The Dangers of Owning A Home In California

I’ve previously written why one should never live in Seattle. The risk of an unprecedented earthquake is too high and you can’t diversify the risk.

While California obviously has significant quake risk as well, thankfully, the potential magnitude is less and the tsunami risk is not concerning, so you have a better chance to survive.

However, the financial risk is far more severe than people realize, especially if you own a home.

Self Insuring Without Knowing It

In last week’s discussion of how humans increase their risk from natural disaster, I discussed how Japan was an exception with their stringent building codes to earthquake proof buildings.

Unfortunately, California does not adhere to the same standards. Worse, the great majority (80-90%) of homeowners don’t even buy earthquake insurance.

That means they are self insuring and essentially rolling the dice on whether they can afford to rebuild after a quake.

While in Florida, people don’t want to pay a fair price for insurance and have to worry about whether their insurer will be able to pay them fully after a large hurricane, at least they are insured for hurricane losses.

Earthquakes may be less frequent, but the severity is arguably worse and, if you plan to live in California for decades, your cumulative probability of one significant quake loss is pretty high.

Gambling Your Home Equity

What this means is you are betting the equity in your home that you won’t have a quake in your lifetime (or that the damage will be limited).

Let’s say you bought a home for $1.5M ten years ago. You put down $300K and borrowed $1.2M. The value has since appreciated to $2.5M while your mortgage has been paid down to $1.0M.

Congrats, you now have $1.5M of equity in your home! Condolences, you can now lose $1.5M to an earthquake.

This doesn’t even require a full loss. Let’s say repair costs are $750K. You’re paying that yourself and you still owe $1M on the mortgage. Half of your equity is now gone.

Also, that home equity wasn’t liquid. How are you financing the $750K in construction costs? Second mortgage? Now you have $1.75M in debt.

By the way, I didn’t even mention demand surge. The damage could cost as much as $1.5M to fix when there are shortages. Then your equity would be wiped out.

Why are Californians so cavalier about this risk? Great question.

California Earthquake Authority

One reason is because there aren’t great options. Insurance is expensive, offers limited coverage, and has high retentions. If you have a partial loss, there is a good chance you will be paying for it entirely yourself.

For those who do want to buy quake, guess what? Lost amid all the press coverage of insurers pulling back on standard coverage was the news that the California Earthquake Authority (CEA) just put new limits on coverage that make it even less attractive.

Coverage for personal property is now capped at $25K and deductibles for homes valued above $1M are now required to be at least 15%.

So a $2M home has a $300K retention. No wonder people don’t buy quake cover! They feel like they’re throwing premium away.

Of course, they won’t feel that way if they had $1M of damage, but if you can’t afford the $300K retention, then you’re not going to feel great because some of your loss was covered.

There are private options outside the CEA but they have similar limitations. So what is one to do?

Risk Transfer

What can you do if you live in California and want to reduce your risk? Other than move?

There is one novel form of risk transfer – rent a home.

Perhaps easier said than done, but if you rent, you have no home equity. You can lose your possessions but that is a lot smaller $ amount.

The landlord would be the one taking all the risk. Better yet, they probably can afford a commercial quake policy if they own a number of properties and can aggregate risk.

But that’s not your problem. Your problem is you don’t want to roll the dice on your home equity so the answer is to rent.

You can move to an apartment if needed, but there are increasing options to rent homes with people wanting to move but not give up their 3% mortgages as well as single family homes that have been bought by private equity for rental purposes.

Let someone else take the risk. The only argument against it is you miss out on the chance to build home equity and you might get lucky and sell before a quake or emerge from one with limited damage. Of course, that is greater fool theory.

Don’t Forget The Other Risks

Note I haven’t even addressed the more recent issues with availability of standard insurance because the state won’t approve necessary rate increases.

A growing number of people are being pushed into the FAIR plan which is a residual risk pool. Coverage is very limited as it’s a named perils policy. You get fire, explosion, and smoke with an option for vandalism.

That’s it. No water, no wind, no falling tree, no liability, etc. One more reason to rent.

But at least if there’s a wildfire, you’ll be able to rebuild. It’s something.

The E&S Opportunity

It’s one thing for carriers to say they don’t want to write in California due to the onerous rules for admitted paper.

However, there should be a land rush of E&S capacity into the market right now. Maybe we’ll see announcements of new capital soon, but there’s no reason CA risk can’t be priced properly, even the quake.

FL has a much higher AAL and 1 in 100 than CA and yet there is still a (teetering) market for wind coverage. Why can’t E&S write comprehensive CA coverage that includes quake and fire?

The industry does itself no favors when it just puts up objections rather than provide solutions.

Throwing Money Away

Many people say renting is throwing money away. That’s a separate discussion but what matters here is any pro/con list someone does of renting vs. buying needs to be amended if you live in California.

The real risk in California isn’t “throwing money away” on rent. It’s throwing away your home equity if disaster strikes and you don’t have adequate protection because you didn’t buy enough insurance.

If a big quake happens, not only will people have damage to their homes, they will possibly face personal bankruptcy. Mortgages won’t get paid. Municipal tax revenue will fall.

The state doesn’t have the $ to pay for reconstruction and it’s unclear that the Federal government will want to pay to rebuild seven figure houses for people who refused to buy quake insurance.

The MacGuffin

It’s been 30 years since any kind of quake in California and over 100 since one of consequence. Have we not learned from Covid to prepare for predictable 1 in 100 year events ahead of time?

California has a lot bigger problems than insurers pulling back from wildfire zones. That’s the MacGuffin.

The real story is Californians have been ignoring their need for better home insurance options for decades and are still unfortunately in the dark.

A lot of people are exposed to risk they are unable to handle and most are sadly unaware. They won’t find out until after disaster strikes. And there is such a simple solution – rent!

Or, you know, maybe insurers can build that robust E&S market Californians need.