Tremors of moral hazard

Is the federal government seriously considering a backstop of the insurance industry for earthquake risk? One would hope not given the speed at which federal debt is being ramped up. However, the Department of Finance has hinted this may be the case.

A consultation document on the federal financial services framework states the department is considering how to limit the system-wide risks that an extreme earthquake could pose to federal property and casualty insurers. Canada is vulnerable to a major earthquake in both the Vancouver region and the Quebec-Montreal corridor. The rationale given is that while insurers can manage the financial cost of any likely natural disaster, including a one-in-500-year earthquake, recent international experiences underline the high level of uncertainty in predicting damages in extreme earthquakes. Insurers remain exposed to tail risks (low-probability severe events) from earthquakes, and it is possible that insured damages could exceed the financial resources of some insurers.

The consultation document does not use the term “backstop,” but this is likely what is meant and the proposal follows calls from industry. The Insurance Bureau of Canada (IBC), an industry association for property and casualty insurers, flagged this issue in a submission that noted the use of public-private solutions in other countries to address catastrophic risks. The IBC submission noted a recent C.D. Howe paper that argued that a last-resort emergency backstop was needed to “ensure that a severe tail-risk earthquake does not become a systemic risk problem.” IBC has requested that the Department of Finance read the C.D. Howe report and engage in consultation with industry on how to implement credit ratings). However, an even bigger problem with a government backstop is the stress that would be placed on government finances.

Even without providing a backstop, Ottawa’s finances would be seriously impaired. The IBC submission cites a such as airports, bridges and ports, Ottawa would face major costs in disaster relief. This includes not only the immediate costs of food, shelter and medical assistance, but also Ottawa’s share of disaster financial assistance provided through an existing cost-sharing arrangement with the provinces. Loss of tax revenue would be another significant cost as there would be significant business disruption. Lastly, there is the exposure of a smorgasbord of federal programs and agencies that offer loans or loan guarantees that might take a hit on their existing loan portfolios or guarantees.

The federal government would be better off measuring its own financial exposure to a major earthquake, and developing a strategy for prudently managing this risk, rather than taking on risk from private industry. A backstop might ultimately prove to be a guarantee to an insolvent industry from an insolvent government.