Insurance and the San Francisco Earthquake

In April 1906, an earthquake struck San Francisco and the event was a disaster for the city, the largest in California at the time, and for insurance globally. The tangible costs of the disaster were mammoth and the damage was felt (figuratively-speaking) far away from San Francisco, in the rest of America, Britain, Germany, and Switzerland and shook not just insurance companies but the larger financial system. The event revealed not only how interconnected the insurance industry is but how connected it is with finance generally.

San Francisco

San Francisco had a population of no more than a few thousand until the California Gold Rush of the middle of the 19^th century. However, by the start of the 20^th century it had grown to over 400,000 people and was California’s largest city. The rapid growth meant that it was largely a city built of lumber. Some 90% of buildings were wood-built, a larger proportion than in any other American city of similar size. When San Francisco was rapidly growing, there was no local source of bricks to offer an appealing alternative. Increasing the risks to the city of a great conflagration were its narrow streets; only two streets were considered wide enough to be effective fire breaks.

Also, while the inherent danger of an earthquake was already high in that region, the local geography of the city did not help matters. Most importantly, much of the developed waterfront was expanded by filling in the bay with landfill. Owners of ‘water lots’ would fill in areas where the water had been 35 feet (11 meters) deep to develop the area. The methods used to fill the bay meant this was less stable soil for buildings, susceptible to movement and sinking. Buildings could sink 6 inches (15 centimeters) in their first year after completion. Earthquakes were a threat to unstable soil and by this point earthquakes in California were not unheard of; one struck in 1865 and another in 1868.

Earthquake and Fire

The San Francisco earthquake discussed here struck on April 18, 1906 at 5:12 am. The 7.9 magnitude earthquake was experienced in two distinct tremors, a few seconds apart, that together lasted for about sixty seconds. The earthquake severed gas lines, especially in the waterfront areas of the city that had been built on landfill. Along with the gas lines, the tremors destroyed the electrical grid as overhead wires fell. Together, these events led to fires that lasted for three days and caused nearly five square miles of the city, including its densest neighborhoods, to burn.

Nonetheless, many fires in the aftermath of the earthquake were believed to be caused by arson. In any case, several conditions in San Francisco at the time made the city susceptible to fire. First, there had been hot and dry weather for the two weeks prior to the disaster. Secondly, winds picked up the day after the earthquake as the fire still burned, increasing the destruction. Thirdly, the earthquake had also destroyed underground water lines, hampering firefighting. Instead, salt water had to be pumped from naval vessels and other ships to fight the fires on land. There was no rain until just after the fires were already put out.

The earthquake and subsequent fires had killed 3,000 people out of a city population of 400,000. The victims included the head of the city’s fire department, killed not in a fire but from the initial earthquake. In total, some 28,000 buildings were lost as over five hundred city blocks were completely destroyed; 200,000, perhaps more, were made homeless. The value of the losses stood at $350 – $500 million, about 1.5% of US gross national product at the time. Charitable and government assistance forthcoming after the disaster was minimal in comparison to these sums.

Losses and Disputes

Insurance companies would pick up most of the cost of rebuilding San Francisco. Insured losses stood at $250 million. The vast majority of this loss was dutifully compensated for by claims honored by the companies. However, this was not straightforward and not only because 137 fire insurance companies were involved. Many policyholders had lost their insurance policy documents in the fire and did not remember the names of the insurance companies which insured their properties. Also, the Fireman’s Fund, the most notable of the California-based insurers ensnared in the disaster, had lost its headquarters and many of its records in the earthquake.

There were many disputes about the legitimacy of insurance claims. These centered on whether the losses had been caused by the earthquake or by the fires. Insurance contracts typically excluded coverage for damages caused by earthquakes either explicitly or implicitly. In some cases, this language was clear. One insurer, Helvetia, had a clause in their contracts that specifically excluded coverage for fires caused directly or indirectly by earthquake.

Most contracts contained a more ambiguous clause though, the so-called “fallen building clause”, which read that “if a building or any part thereof fall, except as the result of fire, all insurance by this Policy on such buildings or its contents shall immediately cease”. This was meant to prevent instances where the owner of an earthquake damaged building purposely set fire to their property after the fact, in order to have a stronger claim to insurance money.

Despite the circumstances, insurers paid out nearly all claims; even those of the quite dubious merit would be settled at 75% of their full value. Thus, when all was said and done, of the $250 million in insured losses, some $235 million was paid by insurers.

Central to the story of insurance in the San Francisco earthquake were the reinsurance companies. Some eighteen companies provided reinsurance to the companies facing losses in San Francisco. Swiss Reinsurance Company, or Swiss Re, incurred the largest loss in its history with the 1906 earthquake.

Even over a century ago, a Swiss reinsurance company was active in America because diversifying an insurance portfolio across geographies is fundamental to offering the most cost-effective insurance possible. Swiss Re reinsured the portfolios of European insurance companies active in America, specifically Swiss Helvetia, the German Preussische National, Northern and London Assurance Company from Britain, and Russia’s Rossija insurance company.

Reinsurers offer insurance to insurance companies; they reimburse insurance companies for a substantial portion of claims they pay in a large enough disaster. As such, reinsurers would have to live with the contracts drawn up by their clients, the primary insurance companies, which varied and were often ambiguous. They also would have to put up with the varied aggressiveness with which their clients denied disputable claims.

Unfortunately for the reinsurers, to please their policyholders, some insurance companies were very reluctant to dispute claims, especially if generosity could allow them to win market share. Also, while insurance companies won some of the legal cases where they refused to make a payment, insurers were also keen to avoid litigation expenses. British firms, which tended to be the most well capitalized, were most likely to pay claims generously. This made business sense because money from the reinsurance companies would be offsetting at least a large portion of the claims anyway.

Whatever the eventual evidence to the contrary, it was sensible at the start of the process to believe that California courts would be keen to side with policyholders in disputes anyway. There were plenty of good reasons to expect this. For one, insurance claims adjusters in the city were beaten and threatened after the earthquake. Also, a California insurance commissioner, Myron Wolf, was threatening to ban insurance companies from conducting future business if they did not pay 100% of what was demanded from them in claims.

An insurance industry journal made the amusing observation that it took intense questioning of the insurance commissioner to get an admission from him that an earthquake had even occurred on April 18. Indeed, the efforts to make insurers pay were so extensive that the Real Estate Board of San Francisco even passed a resolution on April 24 to the effect that members were to only refer to the disaster as ‘the great fire’, an event which would imply insurance coverage for the damage, and not ‘the great earthquake’ which would seem to concede the point to the insurers. The city’s mayor also avoided referring to the disaster as anything other than a fire. It became politically incorrect to refer to the San Francisco disaster as an earthquake, as it is usually known today.

Even insurance companies with the clearest language excluding coverage for any fires caused by earthquakes, even those that said so explicitly, were paying claims. The language of insurance contracts seemed hardly to matter at all to actual practice on the ground. Swiss Re, like other reinsurers, watched on with despair. They came to see California as a legal backwater where the impartiality of courts and the honesty of public officials could not be counted on. The episode was a “never again” moment for the reinsurance industry. After all, they were the ones taking most of the risk but were the most powerless. Some firms, like German reinsurer Kölnische Rück, the ancestor of today’s Gen Re, went so far as to cancel contracts with insurers it believed were not satisfactorily scrutinizing claims.

Insurance Effects

The 1906 San Francisco Earthquake was one of the costliest disasters in insurance history up to that point. At least twelve insurance companies were bankrupted by the disaster. The management of reinsurance companies corresponded frequently after the disaster and a meeting of reinsurance companies was scheduled in Munich for April 30. An informal reinsurance lobby was created; the group compiled information on earthquake clauses from insurance contracts around the world. The results were published in a June 1907 study called The Earthquake Clause in the Insurance Specifications of Fire Insurers.

The reinsurance lobby did introduce what they hoped to become an industry standard earthquake clause to be inserted into contracts, terms which achieved only mixed adoption. Some jurisdictions, like California, established laws that made it harder to exclude coverage for fires caused by earthquakes from property insurance contracts. Reinsurers were also reluctant to turn down business from insurers that refused to include the clause in their contracts. Still, the reinsurance industry was concentrated just enough that refusing their demands would be a risky gamble so some insurers acquiesced. The clause would better protect reinsurers from taking on more risk than they wanted.

Financial Effects

The disaster also had broader financial effects, just as immediate and stinging. The 1906 San Francisco Earthquake helped trigger the Panic of 1907. Losses experienced by insurance companies in San Francisco amounted to the underwriting profit of American casualty insurers earned over the preceding forty-seven years combined. Insurers had to liquidate investment portfolios to make good on claims, depressing stock prices.

British insurers paying American claims with their funds back home resulted in the transfer of $65 million of gold from Britain to America, an amount that constituted 14% of Britain’s gold stock. To support the sterling-dollar exchange rate and restore gold reserves, the Bank of England increased interest rates from 3.5% to 6% and curtailed advances on American bills. The mammoth flow of gold towards the United States was reversed with equally large flows back to Europe by 1907 and credit contracted, triggering the Panic of 1907.

Lesson

Insurance, and reinsurance especially, are global industries by their very nature. However, in the very early 20^th century, though insurance was an international industry, it was not yet very standardized and the moral hazard of reinsurance perhaps was not fully appreciated. These problems, hardly unique to insurance and plaguing other areas of finance as well, became especially apparent after the 1906 San Francisco Earthquake. While an isolated event, the disaster revealed the globally interconnectedness of insurance and how connected insurance was with finance more broadly, both structurally and causally.

More from the Tontine Coffee-House

Read about how Civil War general William Tecumseh Sherman observed the Panic of 1857, which began two years earlier in San Francisco. Also, learn how the Great Fire of Hamburg spawned the creation of the reinsurance industry. Consider subscribing to this blog’s newsletter here.