insurance

Disclosing regulatory actions

Michael Reddell insurance, Regulation, Reserve Bank

I haven’t followed the CBL saga very closely at all. (Disclosure: until the end of 2014 I was a member of the Reserve Bank’s Financial System Oversight Committee, which advised the Governor on prudential policy matters, including insurance prudential supervision.  That Committee rarely dealt with individual institution issues, but nonetheless was part of the overall atmosphere around the Bank’s approach to regulatory and supervisory issues.)

But the one aspect of the CBL story I had paid attention to was the decision by the Reserve Bank in 2017 to ban CBL from telling shareholders, policyholders (actual or prospective), or other creditors of the Bank’s regulatory actions and interventions (specific directions).  It seems extraordinary to say that managers and directors of a company cannot tell their owners –  the people they actually work for – about important developments affecting their (the owners’) company.   It runs against most canons of what we understand about the importance of trust, or disclosure, and of the relationship between principals (owners) and agents (managers and directors).

I also haven’t yet read the full report the Reserve Bank commissioned on its handling of the CBL affair (and remain sceptical that a report commissioned by Bank management –  and which apparently sought no outside perspectives – was likely to be even close to a definitive assessment).  But I did turn to the short chapter 15 (from p136) on “Confidentiality and Disclosure”.

In that section, the reviewers outline the relevant parts of the legislation that the Reserve Bank was using, and was constrained by.   They refer first to Section 135 of the Insurance (Prudential Supervision) Act covers the protection of data supplied to the Reserve Bank for prudential purposes.  This provision is not actually very relevant here: it is mainly designed to ensure that the Bank –  and Bank staff –  can’t, by accident or intent, treat confidential information lightly.     And even then, the Bank itself can choose to release material in a number of circumstances, including these two

(c) the publication or disclosure of the information, data, document, or forecast is for the purposes of, or in connection with, the performance or exercise of any function or power conferred by this Act or any other enactment; or
(e) the publication or disclosure of the information, data, document, or forecast is to any person that the Bank is satisfied has a proper interest in receiving the information, data, document, or forecast; or

Section 136 also allows the Bank to approve publication.   And so stories that suggest that the Reserve Bank was not free to publish information about its concerns or its actions, under pain of potential heavy fines, are just not correct.  The reviewers themselves run this quite misleading line.

The confidentiality obligation on the Bank is an onerous one. Officers and employees of the Bank, and investigators, are liable on conviction to up to three months’ imprisonment and/or a fine up to $200,000 if they do not comply with this provision.

Rogue or cavalier employees are (rightly) at risk.  The Bank itself has considerable protections and freedom of action (again, largely rightly so).

The reviewers then turn to the (much more relevant) provisions around the disclosure of the giving of directives.  In July 2017, the Bank issued to CBL Insurance a direction covering a variety of matters, operating under section 143 of the Act.   Section 150 of the Act makes it an offence for anyone to disclose (other than to directors and advisers of the directed entity) that a direction has been given.      Again, there are substantial fines for breaches.  But, again, this provision of the Act did not constrain the Reserve Bank, because the Bank itself is free to disclose the existence of the direction, or to allow others to disclose the fact of the direction.

The Bank itself has subsequently sometimes sought to imply that really the confidentiality of the directions was CBL’s choice, arguing (factually correctly) that when in February 2018 CBL requested that the confidentiality restriction be lifted, the Bank agreed.    But that looks a lot like distraction. It is clear that, whatever the views of CBL managers and directors, in July 2017 the Reserve Bank was insistent on keeping the fact and content of the direction confidential. It acknowledged as much in a response to an OIA request from NBR in April 2018.

The Reserve Bank’s self-chosen reviewers (the one with some expertise in the field being a former Australian insurance regulator) backed the Reserve Bank’s call on this point.

It was appropriate to maintain confidentiality over these steps. Matters were at a fact-finding stage. The Bank had serious concerns that warranted action, but it had not yet gathered the relevant information, tested it with CBL, and arrived at a sufficiently informed position. Obviously public disclosure of the fact of an investigation or initial concerns that have not yet been tested would be highly damaging to the reputation of CBL and to the value of its parent.

Except that by this time matters don’t seem to have been just at the fact-finding stage.  Rather, the direction imposed specific restrictions on CBL Insurance’s business –  the sort of action the Reserve Bank never engages in lightly (and, as the rest of the report apparently elaborates, coming after several years of concerns and fact-finding).

The reviewers go on to defend the Reserve Bank, arguing

The primary reason for confidentiality is that the Bank, quite correctly, is cautious about releasing information on any licensed insurer (or licensed bank) that may affect public confidence in the licensed company until the Bank is sure of its position. The confidentiality requirement, however, creates a quandary for the boards of listed companies who have a continuous disclosure obligations under NZX rules/Corporations Act 2001 (AU) rules.

In the CBL case, the position is also confounded to some extent by the fact that CBL Insurance is a subsidiary of the listed entity, CBL Corporation, which itself is not licensed.

Given the risks to public confidence in a licensed insurer if the Bank is carrying out an investigation or otherwise querying the credentials of an insurer before anything is proven, it is entirely appropriate for the Bank to maintain confidentiality by not making any public disclosures itself and also exerting control over any potential disclosures by the insurer.

Expressed another way, it is important that the Bank retain the power to intervene at any time in the affairs of an insurer. The Bank has to be able to recognise and choose to act early on any potential risk issue that it identifies and it also has to be able to stand back, without adversely affecting public confidence in the insurer, if the potential risk is not realised.

Before concluding

The Bank’s actions in relation to confidentiality and disclosure in 2017–2018 were appropriate.

We do not consider there was any earlier occasion when it would have been appropriate for the Bank to make public disclosures.

The lack of disclosure at the time of interim liquidation can be said to have been awkward for shareholders because, with no prior disclosure by the Bank or CBL, they were deprived of information that they may well have judged to be relevant to their position as investors. Arguably it was also awkward for policyholders, but that is a secondary matter in the eyes of investors.

On that point we note that CBL Corporation issued two relevant press releases in August 2017. In the first, on 18 August 2017, it disclosed concerns by the Gibraltar FSC over Elite’s claims reserves, the Gibraltar FSC’s reference to possible inadequacy of CBL’s claims reserves, and announced a reserve adjustment. The CBL Corporation share price reacted at the time, falling some 30%, but a week later there was a second press release that promoted the company’s prospects and gave a purported explanation for the claims reserving adjustment. The share price recovered by around 10% and then remained more or less static until suspension of trading in February 2018.

It is the policyholders, however, to whom the Bank owes its responsibility, not the investors. The Bank’s essential prudential concern always must be that policyholder promises can be honoured, irrespective of the fate or views or fortunes of shareholders.

I’m not entirely persuaded, on a number of counts.  And I say that even though it is quite plausible that the way the Reserve Bank handled this specific aspect of the affair (non-disclosure) might have been in accord with common supervisory practice.

Here it is worth having a look at some of the specifics of the New Zealand act.  For example, the purpose provisions in the legislation

IPSA 1

When this legislation was being planned I argued that only the first strand should be included, and recall arguing explicitly that having “promote public confidence in the insurance sector” could, at some future date, be used to defend keeping real problems secret, in ways that might support short-term confidence, but would risk undermining long-term confidence in the sector and in the regulation/supervision of the sector.  That seems like a valid concern.  But even with that provision in the legislation, it provides no clear guidance on whether specific regulatory interventions should be kept secret, since the goal is not to protect individual firms, but with a sectoral focus.  And if one believes in the efficacy of supervision –  I tend to be sceptical –  knowing that the regulator is (a) on the ball, and (b) not hiding stuff, is most likely to support a sound and efficient sector over time, and support public confidence in the bits of the sector where such confidence is warranted.

The Act next has a long laundry list of “principles” –  no hierarchy, no weighting, no nothing (the sort of list Paul Tucker, in his book on delegated power, including to central banks, frowned on).

IPSA 2.png

But they are still worth mentioning because, contrary to what the reviewers imply, the New Zealand framework is not exclusively built around policyholder protection; indeed, even the one bullet that explicitly mentions policyholders puts the “public interest” as of equal importance.  As importantly, look down a couple of rows and you find another principle:  “the desirability of providing to the public adequate information to enable members of the public to make those decisions” (ie regarding insurance), which might argue for as much transparency as possible.  In short, you could pick any approach you like out of these purposes and principles (which makes it bad legislation from a citizen perspective –  albeit beloved by officials), and none of these specific considerations are discussed by the reviewers in considering the disclosure/confidentiality issues around CBL.  At least from the wider public perspective, that was a missed opportunity.

It is worth bearing in mind that as a society we have generally come to favour the continuous disclosure approach various stock exchanges have now adopted. Inside information is supposed to be kept to an absolute minimum, with owners being presumed to be entitled to know of any material developments affecting their companies.  Shareholders provide the capital than underpins the provision of services and markets, including those in insurance.  Continuous disclosure provisions typically have a carve-out where disclosure is prevented by law, and that is what the parent of CBL Insurance relied on in this case (that NBR OIA I linked to earlier has the text of email exchanges with CBL’s lawyers on non-disclosure to the market).   In this case, there was no automatic protection for information about the Reserve Bank’s direction –  which was highly relevant to shareholders, and others dealing with the company and its associates – since the Reserve Bank had full discretion to allow the fact of the direction to be disclosed (an option it explicitly rejected in an email dated 22 August 2018).

In this case, it may well have suited both the Reserve Bank and CBL managers/directors to keep the directions confidential, but their interests are not necessarily representative of either the public interest, or of the specific interests of the owners of CBL, or those dealing with the company. It isn’t even clear that their preferences aligned with the interests of policyholders, here or abroad: rather it is a paternalistic approach that says that the supervisor is better placed to look out for the interests of policyholders than are (actual or potential) policyholders themselves.  The evidence for that proposition seems slim –  including, in this particular case, based on what we read of the Bank’s handling of CBL over several years.

There are no easy or straightforward answers to these issues, which is why it would be valuable to have a fuller, and more open, exploration of the issues.    In principle, I believe it would be better –  including reducing the risk of the supervisory being morally liable for any later losses in a failure event –  for the default presumption to be that any use of formal direction (or similar) powers by a prudential regulator should be disclosed by that regulator, and should be subject to usual continuous disclosure provisions in the case of listed entities.     The alternative both corrodes public trust in regulatory agencies –  what are they up to that we don’t know about? –  and corrodes the trust that needs to exist, and be robustly nurtured, between managers/directors and owners and creditors of private business entities

But there are risks to adopting this approach.  The ones I’m concerned about – at least in the insurance sector –  aren’t some sort of market panic (runs on insurance companies don’t have the meaning they do for banks).  The share price of a listed entity might fall sharply –  but that seems an appropriate possibility –  and people might become more reluctant to deal with the firm (ditto, at least until after hard questions have been adequately answered).   My concern is more that disclosure might make the supervisory entity more reluctant to act when it should, and more reliant on moving into the non-legal shadows, relying on pressure and threats of direction.  Perhaps too we would risk seeing courts more actively involved as the regulated entity sought injunctions to stop a supervisor using directive powers?     Those are real risks that need debating, but they should not be conclusive arguments, especially when the alternative involves the regulator and managers/directors getting together to keep highly valuable information from shareholders (whose money is mostly at stake), policyholders, prospective policyholders, and other creditors.

My interests are really less on the specific CBL case –  although specific cases help focus attention –  than on thinking about potential problems with banks at some future date.  There are very similar powers in the Reserve Bank Act re the confidentiality of directions to banks, and the issues get even more complicated because (a) bank runs are a real issue, (b) our bank supervision legislation does not have a depositor protection focus, (c) the disclosure regime has been designed to encourage creditors to take responsibility for themselves, (d) the proposed deposit insurance regime is very limited in scale, and (e) most of our banks are subsidiaries of foreign listed entities (can the Reserve Bank enforce directions on Australian parents?).  My own prior is that the world’s banking regulators do not have such a stellar record that we should be entrusting them with such powers of coerced silence, preventing companies telling their shareholders and creditors etc that they are subject to directions from the regulatory authority.  Perhaps the best thing might be more directions, made public at the time they are given as a matter of routine, so that markets, media, and the public can learn to weigh and evaluate the significance or otherwise of the issues and risks the regulator is highlighting.

I’m sure mine is a minority position, and I’m putting the issue out there as much as anything to try to encourage some reflection and debate on the issues.  In reality, perhaps the issues are not be black and white (in general –  although each specific involves final decisions), but regulators need to demonstrate that they have earned the trust, and extensive powers, reposed in them.   And our laws, and the applications of them, should be framed against principles of open government, accountability for regulatory agencies, and a belief that –  within government and within firms –  sunlight is typically the best disinfectant.

On which note, it is now the school holidays and we are heading off to find some sunshine and warmth.  Most likely there won’t be another post here until 23 July.

 

 

Handling failed insurers

Michael Reddell insurance

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.

A curious suggestion

Michael Reddell deposit insurance, insurance

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.