgages that are packaged and sold by the federal mortgage
agencies, uninsured losses are absorbed by those agencies, a situation that could create a strain on

10 For more information, see CRS Report RL33060, Tax Deductions for Catastrophic Risk Insurance Reserves:
Explanation and Economic Analysis, by Rawle O. King.
11 Howard Kurreuther and Paul R. Kleindorfer, “Managing Catastrophe Risk: Why Do Homeowners, Insurers, and
Banks Not Use Simple Measures to Mitigate the Risk from Hurricanes and Earthquakes?” Regulation, Vol. 23, Issue 4,
March 8, 2001.
Congressional Research Service
8

Earthquake Risk, Insurance, and Recovery: Issues for Congress

the U.S. financial system and do little to help the owners of the distressed properties. In addition,
federal, state, and local governments would likely be called upon to expend funds in emergency
response and recovery at the same time as they lose tax revenues. Meanwhile, federal
policymakers have focused on finding ways to enhance the private sector’s ability to spread risk.
Is Federal Earthquake Insurance Feasible?
As stated earlier, a basic principle of insurance is the reduction of overall risk by pooling or
spreading individual, independent risks. Insurance companies typically price risks where the
frequency and severity of potential claims are limited, estimable, and stable. This principle and
insurance practice tends not to hold when a single event affects many insureds simultaneously, as
in the case of a major earthquake. In the event of uninsured losses, the federal government has
become the de facto bearer of the cost of repairing or reconstruction of buildings damaged by
catastrophic earthquakes. Another option, however, may be to create a national catastrophe fund
(federal residential earthquake insurance program) to ensure adequate capacity and solvency of
the insurance industry to meet consumer demand for protection against earthquake risks, which
could minimize federal outlays for uninsured losses.
An explicit government insurance program could have several advantages: limited bankruptcy
risk, the ability of the government to spread risk over time, financing of short-run losses by
borrowing, and lower requirements for federal disaster relief. The disadvantages would be the
potential burden on taxpayers, weak underwriting incentives to keep the cost of claims low,
preemption of existing and future private sector capacity, difficulty in implementing or sustaining
risk-based pricing in a political environment, and potential impediments to capital market
innovations, such as catastrophe bonds and options, that securitize catastrophe risk.
Since the late 1960s, the prevailing thinking among federal and state legislators and regulators
has been that earthquake risks could be managed and financed in the private sector. Congress
explicitly chose not to implement a federal earthquake insurance program because the
justification that the earthquake hazards could not be insured by the private sector had not been
convincingly made.12 Policy debate during and after the 88th Congress following the 1964
earthquake and accompanying tsunami at Alaska’s Prince William Sound led to the creation in
1968 of the National Flood Insurance Program (NFIP).13 Congress, however, waited several years
before addressing the nation’s exposure to earthquake hazards with the creation of the National
Earthquake Hazards Reduction Program (NEHRP) in 1977.14 NEHRP established for the first

12 See letter of transmittal accompanying the Federal Insurance Administration report issued pursuant to Section V of
the Southeast Hurricane Disaster Relief Act of 1965 from George K. Bernstein, Federal Insurance Administrator, to
Honorable George W. Rommey, Secretary of Housing and Urban Development, dated November 23, 1971. The letter
was included as the foreword to the report.
13 The National Flood Insurance Program was established under the National Flood Insurance Act of 1968 (P.L. 90-
448, title XIII, § 1360, August 1, 1968, 82 Stat. 476, codified at 42 U.S.C. §§ 4001-4128).
14 The NEHRP was established by the Earthquake Hazard Reduction Act of 1977 (P.L. 95-124; 91 Stat. 1098; Oct. 7,
1977). The NEHRP consists of four agencies: Federal Emergency Management Agency (FEMA); National Institute of
Standards and Technology (NIST); National Science Foundation (NSF); and United States Geological Survey (USGS).
The goals of NEHRP are to (1) reduce earthquake losses, (2) improve techniques to reduce seismic vulnerability of
facilities and systems, (3) improve seismic hazards identification and risk-assessment methods and their use, and (4)
improve the understanding of earthquakes and their effects.
Congressional Research Service
9

Earthquake Risk, Insurance, and Recovery: Issues for Congress

time a federal policy to encourage research on and implementation of methods to reduce
earthquake losses.
Substantial progress has been made in the fields of earthquake science and engineering following
the implementation of NEHRP, particularly with respect to seismic hazard identification and
strategies to reduce seismic vulnerability of facilities and systems through land use practices and
improvements in design and construction techniques. Disaster policy experts agree that despite
the effort of four federal agencies that collaborate under the NEHRP, one issue that has not been
adequately addressed is the economic consequences of a catastrophic earthquake, and the
efficiency and adequacy of present mechanisms for financing catastrophic earthquake recovery.
NEHRP was not required to address this issue.
Policy Issues and Questions
The 111th Congress is likely to face the following key policy questions with respect to earthquake
risk, insurance, and recovery:
• Is earthquake risk uninsurable in the private market?
• Is a federal residential earthquake insurance program feasible?
• What are the costs and benefits of government intervention in the catastrophe insurance
market?
• Do benefits outweigh costs to taxpayers for providing a financial backstop for the
insurance industry?
• Should federal earthquake insurance be compulsory, and, if so, what would be
the enforcement mechanism?
• What should be the role of land-use regulations and building codes? Is current
insurance regulation conducive to creating private sector incentives for
mitigation?
In broadening this discussion beyond earthquake insurance to catastrophe risks insurance in
general, insurance market experts recognize that the risk of a mega-catastrophic event could pose
a significant capacity and liquidity problem for insurers who receive relatively stable premium
flows but suddenly need large amounts of cash to cover disaster losses. A sudden loss of
policyholder surplus, which is the statutory net worth or cushion available to insurers for handling
the unexpected, could have an adverse effect on the financial strength of the property and casualty
insurance industry. To better manage catastrophic risk, insurers have sought to raise premiums,
impose a percentage deductible, and reduce the amount of concentration of their exposures. These
changes have led to availability and affordability problems for many homeowners in disaster-
prone areas.
Finally, various government actions, such as access to federal disaster assistance or insurance, are
likely to affect the behavior of individuals and firms in responding to catastrophe risk. By making
disaster-prone areas safer through a federal earthquake insurance scheme, however, government
policy could have the unintended consequence of creating incentives for people to move into
harms way, which would increase the potential for catastrophic property damages and economic
Congressional Research Service
10

Earthquake Risk, Insurance, and Recovery: Issues for Congress

losses. Hence, Congress will find no shortage of issues to debate and resolve when considering
proposals to establish a federal earthquake insurance program.
Legislation
So far in the 111th Congress, six legislative approaches have been introduced that would broaden
the federal government’s role in insuring, mitigating, and financing recovery from natural
catastrophes in the United States. Proposals include the following: (1) establishing a national
consortium to allow states to aggregate risk from state-sponsored insurance pools and transfer
such risks to the capital markets through catastrophe bonds (H.R. 2555/S. 505), (2) a provision
for a tax-free accumulation of reserves to pay catastrophe losses (H.R. 998/S. 1486), (3) a
Treasury program to guarantee state-issued debt (H.R. 4014/S. 886), (4) a federal reinsurance
backstop (H.R. 83), (5) a provision to establish individual catastrophe savings accounts (S. 1484),
and (6) establishing a bipartisan commission to examine catastrophe risks and make
recommendations for the management and financing of such risks (S. 1487).
H.R. 2555/S. 505 (Klein/Nelson). The Homeowners Defense Act of 2009 would facilitate the
expansion of the market for securitized insurance risks.15 These bills would create a National
Catastrophe Risk Consortium (“Consortium”) that would allow states to pool large natural
catastrophe risks within the Consortium and then transfer them to the private capital markets
through the issuance of catastrophe bonds. The Consortium is premised on finding a low-cost
catastrophic-risk-financing solution that generates market competition by exposing risk-transfer
opportunities in a way that makes evident the cost savings for participants using the system,
possibly in real (or near real) time. On March 10, 2010, the House Financial Services,
Subcommittee on Housing and Community Opportunity and Subcommittee on Capital Markets,
Insurance, and Government Sponsored Enterprises held a hearing on H.R. 2555. A mark up on the
bill is expected in April 2010.
H.R. 998/S. 1486 (Rooney/Nelson). The Policyholder Disaster Protection Act of 2009 would
amend the Internal Revenue Code to allow insurers to accumulate tax-deferred reserves for
catastrophe losses such as windstorms, earthquakes, fires, or floods.
H.R. 4014/S. 886 (Sanchez/Nelson). The Catastrophe Obligation Guarantee Act of 2009 would
authorize the Secretary of the Treasury to establish a program to provide guarantees for debt,
including principal and interest, issued by state catastrophe insurance programs to assist in
financing recovery from natural catastrophes. The guarantees for eligible state programs that
cover earthquake peril shall not exceed $5 million and $10 million for all other perils. The bill
also has a provision designed to encourage and support programs to mitigate losses from natural
catastrophes for which the state insurance or reinsurance program was established to provide
insurance coverage.
H.R. 83 (Brown-Waite). The Homeowners’ Insurance Protection Act of 2009 would create a
federal reinsurance mechanism to encourage states to establish catastrophe funds for
homeowners’ insurance. The program would help states better prepare for and protect their
citizens against natural catastrophes, encourage and promote mitigation, and finance recovery
after a catastrophic event.

15 For more information, see CRS Report RS22756, The Homeowners’ Defense Act: An Overview, by Rawle O. King.
Congressional Research Service
11

Earthquake Risk, Insurance, and Recovery: Issues for Congress

S. 1484 (Nelson). The Catastrophe Savings Accounts Act of 2009 would amend the Internal
Revenue Code of 1986 to create catastrophe savings accounts.
S. 1487 (Nelson). Commission on Catastrophic Disaster Risk and Insurance Act of 2009 would
establish a bi-partisan commission to examine the risks and recommend possible solutions for
Americans living in natural-disaster-prone areas.
Congressional Research Service
12

Earthquake Risk, Insurance, and Recovery: Issues for Congress

Appendix. Standard Property Insurance Earthquake
and Flood Exclusion Language
We do not pay for loss resulting directly or indirectly from any of the following, even if
other events or happenings contributed concurrently, or in sequence, to the loss:
(1) by earth movement, due to natural or man-made events, meaning earthquake including
land shock waves, or tremors before, during or after a volcanic eruption, mine subsidence;
landslide; mud-slide; mud flow; earth sinking; rising or shifting. Direct loss by Fire,
Explosion, Sonic Boom, Theft, or Breaking of Glass resulting from earth movement, mine
subsidence, landslide, mud-slide, mud flow, earth sinking, rising or shifting is covered.
(2) by water damage, meaning:
(a) flood, surface water, waves, tides, tidal waves or overflow of a body of water. We
do not cover spray from any of these, whether or not driven by wind;
(b) water or sewage which backs up through sewers or drains; or
(c) water below the surface of the ground. This includes water which experts pressure
on, or flows, seeps or leaks through any of a building or other structure, sidewalk,
driveway, foundation, or swimming pool.

Author Contact Information

Rawle O. King

Analyst in Financial Economics and Risk
Assessment
rking@crs.loc.gov, 7-5975

Congressional Research Service
13