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.

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.