How to have your quake and beat it
As insurance losses from the recent New Zealand earthquake are estimated to reach up to $3.5bn, Sam Barrett examines the steps the insurance industry is taking to understand and manage this risk
With economic losses potentially running into the hundreds of billions, earthquakes are a major issue for property owners, governments and the insurance industry. But while there are different approaches around the world, having a good understanding of the risk is key to mitigating the full force of the losses. The earthquakes in 2016 demonstrate some good examples of the different approaches, according to Robert Muir-Wood, chief research officer at RMS. “New Zealand and
Italy are at opposite ends of the spectrum,” he says. “Around 95% of people have cover in New Zealand as a result of the government’s Earthquake Commission (EQC). Conversely, in Italy the government compensates property owners for earthquake loss, so very few people bother to take out any cover.”
Although the Italian government would risk unpopularity if it attempted to compel people to take out insurance, the New Zealand model does offer significant benefits for all parties. Originally established in 1945 to provide cover for war damage and earthquakes (the war element has since been dropped from its remit), it gives up to NZ$100,000 of cover for property damage plus a further NZ$20,000 for contents.
“While the Canterbury sequence presented numerous challenges, the EQC has been really successful from a risk financing perspective,” says George Attard, head of Aon Benfield Analytics, International. “As well as helping to ensure the cost of claims are met, it’s also enabled property owners to access affordable cover.
With private insurers providing topup cover above the EQC limit, the EQC also helps mitigate the risk of significant premium increases.”
Other models are also in place between these two extremes. For instance, Turkey operates a compulsory insurance system while in Chile, where cover is a requirement alongside a mortgage, around a quarter of properties are insured. At the other end of the scale, only around one in 10 property owners in California take out insurance.
“A repeat of the 1906 earthquake could result in property losses of US$200bn,” says Nigel Brook, partner at Clyde & Co. “But, with cover expensive and deductibles high, many property owners prefer to retrofit their home or set money aside instead of taking out cover.”
While government and public attitudes to earthquake risk vary around the world, the insurance industry plays an important role
in mitigating the impact of losses. “With the increased focus on closing the protection gap, there has been a concerted effort to increase risk awareness and improve resilience through greater collaboration,” says Mr Attard. “The industry has the expertise to understand, underwrite and manage the risk, as well as work with governments – supported in many cases by international and regional development banks – to provide subsidies and incentives, seed funding, contingent capital and the legal framework for the establishment of such schemes.”
The expertise within the insurance industry can also protect the insurers’ own interests. As risk concentration can be high from a single earthquake, insurers and reinsurers must ensure they mitigate these losses wherever possible. To understand and control their risk exposure, insurers and reinsurers use sophisticated modelling, taking into account everything from the property’s location through to its construction. “Models have become increasingly complicated, adding in additional perils,” says Mr Muir-Wood. “As an example, we’re launching a new North American earthquake model in 2017, which will include further detail on liquefaction, fire and tsunami to help with pricing and aggregation.”
When it comes to a catastrophic risk such as earthquake, aggregation is essential. As well as enabling an insurer to put sufficient reinsurance in place, it also allows it to control its exposure. Antony Holden, partner in DAC Beachcroft’s Auckland office, explains: “An insurer might balance its insured risks in the South Island with commercial property in Auckland.
Getting the right balance is important: some providers were forced to pull out of residential and commercial property insurance in the South Island as a result of their losses after the 2010/2011 earthquakes.” While this is sensible, it can be frustrating for property owners who may find themselves refused cover on the basis their risk doesn’t fit an insurer’s aggregation model. “We try to put insureds into the driving seat,” explains Caroline Woolley, Marsh business interruption centre of excellence global leader. “By doing their own mapping exercises and understanding the exposure, it is easier to present the risk in a positive way, rather than have limits dictated by the insurers.”
Property damage may be the primary concern after an earthquake but there can also be a need for business interruption cover, to replace income while the firm is unable to operate. As well as having a policy that responds to damage to the business property itself, insureds also need to consider other ways in which an earthquake may affect operations.
Rob Powell, claims advocacy international leader at Marsh, explains: “If a business is located in a disaster zone, there can be significant delays on the rebuild. Having a policy with denial of access can be important.” Contingent business interruption is increasingly a consideration too.
“Companies are getting smarter about supply chain risk,” says Mr Brook. “If a supplier is affected by an earthquake, this can also affect the business. The 2011 earthquake and tsunami in Japan had major supply chain repercussions for businesses round the world.”
The scale of the losses means that legal issues can rumble on too, with event allocation a particularly thorny issue for insurers. While an hours clause can provide clarity around the application of limits and deductibles, Mr Holden says it can still be difficult determining the relevant peril for the loss. “Where an earthquake is followed by a serious rainstorm, for example, it can cause landslips and flooding.
As some policies have exclusions for subsidence and landslips, ground-up policy analysis is sometimes necessary,” he explains. Further complications can also arise around property reinstatement. If a property is hit by two losses, rather than paying out for the two separate episodes of damage, it is important to ascertain whether repairs were carried out for the first event and adjust settlement accordingly.
Several cases relating to this are before the courts in New Zealand, but Mr Holden says the court of appeal judges have taken a pragmatic and sensible approach: “Although there have been attempts to look at the events in isolation and make two settlements, the judges ruled that, as this may offend the indemnity principle, the insurer needed to take a realistic assessment of the actual damage that had been sustained.”
While each earthquake raises new challenges, the insurance industry is taking steps to understand and manage this risk.
An earthquake is rarely a one-off event, with most being part of a sequence that can see further tremors within a short period of time. As a result, hours clauses are common in earthquake insurance.
These stipulate a time period, typically 72 hours, in which all earthquake losses a policyholder suffers will be regarded as one loss. This creates clarity but also protects the insurer as any limits can only be applied once during that time period. Similarly, the policyholder has the reassurance that they will only pay one deductible.
Aggregation, where an insurer monitors the total potential losses across its book of business, is an essential part of minimising losses resulting from a catastrophic event such as an earthquake. By understanding its exposure, an insurer can manage the risk it takes on, protect its balance sheet and satisfy regulatory requirements.
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