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October 16, 1981

Earthquake Economics
Much of the United States is seismically
active, but the greatest earthquake risks
prevail in the western states (see map).
Virtually every major metropolitan area west
of the Rockies is in a high-risk zone, facing
the potential of catastrophic losses. Estimates
by the United States Geological Survey
(USGS) suggest that a great earthquake in San
Francisco today would cause 11 ,000 deaths,
44,000 hospitalizations and about $40
billion in propertydamage. Asimilarevent in
Los Angeles would generate 23,000 deaths,
91 ,000 hospitalizations and almost $70
billion in damage.
Against this background, it is sometimes
surprising to learn that the marketplace does
very Iittle to accommodate earthquake risk.
Despite the fact that over 1 50 carriers offer
earthquake insurance coverage in California,
for example, less than 6 percent of the
households carrying home insurance regularly purchase it. Nor do mortgage lenders,
whose assets are secured by real estate
subject to earthquake risk, routinely protect
their portfolios with insurance. (Although a
fire-coverage requirement is quite standard in
mortgage contracts, no such requirement is
widely applied in regard to earthquake risk.)
Similarly, real-estate investors and builders
often balk at incorporating earthquakeresistance measures in construction projects.

Earthquake risk
Decision-making under earthquake risk, of
course, is influenced by the tremendously
powerful and damaging nature of earthquakes. The great Anchorage (Richter 8.6)
earthquake of 1 964, for example, moveda
40,OOO-square-mile chunk of the earth's
crust, thrusting it upward by as much as 30
feet in some places. Even in the comparatively moderate (Richter 6.6) San Fernando
Valley event of 1971 , some structures experienced ground-motion acceleration in excess
of one "g"-meaning horizontal forces equal
to the full force of gravity.

Even well-built structures will be severely
damaged by such forces, although much
depends on the type and quality of construction. Engineering data suggest probable
maximum losses of 7 to 15 percent of value
for typical residences and other wood-frame
construction, 20 to 35 percent for steel-frame
buildings, and 25 to 85 percent for concrete
and masonry construction of various qualities. Loss of life will, in turn, likely be greater
in the more severely damaged structures.
But significant earthquakes are also relatively
infrequent. Indeed, there has not been a
major earthquake in any densely settled
region of the country since the great San
Francisco earthquake of 1906. Even in the
shaky Far West, the probability of a great
quake in any given year is quite low-two
to
five percent in the Los Angeles area and one
percent in San Francisco, according to USGS
estimates.

Decision-making and risk
Earthquakes may thus be characterized as
low-probability, high-loss events. The
conventional economic analysis of decisonmaking under such conditions employs the
"expected utility" theory that Milton
Friedman and Leonard Savage developed in
the 1940's. According to this theory,
individuals weight the psychicvalueof
alternative outcomes (rather than the
outcome itself) by the probabilities of
occurence of each outcome. Risk-averse
individuals assign a smaller psychic value (or
utility) to a dollar gained than to a dollar lost,
wh i Ie the opposite is true for risk-takers.
Expected-utility theory indicates that riskaverse individuals should desire to purchase
actuarially fair insurance to protect themselves from low-probability catastrophic
lossesthat they could not easily bear
themselves. (Actuarially fair insurance is
insurance which has a premium equal to the
probability of the event times the value of the

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()pinions expressed in this newsletter do not
necessarily reflert the views of the management
of the Federal Reserve Bank of San Francisco,
or of the Board of Covernors of tht" Federal
Reserve Svstem.
loss.) Since most economists view the
household as a risk-averse entity, the lack of
consumer enthusiasm for earthquake
insurance (and catastrophe insurance in
general) thus comes as something of a
surprise.

to protect themselves against the financial
effects of massive claims, but they don't have
enough experience to guide them in this area.
In addition, U.S. tax laws don't adequately
discriminate between catastrophe reserves
and normal profits, as, for example, the
Swedish and Mexican tax codes do. Thus, in
those years when no claims are fi led, insurers
are unable to set aside reserves for future
contingencies without tax liability.

The problem may lie with the theory. Indeed,
economists Danial Kahneman and Amos
Tversky have found fault with the FriedmanSavage approach, on the basis of evidence
from behavioral experiments and markets for
other kinds of insurance. In particular, they
find that people underweight remote events,
leading to greater risk-taking than would
otherwise be expected.

Such factors will, of course, affect the cost of
earthquake coverage. The typical pol icy for a
wood-frame residence in California costs $2
per year for each $1 ,000 of coverage, with a
5-percent deductible and an 80-percent
coinsurance provision. The attractiveness of
this type of policy to individual homeowners
depends upon their risk-averseness and the
expected frequency and size of losses.
Experience suggests that wood-frame residences will suffer earthquake losses, on
average, of 7 percent of value. (That was the
average near the epicenter of the San Fernando earthquake, although 50-percent
losses were not uncommon and a few total
losses were recorded.) Under these conditions, the currenttypical premium structure
would be actuarially "fair" for an annualevent probability of 8 percent. This is higher
than current earthquake-probability estimates, and thus tends to make coverage less
attractive to all but the most risk-averse
households.

Howard Kunreuther of the Wharton School,
in a similar vein, argues that the expectedutility theory operates only in an unreal world
of perfect rationality and information. He
argues that people may behave according to
"bounded rationality," reluctant to purchase
insurance or take other preventive steps
because of limited knowledge of the nature of
the catastrophe. For example, even the
availability of heavily subsidized catastrophe
insurance has failed in some major instances
to encourage individuals to protect themselves from risk. Although the residents of
Rapid City, Iowa, qualified for subsidized
National Flood Insurance, only about 30
pol icies were in force there when the flood of
1971 caused $1 60 million in damage to the
community.

Low utilization of earthquake insurance thus
seems to be a problem of weak demand at
current premia rather than lack of awareness
that coverage is available. Indeed, one insurer mounted a major marketing effort after
the San Fernando earthquake and sold less
than 1 00 policies. On the other hand, insu rers probably cou Id not offer coverage if
people took a sudden interest in earthquake
insurance, because existing reserves could
not adequately support greatly expanded
coverage.

Earthquakeinsurance
Nonetheless, we should not ignore more
conventional explanations for the relatively
low level of private hazard-m itigation efforts.
For example, premiums for earthquake
i nsu rance may not attract even rational and
well-informed individuals. Indeed, catastrophe-insurance coverage poses special
problems. Coverage tends to be concentrated
in risk-prone areas-three quarters of all
earthquake-insurance policies are written in
California, for example-so that the insurer
cannot reduce the cost of coverage by diversifying risk geographically. In theory,
insurers could accumulate sufficient reserves

Disasteraid
Other considerations may also act to discourage private mitigation efforts. For
2

Earthquake ,Risk Map of the United States

Darkest areas Indicate highest risk
Source:Applied Technology Council

example, the Federal government provides
liberal disaster relief, mostly through the
provisions of the Federal Disaster Act and the
emergency-lending powers of the Small
Business Administration (SBA). These
programs are activated by a Presidential
designation of a region as a disaster area.

Angeles County, for example, recently found
that the cost of bringing 8,000 hazardous
structures up to current standards would be
roughly 70 percent of replacement cost.
Given the low probability of a damaging
earthquake in anyone location, building
owners clearly were better off risking the total
loss of their properties.

After the Anchorage earthquake of 1 964, for
example, the SBA loaned funds at 3 percent
both to repair structural damage and to retire
outstanding mortgages. Similarly, in 1 971 , it
made special low-interest loans and outright
(forgiveness) grants to uninsured earthquake
victims in the San Fernando area. Such
public-policy conventions, humane as they
may seem at the time, actually increase
further catstrophe potential by reducing the
attention paid by private parties to risk
exposure.

Even for new construction, the cost of adding
earthquake resistance could be a significant
fraction of the cost of construction -perhaps
greater than the expected value of the loss
that would be incurred without such
protection. Reducing the 20-to-35 percent
probable loss to a conventional steel-fr.ame
highrise, for example, might raise
construction costs by 10 percent or more.
Given a less than 50-percent probability of
earthquake in a building's lifetime, investors
may not consider the additional construction
costs warranted, particularly since the
possible dollar losses may occur well in the
future. Much depends, of course, on the type
of structure involved and the risk-averseness
ofthe investors. (Construction insurers report,
for example, that Eastern investors are more
concerned than Western investors about
earthquake damage.) But private incentives
to add earthquake resistance generally are
rather weak.

Building economics
The insurance market is not the only private
activity which pays insufficient attention to
earthquake risk-building design is another.
Since falling structures are the major source
of economic disruption and loss of life in an
earthquake, it is interesting to consider the
economics of earthquake-resistant design.
Even in the absence of building codes,
potential liability for injuries and loss of life
incurred by buildings' occupants should
encourage architects and builders to employ
earthquake resistant design. However, the
courts have seldom found a builder or
designer liable for casualties arising from the
collapse of a structure affected by a
catastrophic natural force. (In contrast, the
ancient Babylonian code of Hammurabi held
the builder liable with his own life!)
Considering the uncertainties involved, such
a legal position is understandable, but it
serves to weaken private incentives to
incorporate special earthquake-resistance
features in new construction.

Conceptually, the burden of coping with
catastrophes such as earthquakes need not be
thrust entirely on the public sector. If
private-market participants accurately
perceive risks and potential losses, and
perceive that they will bear all associated
costs, they will devote appropriate resources
to avoiding or mitigating catastrophic events.
Unfortunately, public disaster-compensation
systems, limited builder liability, and other
cited factors may lead the private sector to
commit insufficient resources to the
mitigation of such hazards. If, in addition,
individuals systematically underweight
high-loss, low-risk events-as some research
suggests-both the public and the
government may be surprised by the
magnitude of their losses in the next major
seismic event.
Randall J.Pozdena

Moreover, designers often have no economic
rationale for adding earthquake resistance to
structures to avoid purely structural losses,
especially in the case of renovation. Los
3

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BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollaramountsin millions)
Selected
Assets Liabilities
and
large CommercialBanks
Loans(gross,
adjusted) investments*
and
Loans
(gross,
adjusted)
-total#
Commercial industrial
and
Realestate
Loans individuals
to
Securities
loans
U.s.Treasury
securities*
Othersecurities*
Demanddeposits total#
Demanddeposits adjusted
Savings
deposits total
Time deposits total#
Individuals,
part.& corp.
(Large
negotiable
CD's)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess
Reserves )/Deficiency
(+
(-)
Borrowings
Net freereserves+ )/Net borrowed( )
(
-

Amount
Outstanding

Change
from
yearago
Dollar
Percent

Change
from

9/30/81

9/23/81

153,294
132,395
40,231
54,575
23,211
1,532
5,673
15,226
42,377
28,630
29,526
85,200
77,292
33,858

1,400
1,409
945
116
172
2
42
33
3,543
1,628
215
87
110
60

-

-

Weekended

Weekended

9/30/81

9/23/81

n/a

59
53
5

148

n/a

11,183
12,261
4,864
6,087
833
591
877
197
4,835
5,370
576
20,687
21,347
9,041

7.9
10.2
13.8
12.6
3.5
62.8
- 13.4
1.3
- 10.2
- 15.8
1.9
32.1
38.2
36.4

Comparable
year-ago
period
96

188
93

* Excludes
tradingaccount
securities.
# Includes
itemsnotshownseparately.
Editorialcomments
maybeaddressed the editor (WilliamBurke) to the author.... Free
to
or
copies this
of
andother Federal
Reserve
publications beobtained callingor writingthe PublicInfonnation
can
by
Section,
Federal
Reserve
Bankof SanFrancisco, Box7702, SanFrancisco 4120. phone(415) 544-2184.
P.O.
9

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