Property owners located within high risk earthquake zones have continued to increase their exposure to catastrophic events by living and working near earthquake fault lines. The rationale is that low probability, high severity earthquakes are rare events that happen to other people. To further exacerbatethe issue, approximately 90% of residential structures do not carry earthquake coverage. This low take-up rate is partially due to the fact that there are no requirement for residential homeowners to purchase earthquake insurance. When price sensitive homeowners analyze low probability, high severity risks they tend to absorb those risks themselves, rather than transferring those risks to an insurance product. The question then turns to whether those same residential homeowners are financially equipped to absorb a catastrophic earthquake, and if not, what would be the impacts to the mortgage and capital markets.
Across the United States, underwriting guidelines for government backed mortgages through Fannie Mae and Freddie Mac require mortgagors to purchase insurance to cover just about every other peril except for earthquake risks, creating a morale hazard. Furthermore, “non recourse” states limit mortgage defaults solely to the lender’s recovery of the property, increasing the morale hazard. Due to low take-up rates for earthquake insurance, when the “big one” does finally occur we could see systemic failures to the mortgage and capital markets with the nation’s taxpayers on the hook for Fannie Mae’s and Freddie Mac’s losses.