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  • Institut C.D. HOWE Institute

    commentary NO. 454

    Fault Lines: Earthquakes, Insurance, and Systemic

    Financial Risk

    The fault lines from a major earthquake in Canada could quickly spread through the insurance industry and have a systemic financial impact. Policymakers should

    take several steps now to avert this chain of events.

    Nicholas Le Pan

  • Essential Policy Intelligence | Conseils indis pens

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    Daniel Schwanen Vice President, Research

    Commentary No. 454 August 2016 Financial Services

    C.D. Howe Institute publications undergo rigorous external review by academics and independent experts drawn from the public and private sectors. The Institute’s peer review ensures the quality, integrity and objectivity of its policy research. The Institute will not publish any study that, in its view, fails to meet these standards.

    The Institute requires that its authors publicly disclose any actual or potential conflicts of interest of which they are aware.

    In its mission to educate and foster debate on essential public policy issues, the C.D. Howe Institute provides nonpartisan policy advice to interested parties on a non-exclusive basis. The Institute will not endorse any political party, elected official, candidate for elected office, or interest group.

    As a registered Canadian charity, the C.D. Howe Institute as a matter of course accepts donations from individuals, private and public organizations, charitable foundations and others, by way of general and project support. The Institute will not accept any donation that stipulates a predetermined result or policy stance or otherwise inhibits its independence, or that of its staff and authors, in pursuing scholarly activities or disseminating research results.

    The Institute’s Commitment to Quality

    About The Author

    Nicholas Le Pan is the former federal Superintendent of Financial Institutions. He is a Senior Fellow of the C.D. Howe Institute and Chair of the Institute’s Financial Services Research Initiative.

    $12.00 isbn 978-0-88806-977-1 issn 0824-8001 (print); issn 1703-0765 (online)

  • The Study In Brief

    The fault lines from a major earthquake in Canada could quickly spread through the insurance industry and have a systemic financial impact. Policymakers should take several steps now to avert this chain of events.

    Since the financial crisis of 2007/08, policymakers have focused on systemic risk to financial and economic systems, with most of the attention on the banking system. The framework for these efforts has been to build resiliency and shock absorbers to minimize the impact of financial shocks on the real economy. The inevitability of an earthquake in Canada poses a similar systemic financial risk for the insurance industry and the economy as a whole, and similar remedial efforts are required.

    A federal emergency backstop arrangement for property and casualty insurers, properly designed, would minimize the systemic financial impact resulting from such a catastrophic and likely uninsurable event on those affected and on the economy at large. The moral-hazard implications appear small compared to the benefits of avoiding serious systemic risk. The backstop arrangement should, however, apportion costs, including a possible tranche of further contingent risk-sharing with industry in a way that lessens moral- hazard issues. A federal last-resort backstop guarantee could kick in beyond an industry-wide trigger of expected losses, say those associated with a one-in-500-year earthquake – currently approximately $30 billion to $35 billion. This loss estimate would be updated periodically, and the trigger could be set somewhere in excess of the one-in-500 threshold to promote further industry risk-sharing.

    That said, as part of any Canadian reform package, it is important to bolster the Property and Casualty Insurance Compensation Corporation to deal with insurance industry problems and reduce systemic impacts from severe catastrophes. This would also reduce the likelihood that a federal financial commitment would be triggered and, if triggered, would have minimum costs. Having more tools available in advance to deal with catastrophic events would reduce post-catastrophe disaster claims. This Commentary recommends the following:

    • Strengthen PACCIC so it can intervene before insurance companies in financial difficulty become insolvent. • Ensure PACCIC has the capability to borrow to reduce its liquidity needs in a crisis. • Following these structural changes, PACCIC should rerun its scenario models to examine how much that

    could increase resilience to extreme events. Furthermore, insurance industry bodies, as well as the federal and provincial governments, should undertake awareness programs to enhance homeowners’ understanding of catastrophe risks. This should encourage Canadians to evaluate the merits of disaster insurance coverage, particularly in the Quebec City-Montreal-Ottawa corridor where such insurance penetration is far too low.

    Finally, the insurance industry, under active OSFI supervision, should further develop its models for setting aside adequate capital and claims-paying capacity. Regulators should ensure there is an adequate degree of conservatism and that models are as up to date as possible. OSFI should regularly assess the adequacy of major insurers’ models, as they have done in the banking industry.

    C.D. Howe Institute Commentary© is a periodic analysis of, and commentary on, current public policy issues. Michael Benedict and James Fleming edited the manuscript; Yang Zhao prepared it for publication. As with all Institute publications, the views expressed here are those of the author and do not necessarily reflect the opinions of the Institute’s members or Board of Directors. Quotation with appropriate credit is permissible.

    To order this publication please contact: the C.D. Howe Institute, 67 Yonge St., Suite 300, Toronto, Ontario M5E 1J8. The full text of this publication is also available on the Institute’s website at www.cdhowe.org.

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    Beyond the immediacy of the crisis, the impact of such a catastrophe on the financial system needs to be understood and assessed so that systemic risks do not exacerbate an already challenging situation.

    Currently, well-known backstop arrangements exist for the banking industry. Indeed, systemic resiliency of the banking system has been a preoccupation of policymakers since the 2008 financial crisis. However, such formal protection from the impacts of natural disasters is non- existent. For their part, severe quakes would affect all economic players, in particular those who fund or insure commercial, municipal or residential housing infrastructure. Canada’s property and casualty (P&C) insurance industry has warned that a catastrophic earthquake could overwhelm its ability to meet claims, thereby undermining insurers’ ability to satisfy their obligations to other personal and commercial policyholders across the country, deepening the quake’s economic aftershocks.

    In many ways, Canada is ahead of other jurisdictions in financial preparedness for such an event, but there is a financing gap for the most extreme possibilities. How should Canada deal with this potential systemic financial risk? Is there a case for federal involvement? Could the private sector do more? How should the new finance minister look at this issue? This Commentary addresses these questions.

    It concludes that earthquake damage at the catastrophic level is an uninsurable risk that is currently not adequately covered. Therefore, government needs to address gaps in the existing Canadian insurance scheme to ensure that a severe tail-risk earthquake does not become a systemic

    financial problem. Indeed, there is a strong case for establishing a federal government/industry backstop arrangement that could be activated to deal with such an uninsurable catastrophic risk. As well, this Commentary advocates enhancements to the existing survivor-pay, private-sector insurance industry compensation system to lessen accentuating impacts from a crisis event. Meanwhile, companies that insure against this risk and their regulators need to be more transparent about their stress tests. Finally, national authorities should coordinate with their provincial counterparts to assess the broader readiness of the financial system to deal with such a natural catastrophe.

    The Right Policy Framework

    Well-developed frameworks for analyzing the adequacy of policy responses to potential natural disasters consider three aspects – prevention, insurance and coping capability after such an event (UN 2010). Economic frameworks suggest that incentives matter – for individuals, businesses and for the insurance industry. That means, for example, risk-based pricing, and governments providing frameworks that incentivize the desired behavior.

    There are three main categories of losses from a severe earthquake. The first is damage to public infrastructure, where the rebuilding costs will be borne by governments; i.e., the public. The second is damage to private assets financed by the financial system, such as loan losses on mortgaged properties. In this area, government backstops and resolution frameworks are generally well developed. The third loss category – damage covered by the P&C insurance industry, is the focus of this

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