Balance crucial for capital requirements on earthquake, OSFI superintendent Rudin says at NICC

VANCOUVER – Capital requirements could always be increased to cover an extreme event, such as a huge earthquake in British Columbia, but a balance must be struck, Jeremy Rudin, superintendent of the Office of the Superintendent of Financial Institutions (OSFI), suggested during a Q&A at NICC in Vancouver.

“We have to pick a spot that finds the right balance between the two parts of our mandate. 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,” Rudin said in response to a question posed by Don Forgeron, president and CEO of Insurance Bureau of Canada (IBC).

Pointing out that “in a few years, Canada is going to have one of the highest capital standards for earthquake,” Forgeron had asked Rudin’s thoughts on a new C.D. Howe paper, written by former federal superintendent Nicholas Le Pan.

Le Pan recommended development of a last-resort federal emergency backstop arrangement for property and casualty insurers to minimize the systemic financial impact resulting from a “catastrophic and likely uninsurable natural disaster.”

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

Calling earthquake his “favourite example of the balancing act,” Rudin told attendees that OSFI “can raise capital requirements even further and that will make even more secure the potential payment to insure earthquake peril.”

However, “we know that increases the cost of providing the coverage.” As such, and because earthquake coverage is not compulsory, “it will reduce the number of people who are covered,” he explained.

“At some point, we could have what we believe to be completely bullet-proof earthquake capital requirements and it will definitely protect the one person who bought earthquake insurance,” he quipped.

Still, “implicit in this is that there is a not completely unimaginable peril beyond which the capital requirements will not be sufficient,” Rudin told attendees.

“A high-intensity earthquake in a large urban centre is a severe, but plausible, event that Canada has yet to experience,” he said in a speech prior to the Q&A.

“It 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,” Rudin said.

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.”

Insurers still must continue to stress test their particular exposures in assessing their own capital needs, he said.

During the Q&A, Rudin pointed out the MCT is “not a substitute for the analysis that each individual firm needs to do and it’s important to emphasize the responsibility of the firms themselves.”

Rudin said in his speech that “catastrophic disasters are, by definition, rare, so previous loss experience is a relatively poor guide to the future. The industry is always running a race between its ability to gain and understand data and potential drift in the exposures.”

Both insurers and regulators “have to be conscious of the fact that mitigation activities may not keep pace with the evolution of the risks for whatever reason, in part because the evolution of the risks is very difficult to assess,” Rudin said during the Q&A.

This is why he views Cats as “the prototypical emerging risk issue. Even if the underlying distribution of Cat losses doesn’t change, we don’t have a very good sense of what it is. Why? Because we don’t get enough observations,” he said.

“If the distribution is changing – as we have every reason to believe it is – and in an adverse way, we have very few observations that allow us to update that.”

Insurers would be well-advised to focus on staying ahead of risks and “be aware of the possibility that catastrophic events, particularly weather-related disasters, may become more frequent and more severe,” he noted in his speech.

As well, a need exists “to go beyond focusing on the most apparent risks and broaden their scope to include emerging risks and the exposures that arise from risk transfer and mitigation activities.”