Quake Stakes

The “not if, but when” argument – quickly and encouragingly becoming well-entrenched for cyber risk – could have a new partner in earthquake.

True, the near-daily barrage of articles about the latest organization to have been hit by cyber woes seems more relatable than an event, even on a smaller scale, most have never experienced and for which grasping the impact is a challenge.

Even so, a catastrophic and likely uninsurable natural disaster poses a very real threat to the property and casualty insurance industry.

It was a scenario explored in the recent C.D. Howe Institute commentary, Fault Lines: Earthquakes, Insurance and Systemic 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,” writes Nicholas Le Pan, a senior fellow at the institute and a former federal superintendent of financial institutions.

Although policymakers have paid plenty of attention to the banking system since the financial crisis of 2007-2008, “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,” Le Pan emphasizes. Still, “no equivalent discussion exists for the impacts of natural disasters to Canada’s economy,” he adds.

“A gap exists in Canada between the potential losses from a severe event and the insurance industry’s capacity to withstand such a catastrophe,” Le Pan explains. Further, a severe quake would exceed the ability of the Property and Casualty Insurance Compensation Corporation (PACICC) to meet policyholder claims if losses were beyond $30 billion.

Le Pan recommends that Ottawa adopt a federal emergency backstop arrangement to serve as a last resort for p&c insurers to minimize the systemic financial impact associated with such an event.

“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 earthquake – currently approximately $30 billion to $35 billion,” he notes. “This loss estimate would be updated periodically,” he writes, which could help “to promote further industry risk-sharing.”

The commentary notes Canada has well-known backstop arrangements for the banking industry, but such formal protection from the impacts of natural disasters is non-existent. Ottawa does backstop nuclear operators for losses above a $1-billion liability limit (and similarly for offshore oil spills).

Yet, looking globally, “Canada is an outlier with no federal financial involvement to either cap exposure or provide or even facilitate backstop arrangements for very severe earthquake-related events,” Le Pan writes.

With the proposed backstop, “the trigger would be an event with losses beyond the level that the Office of the Superintendent of Financial Institutions (OSFI) requires insurers to provide for;

i.e., a one-in-500-year event as of 2022.” Some government responsibility, “would provide an incentive for authorities to keep mitigation measures (e.g., building codes) as up to date as possible.”

In step with the backstop, Le Pan notes it would be important to bolster PACICC “to deal with insurance industry problems and reduce systemic impacts from severe catastrophes,” by allowing the body to effectively intervene, including isolating earthquake business from other insurance business, and borrowing, perhaps from the federal government, to reduce liquidity needs in a crisis, before insurance companies in financial difficulty become insolvent.

“In the case of a catastrophe, a liquidity problem can become an industry-solvency crisis as assessments on healthy companies turn out to be too much for them to bear and maintain solvency requirements,” Le Pan points out.

The approach “would bridge more effectively the time between paying claims against failed companies and when assets to meet those claims are available,” he adds.

In a statement, Paul Kovacs, president and chief executive officer of PACICC, since urged the federal finance minister to look at the policy recommendations.

Noting Canada’s p&c companies can likely pay as much as $30 billion from insured losses from a major quake, “beyond this threshold, however, 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,” Kovacs said.

OSFI superintendent Jeremy Rudin, recently suggested that regulators can up capital requirements to cover an extreme event, like a severe earthquake, but maintaining balance is key.

Speaking at the 2016 National Insurance Conference of Canada, Rudin explained that “we have picked a spot for capital requirements on earthquake that needs to balance the interest of the policyholders and, at the same time, allow companies to take reasonable risks.”

A high-intensity earthquake in a large urban centre is “a peak peril that has a loss potential greater than any other event. Indeed, catastrophic losses from earthquakes may pose a threat to the financial well-being of many p&c insurers.”

By complying with OSFI’s Minimum Capital Test (MCT) “insurers take a big step towards being financially prepared for an earthquake,” he said, but emphasized the MCT requirements are “not a safe harbour for earthquake preparedness.”

Le Pan writes some 40% of Canadians live in areas classified as “moderate” or “high” risk for earthquake. “From an economic perspective, this is a classic low-probabilility, severe-impact tail-risk event. However, from a public-policy perspective, it pays to think of a severe earthquake as a certain event whose timing is uncertain, and plan accordingly,” he adds.

That may be why it is so critically important for all stakeholders to do their parts. That will demand additional education on a number of fronts to clear the hurdle that a remote event does not equate to an impossible event.

Le Pan urges insurance industry bodies, as well as federal and provincial governments, to 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.”

Taking part in the Global Leaders Panel at NICC, John Charman, chairman and chief executive officer of Endurance Specialty Holdings Ltd., suggested “the reality of the numbers that we are using for what we believe may be extreme risk for either economic loss or insured loss, I think, are fractions of the reality from what we may have to deal with, let alone the human misery and suffering that will have to be dealt with for years thereafter.”

Should there be a large quake, Mike Sapnar, president and chief executive officer of Transatlantic Reinsurance Company, said during the panel “you’re going to be in a situation where people are out of work, you’re not going to be collecting property taxes, people are going to be moving to new locations, you’re going to have potentially major economic centres gone and that means your revenue is shrinking at a time when you need to be spending to rebuild.”

Added Mark Cloutier, group chief executive officer for Brit Insurance Ltd., “If we think Fort McMurray is an interesting loss, and it was a bit of a surprising loss, I shudder to think what liquefaction is going to do to Richmond and to Delta and to the Fraser River system (in British Columbia).”

The loss, Cloutier said, “could be so enormously beyond what anyone is expecting, we really, as an industry, need to get down to the science of this to really truly identify the exposure and risk.”