Strengthening Quake Preparedness

New guidelines from the Office of the Superintendent of Financial Institutions (OSFI) will require property and casualty insurers operating in Canada to take a more comprehensive approach to managing their earthquake risk by considering their exposure across the entire country.

The guidelines, which come into effect in 2015, are a positive step forward for managing Canada’s high earthquake risk. The aim is to strengthen the insurance industry’s financial preparedness to meet its obligations to policyholders in the event of a major earthquake.

Foreign regulators are considering the OSFI guidelines as a model for their own jurisdictions. However, the guidelines do not consider earthquake risk from a fully probabilistic perspective, which could have implications for some insurers.

Previously, OSFI notes, insurers in Canada calculated their total Probable Maximum Losses (PMLs) based on the larger of the British Columbia or Quebec PMLs. Under the new guidelines, insurers must use a new formula to calculate their total PMLs that includes their entire country-wide exposure. This change was introduced because the historical approach understates PML for insurers with exposures in both of Canada’s major earthquake regions.

The draft formula that has been published by OSFI includes PML500, which refers to the 1-in-500 year event for the given geographic region.

The new formula is as follows.

Recognizing the significant impact of the new guidelines to insurers’ capital requirements, OSFI is allowing insurers to gradually phase in their increased earthquake risk exposures through to 2022. Until then, insurers can calculate their country-wide PMLs using a formula provided by OSFI that will gradually increase their PMLs.

NEW AND OLD

To test the accuracy of the new OSFI formula, RMS analyzed the differences between the new and old OSFI formulas against a fully probabilistic model for earthquake risk to insured property in British Columbia and Quebec.

To model the expected losses, RMS’ Canada Earthquake model and Industry Exposure Database (IED) for Canadian earthquake exposure were used. The earthquake model has been developed using industry and government data.

The IED estimates total insured values for buildings, contents, business interruption and living expenses coverage, and includes residential, commercial, industrial and auto lines of business.

RMS found that while the new formula more accurately captures earthquake risk than the old formula, there are significant differences between the losses calculated using a fully probabilistic model and the new formula. Up to the 1,000-year return period, the new formula underestimates risk for carriers with significant insured exposure in both British Columbia and Quebec compared to the fully probabilistic perspective.

For example, the new formula produces losses that are more than 15% lower than the fully probabilistic results at the 500-year return period, which is the return period that the new OSFI guidelines use as the basis for determining insurers’ capital requirements.

Losses using the old formula are more than 35% lower than the fully probabilistic model. While the new formula will be used to determine capital requirements at the 500-year return period, it is also interesting to explore the full exceedance probability curve, and the average annual loss (AAL), which is derived from this curve.

The fully probabilistic model produces a $296 million AAL, whereas the new formula produces $235 million and the old formula $151 million.

The new formula results are almost 30% closer to the fully probabilistic results than the old formula. However, the new formula does underestimate AAL by about 20% compared with the fully probabilistic results.

Insurers could purchase additional reinsurance as a way to safeguard their financial preparedness in the face of a catastrophic earthquake. OSFI estimates that by 2022, the new formula will require that insurers must allocate at least $1.4 billion more in capital than would have been required using the old formula.

If these additional resources are achieved by purchasing more reinsurance, OSFI estimates the annual price tag to be less than $50 million. However, reinsurance pricing could continue to soften, lessening the financial impact of the new requirements.

CHANGE NEEDED

OSFI has made the change for good reason. The Canadian insurance industry is highly vulnerable to very large earthquakes that could produce unprecedented insured losses.

For example, RMS estimates a magnitude 7.1 earthquake in the Charlevoix Seismic Zone, approximately 100 kilometres northeast of Quebec City, could produce insured property losses of approximately $6.5 billion to $12 billion.

A magnitude 9 earthquake in the Cascadia Subduction Zone, just off the coast of Vancouver Island, could produce insured property losses of $18 billion to $26 billion.

A $26-billion loss is 15 times greater than the insured loss from the 2013 Alberta floods, which the Insurance Bureau of Canada reports is the costliest insured natural disaster in Canadian history.

Both of these simulated earthquake events are a low probability – yet highly plausible. In addition to the humanitarian loss from these potential earthquakes, Canada’s insurance industry would be severely tested and weakened.

A 2013 report issued by the Toronto-based Property and Casualty Insurance Compensation Corporation estimated that catastrophes resulting in damage claims of $15 billion to $25 billion could overwhelm some insurance companies, while causing others to go out of business.