Academic journal article Risk Management and Insurance Review

An Analysis of the Demand for Earthquake Insurance

Academic journal article Risk Management and Insurance Review

An Analysis of the Demand for Earthquake Insurance

Article excerpt

ABSTRACT

This research examines the decision to purchase earthquake insurance by analyzing data on earthquake insurance price and penetration in the New Madrid fault zone in Missouri. Earthquake risk is of concern to consumers, the insurance industry, industry regulators, and government agencies because of the potentially catastrophic nature of losses resulting from a major earthquake. Despite the significance of the earthquake peril, the recent literature does not contain estimates of the price and income elasticity of the demand for earthquake insurance. Our analysis indicates that homeowners acquire earthquake insurance because of risk considerations, at higher levels of risk the demand for earthquake insurance is higher, and the price of earthquake coverage does not provide incremental information in explaining the demand for earthquake coverage.

INTRODUCTION

Earthquake insurance is generally characterized as low-probability, high-severity catastrophic loss coverage. The standard homeowner's policy does not cover the insured against loss caused by an earthquake unless the policyholder purchases an earthquake endorsement. While some homeowners obtain earthquake coverage from an insurance company or participate in a state-sponsored earthquake insurance pool, many others decide to remain self-insured.

Earthquakes and other catastrophic events like floods and hurricanes have the potential to cause widespread economic chaos in the affected area. Earthquakes of significant magnitude have recently occurred in Haiti, Turkey, Chile, China, and New Zealand, causing death, injury, and damage to property. Although categorized as low-probability events, earthquakes do occur with alarming frequency (Murdoch et al., 1993). The National Earthquake Information Center of the U.S. Geological Survey records thousands of earthquakes of varying intensity in the United States each year.

Earthquake insurance is of importance to consumers, the insurance industry, industry regulators, and government agencies because of the potentially catastrophic nature of losses resulting from a major earthquake. Such an event could seriously impair the claims paying ability of insurance companies and adversely impact the insurance industry (Currirnins et al., 2002). Fortunately, damaging earthquakes have been infrequent events. If insurance consumers anchor their expectations to recent experience, few property owners may have earthquake insurance even in areas which have a higher probability of occurrence and when insurance is available and offered at a reasonable price. Of course, if a large number of homeowners choose to remain uninsured against the earthquake peril, there will be a high cost associated with disaster relief and recovery efforts.

Despite the significance of the earthquake peril to the insurance industry, the recent literature does not contain estimates of the price and income elasticity of the demand for earthquake insurance.1 We therefore seek to present information about the demand2 and price of earthquake insurance, and examine the impact of price, income, and risk on the demand for earthquake insurance. This article is organized as follows: first, we describe the earthquake peril from an insurance industry perspective; second, we describe the earthquake peril from an insurance consumer's perspective; third, we examine the demand for earthquake insurance and develop our hypotheses; fourth, we describe the data and methods used in the analysis and present the results of our analysis; and finally, we offer concluding comments of relevance to the insurance industry and policy makers.

AN INSURANCE INDUSTRY PERSPECTIVE

Earthquakes are not an ideal insurable event for an insurance company (Soberon, 1995, p. 144). Insurable events are ideally both predictable and statistically independent. In the case of earthquake insurance, the loss event is infrequent and estimates related to the likelihood of occurrence and the severity of loss is subject to substantial error. …

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