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December 11, 2014

Don’t get rattled by earthquake insurance changes

  • In some cases, the 2011 Christchurch earthquake caused U.S. insurance companies to reduce the upper limit of coverage by 75 percent. Property managers of large portfolios have needlessly bought extra insurance to compensate.
    HUB Northwest


    The well-worn phrase “knowledge is power” certainly applies to commercial property managers and owners when analyzing earthquake insurance for large properties like high-rise office buildings, warehouses and server farms.

    To put it another way, they should “know what they don’t know” before succumbing to the temptation to purchase additional earthquake insurance for their portfolios that perhaps they don’t need. That lack of knowledge could cost at least $75,000 annually for owners of large commercial property portfolios (worth $100 million or more) who mistakenly decide — without careful analysis — that they should have that coverage.

    What’s going on?

    An event that occurred nearly four years ago and almost 7,500 miles from the Puget Sound area has had a considerable impact on the market for earthquake insurance in Seattle and elsewhere in the U.S. The Feb. 22, 2011, quake in Christchurch, New Zealand — which claimed 185 lives and caused more than $30 billion (U.S.) in damage — got the attention of the U.S. insurance industry.

    Before the Christchurch earthquake, a commercial property portfolio in the Puget Sound area worth $100 million or more could be insured against earthquakes for a total up to $100 million per occurrence. But, following Christchurch, the upper limit (or “cap”) for that same $100 million portfolio has been reduced on average to $25 million, while the annual premium has remained unchanged. (Portfolios valued at less than $100 million may have smaller caps.)

    The reaction

    The initial reaction by many portfolio managers who saw their earthquake insurance coverage drop by 75 percent — but their premiums remain unchanged — was to seriously consider making up that shortfall by purchasing additional earthquake insurance (from an offshore market or a large reinsurer, for example). Many commercial property owners and managers have paid an additional $75,000 or more to bring them back to the $100 million level.

    But, before they renew their earthquake policies in 2015, it’s in a property manager’s best interest to “know what they don’t know.” In technical insurance terms: they should consider what’s known as the probable maximum loss (PML) of a catastrophe during a 450-year period for their portfolio. Wikipedia defines PML as “the value of the largest loss that could result from a disaster.”

    Understandably, most commercial property owners and managers have never heard of PML and how it can affect their insurance rates. They have enough to worry about, without schooling themselves in the minutiae of the insurance industry.

    Indeed, the question “What’s the probable maximum loss for your $100 million building?” posed to a property manager elicits this typical answer: “I don’t know. But it must be $100 million, because that’s what I insured it for.”

    How can a commercial property manager or owner be certain that they have the right amount of earthquake coverage and avoid spending money on extra coverage that perhaps they don’t need?

    The solution

    Insurance brokers that specialize in commercial real estate have access to risk-management computer systems that can help answer that question. For no charge, they can analyze a portfolio and give the owner or manager a benchmark for their probable maximum loss for an event occurring at any one location during a 450-year period. An algorithm in the system will consider the type of soil at the building’s location, its foundation and height, ground acceleration rates and countless other variables to come up with that number.

    The odds are excellent that the PML for a $100 million building is dramatically less than $100 million — ”news you can use” for the manager of a portfolio who was considering bumping earthquake coverage back up to its previous level.

    To put it another way, the 75 percent reduction of the earthquake-coverage cap for a $100 million portfolio is a non-issue to the vast majority of commercial property owners and managers. They can still sleep soundly at night with a $25 million policy, while knowing that they didn’t spend an extra $75,000 for coverage they probably didn’t need.

    Additional safeguard

    In addition to the free PML analysis, property owners and managers have another safeguard to consider. For a fee of approximately $3,500 to $5,000 per building, an engineering firm will perform a seismic risk evaluation and suggest measures that can be taken to mitigate losses on the structure. For example, the evaluation might determine that HVAC ducts lack lateral bracing or boiler piping doesn’t have a flexible connection.

    That analysis can be pricey, but it might make sense for owners of large portfolios who are seriously considering purchasing additional earthquake insurance beyond the $25 million cap.

    Crystal ball

    Of course no one can predict the future and that’s why portfolio managers embrace the responsibility to provide the proper amount of earthquake insurance for their properties. The “proper amount” varies by individual property (such as its location and the soil it’s built on), a person’s risk tolerance and other factors — but it shouldn’t be determined solely by a change in the insurance industry resulting from a major earthquake that occurred almost four years ago on the other side of the world.

    In short: “learn what you don’t know” — with the help of a knowledgeable insurance broker — and act accordingly.

    Erik Kuhn is vice president and commercial practice leader at Bothell-based HUB Northwest, a provider of general commercial insurance, group benefits insurance, surety bonds and risk management products to owners and managers of commercial real estate.

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