A curious suggestion

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.

 

 

8 thoughts on “A curious suggestion

  1. An aside ….

    “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”

    That is precisely the intention of Benjamin Shalom Bernanke when he commenced Helicopter Money Drops – it was a six-month safety-net that didn’t work followed by 4 more programs lasting 10 years and the safety-net is still there

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  2. partly true, altho there is no new QE occurring.

    But the parallel i had in mind, but didn’t mention in the post, was the govt intervention in the US post 9/11 to provide emergency insurance for airlines for a limited period in circumstances in which the market had ceased to operate for a time.

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  3. Just after the Christchurch earthquakes I “tried” to research the financials of the EQC – how much money they were holding in their saddle-bags – There was no information available in the public domain – none that I could find despite persistent effort. It was fairly evident that while the government was claiming the event as a $15 billion disaster it was going to be more in the region of $40 billion – they said EQC would cover approximately $5 billion which after allowing for re-insurance has turned out to be beyond incompetent. This was an organisation that had quietly collected premiums for 60 years and when the SHTF was found wanting – since then premiums have doubled from their 1950’s base – hardly comforting

    Given the nature of NZ I would like to see an EQC run on totally professional lines and not just a bureaucratic back-water with fully published and audited annual financials

    It grieves me to see Southern Response and EQC wielding immense power over the lives of (affected) New Zealanders in a less than professional manner

    In the meantime EQC has disappeared back down into the swamp where sunlight doesn’t penetrate

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    • It is quite easy to check EQC’s financials. It reads “zero”. Unfortunately the cupboard is bare. Repairs have been slow because the National government has been trying to aim for a budget surplus when there should have been deficits which a planned mini QE of $50 billion would have been the best option at the time.

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  4. Reblogged this on The Inquiring Mind and commented:
    This is an interesting area worth debate, especially in the NZ context. Unfortunately many people, including our politicians have never it seems taken the time to understand insurance, especially the critical role that reinsurance plays

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  5. How about looking at the exercise differently.
    The failures were bought about by two simple items.

    1. Failure to properly know fully and quantify the risks.
    Insurance companies were happy to compete on price and on desktop rather than do the hard graft and identify the risks which were well known but ignored by councils and govt. alike. That led to the under insurance of the risks. CHCH is the second most likely area in NZ to have these earthquakes.
    On that basis alone everyone was under insured.

    2. Cheap insurance and cheap results. Cheap rents for old buildings that would not have been rented if the insurance costs had properly reflected the rebuild costs. (that includes the infrastructure costs that the council needed to fund. i.e. higher rates reflecting the risks.) Buildings that should have been torn down years ago in anticipation of the certainty that those risks would arrive sooner or later. Much driven by the Heritage rubbish that prevented better developments being in place. Note that while lots of the old just fell over mostly the big new did their job. None collapsed in the first quake thus allowing occupants to escape safely. The problem then was that unsafe buildings were certified as safe and reoccupied. (Note that in Wgtn,. that hasn’t happened. Every body out and stay out.)

    IMHO CHCH Council were culpable for the deaths that occurred because they were and remain the certifying authority that allowed the risk buildings to remain and allowed new building on land that the engineers had long ago warned was not suitable for building on.

    All this to suggest that in the case of insuring events of nature NZ needs to better understand and have a published risk table that cannot be ignored when it comes to insurance.
    Different area’s different risks.

    Its often said that Insurance companies are good at assessing risk. CHCH proves that simply is not so.
    AMI’s failure was because they undercut other companies, didn’t have enough margin to re insure at the level needed and more importantly had too much of their business with one customer i.e. CHCH.

    Why would we not set the risk levels that need to be insured against?
    Monitor those companies who sell that insurance in the market.
    Require those companies to have an adequate level of reinsurance and a cash tin where the cash is available when needed.
    After that make the shareholders of those companies responsible like all other companies have to be, much as in the H&S regulations. No sneaking out of those ones anymore.

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    • To be fair, I don’t think anyone anticipated a Earthquake fault line in Christchurch. You can’t very well price a unknown risk. The question now is with billions of dollars of property along the ocean waterline and rising oceans. Are these properties going to be insurable in the next 5 to 10 years?

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