I’m a limited partner with a small ownership share in a fairly large apartment complex. The general partner, who has become a friend, is a very bright guy, but he sometimes runs ideas by me to get my take.
Two days ago, he left a voicemail asking me if we should renew our earthquake insurance. He said that it was priced at about $20,000. (I estimate that the property is worth close to $40 million.) He said he was concerned about other limited partners being upset that we had bought earthquake insurance for the last 20 or so years and we never got a return.
So I called him back immediately and said, “I bought life insurance for 30 years and I’m really pissed off that I didn’t die.”
He laughed and got the point immediately. He renewed our earthquake insurance.
I wrote about something similar in David R. Henderson, “Behave!” Regulation, Summer 2013, my review of Insurance and Behavioral Economics by Wharton School economics professors Howard Kunreuther and Mark Pauly and Urban Institute research associate Stacey McMorrow Here’s the passage:
The authors note, though, some systematic anomalies in buyers’ purchase of disaster insurance. Shortly after a disaster, they report, the demand for disaster insurance increases. They give the example of Californians after the 1989 Loma Prieta earthquake. Before the earthquake, 22.4 percent of homeowners in the affected counties had earthquake coverage. Four years later, 36.6 percent had coverage. According to the authors, seismologists say that the probability of another severe quake actually falls after a big earthquake because the stress on the fault has been relieved. So if buyers are informed and rational, the percentage of homeowners with earthquake coverage after the 1989 quake should have been lower, not higher.
Related to this anomaly is the fact that many buyers of flood insurance cancel their insurance after they have gone a few years without a flood. The authors suggest two possible reasons: (1) the longer homeowners go without experiencing a flood, the lower they estimate the probability of a flood, or (2) they think (like my friend’s mother‐in‐law) that the money they spent on flood insurance during dry years was wasted.
Note that the fact that we haven’t had a big earthquake in California for decades means that we should be more inclined, rather than less inclined, to buy earthquake insurance now.
The pic above is of the aftermath of the San Francisco earthquake of 1906.
READER COMMENTS
Evgueni Damaskine
Dec 23 2022 at 8:30am
“Note that the fact that we haven’t had a big earthquake in California for decades means that we should be more inclined, rather than less inclined, to buy earthquake insurance now.”
Are you suggesting that probability of an earthquake increases over time?
I do agree that the earthquake insurance is a good idea where this particular building is located, but for geological reasons.
David Henderson
Dec 23 2022 at 3:39pm
You write:
No. Read or reread the conclusion of the seismologists in the excerpt from my book review. The key is not “over time” but time since the last earthquake.
Jim Glass
Dec 23 2022 at 10:54am
Long-term care insurance is grossly under-purchased because people believe only other people will ever need it, surely they won’t. Though a nursing home stay costs >$100k/year, and can happen to anyone at any age.
This is explicitly built into the structure of Medicare, which covers first-dollar costs of routine checkups etc. — but leaves you all on your own should you owe that $100k+ annually. Seniors know they will pay routine costs and want them covered, but they don’t believe they will ever end up in a nursing home. And politicians give voters what they want.
But it’s even worse than that. Congress did add nursing home coverage to Medicare back in 1988 — funding it with a surcharge to Medicare premiums. As a result, Dan Rostenkowsi, Chairman of the Ways & Means Committee, was attacked on the street by an angry mob of seniors. Congress repealed the coverage pronto, and to this day has never forgotten the lesson from that.
The leaders of the seniors’ revolt bragged…
Even seniors think they’ll never need nursing home care – and they’re not paying for others!
People are really bad at evaluating risk.
vince
Dec 23 2022 at 2:09pm
Many are depending on Medicaid rather than private insurance.
Jim Glass
Dec 23 2022 at 7:22pm
Many are depending on Medicaid rather than private insurance.
Medicaid is for the poor. Middle class people who count on Medicaid for this will be poor after spending $100k+/year for some years.
vince
Dec 23 2022 at 8:49pm
It’s not just for the poor. There’s an army of attorneys who specialize in ways to divert assets through trusts in order to qualify.
Jim Glass
Dec 24 2022 at 11:39am
Yes, and I’m one of them!
Believe me, you don’t want to pay the likes of me for this service — getting rid of all you have to leave you this poor — and you actually have to wind up like this, trusts ain’t shams.
Take a tip: If you can’t stay healthy, stay wealthy.
Buy the insurance.
vince
Dec 26 2022 at 3:25pm
Coincidentally, Discourse magazine published an article 12/20/22 about Medicaid and NY in particular. The article says:
“It should be remembered that all Medicaid benefits are intended for those without ability to pay. … But the practice of shielding actual holdings has become widespread, and few jurisdictions show an ardor for collecting on what the law allows.”
Mark Barbieri
Dec 24 2022 at 9:12am
Long-term care insurance is a tricky thing. For my other insurance policies – auto, home, health, life, and even an umbrella policy I’m paying today for protection today. With LTC insurance, the primary risk I’m insuring for is decades away. That adds a lot of extra risks. Will the insurance company remain solvent? Will the laws around long-term care change in a way that negatively affects the policy?
I opted to self-insure, but that requires setting aside a lot of financial reserves. If I didn’t have heirs that I would be happy to see inherit those reserves, I might have come to a different conclusion. My ideal would have been a policy with a $250,000 deductible and a 20% copay after that. Those stipulations would be enough to make the cost more acceptable while still providing coverage for an early stroke leading to decades of needed care.
MarkW
Dec 23 2022 at 12:50pm
Not long ago after getting an auto insurance bill with a large increase, I considered dropping all collision coverage. Over our adult lives, we have spend far more in such coverage than we’ve ever gotten back in a tiny number of claims. We own our cars outright, they’re a few years old, and not luxury brands. If we totaled one (something we’ve never done before), we could afford to buy a replacement without a major impact on our finances. In the end, I didn’t do it, though, because without insurance, loaning your car to anyone would be a fraught undertaking. So I didn’t do it (though I did find a better deal).
I have a well off friend who always buys trip cancelation insurance. She could very easily afford to eat the cost of a canceled trip, but I think the psychological impact of such a loss would really bother her. Even the experience of being financially exposed to loss between the time the vacation was booked and the departure would bother her. So it seems to me she’s not insuring against financial loss but rather the psychological discomfort that would come from the exposure to risk. So is her buying this insurance rational or irrational?
Insurance is weird.
Henri Hein
Dec 23 2022 at 12:54pm
I didn’t have earthquake insurance when I lived in California. I lived in the Santa Cruz mountains, not far from the Loma Prieta epicenter (as the crow flies at least). The house took no serious damage in that earthquake. Looking at the fault maps in relation to where I lived, the chance of another earthquake either more serious or closer than Loma Prieta seemed so close to 0 I didn’t see an upside. The coverage was not cheap, either. (It wasn’t $20k, though…)
vince
Dec 23 2022 at 2:11pm
$20k to protect 40,000k? I would do it. Why not let the partners vote on it? Or put it in the partnership agreement?
David Henderson
Dec 23 2022 at 3:40pm
You write:
Because it complicates things. The general partner owns a huge percent of the apartment complex, so he has the right incentives. Why ask people to vote on things they don’t know much about? And why complicate the partnership agreement?
vince
Dec 23 2022 at 6:08pm
“Why ask people to vote on things they don’t know much about? ”
I’ve been asking myself the same question about voting reform and things like automatic registration. I would like voters to put a little effort into it. And then there were the Democratic party candidates in 2020 who wanted to reduce the voting age to 16.
Jim Glass
Dec 23 2022 at 7:27pm
Why ask people to vote on things they don’t know much about?
The question some ask every election day.
But I agree, you’re doing the right thing in your situation.
Vivian Darkbloom
Dec 24 2022 at 3:15am
I’m not sure I agree with the decision; however, I’m not in possession of all the facts.
Fundamentally, I view insurance as something to purchase for potential losses that would prove catastrophic for me financially. That’s one of the reasons people, when they do buy insurance, choose an appropriate deductible.
Insurance companies are in that business to make money. And, they have pretty good actuaries and other professionals well-equipped to analyze risk. Property and Casualty insurance companies have gross margins of around 45 percent. The difference between that and a very respectable after-tax profit is eaten up by various costs (such as haggling with insured clients over whether their building is worth $40 million or that that is the amount of their loss should a claim arise).
My guess is that David Henderson’s financial loss in the event that the entire building were destroyed (not just partially damaged) would not prove catastrophic to him. Unfortunate, perhaps, but not catastrophic. If it were catastrophic, a different mistake has already been made—putting too many eggs in one basket. I suspect that this is true of other investors in that building as well.
If the insurance company is making money on a statistically good bet, why shouldn’t you? Or, are there other emotional reasons to have that insurance?
David Henderson
Dec 24 2022 at 11:21am
Interesting point.
You’re right that it wouldn’t be catastrophic for me. I estimate that I own slightly over 0.75% of the apartment complex, which means my share is worth about $300,000. That’s a substantial part of my net worth, but it’s not close to catastrophic. Moreover, an earthquake that reduced the value is virtually impossible because even it totally destroyed the buildings, it would not destroy the land, which is probably about half of the value. So then the maximum loss is down to $150,000.
On the other hand, my share of the $20,000 premium is about $150 annually and, because it’s a business expense, my net share of the cost is about $100. So not a big mistake, from my viewpoint, to buy the insurance.
Vivian Darkbloom
Dec 25 2022 at 3:44pm
I would not assume that your earthquake insurance insures a loss of up to $20 million. Typically, property and casualty insurance policies list a maximum amount, which may or may not coincide with your estimate of the current value of the property. Average earthquake insurance premims in CA are about $3.50 per $1,000 of coverage.
Also, while earthquake insurance is a deductible business expense, if you are going to tax effect the cost of insurance, to be consistent has to do the same with respect to the potential loss (casualty losses are deductible, too). Thus, I don’t see this as a major factor in the anlaysis.
Again, the insurers know the odds better than we do and also know that the $20k premium is a recurring annual expense, not a one-off item. Buying insurance that you don’t need is like betting against the house. Would you spend $150 per year on lottery tickets in the hope that you might get a $150,000 payout? The bottom line is that insurance makes sense for losses that you are not able to absorb—otherwise, regardless of whether it is a big mistake or a small one, it is not a good bet.
David Henderson
Dec 25 2022 at 5:36pm
Hmmm. Your reasoning makes sense. I’ll think about it more.
Matt Fox
Jan 10 2023 at 1:51pm
Consider the policy deductible too. Earthquake insurance usually uses a percentage, so the property owner might self-insure for the first $3million of a $20million property. Or perhaps the policy has separate limits/deductibles for various buildings on the premises?
vince
Dec 26 2022 at 3:29pm
“If the insurance company is making money on a statistically good bet, why shouldn’t you?”
Loss aversion. And it’s unique to each partner.
Also, the general partner’s situation is much different than the limited partners. Limited partner losses are typically limited to their investment. General partners losses include the liabilities of the partnership.
Thomas Lee Hutcheson
Dec 26 2022 at 2:07pm
I’m surprised that insurance costs are not a bigger facto in location and building and location decisions. I understand that earthquake are especially hard to predict and therefore to price well, but foods, hurricane and wild fire vulnerability ought to be easier to price, especially with the growing sophistication of climate models that allow risks to be estimated on a forward-lookin basis. Whenever I see these scenes of wildfire ad hurricane damage I wonder why the cost of insurance did not make building vulnerable structures in those locations unattractive.
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