P&C the October 2015 issue

The Long Walk Home

The Big One will be much worse than you can imagine. It could depopulate California and send the U.S. economy into a tailspin.
By Daryl Lease Posted on October 24, 2015

But in a worst-case scenario, it’s a walk he and millions of other Californians might one day need to confront.

“You hope you have a way to get there,” says Wallan, whose firm, Pillsbury Winthrop Shaw Pittman, knows a thing or two about earthquakes. It was part of a landmark court case that secured insurance claims for policyholders after a quake and subsequent fires destroyed much of San Francisco in 1906.

According to estimates by the U.S. Geological Survey, if a similar quake were to occur today, economic losses would reach $84 billion. But even that level of damage would be overshadowed by the cataclysm that could be unleashed by The Big One—an earthquake of epic scale that seismologists regard as a matter of when, not if, in California.

When that megaquake hits, many of the bridges and roads Wallan and others crossed en route to work that morning won’t be passable. The car they drove, the bus or train they rode, probably won’t be reachable. Or upright.
Those shoes will be critical for the first steps toward home, the first steps on an even longer journey to a recovery that appears likely to take Californians—and rest of the nation—decades to complete.

In a state with more than 2,000 fault lines, it seems there are nearly as many scenarios for The Big One, each portraying the devastation of city centers, neighborhoods and public infrastructure, each describing a nightmarish loss of human life, livelihoods and property.

The worst of the worst—and arguably the most instructive—scenario is a model generated by EQECAT, a subsidiary of CoreLogic. The company provides catastrophe risk management analysis for companies in casualty insurance, reinsurance and financial markets.

In their projection, EQECAT modelers envision a quake of 8.5 or greater on the Richter scale that would stretch the full 800-mile length of the San Andreas Fault.

The epicenter would be about 250 miles north of San Francisco at Cape Mendocino, and the rupture would extend southward to Indio in the Salton Sea—rumbling through the metropolitan hubs of San Francisco and Los Angeles and through much of the Golden State landscape between and beyond those urban pillars.

The Big One, says Mahmoud Khater, executive vice president and chief technical officer at EQECAT, would “trigger strong ground shaking throughout California and cause severe liquefaction and other soil failures that would result in significant damage to residential, commercial, industrial and public structures in northern and southern California.”

Tens of thousands of lives would be lost. Los Angeles and San Francisco would sustain catastrophic damage, with economic losses for the state surpassing $1 trillion—with only about $140 billion of that insured. “We have not seen these types of losses before,” Khater says.

In addition to the damage caused by ground shaking and liquefying soil, the quake would set off a wave of fires that—reminiscent of the 1906 San Francisco quake—would quickly overwhelm firefighters. Access to water would be limited because of damage to aqueducts and pipes that crisscross the San Andreas Fault. Tens of thousands of homes and businesses would be destroyed by flames, with the number climbing higher if the quake occurs during fire season.

And then there’s the tsunami. An 8.5 magnitude quake could trigger a submarine landslide off the coast of Los Angeles, from Santa Barbara to San Luis Rey, with tsunami waves of 50 to 65 feet, according to Khater’s model.

The ports of Los Angeles and Long Beach would be severely damaged, shutting off 40% of the nation’s container traffic. The tsunami would destroy or disable nearby industrial and port-related businesses, and the waves also would strike oil refineries—adding spills and cleanup costs to the economic damage.

The Bay Area would take additional hits from the tsunami. San Francisco’s four-mile seawall would be breached in numerous places, with fill soil behind and near the wall liquefying, in turn collapsing roads, public transit and utilities.

The EQECAT model estimates a million homes in California would be destroyed or seriously damaged by the quake, fires and tsunami, leaving more than three million people in need of shelter. In a state where about 10% of homeowners have earthquake coverage, insured residential losses would be about $36 billion.

The uptake rate for commercial earthquake insurance is even lower—9.3%, according to the California Department of Insurance. In EQECAT’s model, insured losses for businesses would reach $104 billion—with $68 billion from the quake itself, $21 billion from fire loss and $15 billion from tsunami loss.

To get a sense of the scale of a catastrophe generating more than $1 trillion in economic losses with only about a tenth of that insured consider this: Munich Reinsurance reported that catastrophe losses worldwide in 2014 totaled $110 billion, with $31 billion—less than a third—covered by insurance.

Damage from The Big One would dwarf recent catastrophes in the United States. Hurricane Katrina’s losses reached $125 billion, with more than half that amount covered by insurance and federal flood policies. Superstorm Sandy’s losses totaled $70 billion, with about $35 billion covered by insurance and federal flood policies.

The EQECAT model is the worst of the worst, with the magnitude significantly stronger than most projections. Khater says the likelihood of a quake rupturing the entire fault at a magnitude of 8.5 is very low—once every 1,000 years or longer.

But the unimaginable isn’t quite so hard to imagine any more.

“People thought having a magnitude of 9.0 was impossible,” Khater says. The most recent was Tohoku, the 2011 quake and tsunami in Japan that claimed more than 15,000 lives, touched off a nuclear crisis at Fukushima and caused more than $30 billion in insured losses and more than $200 billion in total losses. It also shook conventional wisdom on just how bad California’s Big One could be.

The Inevitable

Even the milder scenarios that seismologists present for The Big One are nightmarish. Take any portion of the EQECAT model, or any variation generated by other firms, and California is facing the largest natural disaster in U.S. history—and soon.

We have not seen these types of losses before.
Mahmoud Khater, EVP and chief technical officer, EQECAT

According to the Uniform California Earthquake Rupture Forecast, there’s a more than 99% probability that Californians will be hit by a magnitude 6.7 or bigger quake in the next 30 years. For the Greater Bay Area, the probability is only slightly better: 63%.

Here’s a quick sampling of other scenarios:

  • A quake on the Puente Hills Fault, running beneath Los Angeles and ending in Hollywood, would claim thousands, perhaps tens of thousands, of lives, displace as many as 735,000 households and cause more than $250 billion in total damages, according to the U.S. Geological Survey and Southern California Earthquake Center.
  • The Hayward Fault, which last ruptured in 1868 and damaged much of San Francisco and Oakland, experiences a major quake an average of once every 140 years. Today, about 2.5 million people live on or near the fault zone, and more than seven million people live in nearby counties. According to Patricia Grossi, senior director for earthquake models at Risk Management Solutions, the total economic loss from a high-magnitude quake on the Hayward would be about $200 billion, with only $20 billion to $25 billion of that insured. Roughly half of the risk for a major Bay Area quake lies along Hayward and the nearby Rodgers Creek Fault.
  • AIR Worldwide’s U.S. Earthquake Model simulates a 7.9-magnitude quake rupturing 22 segments of the San Andreas. The damage, across 13 counties in Southern California, would cause more than $200 billion in total residential and commercial losses, with only about 15% of that insured.
  •  “The ShakeOut Scenario,” jointly published by the U.S. Geological Survey and the California Geological Survey, estimates that a 7.8 magnitude quake on the southern San Andreas Fault would kill approximately 1,800 people. Southern California would sustain $213 billion in economic losses, including $47.7 billion in damage from earth shaking, $65 billion from fire damage and $96.2 billion from business interruption.

Insurance industry analysts and earthquake experts say California is better prepared for a megaquake than ever. Major events such as the Loma Prieta quake in 1989 and the Northridge quake in 1994 prompted upgrades in building codes and major public infrastructure like the Golden Gate Bridge.

But experts say there are still major shortcomings in California’s—and the nation’s—preparedness for The Big One.

No Place Like Home

Two thirds of the nation’s earthquake risk is in California, but for most of its residents, says Glenn Pomeroy, “The tendency is to think it’s not going to happen to them.”

Pomeroy, a lifelong Midwesterner until he became CEO of the California Earthquake Authority in 2008, has overseen a slow but steady increase in the percentage of state residents who purchase earthquake coverage for their homes.

But the number of policies—about 865,000—still covers only about 10% of the state’s homes. That’s a lower uptake rate than in Oklahoma, where about 15% of homeowners now have coverage following a sharp increase in tremblors in the past five years.

Before the Northridge quake in 1994, roughly 25% of California’s homeowners had earthquake coverage. The premiums were relatively low, Pomeroy says—too low for the residential insurance industry’s liking, as it turned out.

The extent of the damage from the magnitude 6.7 quake, which was followed by two 6.0 aftershocks, caught many by surprise because it occurred on a previously unknown fault line. According to the state Senate Insurance Committee, the Northridge quake caused $49 billion in economic losses.

“Seven major freeway bridges in the area collapsed, and 212 bridges were damaged, disrupting traffic in the Ventura-Los Angeles region for weeks following the quake,” recalled a recent committee report on earthquake readiness. “Communication, water and power distribution systems were affected and several fires started. At least 50% of small businesses were still not open nine months after the disaster.”

The Northridge quake caused about $10 billion in insured losses to homes. The following year, Pomeroy says, more than 90% of residential insurers in California severely restricted coverage or threatened to stop writing policies in the state altogether.

The crisis prompted the creation of the California Earthquake Authority, which now has 19 insurers who offer earthquake policies and share the risk. The publicly managed, privately funded authority is the largest residential earthquake insurer in California.

According to Pomeroy, the CEA has the ability to pay more than $11 billion in claims, with about $4.5 billion of that risk transferred to the global reinsurance market. “The ratings agencies—A.M. Best, Moody’s, Fitch—require us to have enough claim-paying capacity to handle an event that would occur once every 450 years,” Pomeroy says.

If the Northridge quake were to happen today, the CEA estimates the insured losses would be $4 billion, which means the authority has the capacity to handle two quakes of that size.

“I don’t lose sleep at night about not having enough claims-paying capacity. We do,” Pomeroy says.

But he and others say there is one industry in particular that will be hit hard by The Big One—mortgage companies. EQECAT’s model predicts widespread mortgage defaults because so few Californians have earthquake insurance, and very few of the uninsured would have the means to repair or replace their homes. About 800,000 of the one million homes that would be damaged under EQECAT’s Big One scenario are not insured for quake damage.

Because so many California homeowners lack insurance, Pomeroy fears there will be a “keys thrown on the table” mortgage crisis and, in turn, a credit crisis for people walking away from their debt.

Frankly, I’m constantly surprised that this isn’t of greater concern to public officials in Washington.
Glenn Pomeroy, CEO, California Earthquake Authority

Jamie Miller, managing director for North American property for the Swiss Re Group, agrees. In the damage estimates, Miller says, “the wild card is how much default we’ll see on mortgages.”
In Florida and other hurricane-prone states, many mortgage companies require borrowers to purchase wind insurance as part of their homeowners policy or as a separate policy. But earthquake insurance isn’t a requirement for lenders in California.

“We’ve talked to banks from time to time,” Pomeroy says, “and basically the answer back is that no bank is willing to do it alone because people would go across the street to another bank.”

“Frankly, I’m constantly surprised that this isn’t of greater concern to public officials in Washington and bank regulators and Fannie Mae and Freddie Mac. We raise it, but it doesn’t seem to be under serious consideration in Washington or anywhere else. I think that’s the out-of-sight, out-of-mind thinking.”

The default crisis also worries Grossi at RMS. “The banking and real estate industries need to be involved in the discussion,” she says. “We need to try to minimize the default percentage.”

For now, the focus is educating homeowners on the availability and value of earthquake insurance, as well as retrofitting their homes to reduce damage. Janet Ruiz, who works for the Insurance Information Institute, says the CEA has made a lot of progress in raising awareness.

But it’s a challenge to convince many homeowners, she says. “They don’t always feel they’re in an earthquake-prone area. They don’t realize what kind of coverage is available. I think they don’t take the time to get a quote and find out it’s not as expensive as they thought.”

Grossi is concerned that California’s transient, youthful population isn’t making educated choices. She points out that 25% of the Bay Area is age 25 or younger and many have never experienced a major quake.

The average annual statewide earthquake premium last year was $798 for homeowners, $381 for condo owners and $120 for renters, according to the CEA.

Those averages can be tricky to assess, Pomeroy says, because the rates are higher in parts of the state where the risk is greater. “Generally speaking, it doubles your insurance rate,” Grossi says.

“Some people, especially in a high-risk area, think that’s too much,” Pomeroy says, and they decline earthquake coverage. “That’s a choice for them to make. But we encourage people to think about the cost for them if their homes are destroyed.”

No Business Like No Business

At a recent conference on earthquake insurance, attorney Robert Wallan asked how many in the room had coverage for their homes and businesses. About half of the audience—many of them lawyers—raised their hands, he says.

“I know individuals and companies who have concluded it costs too much and said, ‘I’ll put the money aside and take care of it myself,’” Wallan says.

That works for some, but Wallan says it’s a risky move for others. He says commercial earthquake insurance—supplemental to general commercial insurance policies—should be considered as part of a long-term business plan. Policies typically cover damage to buildings and property, loss of business income, water damage from sprinklers and other effects.

Yet less than a tenth of California businesses are insured for an earthquake. A megaquake would shut down many of the uninsured, but—as the report on earthquake readiness by the California Senate Insurance Committee notes—the effects wouldn’t end there. “Businesses that may have survived with little or moderate damage may be hindered from reopening if a building in close proximity to them has been more seriously damaged, or ‘red-tagged,’” Wallan says.

Coverage for business interruption is critical, Wallan and others point out. “You’ve got to assume you’re going to be shut down for some period of time,” he says. “If freeway ramps are closed for three months, six months, a year, what’s that going to do for your business?”

The state Senate Insurance Committee points out that a magnitude 7.8 earthquake in Southern California would cause $213 billion in economic losses, according to USGS estimates—with the largest component of that, $96 billion, from business interruption.

EQECAT’s model for a full eruption of the San Andreas Fault puts business interruption losses at $25 billion, but that calculation doesn’t include contingent business interruption, or CBI, from disruptions to supply lines and other obstacles to daily operations.

Other business-related losses would be substantial. The loss from workers compensation would be about $10 billion, according to EQECAT’s model. A Risk Management Solutions analysis of a repeat of the 1906 San Francisco quake estimates workers comp losses would hit $11.5 billion to $35.8 billion.

If freeway ramps are closed for three months, six months, a year, what’s that going to do for your business?
Robert Wallan, attorney, Pillsbury Winthrop Shaw Pittman

The state Senate Insurance Committee offers a grim picture too: “The State Compensation Insurance Fund, with approximately 11%-12% of the California workers compensation market, has estimated its potential exposure to a repeat of the 1906 San Francisco or a major southern San Andreas earthquake could reach about $500 million to $750 million per event, depending on the time of day the earthquake hits. If a major earthquake hits during peak work hours, the losses would be significantly higher.”

Miller at Swiss Re anticipates the rate of bankruptcies for businesses would be high, rivaling the mortgage default crisis in severity. The uninsured will be hard hit, he says, as will “companies that have a lot of debt and are tight to the margin.”

Miller also worries about delays in getting insurance money to businesses during the recovery because of the magnitude of losses and the time it could take to assess and pay claims. “All of these pieces—whether it’s residential or commercial—all have a significant delay component,” he says. “What is that going to mean when people need money to rebuild but can’t get it?”

The Senate insurance panel report expresses concern about the number of small businesses that will disappear before a recovery can get under way. In San Francisco, for example, more than 90% of the city’s businesses have 25 or fewer employees.

“The committee has spoken with one insurance broker serving small businesses in San Francisco who estimated that fewer than 5% of small businesses [there] have earthquake insurance,” the report states. Those businesses face “a downward spiral of bad credit, exhausted savings, and taking on additional debt” if they try to reopen. And many of their employees would have no job to report to.

So Goes the Nation

Because California plays such a large role in the U.S. economy, the economic impact of a megaquake would reach far beyond the state’s borders. According to Risk Management Solutions, the Bay Area Gross Domestic Product is $535 billion—the highest economic productivity in the United States and 19th in the world compared to national economies.

Los Angeles has a gross domestic product of about $820 billion, and it’s home to the largest container and cargo port in the United States. According to a report last year on earthquake readiness issued by the office of Los Angeles Mayor Eric Garcetti, “The economic consequences from a large earthquake would be devastating and could generate unforeseeable rippling effects beyond city boundaries.”

For the Los Angeles region, the Senate insurance committee breaks it down this way: “The seven southern California counties that would be most affected by the ShakeOut earthquake are home to 621,000 business establishments, 6.3 million employees, and an annual payroll of $303.3 billion, according to data from the Quarterly Census of Employment and Wages published by the U.S. Bureau of Labor Statistics (BLS) in 2011. The study showed that roughly 430,000 businesses and 4.5 million employees would be affected in the hardest hit zones.”

The Big One, the committee concluded, “could bog down the national economy. The seven hard-hit counties account for roughly one out of every 15 workers in the U.S., and the nationwide toll on unemployment and lost productivity could be severe.”

The damage to the Los Angeles port, which handles 40% of the nation’s container traffic, would affect communities across the United States. “If that’s interrupted, what’s that do to the supply chain for those products?” Miller says.

And Khater, at EQECAT, points to another economic wallop from The Big One: “The property and casualty insurance industry is not a liquid market; it is largely invested in municipal bonds. To pay claims, the industry would be forced to liquidate tens of billions of dollars of these investments, which would have a significant short-term effect on the security markets.”

And the short-term effect could spiral into a long-term effect from the overall economic loss. “What would it do to the stock market?” Miller asks.

The recovery for California could take years, and the forecasters warn the economic damage could worsen if history is any guide.

The Los Angeles mayor’s report on earthquake readiness notes, “One of the most chilling effects of [Hurricane Katrina] was how it severely reduced the long-term population in affected areas. From July of 2005 to June of 2006, 237,000 people migrated away from Louisiana. By 2014, census data showed that only 100,000 of those people had returned.”

Miller says a slow recovery in California could have a similar effect. “Would that happen in L.A.?” he says. “After you live through one of those events, do you just pack up and say, I’m out of here?”

The state Senate Insurance Committee report also warns of major job and population losses. “Communities must have basics in order to return to work. If these are not met, population flight occurs and blighted areas become a new or exacerbated problem,” the report states. “There is a potential loss of workforce to long-term displacement or voluntary relocations.”

For the out-of-work who remain behind, financial help may be hard to obtain. “At the end of 2013, the state’s deficit to the federal unemployment fund was $9.7 billion,” the Senate insurance committee’s report. “Much as the recent recession caused a dramatic increase in unemployment claims in California, a major earthquake would also drive a surge in unemployment claims, some likely to be long-lasting as the region seeks to rebuild, and many jobs may be permanently lost as businesses either fail or move out of the region.”

Swiss Re’s Miller, among others, expresses concern that many Californians are relying too heavily on the expectation that the federal government will bail them out after a major quake. But providing emergency funds for communities and residents isn’t a given after a natural disaster, as the debate on Capitol Hill after Superstorm Sandy demonstrated.

“It would be very, very difficult for state of California to fund a recovery like that on their own,” Miller says. “The federal government has the means, but the question is whether they have the will. And how much would they be willing to provide?”

With the uptake rate for residential and commercial earthquake insurance at about 10%, he says, “you’re asking national legislators to spend a lot of money to protect areas that people chose not to protect themselves.”

Grossi at RMS shares those concerns. “There probably is some sort of notion that the federal government will come in and help us,” she says. “People could be in for a rude awakening.”

Relying on Washington also could complicate the recovery for businesses, Miller says. “If the port gets wiped out, what’s that going to look like in terms of priority?” he says. “The pressure would be on rebuilding homes.”

Nancy Kincaid, the press secretary at the California Department of Insurance, says the message to residents and business owners is clear. “We remind people that the federal government is not here to bail you out,” Kincaid says. “It’s your responsibility as a homeowner and a resident to understand the risk you face.”

Ultimately, though, federal taxpayers are likely to help pick up the costs. “Given California’s importance to the national and world economy,” Wallan says, “you’d have to expect the federal government to do something.”

How much, and how quickly, is the unknown.

Minimizing the Damage

In addition to encouraging homeowners and business owners to reassess their insurance needs, public officials have been a waging a long-running campaign to promote retrofitting older buildings to improve their chances of surviving a quake. Among the highest-profile efforts is a major push from Los Angeles Mayor Garcetti, who enlisted the help of the USGS to prepare a plan for improving earthquake readiness.

The Los Angeles plan would require owners of older apartment buildings and large concrete offices to retrofit with earthquake protections. The effort would affect 15,000 apartment buildings built before 1980 and an estimated 1,000 to 1,500 office buildings. Owners of wooden buildings would have five years to complete retrofits, while owners of concrete buildings would have 30 years. The plan also calls for strengthening the region’s ability to respond to fires caused by earthquakes and supply drinking water to residents and businesses afterward.

Supporters of the initiative want to replace aging water pipes with new earthquake-resistant pipes and strengthen more than two dozen aqueducts along the San Andreas Fault. The plan also calls for using ocean water and reclaimed wastewater to fight fires.

“The water system is the utility most vulnerable to earthquake damage, and that damage could be the largest economic disruption following an earthquake,” the mayor’s report states. “Portions of the system are more than a century old and vulnerable to many types of damage. Lack of water would impede recovery and the long-term loss of a water supply could lead to business failure and even mass evacuation. Developing a more resilient water system is imperative for the future of Los Angeles.”

The mayor’s plan also recommends creating a telecommunications system that would be usable after a megaquake, creating a solar-powered Wi-Fi system and strengthening the electric supply near fault lines.

“This will cost us billions of dollars in the private and public sector,” Garcetti said when his task force unveiled plans. “But we cannot afford not to do it.”

The federal government has contributed several million dollars to a long-term effort to develop an early-warning system for earthquakes. The sensors would not give much of a heads up—a minute or less—but it might be enough to help fire stations lift electronically operated doors before the power fails, shut down public transit and take other quick steps to mitigate damage.

The California Earthquake Authority, meanwhile, is in the midst of a campaign to help Californians retrofit their homes. “We need to be doing more mitigation,” Pomeroy says. “We’re pioneering ways to encourage and incentivize.”

A pilot program, Earthquake Brace + Bolt, offers up to $3,000 to homeowners to strengthen their homes. “You can’t completely eliminate the risk, but you can certainly reduce it,” Pomeroy says.

A typical retrofit ranges from $2,000 to $10,000, and the earthquake authority and others are looking for ways to expand assistance to homeowners.

California Insurance Commissioner David Jones has pledged support. “There are important efforts underway to explore retrofitting homes in Los Angeles, San Francisco, at the California Earthquake Authority and elsewhere,” he said in his inaugural address in January. “We should build on these efforts to create a statewide earthquake retrofit program for homes.”

It’s a major challenge. “By some estimates, there are a million or more homes—pre-1940s homes with so-called ‘cripple walls,’ and homes on hillsides, and those with living space over garages—that are at serious risk in even a minor quake, let alone a major one,” Jones says. “The good news is we can retrofit these homes to make it much more likely they won’t topple off their foundations or slide down hills or collapse. And if homeowners do retrofit, they can qualify for steep discounts on earthquake insurance, which might help us get more Californians insured.”

The prospect of requiring some level of insurance in higher-risk earthquake areas, meanwhile, appears dead—despite hints from the state Senate Insurance Committee that it’s only a matter of time.

“To date, the private market has shown little interest in taking on more natural catastrophe exposure for residential or commercial risks,” the committee’s report states. “High premiums and big deductibles discourage most property or business owners from voluntarily purchasing such coverage. Without some kind of government backing or participation to spread the risk prior to such an event, recovery will take longer and ultimately cost more for all taxpayers.”

The focus, for now, is on mitigation and educating homeowners and business owners about their choices.

Swiss Re’s Miller expects the earthquake readiness won’t become urgent until after the next major quake. “History shows this stuff happens,” he says of The Big One. “The challenge we face is that it hasn’t really happened in a modern era.”

Looking to the future, and the inevitable catastrophe it promises, Grossi turns wishful. “I hope,” she says, “we are as resilient as we think are.”

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