There was a curious suggestion in the New Zealand Initiative’s new report on the handling of the Canterbury earthquakes and possible ways ahead. Almost in passing they suggested that perhaps one way of handling failed insurance companies might be to consider an insurance company version of the Open Bank Resolution (OBR) scheme, that now sits in the toolkit as one (not terribly credible, in my view) instrument that might be used by a government to help manage a bank failure.
I think I see what motivated the suggestion. After the February 2011 quake, AMI failed, but instead of being allowed to close, with losses lying where they fell, the government (backed by – questionable – advice from The Treasury and the Reserve Bank) launched a bail-out. No policyholder lost anything. It set a terrible precedent – and wasn’t cheap either (final costs as yet unknown). And the OBR scheme had been motivated by a recognition that governments would probably prove relucant to let major banks close – how, for example, would solvent firms make their payrolls next week if their bank, relied on for overdraft facilities, suddenly closed? Rather than jump straight to a bailout – which would be expensive, send terrible signals about future distress episodes, but which would keep the lights on and the doors open – the OBR option was designed to allow a failed bank to remain open without any direct injection of public money. Losses would rest with creditors and depositors, but the payments system and the information-intensive business of business credit needn’t be directly disrupted.
As I say, the New Zealand Initiative people really only mentioned the issue in passing, but interest.co.nz picked up the reference and devoted a substantial article to it, including an interview with my former Reserve Bank colleague Geof Mortlock. So it is worth giving more space to my scepticism than the NZI reference alone would typically warrant.
In doing so, it is worth stressing that:
- banks and insurance companies are two quite different sorts of beasts,
- keeping a failed company open and operational is, at least in concept, a very different issue than protecting depositors or policyholders once a failure has happened.
Most of rely on banks being there almost every day. Whether we rely more on cash – and thus use an ATM every week or so – or mostly on direct electronic payments, we count on our bank being there. Incomes flow into bank accounts – be it wages, welfare payments, or whatever – and we count on being able to use those accounts to make routine payments, including things as elemental as food. Businesses often rely on bank credit to make routine payments, including such regular commitments as wages or materials. For small businesses in particular, those credit relationships are not easily or quickly re-established (and perhaps especially not if a bank with a quarter of all the country’s small businesses failed).
So there is quite a plausible case that there is some wider public interest in keeping the doors of a (large) failed transactions bank – Lehmans might be quite a different issue – open, even if the bank has been badly managed enough to have failed. There is a basic utility dimension to some of the core functionality. That is the logic of OBR – creditors (including depositors) should take losses, if losses there are, but keep the doors open and the payments flowing (even if the available credit balances are less than depositors had been counting on).
What about insurance companies? I’m sure most of you are like me. You pay your bills each year, and hope never to have any other contact with an insurance company ever. And even when bad things do happen, there (a) isn’t the same immediacy as about buying today’s groceries, and (b) a bad thing happening today isn’t generally followed by another bad thing happening tomorrow.
And banks are prone to runs in ways that insurance companies aren’t. They are just different types of contracts, for different types of products/services.
But focusing on insurance companies, it is worth unpicking the two possible (decent, economic) reasons why people might make a case for keeping a failed insurance company open, even with writedowns of policyholder claims.
The first relates to the immediate interests of people with claims outstanding at the point of failure. Typically that will be quite a small number of people (in which case there is no real public policy interest at all, and the failed company can simply be allowed to close, as was done with one other small insurer after the Christchurch quakes), but not always. AMI was brought low by one specific set of events – the Canterbury quakes – affecting quite a large chunk of their policyholders. Had AMI simply been left to fail, and normal commercial procedures taken their course, what would have happened? The policyholders with claims outstanding at point of failure (including those with houses damaged/destroyed in the quakes) had no particular interest in AMI continuing to trade as a going concern. They just wanted their claims settled, to the maximum extent possible. Wouldn’t a liquidator have needed to work out how large those claims actually were – an issue still in dispute in some cases – and then made a final division of the assets (including reinsurance) assets of the firm among all the creditors, including policyholders with claims?
Policyholders with outstanding claims had two interests:
- being paid out (whether in cash, or new home – under replacement policies) in full, or as near as possible, and
- being paid out expeditiously.
Liquidation is unlikely to bring about either, but neither is an OBR-type of instrument. The whole point of an OBR is that losses fall on policyholders with outstanding claims, and a statutory manager operating under an OBR faces much the same issues as a liquidator – needing to know the final value of all outstanding claims before final payments can be made and (thus) losses allocated.
So the interests of policyholders with outstanding claims can either be met by a bailout – often at considerable direct Crown expense, and rather bad market discipline incentives (although the role of reinsurance might mean those effects as less bad for banks) – or by a policyholder protection scheme, something similar in conception to deposit insurance. This is an option canvassed in the interest.co.nz article (and which I also favour, as a second best). Such a scheme – funded by levies on policyholders with cover – could be rather better tailored.
As I’ve noted, one reason OBR will probably never be used is because losses will fall as heavily on “innocent” grannies as on sophisticated offshore wholesale investors. There is public sympathy for one group, but not the other. Deposit insurance allows that distinction to be drawn. No doubt the same goes for the creditors of insurance companies. There is likely to be a great deal of sympathy for a poor family with a modest dwelling caught up in an extreme series of earthquakes – and an unwillingness to see them face, say, a one-third write-down in the value of their claim. But probably no one (other those directly involved) cares greatly if a family trust with a $4 million house in Fendalton and an expensive holiday home in Akaroa finds that, after the failure of their insurer, they can afford to spend only $2 million on a new house. It was one of the offensive things about the AMI bailout that everyone – rich and poor, sophisticated and not – was bailed out in full.
And so I probably would favour some sort of statutory policyholder protection scheme. I’d probably limit it to house insurance, fund it through levies on policyholders, and perhaps payout 100 per cent of claims for the first, say, $500000 of a claim, 50 per cent of the next $500000, and then leave people to the market for sums beyond that. It would meet most of the probable and inevitable political demand, if and when a major insurer fails amid a claims-surge such as a natural disaster, would facilitate early settlement of a major chunk of any residential claim, and would keep separate the protection of small policyholders from the managment of the failed business itself.
But perhaps the argument for something like an “insurance OBR” is stronger on another count, which has nothing to do with those with outstanding claims on the failing company at the point of failure. When an insurance company fails, your existing insurance policies with that company are no good. You need to take steps, perhaps quite quickly, to replace the insurance.
Sometimes that will be easy enough. If a small contents insurer failed today, out of the blue, most customers would have no great difficulty getting a new policy in place quite quickly. But in other circumstances it could be quite difficult. The failed insurer might have specialised in a particular type of insurance which few other companies offered (this was an issue when the big Australian insurer HIH failed).
In a domestic New Zealand context, there seem to be two sorts of plausible problems. The first is that one company – IAG, through its various labels – has around 50 per cent of the general insurance market in New Zealand. As the interest.co.nz articles notes, even the Reserve Bank has expressed some unease about this concentration. Should IAG fail, it might be very difficult for customers to replace their policies quickly with other companies. “Might” because other companies, including abroad, might be keen to pick up the customer base, especially if the failure resulted from a well-understood, limited, idiosyncratic event. But even if this is an issue, it looks like an issue that should have been able to be taken into account when the various takeovers that led to IAG’s dominant position were approved.
Perhaps more of an issue is if we were to see a repeat of a large failure associated with a series of destructive earthquakes. In the wake of the Canterbury earthquakes – and indeed, after Kaikoura in 2016 – people kept their existing house cover with their existing insurer, but insurers were very reluctant (typically simply refused) to extend cover. Even alterations to an existing dwelling didn’t get covered, and it was almost possible for a new purchaser to get insurance. It was quite rational behaviour by the insurers – risk (of further quakes) around the affected locality, and unpriceable uncertainty, had increased a lot. That complicated the house sales market for a time – an inconvenience but not the end of the world. But imagine that a large company simply failed, leaving most of their customers needing to replace their policies immediately (from personal prudence as well, typically, as from a requirement of a mortgage lender). There would simply be no takers, at least in affected regions. I don’t suppose banks would suddenly start selling up customers caught temporarily without insurance, but one can’t deny that there would be an issue. Politicians would respond.
Something like an OBR for general insurance might be a remedy to that particular problem. The failed company would remain open, and presumably existing policies would remain in place.
But is it worth it? Personally, I’m a bit sceptical. There is no widespread public interest in the continuity of insurance companies across all products. Housing may well be different – and would no doubt be seen so politically. But in the event of a failure, in circumstances akin to AMI (natural disaster with ongoing extreme uncertainty) but in which the insurer was actually allowed to close, might not a less bad, less intrusive, intervention be something like an ad hoc intervention in which the Crown took over the existing residential insurance policies for six months after the failure, in the expectation that after six months policyholders would have been once again able to make private insurance arrangements. It doesn’t look like a scheme that would materially undermine market discipline – those with outstanding claims at point of failure would still be exposed – but might recognise that in certain rare circumstances markets can simply cease to function for a time. And still allow the salutary discipline of a failed entity passing into history.
In sum, I probably would favour a limited policyholder compensation scheme, funded by policyholders, at least for residential insurance policies. It isn’t a first-best policy, but in a second or third best world it seems better, and fairer, than generalised bailouts such as the AMI one. But an OBR-type arrangement doesn’t seem appropriate for the general insurance industry – it wouldn’t speed final resolution of claims, wouldn’t focus protections where the greatest public sympathies are likely to be. If it didn’t involve the sort of panoply of new controls and provisions the bank OBR system does, it just doesn’t seem well-tailored as a general response.