TCH: Earthquake Insurance in Japan

??????????? While certain risks are easy to insure against in a cost-effective manner, others are more difficult. Some risks are nearly impossible to insure against because they are too costly or the risk is either very difficult to measure or very high. In these cases, insurance may become completely unavailable if not offered with some government support. In Japan, such support is provided to make earthquake insurance available for purchase in the most earthquake-prone country in the world.

Earthquake Risk

??????????? Tokyo lies on or alongside some of the most active and potentially dangerous faults. The Great Kanto Earthquake of 1923 had its epicenter at a fault running along the Sagami Trough, just south of the city. Smaller earthquakes in 1855 and 1894 still caused a lot of damage in the city because those struck at faults just beneath Tokyo itself. Besides Tokyo, East Japan generally experiences many earthquakes. Inconveniently, the most earthquake-prone parts of Japan are also its most densely populated parts.

??????????? To investigate earthquakes, the Earthquake Prediction Research Programme was launched in Japan in 1965. This organization shares information between various institutions such as universities and the Meteorological Agency. You might think predicting earthquakes is impossible but they are not random events. Consider the risk of aftershocks; these predictably diminish in frequency as time passes.

???????????After the aftershocks become rare, strain begins to build in the fault line once more and this will eventually lead to the next big earthquake. Energy accumulates in tectonic plates until a limit is breached and an earthquake happens. So, though it may be difficult to predict earthquakes, there is something of a cycle involved. For example, at the Nankai Trough, an earthquake seems to occur every 120 years, give-or-take 30 years. They occur in Tokyo every 69 years, give or take 13 years. These cycles are relevant to how earthquakes are insured against.

Uninsurable Risk

??????????? Insurance is most effective for protection against rare but costly perils. After a major earthquake in an area, when the risk of a subsequent earthquake has fallen, the risk may be insurable because it is a remote but costly peril, the kinds of risks for which insurance is most suitable. Once an earthquake is due to occur in the near future, insurance becomes less effective a solution since the uncertainty is removed.

???????????The very high likelihood of earthquakes in certain times and places makes adverse selection more likely. This happens when the pool of interested customers expands when and where the risk of an earthquake is higher and then diminishes when it becomes less likely. Such consumer behavior makes it hard to offer an earthquake insurance product that is profitable in the long term. It would be akin to offering car insurance in a market where only suicidal drivers, or in any case reckless drivers, care to buy insurance.?

??????????? Earthquakes can also be difficult to insure against because of the scale of potential losses. East Japan is very urban so lots of property lies in the vicinity of fault lines. Earthquakes also come with coincident damages. They can trigger fires; in the past, the fires caused by earthquakes in flammable urban environments were routinely more damaging than the earthquakes themselves. More frightening today is the risk of tsunamis causing flood damage even far from the sea. The costs involved mean it is riskier to insure against earthquakes so more capital is needed, making insurance expensive when it is offered. A high cost can make adverse selection worse. Those who think, maybe rightfully, that an earthquake is a remote possibility or that their property is more likely to survive unscathed are less likely to buy insurance.

??????????? Lastly, insurance companies rely on data to measure risk. Compared to other insurance products, earthquake insurance does not have the benefit of as much historical data. Also, efforts to design more earthquake and fire-proof buildings make past experiences of less value in predicting future losses.

Japan Earthquake Reinsurance Co.

??????????? The most consequential legislation affecting this industry was the ‘Law Concerning Earthquake Insurance’ passed in 1966. This was enacted in the aftermath of the Niigata Earthquake in 1964. Tens of thousands of homes and just over 16,000 other buildings were damaged. As a result of the new law, a reinsurance arrangement was formed between a new company, The Japan Earthquake Reinsurance Co., Ltd. (JER), and the Japanese government. Private, non-mutual, insurance companies were required to offer earthquake coverage and reinsure this risk with the JER.

??????????? By the late 1970s, the government provided reinsurance to the JER in the form of 50% cover on the ￥120 billion in losses beyond the first ￥30 billion and then 95% coverage on the next ￥650 billion in losses from there. In sum, the total potential payment to the insured victims of an earthquake was capped at ￥800 billion. These numbers have of course increased over time, with total cover reaching ￥5.5 trillion by 2011. The JER pays the government a premium that is determined not at the beginning but at the end of the insured policies’ terms. This works in practice by the JER making an advance deposit and any final payment being made at expiry of the reinsurance contract to adjust the total cost as needed.

Insurance Companies

??????????? The JER did not carry its potential share of the burden on its own; it in turn left some of the exposure with the direct insurance companies who sold the policies. As of the late 1970s, they were responsible for the first ￥50 billion in losses that would otherwise be borne by JER, essentially the first ￥50 billion in losses net of the reinsurance provided by the government. Against this potential loss, these insurers were required by law to set aside a reserve.

??????????? The risk sharing formula has been tinkered with over time but by 2012, in the aftermath of the Great East Japan Earthquake the prior year, the government was taking on 87% of the maximum liability with the JER and private insurers taking 10% and 3% respectively. Of course, given the tiered nature of the JER’s reinsurance with the government, the exact risk sharing in any particular earthquake would depend on the size of the losses sustained.

??????????? In 1976, ￥5.66 trillion was insured across the country. Some 14.54% of households owned earthquake insurance coverage; this proportion rose to 24.56% for Tokyo and its surrounding prefectures. For this coverage, ￥12 billion in premium was collected in 1975, net of agency commissions and insurers’ expenses. The direct insurers’ reserves summed to ￥36.4 billion and JER possessed another ￥9.6 billion. These are not particularly large numbers. Consider that the premium income on fire insurance policies in 1975 came to ￥430 billion and across all business lines was ￥2.4 trillion.

A Typical Policy

??????????? A typical earthquake policy would cover fire, destruction, burying, and washing-away caused by earthquake, volcanic eruption, or tsunami. Earthquake insurance was automatically woven into comprehensive insurance policies sold to households and businesses, often by cooperative mutual insurers. The insurance could not be bought on its own, limiting adverse selection and thus solving a problem for insurers. After 1975, coverage was offered as a supplement to fire insurance policies as well, so existing private insurance companies which were dominant in this area began offering coverage too. This supplement was optional but protection against earthquakes still could not be bought on its own.

??????????? The earthquake coverage limit was set to just 30% of the larger policy so the coverage would not necessarily make the insured whole in the event of an earthquake. When the program was introduced, there was also a coverage limit of ￥900,000 per building and ￥600,000 for possessions within the insured building. These limits were steadily raised, reaching ￥50 million per house and ￥10 million for personal property by 2012. The earthquake coverage as a percentage of the policy limit increased from 30% to 50%; still, the coverage was not meant to be comprehensive. These limits were designed to ration the available protection across the greatest number of people, rather than protecting all property

??????????? Coverage would be priced based on construction material and location; the riskiest buildings in the riskiest locations would pay a premium more than eight times greater than buildings with superior construction in less risky areas. Tokyo was included in the riskiest zone for pricing purposes. This arrangement was based on data that spanned 331 earthquakes that had occurred in Japan across 467 years. By 2012, to insure a nonwooden structure in Nagazaki Prefecture would cost ￥5,000 per year per ￥10 million in coverage; the equivalent cost for a wooden structure in Tokyo would cost ￥31,300. Discounts would be given for property characteristics like earthquake resistant design or buildings built after 1981.

Great East Japan Earthquake

??????????? The Great East Japan Earthquake of 2011 was the fourth largest ever recorded. It caused damage of nearly ￥17 trillion, inclusive of damage to public infrastructure. Insured losses were ￥2.75 trillion. The catastrophe depleted about half of earthquake insurance reserves available; though overall, losses to insurance companies were manageable. Unfortunately, most Japanese homeowners did not have insurance coverage for earthquakes.

??????????? Private insurance companies handled claims on a simplified basis of a total, half, or partial loss, resulting in payout of 100%, 50%, or 5% of the policy limit for earthquake damage respectively. This simplicity meant that of the 741,000 claims payments made after the Great East Japan Earthquake, 60% were paid within two months. Thanks in part to government involvement via reinsurance, after the earthquake, the claims-paying capacity of the industry stood at a still considerable ￥5.5 trillion.

??????????? Not all insurers relied on the JER though. Cooperative insurers automatically weaving earthquake coverage into more comprehensive products, most notably the large cooperative JA Kyosai, were able to secure reinsurance in international reinsurance markets and through issuance of catastrophe bonds. These groups generally had more complex claims payment processes with damages being measured to determine the payout. Unlike the mutual insurers, private companies did rely on JER, and its government backing; there was no other option afforded to these companies under the 1966 law concerning earthquake insurance.

Lesson

??????????? Earthquake insurance in Japan is a peculiar product with challenges less commonly found in more ordinary insurance products. However, the business of insuring against earthquakes still illustrates different paradigms for insurance and reinsurance. Distinct approaches include government supported or private markets. Governments generally want claims paid quickly whereas insurers and reinsurers want to scrutinize claims so the method of claims settlement in each system is distinct and illustrated by the different insurers’ practices in Japan.

??????????? There is also the distinction between a for-profit or cooperative model. The latter sort of insurance organization builds its reserves via its members, or rely more than private for-profit firms on reinsurance, whereas the former can attract investor capital. Another distinction is between standalone or comprehensive policies. Though at the expense of consumer choice, the latter can mitigate against adverse selection and this can make an otherwise uninsurable peril insurable and reinsurable.

More from the Tontine Coffee-House

???????????Read?about the?role of insurance companies after the Great Kanto Earthquake of 1923 and the development of life insurance in Japan . Consider subscribing to this blog’s?newsletter ?or checking out?book recommendations , which include many of the sources often referenced in my posts.?

Further Reading

1.????? Earthquake Insurance in Japan (4th Edition). General Insurance Rating Organization of Japan (GIROJ), Oct. 2022.

2.????? The Great East Japan Earthquake: Learning from Megadisasters - 6.2 - Earthquake Risk Insurance. International Bank for Reconstruction and Development / The World Bank, 2012.

3.????? Wakuri, Masao, and Yasuyuki Yasuhara. “Earthquake Insurance in Japan.”?ASTIN Bulletin, vol. 9, no. 3, Dec. 1977, pp. 329–364. Accessed 27 Sept. 2022.