Funding the inevitable: the California Earthquake Authority appears ready for the big one.

Florida had never seen anything like it--four hurricanes in six weeks that killed 32 people and damaged thousands of homes and businesses. While insured losses for the four storms reached more than $21 billion in Florida, no single one of these hurricanes packed the devastating punch of Hurricane Andrew, the 1992 powerhouse that brought nearly $16 billion in insured losses and spurred Florida legislators to create the Florida Hurricane Catastrophe Fund.

It took another natural disaster, this time the Northridge earthquake in California in 1994, which caused more than $15 billion in insured losses, to prompt that state's lawmakers to establish their own state-directed pool, the California Earthquake Authority.

But that's where the similarities between the two funds pretty much end, as noted in a recent Credit Suisse/First Boston equity research report that focused on the California Earthquake Authority and how it operates. The differences include the way insurance is sold, the purchase of reinsurance, the aggregate claims paying ability, and the groups that are assessed in the event that capital is depleted.

A Look at Both Funds

The Florida fund, for example, provides reinsurance capacity for many of the start-up companies that surfaced in the state after Hurricane Andrew. This fund is designed to handle a high severity event of Andrew's magnitude, and is not meant to deal with frequency, as was the case with the four hurricanes in 2004. As a result, while the Florida fund did help mitigate losses from the four storms, paying out about $2 billion in claims, and Citizens Property Insurance Co., the state-run insurer of last resort, as well as non-U.S. reinsurers and the Federal Emergency Management Agency helped, too, the heaviest burden fell on many of the primary insurance companies in the state. To name just a few, Berkshire Hathaway reported hurricane losses of more than $1 billion, RenaissanceRe posted $522 million in losses and Chubb, $180 million.

"The FHCF was originally formed to respond to a severe event similar to Hurricane Andrew and needs to evolve to consider frequent events like those that transpired in 2004," said Anthony Diodato, vice president of A.M. Best Co.'s property/casualty division. "Although Florida's losses were more than $21 billion, the FHCF only had to pay out approximately $2 billion, which was less than 1% of its overall capacity."

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While the Florida fund acts as more of a reinsurer to primary insurance companies, the California fund offers primary coverage on shake loss, or structural losses arising from a seismic event.

This means that the CEA would pay the insured's claims after a deductible, whereas the Florida catastrophe fired would pay the insurance companies directly. However, the CEA does not cover losses arising from a subsequent fire, explosion or water damage. These would be covered by a standard homeowners or commercial property policy, Credit Suisse said.

In the event of a Northridge-scale earthquake or worse, economic losses are expected to surpass insured losses by a wide margin, the report said. That's because only 13% of property owners have earthquake insurance in California, said Pete Moraga, a spokesman for the Insurance Information Network of California. "The farther away you get from a large type of event, the more people forget," Moraga said. His organization is "working all the time to get the message out" that earthquake coverage is essential, he said.

People also tend to think the deductibles for earthquake insurance are too high and the coverage is too limited. Earthquake insurance premiums average $600 to $800 a year and carry a 10% to 15% deductible, reported the Insurance Information NetWork. "There hasn't been a significant event in California since Northridge, therefore the average homeowner doesn't see the necessity of paying a large premium for earthquake insurance" Diodato said. "Despite the events that have occurred over time, many homeowners are in denial that either a larger earthquake will happen or it just will not impact their property"

Of the 13% who had California earthquake coverage in 2003, Credit Suisse said that the CEA had a 39% share of premium, with the remaining 61% share held by the private insurance market.

Earthquake Writers

Safeco is among a handful of public companies that write California earthquake insurance directly. The Seattle-based insurer has two different versions of earthquake coverage. One is a separate mini-policy that is offered as a companion policy to homeowner or dwelling fire policy forms where there is structural coverage. The other, on tenant-condo policies, is an endorsement that attaches and becomes part of the policy.

These policies are similar to what the CEA offers, said Brian Guimond, assistant vice president and senior product manager of personal property for Safeco Personal Insurance. "Our mini-policy provides the same level of coverage," he said. "It must match the coverage on the parent homeowners policy. So if you have a $600,000 house, you're going to have a $600,000 earthquake policy."

It also provides a maximum of $5,000 for personal property and $1,500 for additional living expenses. No additional options are available to be purchased. The minimum deductible on this policy is 15% of the coverage value, meaning with a $1 million house, the deductible would be $150,000.

Like Safeco, the CEA's policy typically will provide coverage matching the dwelling coverage on the companion homeowners policy, Guimond said. Their base deductible also is 15%, but they have the option to buy back to a 10% deductible. Their personal property and additional living expenses are sold as a package and, like Safeco's, are a base of $5,000 for personal property and $1,500 for additional living expenses. However, the CEA offers four other options that reach up to $100,000 in personal property and $15,000 in additional living expenses with various increments in between, he said.

In recent years, Safeco has not focused on trying to grow its property business in California as it worked through legislative, regulatory and catastrophe management issues, Guimond said. "Frankly, our focus in California has been auto and small business in the last couple of years," he said. "During that time, we have continued to work on the homeowners issues and we think that we're coming very close to a point where we can start thinking about growing our property book of business again" If Safeco does, it will be with an eye toward taking a cautious approach to managing catastrophe exposure, Guimond said.

"The CEA assesses premium based on the characteristics of each risk for earthquake coverage," said Ken Tappen, senior financial analyst in A, M. Best Co.'s property/casualty division. "Since the CEA is a nonprofit type of organization, the money it receives in premiums is allocated to loss and loss adjustment expenses, underwriting expenses, reinsurance costs or contributed to surplus."

If another Northridge-like event or worse occurred, reinsurance rates would likely rise for the CEA, but not right away. "The renewal date for the CEA's reinsurance programs is April 1 each year," Tappen said. "That provides a nine-month leeway [until the contract goes into effect Jan. 1] for the CEA to evaluate deeper reinsurance market and/or other capital markets solutions, should rates increase dramatically or the traditional reinsurance market be inadequate to cover its risk."

It's only a matter of time, the experts say, before another significant earthquake of a magnitude 7 or greater strikes California. Catastrophe modeler RMS estimates that a major quake with losses of more than $3 billion is 65% likely in the next 10 years, the Credit Suisse report says.

As yet, the CEA is untested, but based on the probable maximum loss information the authority provides, its capital could stand up to losses from an extremely powerful 250-year earthquake and beyond, Diodato said. Northridge was a 90-year event.

"By statute, the CEA is set up so that its capital is at the bottom layer and that's what's paid out first," Tappen said. "But there are two significant layers which total $3.6 billion that they can assess the insurance companies that are members of the CEA. When combined with the additional reinsurance layers purchased, the total coverage is about $7.2 billion"

There's always the potential for something to arise that hasn't been anticipated, but the amount of thought and planning that has gone into the CEA is impressive, Tappen said. The expertise of the CEA staff is supplemented by people brought in from other government agencies. "They bring in many consultants--actuaries, the U.S. Geological Survey--all different elements are contemplated to help them make sure that this organization will run smoothly in the event of a major earthquake," he said. "So I think it will respond well"

The CEA has a five-member governing board which includes Gov. Arnold Schwarzenegger, the state treasurer, insurance commissioner, speaker of the Assembly and chairman of the Senate rules committee. "There's a lot of power there to make sure that this works properly and that insurance companies, should there be an assessment, follow it through," Tappen said. Public companies that participate in the CEA include Allstate and Mercury General, Credit Suisse reports.

Earthquake: Top U.S. Writers
Direct Premiums Written--2003
($ Millions)

                                              Direct
Companies                           AMB#    Premiums
                                             Written

California Earthquake Auth.         12534     $436.8
State Farm Group                    00088      168.8
Zurich/Farmers Group                18549      144.1
St Paul Cos.                        00080       90.6
Travelers Prop. Cas. Group          18358       83.4
Ace INA Group                       18498       81.2
American International Grp. Inc.    18540       67.7
Allianz of America Inc.             18429       65.3
Great American P&C Ins. Group       04835       63.8
ICW Group                           02967       45.4

Source: Best's State/Line Database (Standard Lines)

Key Points

* The Florida Hurricane Catastrophe Fund and the California Earthquake Authority differ in several ways, including the purchase of reinsurance and the aggregate claims paying ability.

* Only 13% of California property owners have earthquake coverage.

* As yet, the CEA is untested, but based on probable maximum loss information, its capital could stand up to losses from a powerful 250-year earthquake and beyond.

The California Earthquake Authority

History: Created by California legislators in 1996 after the Northridge earthquake

Management: Privately financed, publicly managed by a five-member governing board that includes the governor, state treasurer, insurance commissioner, speaker of the state Assembly, chairman of the state Senate Rules Committee and advised by a panel of insurers, agents and members of the public

Chief Executive Officer: Elaine Bush

Public Companies Involved: Allstate and Mercury General; they participate in an agency capacity as all premiums collected are paid into the fund.

Assets *: $1.9 billion

Liabilities *: $228 million

Equity *: $1.6 billion

Net Premiums Written *: $299 million

Net income *: $225 million

* According to the CEA's 2003 income statement

Source: California Earthquake Authority

Difference in the Details

Their designation as state-directed pools is where the similarities end when comparing the California Earthquake Authority and the Florida Hurricane Catastrophe Fund.

                                                FLORIDA HURRICANE
CALIFORNIA EARTHQUAKE AUTHORITY                 CATASTROPHE FUND

HOW COVERAGE IS SOLD Policyholders              Wind and water-related
purchase coverage as an add-on policy with      losses are included
the exception of auto insurance in which        in homeowners and
losses are covered under comprehensive          commercial property
policies.                                       coverages.

LOSS RETENTION The first dollar of earth-       The FHCF requires the
quake-related losses for residential proper-    industry to retain the
ty is typically borne by the CEA.               first $4.5 billion of
                                                loss.

REINSURANCE The CEA buys reinsurance            The FHCF purchases as-
from private reinsurers every year.             reinsurance on an
                                                needed basis.

ASSESSMENT In the event that capital is         Policyholders fund the
depleted, the CEA can assess insurers.          assessments in the form
                                                of a surcharge on
                                                all property/casualty
                                                insurance-related
                                                premiums, with the
                                                exception of workers'
                                                compensation and medical
                                                malpractice.

AGGREGATE CLAIMS PAYMENT The CEA                The FHCF provides
aggregate claims paying ability is reduced      $15 billion of aggregate
by any claims payments regardless of when       protection for each
they occur and can only be increased as a       hurricane season and is
result of industry assessments for which        renewed each year.
there are only two opportunities. For
example, if the CEA has claims paying
capacity of $7.2 billion and it suffers a
$1 billion loss, only $6.2 billion would
remain to fund a second loss.

Source: Credit Suisse/First Boston Equity Research

Largest U.S. Catastrophes by Insured Loss

Hurricane Andrew and the Northridge earthquake are the second and third largest U.S. catastrophes by insured loss. ($ Billions)

                                             Insured Losses

                                          When       In 2003
Year                       Catastrophe    Occurred   Dollars
Sept. 2001   World Trade Center Tragedy      $30.0     $31.1
Aug. 1992             Hurricane Andrew        15.5      20.3
Jan. 1994        Northridge Earthquake        12.5      15.5
Aug. 2004            Hurricane Charley         6.8       6.8
Sept. 1989              Hurricane Hugo         4.2       6.2
Sept. 1998           Hurricane Georges         2.9       3.3
June 2001       Tropical Storm Allison         2.5       2.6
Oct. 1995               Hurricane Opal         2.1       2.5
Sept. 1999             Hurricane Floyd         2.0       2.2
March 1993              Winter Storm *         1.8       2.2

* The storm hit 20 slates.

Source: Insurance Information Institute. CSFB estimates

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Safeco Insurance Cos.

A.M. Best Company # 00078

Distribution: Independent agents

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