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.

15 thoughts on “Handling failed insurers

  1. Reblogged this on The Inquiring Mind and commented:
    Interesting and I will need to think about this for a while. The lack of an appropriate regulator is a worry.
    Plus re AMI it was a mutual and as such the policyholders were technically at risk for at least part of the losses. It could well be argued in AMI case that it was doomed to fail. It was just a case of when.

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    • This recent storm affecting coastal and low lying properties close to waterways throughout NZ with King tides and flooding is just a taste of more to come in the future. Insurere will have to stop insuring these properties at risk within the next 5 to 10 years or even sooner. So who will be responsible to pick up the tab for these billions of dollars of at risk properties??

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      • My hope is that actual losses are small enough and scattered enough across place and time etc that the losses are largely left to lie where they fall. But there are choices for larger communities about sea-walls, barriers etc. Amsterdam, after all, is 2 to 4 metres below sea level.

        I’m personally not that bothered about climate change etc – this warmer summer in Wgtn has been wonderful – but holidaying in places like Ohope, I realised that I would now be very reluctant to buy beachfront property there. Presumably many of the losses are slowly crystallising already – lower market values for these properties now, and any future buyers will – in principle – be trading cheaper entry levels against a rising probability of uninsurable flood damage etc.

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      • Unfortunately, most of these beachfont properties are already in private ownership and rates are being paid to the local council, some are at very high valuations.

        Phil Goff is already making noises about protecting these coastal properties and the local council rates of many will go towards maintaining the lifestyle of the few that have already made poor investment decisions by buying at high valuations or maintaining local council valuations. Of course he will will try and seek government/taxpayer bailout if there is a budget blowout.

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  2. AMi was a domestic mutual insurer – each policy holder reinsuring the other. Ok for random events I guess reluctantly – but for a country prone to natural occurrance, no.
    There may have been no Regulator, but that is just a Government deficiency – which they acknowleged and paid for.
    AMI was a low cost operator (except probably for commissions), it swamped the residential housing market with pricing based on no capital to service and inadequate reinsurance. It distorted any true market and
    deflected alternate entry.
    It’s no surprise that RBNZ Financial System Oversight Committee solvency standards would not have prevented AMI failure; but they might/should have prevented AMI continuation.

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  3. Not sure I agree – including not that the mutual model for insurance was a pretty longstanding successful one. I’m not sure it is particularly suitable for banking, but in insurance – given pretty extensive offshore reinsurance markets – it doesn’t seem particularly problematic. Solvency standards take account of the extent of reinsurance.

    My specific point about the new solvency standards was whether they would have compelled enough reserves and/or reinsurance that would have covered the losses from the Canterbury earthquakes. If it didn’t, one had to wonder what was being gained by the addition of legislated prudential supervision, given that without prudential supervision we had gone for 100 years or more with no major domestic insurance failures (Standard Insurance was about the Aus operations).

    My point about the prior absence of supervision is that policyholders pre 2011 were not relying on prudential regulators: it was no secret that there were none. But even if prudential supervision had been in place pre 2011 one would have to wonder how much difference it would have made, incl to the later govt losses. After all, the RBNZ solvency stds, imposed after the quakes, were more demanding than those in Aus, and yet Bank staff were quite clear that even those more demanding standards would not have covered the losses. RBNZ supervisory philosophy was never likely to have intervened in underwriting standards directly, let alone product pricing.

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    • My point is more simple. MFL were selling insurance with an undisclosed cap on the amount they could possibly payout. Like the so called finance companies it shouldn’t have been allowed to evolve. Not neccessarily a supervisory issue; but in the realm of misleading, deceptive or fraudulant offerings.

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      • Of course, all limited liability companies are trading with an implied but unstated cap on what shocks they can endure. (I’m not attempting to defend AMI or its management, but it is probably fair to note that the scale of the Chch earthquake shock was well outside the range of reasonably expected events, and several other insurers were placed under severe stress – in some cases, might not have survived to make complete payouts without overseas parents)

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  4. The layman buying insurance is not buying a financial gadget, they are trying to buy peace of mind.

    Buying my first car in NZ many years ago I bought insurance from what appeared to be a large well reputed insurance company and over the last decade I have renewed without considering what might happen until reading this article. If my car insurance company went bust in the interval between having a serious accident and a claim being processed and that left a 3rd party needing millions in future health care then I would be in a very sticky place having to liquidate all the assets that I was intending to bequeath to my family. Obviously I need my insurance company to be doing its job properly with a CEO and board that ensures suitable reinsurance is in place. By my concept of fairness I would like the government to bail me out and the management of the failed company to be in jail and their possessions confiscated. This may be difficult with foreign owned businesses.

    The problem in the UK and NZ is that bosses accept very large salaries for their responsibilities but when the ***t hits the fan they duck. That doesn’t apply to partnerships in Lloyds of London with unlimited liabilty.

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    • Fortunately in NZ we have ACC which eliminates any exposure to you or your insurers to current and future medical liability. Damages not covered is mainly in the damage of vehicles and property. Just don’t whack a brand new Lambrogini or plough into the nearest Macdonalds and wreck a million dollars worth of kitchen fittings.

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  5. With respect to the Insurance (Prudential Supervision) Act 2010, one odd note that sticks out that deserves explanation unless it was pure coincidence – but then I don’t much believe in coincidences

    Here is a timeline of the passage of the Bill through the Parliament
    https://www.parliament.nz/en/pb/bills-and-laws/bills-proposed-laws/document/00DBHOH_BILL9659_1/insurance-prudential-supervision-bill

    The National Government was elected in November 2008 and Bill English introduces this bill in October 2009

    Introduced October 2009
    First Reading December 2009
    Select Committee May 2010
    Second Reading July 2010
    Whole House Committee August 2010
    Third Reading August 2010
    Royal Assent 7 September 2010

    First Christchurch Earthquake 4 September 2010 4 days earlier

    Question is, after 100+ years without Prudential Supervision, in the first year of government of 2009 Bill English introduces a bill of great significance

    what did he know?
    What suddenly prompted that bill?
    Were there urgings from within the industry or was it from the mandarins within Treasury or RBNZ?

    There’s an element of prescience to it

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    • From memory, the prudential regime for insurers (as for finance companies) stemmed from the IMF’s FSAP (financial system assessment programme) on NZ in 2003/04. It is largely a box-ticking exercise – do we do things as per international regulatory templates – and in the process the reviewers highlighted that we didn’t have much of a regulatory regime for either class of financial institution (again, from memory one used to have to lodge a bond of $0.5m to be an insurance company). Finance company failures stepped up progress on a supervisory regime for non-bank deposit takers, but insurance lagged behind – there was no domestic imperative for it, and no one really wanted to do the job (the RB was quite explicit we didn’t want it – different set of expertise etc). I remember going as far – while i was at Treasury in the early days of the Key/English govt – as arguing that if the govt was really serious about lightening business regulatory burdens and making fiscal savings, they could simply not proceed with the planned insurance regime. It was probably just as well no one heeded that perspective, or we’d just have rushed a new regime anyway after AMI failed.

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  6. It is completely wrong to say that FSAPs are ‘tick the boxes’ exercises. Michael – you have never participated in an FSAP to my knowledge. (Correct me if I am wrong.) In contrast, I have undertaken FSAPs in many countries for the IMF and World Bank. And I can assure you that they are not tick the box processes. That is an ignorant view popularised in the RBNZ out of a defensive position the RBNZ takes on just about everything. FSAPs involve comprehensive assessments that draw on international standards but are tailored to the particular needs of the country in question. And they involve far more than just assessment against standards and codes. So, please, in future, if you are to comment on the FSAP process, do it from a well-informed basis rather than a simplistic knee-jerk reaction.

    And just to get the story right on this – from someone who actually was involved in the insurance reforms – the thinking that led to the IPSA reform was triggered in part by the IMF FSAP of 2003/04 and in part by a domestic reform agenda to review the entire non-bank financial sector regulatory framework, led by MBIE with active RBNZ participation. That reform process was already in part under way and already planned in other respects. It looked at much more than insurance. And it found the pre-existing regulatory framework lamentably inadequate. I dread to think what kind of mess the country would be in now without those reforms if we face another natural disaster or severe financial shock.

    The FSAP is the ONLY independent external review/audit of NZ financial sector arrangements. Without it, NZ would drift from ad hoc reform to ad hoc reform without any meaningful anchor or benchmark. Thank God for the FSAP or something like it.

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    • Geof

      I don’t want to get into a big argument about the IMF generally, but suffice to say I have less confidence in them, and their reviews – whether macro or financial – than you appear to. I did get to observe quite a few FSAPs coming thru the Fund Board during my time on the Board, and was involved in the 2003/04 FSAP, travelling with the mission team and articulating the NZ case to the Board. My memory of that particular FSAP was fairly “tick boxes” in nature, and when I went back to read the report I didn’t find anything of particular added-value in it. The real point of my comment you are objecting to was simply that that particular FSAP offered no real insight on looming vulnerabilities/risks and (around insurance) there wasn’t much such awareness around Wellington over the following few years – a response to my commenter’s suggestion that perhaps someone was prescient. That wasn’t a criticism, just a description.

      I guess the real difference between us is captured in this comment: “I dread to think what kind of mess the country would be in now without those reforms if we face another natural disaster or severe financial shock.” By contrast, I don’t. It isn’t that i strongly object to all the various reforms – actually, I’d probably make NBDTs subject to a standardised bank regime – but officials (and consultants) are often prone to overstating the extent of any beneficial difference regulation makes.

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