Handling failed insurers

Last week I wrote a post prompted by the New Zealand Initiative’s passing suggestion that something like an OBR scheme might be established to handle failed (large?) insurance companies.  The New Zealand Initiative didn’t like the AMI bailout (neither did I) and the suggestion that an OBR option might be considered seemed to be mainly a way of helping ensure that losses lay where they fell, not with taxpayers generally.

I didn’t think that the OBR type of scheme –  focused on keeping the failed institution open –  made a lot of sense for insurers, but recognised the probable political imperative to limit the losses of at least some of those caught in a failure.   Deposit insurance is the typical, and sensible, response to that imperative in the case of bank failure, and some sort of limited policyholder compensation scheme could make sense for insurer failures.

I ended that post this way

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.

I wouldn’t have come back to the topic except that I just noticed a column on the idea of an insurance OBR from a columnist –  Fairfax’s Rob Stock –  who I usually have quite a bit of time for.   And there were a couple of aspects of that column that seemed quite misleading.   Here were some of the concluding sentences.

Taxpayer will end up spending about $1.5 billion rebuilding AMI policyholders’ houses.

That’s a lot of money, and economics think tank The New Zealand Initiative thinks we should consider an OBR for insurers.

In the case of AMI, which had around half a million customers with 1.2 million policies, that’d be around $1230 per policy.

Less OBR than OMG to people already in a financial hole as a result of their homes and belongings being damaged by the earthquakes.

It’s one thing giving bank depositors a haircut. It’s quite another putting families in dire financial straits into deeper holes.

 

Big general insurers fail after natural disasters, which really isn’t the time Kiwis will feel comfortable asking victims to stump up more money.

It also fails the fairness test.

How was any ordinary householder supposed to recognise AMI’s lack of reinsurance if expert regulators didn’t?

But…..losses don’t fall in all policyholders (and certainly not evenly –  someone with a $10000 contents policy, and another person with a $5 million house policy) but on the people who had claims outstanding at the point the insurer fails.   That is the parallel to the bank situation –  in a bank failure, all depositors have a claim on the bank, but in an insurance failure most policyholders have only contingent claims –  if something had gone wrong which could be claimed for under the terms of their own policy.  For some it had gone wrong at the point of failure –  eg a house severely damaged in an earthquake.  Other policyholders –  having paid their premium – will simply walk away from their worthless policies and look for alternative cover elsewhere.

I’m not sure quite how many claims AMI had outstanding at the point of failure, but I assume that the reported Southern Response numbers are a close approximation.    Their website suggests around 30000 claims.     If the bailout cost really does come to $1.5 billion, that would be an average loss –  for those with outstanding claims –  of around $50000 (the median losses would presumably be a bit lower).   That –  not Stock’s $1230 –  is the nature of the political problem: relatively heavy losses on a middling number of people.

Revealed preference –  the AMI experience –  suggests that governments are likely to jump in when a failure of this particular sort occurs (a lot of claims outstanding at point of failure, and the association with a natural disaster).  It might be better, even fairer in some respects, if they didn’t, but they almost certainly will.   (Why might it be fairer not to intervene?   Because there are all sorts of ways in which people experience unexpected, and not really foreseeable, shocks to their wealth and expected lifetime income.    There is serious illness for example, a cheating spouse and the end of a marriage, unemployment, or structural decline for a region of the country one had spent one’s life in.  In many cases, those losses will amount to materially more than the typical loss in, say, the AMI case, and generally we run a welfare system as a safety net against extreme poverty, rather than attempting to compensate people for the unexpected, perhaps uninsurable, losses.)

But if, dwelling in the world of the second-best, governments are likely to respond sympathetically to another failure like that of AMI –  which might well be 100 years away, or never happen –  we should be trying to devise schemes that channel, and limit the cost of, that political sympathy.    That is the point of suggestions like deposit insurance or –  in this case –  policyholder compensation schemes: the protection can be pre-funded, paid for by policyholders receiving the cover, and it can be limited (capped, to provide full or near-full cover to people at the bottom, and little to people insuring multi-million dollar houses or commercial buildings).    General bailouts –  like that of AMI, which Stock seems to have favoured –  are indiscriminate and unfunded.    Even without a pre-established scheme, a general bailout wasn’t the only option in the AMI case.

Stock’s final line also caught my eye

How was any ordinary householder supposed to recognise AMI’s lack of reinsurance if expert regulators didn’t?

Which might be a reasonable argument, except that………in February 2011 there were no “expert regulators”, or even inexpert ones, assessing AMI’s solvency, reinsurance etc.    The Insurance (Prudential Supervision) Act received the Royal Assent just a few days after the first Canterbury earthquakes in September 2010, and the Act came into effect in stages over the following three years.   There had never been prudential supervision of insurers in New Zealand –  and actually, there hadn’t been many failures either (as I understand it, one significant insurance company failure –  and that unrelated to a natural disaster –  in the previous 100 years).

Does that absolve policyholders of all responsibility?  No, I don’t think so.  I gather AMI was one of the cheaper options in the market, and everyone knows that that in itself can be a warning signal.  It was also a NZ-only firm, without any sort of parental support.  And markets develop mechanisms to monitor the strength of firms operating in all sorts of markets.  I’m not unsympathetic to people near the bottom of the heap who might have been caught up in the AMI failure, but the mere fact of the failure doesn’t make a compelling case for a general bailout.

What perhaps concerns me a little more is that (unlike 2010/11) policyholders do now have reason to think that “expert regulators” are monitoring and limiting risks on their behalf.  But I recall a discussion at the Reserve Bank’s Financial System Oversight Committee when the solvency standards for insurers were being put in place.  I asked the experts whether the proposed new standards would have been demanding enough to have prevented the AMI failure, and I was told that they were not.   After all, I was told, the ground acceleration experienced in Christchurch had been the sort of thing that might be expected every few thousand years, and no prudential regime was designed to prevent all failures.    I wasn’t entirely convinced, but I’m no seismologist.  And so it was sobering to read a few months ago that the November 2016 Kaikoura earthquake had recorded maximum ground acceleration substantially larger than that experienced in Christchurch only a few years earlier.   Fortunately, it didn’t occur close to a major residential or commercial area.

There still seem to be real limits to our understanding of the geology of this country.  Perhaps it raises some real questions about just how insurable earthquake (and associated tsunami) risk really is –  at least at prices that are generally affordable.  The idea of an insurance OBR seems to be ill-targeted, and really just a distraction from the real issues.  But a limited, funded, policyholder compensation scheme in respect of failures associated with residential earthquake (and perhaps volcano/tsunami) losses looks like something the government should be looking into.  Better that than rushed indiscriminate bail-outs when –  very rarely –  failures happen.

Of course, if – or when –  the very worst happens and there is another mega Lake Taupo eruption, what remains of the New Zealand government will have bigger concerns to worry about than the fate of specific insurance policyholders.