Federal government should consider emergency back-stop mechanism for catastrophic earthquake: conference board

The Conference Board of Canada is echoing a recent recommendation by a former federal superintendent of financial institutions for Ottawa to consider adopting a last-resort, emergency back-stop mechanism for a catastrophic earthquake given the long-reaching, adverse effects that the event would have on the country’s economy.

“A major earthquake in British Columbia could put the national economy in jeopardy, leading to significant and long-lasting economic losses,” concludes Canada’s Earthquake Risk: Macroeconomic Impacts and Systemic Financial Risk.

“Policyholders across Canada – whether homeowners or businesses – would be left exposed and be unable to rely on claims payments from their insurers,” notes the report, released Tuesday.

Funding for the research was provided by Insurance Bureau of Canada.

A conference board scenario estimating the macroeconomic and financial impacts of a major quake off the coast of B.C. over a 10-year period following the disaster would generate insured losses just above the property and casualty insurance industry’s current capitalization levels (in excess of a 1-in-500-year loss event).

The report explores an extreme tail-risk event to stress test Canada’s resiliency to the risk of a large quake and highlight gaps and fragilities within the existing Canadian insurance system. To do so, it relies on the conference board’s model of the Canadian economy to produce a shock-minus-control analysis, which allows for comparing a world in which no earthquake occurs to a scenario in which one does occur.

The aforementioned quake off the coast of B.C. would result in $127.5 billion in total economic losses, of which some $42 billion would be insured, concludes the report.

Assuming total economic losses would grow in line with insured losses, the current direct cost is estimated at $127.5 billion. And based on reports and scenarios, “an assumption was made this earthquake would result in approximately 15,000 deaths.”

In following years, the report notes, “Canada’s economy is affected by the rebuild efforts that take place after the disaster and by the impact of insolvencies for P&C insurers and the potential financial contagion associated with those insolvencies.”

With data presented in current dollars, and values used for economic impact analysis adjusted for inflation, the conference board cites the following direct impacts on capital stock from the aforementioned quake.

“Because the current system holds all insurers liable for any companies that become insolvent, insolvencies would spread, both within the insurance industry and to other sectors of the economy, affecting business flows and the availability of critical financial services from coast, to coast, to coast,” cautions the report.

There would be a likely chain of “insolvencies that would be triggered among insurers and across the broader financial sector, due to the emergence of substantial unfunded liabilities across the sector and the interconnectedness of market players,” it states.

“If widespread failure in the P&C industry followed the earthquake and rebuild, the net cumulative effect in the ensuing 10 years would be a loss of $96 billion in real GDP and 437,000 person-years of employment,” the report notes.

Real GDP losses peak at almost $38 billion in the third year after the quake, and the rebuild effort would not contribute positively to growth until six years after the earthquake, the conference board reports.

However, the report adds, “if P&C insurance failures were prevented, economic and financial costs to the federal and provincial governments would be significantly mitigated.”

The call for Ottawa to consider a federal emergency back-stop is similar to a recommendation within a recent report by former superintendent Nicholas Le Pan, currently a senior fellow at the C.D. Howe Institute.

The last-resort, federal emergency back-stop arrangement would help p&c insurers minimize the systemic financial impact from a “catastrophic and likely uninsurable natural disaster,” Le Pan suggested.

Related: C.D. Howe Institute report calls for federal emergency backstop arrangement for earthquakes

Currently, the report explains, insurance companies must demonstrate they have the resources to pay claims generated by a 1-in-500-year quake, using a combination of up to 10% of company capital, reinsurance and dedicated earthquake reserves.

“In addition, companies must, of course, have sufficient capital to meet all their other non-earthquake-related obligations,” it adds.

Current industry capacity sits in the $30 billion to $35-billion range, “meaning that the industry is already well on track to have, by 2022, sufficient claims-paying capacity for a 1-in-500-year earthquake,” the report states.

The conference board report acknowledges a quake generating losses above the insurance industry’s capacity “would be an exceedingly rare event.”

But should such an event occur, not only would individual insurers and the p&c industry as a whole be under fire, so, too, would the country’s economy and taxpayers.

“Insurer failures are, indeed, inevitable and there is a point at which the entire insurance industry is threatened,” the report warns.

Citing a 2013 report from the Property and Casualty Insurance Compensation Corporation (PACICC), the conference board acknowledges “there have been only two company failures in Canada from natural disasters since 1950.”

The National General Insurance Company failed in 1952 as a result of losses due to the flooding of the Red River in Winnipeg in 1950, and the Mennonite Hail Insurance Company closed in 1984 as a result of losses stemming from two hailstorms – Manitoba in 1978 and Alberta in 1981, the report points out.

Again citing PACICC figures, “a disaster totalling $15 billion to $20 billion is thought to be easily handled by the Canadian insurance industry, with no insolvencies. However, a disaster between $25 billion and $30 billion would see the failure of some otherwise healthy insurance companies,” the conference board reports.

“At amounts above $30 billion in losses, as is the case in our earthquake scenario, the losses would be greater than the existing capacity of the Canadian insurance industry, and also larger than PAICC’s ability to address the needs of policyholders,” the report adds.

Following the release of Le Pan’s report, Paul Kovacs, CEO of PACICC, noted that beyond $30 billion in insured losses from a major earthquake, “the risk of financial contagion rises sharply because the financial health and stability of surviving insurance companies becomes threatened by the need to fund the compensation paid to the policyholders of insolvent insurers.”

Related: PACICC warns of ‘risk of financial contagion’ if earthquake losses exceed $30 billion

“Even limited failures would likely result in stock market volatility, financial uncertainty and declines in business and consumer confidence,” the report states. “And the extent of contagion would depend on the timing at which government intervenes,” it adds.

“Given the degree to which the insurance industry and financial services firms are connected, such an event would naturally raise the likelihood of defaults among other financial institutions, thereby resulting in financial contagion outside the P&C insurance sector,” the conference board reports.

Taking into account property destruction, loss of life, post-disaster reconstruction challenge, decline in economic activity and the likely chain of insolvencies that would be triggered among insurers and across the broader financial sector, “the fiscal and macroeconomic impacts of such an earthquake would be devastating,” it notes.

“Financial contagion would not only delay the rebuild and recovery efforts by an estimated two years, but also nearly completely offset the growth stimulating effects of the rebuilding effort,” the report points out.

More specifically, it explains, the rate of economic growth in the short term would be halved, remaining below the case in which a quake does not occur until year three, cumulative real GDP losses would amount to almost $100 billion over the long term and lower employment and income would reduce consumer spending by $133 billion.

Additionally, the rebuilding effort would take an enormous toll on all levels of government finances, with taxpayers left to absorb the costs of losses to both public assets and infrastructure, as well as uninsured private losses.

The reduced revenues and increased government spending would translate to “an $87 billion hit to the federal treasury and a $35 billion hit to provincial finances, adding $122 billion in net new public debt to government coffers,” states the report.

That amount is “nearly double the $63 billion in government borrowing that would be necessary if Canada had a mechanism in place to avoid financial contagion following the earthquake,” the board notes.

“This also raises concerns around funding future government programs and the possibility of an increased future tax burden as a means to pay for the increased debt,” the report continues.

All that said, with current industry capacity in the $30 billion to $35 billion range, “the industry is already well on track to have, by 2022, sufficient claims-paying capacity for a 1-in-500-year earthquake,” it points out.

Still, recent experience with earthquakes in Japan, New Zealand and elsewhere show “there is the possibility of something larger and more devastating.”

Related: Powerful aftershocks, some as high as magnitude-6.5, strike New Zealand after original M7.8 earthquake: AIR

“By enabling firms and individuals to limit their liabilities and protect their assets,” the report notes of p&c insurance, “it helps stimulate investment and economic growth.”

While earthquakes cannot be prevented, beefing up building codes is one way to help mitigate the physical damage an earthquake will inflict on Canadians, it states.

“One option is for government to focus on pre-planning and remedial actions now, as opposed to relying on ad hoc measures when such an event occurs,” it suggests, citing consideration of the last-resort, emergency back-stop mechanism.

Such a mechanism “would be consistent with the approach most other jurisdictions take to address the financial management challenges posed by tail-risk and extreme disasters,” the report notes.

Figures cited in the report from Catastrophe Indices and Quantification Inc. show that insured losses from catastrophic events over the 2008 to Jan. 2016  period totally $11 billion. But this does not cover 2016 events, including the Fort McMurray wildfire, with estimated insured losses of about $3.6 billion.

Though Canada has not experienced a devastating earthquake since 1700, the report notes, Natural Resources Canada estimates the probability of a significant quake in western Canada at 30% and 5% to 15% in eastern Canada over the next 50 years.

“Although the frequency of extreme earthquakes would make it unlikely that such an emergency back-stop would ever be triggered, this is one example where pre-planning could help avoid a sizable and long-lasting economic loss,” it states.

“Recent catastrophic events and financial crises make the need to prepare for these events obvious,” the conference board emphasizes.

Simply raising capital and reinsurance requirements for insurers is unlikely to be an effective solution, the report notes.

“Nevertheless, insurers should continue to maintain high levels of capitalization and focus on disciplined risk management practices,” it adds.