Fault Line

DisastersNatural disaster insurance can mean costly premiums and steep deductibles for associations. In California, some communities are asking: Is earthquake coverage an exorbitant luxury or complete necessity?

Earthquake-prone California experiences about 10,000 small-to moderate-sized tremors annually. A study released earlier this year by the U.S. Geological Survey found that the Golden State can expect a magnitude-6.7 quake every 6.3 years. And according to the new estimates, there’s a 72 percent chance the Bay Area will be hit by a severe temblor within the next three decades.

From the Hayward and San Andreas to San Jacinto and other faults bisecting the state, nearly 40 million people call home one of Earth’s most violent seismic areas, putting lives and the destruction of housing, businesses, transportation and energy infrastructures on the line. Considering the risks, it might seem like a no-brainer for California community associations to purchase quake insurance, but not all do.

“In my experience, the financial condition of the association is the most common factor in the decision not to purchase, or not to continue with, earthquake coverage,” says Michael Berg, CMCA, CIRMS, owner of the Berg Insurance Agency in Lake Forest, Calif. “The other common factor is the ‘it-won’t-happen- to-me’ mentality. Or the perspective that the cost of insurance doesn’t mean much because the association has to sustain such a large loss before the insurance is triggered.”

But experts say community associations should never take the “it-won’t-happen-to-me” approach without sound research. Sophisticated online modeling tools—most of which rely on U.S. Geologic Survey data—can assess an area’s risk for quakes by measuring the distance to known fault lines, how often those fault lines have produced tremors and at what magnitude, the type of soils on which the property is located, and the property’s susceptibility to liquefaction—when a saturated soil substantially loses strength and stiffness.

California is hardly alone in being prone to quakes. The Pacific Northwest has a potential for a mega event, and a large swath of the Midwest is threatened by the New Madrid fault line, says Timothy Cline, CIRMS, president of his own insurance agency in Santa Monica, Calif.

Meanwhile, central Virginia was rocked in 2011 by a 5.8-magnitude quake—one of the largest to hit the East Coast in a century. Damage totaled more than $200 million.

So, when should an association buy earthquake insurance? When do the costs of insurance outweigh the risks of being uncovered? How expensive are premiums? What’s covered? Association leaders can ask themselves similar questions for other types of disaster insurance.

“If you believe that catastrophic earthquake damage is possible, and you can afford the monthly increase to your homeowners’ assessments, then you should vote to obtain a master earthquake policy,” advises Cline.

JUDGMENT CALL

Single-family home communities with few common-area structures or amenities often can make a “judgment call” about buying insurance because the amount of property exposed to earthquake damage is typically minimal, Berg says. Those with several community buildings and significant amenities may find the coverage more beneficial.

Condominiums face a much different decision and often elect to obtain coverage because only the association can purchase insurance on the numerous common areas, including the building infrastructure and facilities.

Generally, when considering coverage, all community association boards should review earthquake models and predictions, the age of the development—an indicator of the seismic building codes, whether owners have significant equity and the community’s risk tolerance.

More often than not, the decision comes down to cost.

“Premium, premium, premium,” says Kelly G. Richardson, managing partner with Richardson Harman Ober in Pasadena, Calif., CAI’s president-elect and a fellow in CAI’s College of Community Association Lawyers (CCAL). “Most homeowners agree they would prefer to be protected, but the cost is often seen as prohibitive. The deductibles can be so large that it’s a problem.”

Rates vary wildly based on a property’s distance from fault lines and other factors, including market competition, but Berg estimates quake insurance costs about $1,000 to $1,500 for every $1 million of coverage.

Cline estimates the average policy for a Los Angeles County condominium could range from as little as $30 per unit per month to $100 per unit per month. But in areas like Virginia, where the 2011 quake was a rare occurrence, protection is much more affordable.

“The association’s master policy earthquake coverage probably costs the average unit owner far less per month than that same unit owner is paying to insure their private automobile. But the automobile is a depreciating asset, while the earthquake coverage is protecting the owner’s equity in one of his or her largest investments,” argues Cline.

Berg says some policies contain 5 percent deductibles—very low when compared to the market historically. “In the past, an insured may have needed to consider 20 percent to 25 percent deductibles to approach this cost,” he says.

Deductibles apply to the replacement cost of affected buildings. When the association has a 5 percent deductible, for example, then a given building must be more than 5 percent damaged for the policy to be triggered. The association will pay for all repairs up to 5 percent of the building’s replacement value, and the insurer will respond to damage beyond that threshold.

However, depending on a community’s risks and the breadth of coverage, policies can contain fairly significant deductibles.

“Many associations get hung up on the idea that they are paying a substantial premium only to later pay a high deductible, and this is a fallacy,” says A. J. Scott, assistant vice president at Cline’s firm. “The master earthquake policy serves to reduce the community’s exposure from 100 percent down to the amount of their deductible—an amount they could conceivably come up with after an earthquake.”

Online tools such as www.earthquakeauthority.com offer a premium calculator for earthquake insurance.

COVERING THE BASES

Master quake insurance policies typically cover buildings, foundations, underground utilities, garages, pools, tennis courts, streets, entry features, walls, fences, association-owned business property and homeowners’ assessments if a covered earthquake renders homes uninhabitable.

Instead of blanket coverage, policies are subject to a schedule of locations called a “statement of values.” If a building, structure or improvement is omitted from the schedule, it won’t be covered at the time of loss. “Foundations and underground utilities are frequently overlooked—and while some carriers include these within the building definition, many don’t,” says Scott.

In addition, most policies never automatically include the cost of complying with updated building codes, such as those that address safety. “It must be specifically requested at the time of quoting,” Scott adds.

When determining coverage, associations need to be sure the value of their assets is up to date; the amount of insurance might be too low otherwise. Meanwhile, some insurers have a “depreciation hold-back” clause, meaning they won’t release all the money for repairs and rebuilding until the work is completed.

AFTERSHOCKS

Associations also should consider the residual impacts from an earthquake—beyond the destruction.

Property values are likely to decline. There may be higher foreclosure rates in the area and blight due to unrepaired properties, and the cost of insurance is likely to increase dramatically in a region following an earthquake.

“All these phenomena were observed in the greater Los Angeles area in the years after the Northridge earthquake,” Richardson says.

That 1994 quake near Los Angeles killed 57, injured more than 5,000 and caused roughly $20 billion in property damage. In the aftermath of Northridge, condominiums without earthquake insurance often found it impossible to raise the money necessary to rebuild. Some boards first liquidated their reserve accounts, then levied large special assessments, causing many owners to walk away.

Much like it does today, the Federal Emergency Management Agency limited its assistance at the time to individual homeowners, generally providing about $3,500 per household at the most for emergency food, water and shelter. FEMA directed community associations to the Small Business Administration, which offered loans up to a maximum of $1.5 million.

“We’re fortunate to live in California, where property values do recover relatively quickly compared with other parts of the country, but (Northridge) was still a painstaking process, and many owners were forced to start over, with nothing to show for the years that they had invested in their properties,” Cline says.

After any natural disaster, construction labor and materials costs typically spike because of the increased demand, making it even more difficult for a community to recover. Meanwhile, lenders may be wary of granting loans on homes that already have active mortgages before a quake, which means that even those owners willing to take on a double mortgage may have a difficult time finding a willing creditor.

TAKING A RISK

If an earthquake strikes and an association doesn’t have coverage, “the accusations will fly, and lawsuits could ensue,” says Beth A. Grimm, an attorney in Pleasant Hill, Calif., and a CCAL fellow. “When there’s a big loss, a lawsuit often follows if anyone believes that all wasn’t done that could’ve been.”

Unless the governing documents specify otherwise, the cost of repairs to association property would be split evenly among community members. For example, even if a quake destroys one building in a community with 10, 10-unit buildings, all 100 owners would share the costs.

“Each owner has an equal fractional interest in all of the association property, which includes the residential structures,” Berg says. “This is the essence of a common interest development.”

Owners without equity often abandon their properties to avoid paying their fair share of repairs, notes Grimm.

“They won’t share in the rebuilding … and that leaves the owners with equity holding the bag. All the expense falls on them,” she says. “Since the ratio of low equity owners versus high equity owners is commonly somewhere around 50 percent, this puts a large portion of a community at risk.”

Scott cautions that developers rarely include coverage for the peril of earthquakes in community budgets.

“It takes some time for a board to recognize the omission and find a way to pay for it without a dramatic increase in homeowners’ assessments,” she says.

“Because it’s not in the budget, there’s a perception that earthquake coverage is something other than essential.”

Board members and unit owners also can grow perplexed by the association’s coverage terms.

“They allow some factors to paralyze them,” Scott says. “Policy contract minutiae should be analyzed and understood, but the decision to buy this coverage shouldn’t be complicated. Boards and unit owners should ask themselves, ‘Is it worth the cost of the premium to reduce our exposure from 100 percent to 20 percent—or whatever deductible is being considered?’ ”

Ultimately, Berg stresses the importance of working with professional agents and brokers specializing in the community association insurance industry.

“In the same way that many people don’t realize that their homeowners’ insurance doesn’t cover flooding until after a flood, some boards don’t realize the coverage they don’t have until they experience a loss,” he says.

By Dana Wilkie

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