Fault Lines: Earthquakes, Insurance, and Systemic Financial Risk

The fault lines from a major earthquake in Canada could quickly spread through the insurance industry and have a systemic financial impact. Policymakers should take several steps now to avert this chain of events. Since the financial crisis of 2007/08, policymakers have focused on systemic risk to financial and economic systems, with most of the attention on the banking system. The framework for these efforts has been to build resiliency and shock absorbers to minimize the impact of financial shocks on the real economy. The inevitability of an earthquake in Canada poses a similar systemic financial risk for the insurance industry and the economy as a whole, and similar remedial efforts are required. A federal emergency backstop arrangement for property and casualty insurers, properly designed, would minimize the systemic financial impact resulting from such a catastrophic and likely uninsurable event on those affected and on the economy at large. The moral-hazard implications appear small compared to the benefits of avoiding serious systemic risk. The backstop arrangement should, however, apportion costs, including a possible tranche of further contingent risk-sharing with industry in a way that lessens moralhazard issues. A federal last-resort backstop guarantee could kick in beyond an industry-wide trigger of expected losses, say those associated with a one-in-500-year earthquake – currently approximately $30 billion to $35 billion. This loss estimate would be updated periodically, and the trigger could be set somewhere in excess of the one-in-500 threshold to promote further industry risk-sharing. That said, as part of any Canadian reform package, it is important to bolster the Property and Casualty Insurance Compensation Corporation to deal with insurance industry problems and reduce systemic impacts from severe catastrophes. This would also reduce the likelihood that a federal financial commitment would be triggered and, if triggered, would have minimum costs. Having more tools available in advance to deal with catastrophic events would reduce post-catastrophe disaster claims. This Commentary recommends the following: • Strengthen PACCIC so it can intervene before insurance companies in financial difficulty become insolvent. • Ensure PACCIC has the capability to borrow to reduce its liquidity needs in a crisis. • Following these structural changes, PACCIC should rerun its scenario models to examine how much that could increase resilience to extreme events. Furthermore, insurance industry bodies, as well as the federal and provincial governments, should undertake awareness programs to enhance homeowners’ understanding of catastrophe risks. This should encourage Canadians to evaluate the merits of disaster insurance coverage, particularly in the Quebec City-Montreal-Ottawa corridor where such insurance penetration is far too low. Finally, the insurance industry, under active OSFI supervision, should further develop its models for setting aside adequate capital and claims-paying capacity. Regulators should ensure there is an adequate degree of conservatism and that models are as up to date as possible. OSFI should regularly assess the adequacy of major insurers’ models, as they have done in the banking industry.