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The burden of earthquake insurance Earthquake insurance rates, relatively soft in the late 1990’s, have
hardened considerably over the past two years. A downturn in the financial markets coupled
with increasing concerns nationally about catastrophic loss has led to a dramatic rise in
premiums. It is not uncommon to hear building owners complain of two or threefold
increases.
Many commercial building owners recognize the value of earthquake insurance as a
risk management tool. However, given the often unaffordable cost of insurance and the real
concern that in a major catastrophe insurers and re-insurers will be unable to absorb the
losses, many consider insurance itself too risky an investment. However, it is not
uncommon for a lender financing the purchase of a property to require earthquake insurance
if it determines there is an unacceptably high risk of building damage.
When requiring earthquake insurance, lenders
must weigh the need for due diligence and asset protection against the highly competitive
mortgage lending market. If a bank is too restrictive, and requires earthquake insurance
too often, it will lose business to other banks who are less restrictive. On the other
hand, if it is too generous in its acceptance of risk, it may be unable to sell its loans
on the secondary market at a competitive price.
For more than a decade lenders have used engineers to estimate property risks
caused by earthquakes. They use this information to determine whether a loan is viable and
whether or not to require insurance. This has created a market in loss estimation, but one
that has very little standardization or accountability. It relies in large part on
subjective reasoning, rather than sound engineering and financial analysis to determine
the need for insurance.
The following examples show how thoughtful and objective technical nad financial
tools can be used to reduce or eliminate the need for earthquake insurance while
preserving a high standard of due diligence.
Improve performance, eliminate insurance
San Leandro is a city on the San Francisco Bay, about five miles from the Hayward
Fault. Recently a national chain of car dealerships proposed to build a new sales and
repair facility in the city. The projected cost of the building was $5 million with an
inventory value of $2 million and projected gross profits of nearly $4 million. The
owner’s bank told him that to finance the property he would need earthquake
insurance. Even though the design met the minimum provisions of the Building Code, because
of its proximity to a major earthquake fault the risk was considered too high. The best
quote the owner could find was $150,000 per year.
The engineer of record contacted CDComartin, INC to help develop a seismic risk
profile for the building and look at ways to reduce the risk. The owner had both a
long-term interest in reducing future potential losses, and a desire to reduce the amount
of earthquake insurance the bank would require.
CDComartin, INC performed a nonlinear analysis of the building to identify its
probable maximum loss (PML), a term used by most lenders to gauge the possible losses that
the building could suffer. The PML was about 40% of the building’s replacement cost.
Typically, most lenders require that the PML be under 20% in order to remove insurance
requirements. We worked closely with the engineer of record to develop an enhanced
structural design that would reduce the expected losses. The design added structural
elements and increased the size of others. The total expected cost of the enhancements
were estimated at $200,000.
CDComartin, INC reanalyzed the building with the proposed enhancements, and
obtained a PML of 16%. Furthermore, we also calculated the expected reduction in capital,
contents and business interruption losses on an annualized basis over the projected
building life. The savings were substantial. The return on the $200,000 investment was
nearly 14% in terms of reduced losses. This alone convinced the owner to implement the
enhanced design. However, the greater value came in presenting the lender with the
proposed enhancements and risk analysis. The lender agreed to waive the earthquake
insurance if the enhancements were implemented. This made the effective return over 77%!
Furthermore, most of the return, was in “hard dollars;” an insurance check that
did not have to be written every year.
The bank achieved a higher measure of due diligence than it would have using many of the standard simplified estimates of PML, and the owner paid for the analysis. The owner reduced his risk and saved a substantial amount of money.
Waiting out the problem An owner purchases a property with a 15 year loan and finances 80% of the $10 million purchase price with a 7% loan. The lender calculates a PML of 33% and requires that the borrower obtain earthquake insurance. The best quote the borrower can find is $200,000 per year.
Lenders typically use 20% as a threshold for loss because it historically represents the borrower’s equity in the property, considering a 20% down payment. If an earthquake causes more than 20% loss, the lender reasons, he is at risk that the borrower will walk away from the property, forcing the bank to foreclose and sell the property at a loss. This calculation is similar to that done for private mortgage insurance.
One strategy is for the borrower to seismically retrofit the building to reduce the PML. But if that proves too disruptive to the building’s operation he may have other options.
First, suppose the borrower puts down not 20% but 33% of the purchase price. The added cost to him is $1.33 million. This relieves the bank of the worry that the expected loss will be greater than the borrower’s equity. The borrower spends $1.33 million but recovers $200,000 per year. He also reduces his annual mortgage payments by nearly $150,000. The resulting reduced expenses return 30% on his $1.33 million investment.
Alternatively, suppose the borrower accepts the loan terms and pays the insurance for four years. By that time, his equity is increased to 34% of the purchase price, again taking the risk off the owner if an earthquake causes 33% loss. Just like private mortgage insurance, the borrower should be able remove the requirement for insurance when the lender’s risk drops below the borrower’s equity.
If the building appreciates 5% per year, then after only two years, the property value increases to over $11 million and the loan’s remaining principal drops to $7.3 million. Even if an earthquake occurs resulting in damage equal to 33% of the property’s market value, or $3.6 million, the bank is still able to recover its costs if it has to foreclose, repair the property and sell it. Meeting the challenge
These examples suggest that there are more sophisticated ways to address the insurance challenges facing borrowers in the current market that do not sacrifice necessary due diligence and asset protection on the part of the lender. The results can allow borrowers to make a choice about insurance based on their resources, and give a competitive edge to lenders who are insightful enough to advise their clients of these strategies.
CDComartin, INC specializes in integrating
seismic risk management strategies into existing finance, risk management, and facilities
programs. We apply state-of-the-art technical
and financial processes to help our clients achieve a positive return on their capital
investments. Our efforts have saved our clients millions of dollars in risk reduction and
expenditure optimization. |
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Send mail to ccomartin@comartin.net with questions or comments about this web site.
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