DATELINE: NORTHERN CALIFORNIA. At 2:00 p.m., a massive earthquake measuring 8.3 on the Richter scale - roughly the same magnitude as the catastrophic 1906 San Francisco earthquake - rocked this northern California region. The quake, whose epicenter was located on the North San Andreas fault line, jolted office workers from their workstations and sent schoolchildren scurrying for safety.
Given this scenario of a midday, midweek catastrophic earthquake, would insurance firms be able to meet their financial obligations to settle claims in full? Would there still be a sufficient number of financially healthy firms selling high-quality insurance products following such an event? What impact would the decrease in the insurers' surplus, as caused by the earthquake, have on their future operations?
Several responses from the insurance industry are possible. For example, insurers may not be able to replace surplus in the short-run, but they could choose to maintain their pre-earthquake volume of business. Since the surplus determines the capacity of the insurer to write business, the lower the surplus, the smaller the volume the insurer can sell while still offering financial security to policyholders. By maintaining the same premium volume without replacing surplus, the probability of future insolvencies increases. For a large reduction in surplus, insurers will probably be forbidden by regulators to maintain current levels of supply.
Another possibility is that insurers can't replace their surplus, but do reduce volume to a level that provides similar financial security to the pre-earthquake period. While the quality of insurance will be maintained, there will be a problem of insurance availability. It would also be conceivable that insurers are able to replace surplus and maintain volume, where neither quality nor availability will be long-standing problems. However, even in this case, raising new capital takes time, and consumers will be exposed to some mixture of quality and availability problems in the immediate post-earthquake phase.
In the normal course of their business, insurers do not have to sell off financial assets in order to pay their claims. Normal loss experience is fairly predictable and can be met from the natural maturing and turnover of longer term financial assets and by holding some assets in near cash form. However, catastrophic losses require that the insurer liquidate substantial quantities of financial instruments. Nonetheless, the release of large blocks of assets by insurers in order to pay earthquake claims is not expected to significantly depress prices.
Under the above set of conditions, the insurance industry can expect an estimated $40.3 billion in total losses (based on aggregates in 1987 dollar values). It should be noted that some recent estimates predict losses upwards of $43.9 billion (1991 dollars) for shaking damage and "fire following" losses alone. To the extent that there is inflation and/or an increase in property values, this figure will underestimate the total cost of a catastrophic earthquake. The considerable uncertainty associated with the magnitude of the earthquake, its epicenter and the time of occurrence suggest that the range of possible damage is very wide. Hence, the estimate should be viewed as an illustrative example to examine relative impacts.
To put the $40.3 billion estimate into some perspective, this figure may be set against the total surplus of the insurance industry, estimated to have been $165 billion in 1992. It must be further noted that this $165 billion figure overstates the actual surplus available to pay losses since some carriers do not operate in California and some surplus must be available to pay other losses. Furthermore, the actual surplus may be overstated due to an overestimation of capital assets or understated reserves given the long-tail nature of liability claims. In other words, at least one third of the industry's surplus is at risk in a catastrophe of the magnitude depicted above. …