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I live in the bay area, CA where there are many earthquakes. I was recently reading: http://blog.petetheplanner.com/financially-what-happens-when-your-house-burns-down/ which stated that your home owners (fire etc) insurance goes first to your mortgage and then to you.

The value proposition of buying earthquake insurance in this context seemed to not make sense to me.

It is my understanding that mortgages require home owners insurance (at least in my area) but do not require earthquake insurance.

Here are my assumptions:

  • Earthquake insurance is not required by lender
  • It's quite expensive as well
  • Most other homeowners are not buying it (reason for slower price recovery)
  • A home owner in the area would put maybe 20% down on a loan
  • In the case of a catastrophic earthquake (enough to destroy a home past the deductible) prices would drop significantly, the housing market would be significantly impacted.
  • Earthquake insurance insures the value of the house not the land value (aka purchase price of the home before the earthquake) Ex bay area houses might cost 200k to build but sell for a million.

Question(s)

  • So would earthquake insurance pay out go to the lender?
  • If that's the case and house prices have fallen significantly isn't the borrower just insuring their ability to pay back the lender vs. say in a traditional house fire where the area (land) would retain value and they might rebuild and not lose significant value? Ex if they didn't pay for the insurance they would probably be forced to walk away from the property (assuming large losses).

I guess I'm trying to figure out the values of earthquake insurance for a home buyer.

Fundamentally it seems to me that a major earthquake would change the value of the actual area significantly in a way a fire or flood would not.

Here's my example scenario:

House fire: A house burns down and the insurance company pays the cost to rebuild and the family's living expenses while that occurs. Property values do not change. Deductible cost lost.

Major earthquake (made up prices for simplicity): Nearly all of the buildings are severely damaged. The original cost to buy a house in the area is 100k. The buyer buys with 20% down (mortgage of 80k). The cost to build a house 50k. Insurance pays 50 + living expenses. 50 is applied to the mortgage. The home owner still owes 30k, and the land has little to no value.

What am I missing? It seems to me that with or without insurance the home buyer will never see a cent. Is the home buyer just paying to prevent a mortgage default? It seems like a pretty high cost to do so.

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  • If you home is made uninhabitable by the disaster and the insurance pays out, you essentially have two choices: (a) rebuild your home using the insurance money and continue with your mortgage; or (b) pay off your mortgage with the insurance money (keeping any excess insurance money for yourself or still owing the difference if the other way). What is not legitimate is (c) keeping all the insurance money for yourself and not paying off the mortgage. In that sense the lender has first call.
    – Henry
    Commented May 20 at 23:45
  • In your "Major earthquake" example, rebuilding the house for 50k to get a house worth 100k seems the optimal choice.
    – Henry
    Commented May 20 at 23:46

2 Answers 2

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The reason people buy earthquake insurance is not because normal insurance goes straight to the lender (it does not) but because oftentimes earthquake damage is not covered under normal homeowner's insurance. Natural disasters are often not covered under regular insurance. This is why people buy flood insurance. If your pipes burst and flood your house, your home owner's insurance will typically cover. If the local river floods and floods your house, oftentimes insurance will not cover. This is why a lot of state/federal agencies have separate pools of insurance. All earthquake insurance in California is technically through the state agency, though you may go through your homeowner provider to get it. I pay $200 a year for mine, I wouldn't say it's very expensive. My concern is not a giant earthquake that destroys my house. My concern is a large earthquake that might cause cracks in my slab or structural damage that my regular insurance is in no way obligated to cover but I need to fix. I think if you live in an earthquake prone area it's as reasonable as getting flood insurance if you live in an area known to flood.

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  • I should point out that some types of natural disaster are covered under an "all-perils" policy; e.g., wildfire, and wind/hail (tornado, hailstorm, hurricane). Floods and earthquakes are not covered because these are rare events that result in catastrophic damage for a large number of homeowners in a geographic area, and as such the risk is difficult to price and retain for any single insurer (wildfires and hurricanes also get a special catastrophe status and this is where reinsurance contracts come into play).
    – heropup
    Commented Sep 5, 2016 at 9:11
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Insurance you purchase is paid to you. However, even if the home is destroyed, you still owe all the money to the bank, and you no longer have the house as part of the land's value to guarantee the loan. So depending on how much the land is still worth versus how much you owe -- and exactly what the terms of the loan are -- you may need to use some or all of that money to repay enough of the loan to bring it back within the bank's policies. Read the terms of the loan -- consider asking a lawyer to clarify it for you if necessary; having a lawyer review that kind of major contract is always wise anyway. –

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  • I don't have a mortgage nor insurance, it was more hypothetical. So essentially you're saying home insurance (fire, etc) goes to the bank but earthquake insurance is paid to you?
    – Tai
    Commented May 11, 2016 at 23:05
  • The other insurance doesn't go to the bank directly either. It's your policy, even if you pay it through escrow as part of your monthly mortgage check. It's also your loss of something happens, of course. But the bank may decide to make demands upon the loan if the equity you used to guarantee it is sufficiently damaged that they feel it no longer meets the trend under which the loan was signed. Luckily, in most places most of the value is in the land.
    – keshlam
    Commented May 12, 2016 at 1:05

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