Political Tremors

Welcome to a bright new bushy-tailed beginning of a year, or for that matter a new millennium, depending on your sentimental versus mathematical calculation. And, indeed, it would appear to be a bright year ahead, with fat company surpluses on record and a definite sense that market rates, both commercial and personal, are turning the corner for the better. Although this more upbeat marketplace will not translate into significantly improved bottom-line figures for the financial 2000 year, it would seem based on current data that the industry is set to achieve a reasonable return for the year after.

However, there is perhaps one area of concern for insurers in coming months — that being an apparently strong position being adopted by the Office of the Superintendent of Financial Institutions (OSFI) on earthquake reserving, or to be more precise, the lack thereof. Despite repeated assurance by OSFI sources that prescriptive earthquake reserving will be brought to the table in coming months, industry sources involved in discussions with the regulator in this regard believe that such a possibility is unlikely. That said, an industry source admits that the prospect of compulsorily reserving will prove a major headache for companies.

Although OSFI is not willing to release figures on the current level of voluntary earthquake reserving made over the past year since the legislation was introduced to do so, the amount set aside by insurers is believed to be minimal. According to Paul Kovacs, vice president of the Insurance Bureau of Canada (IBC), the reason for this has been obvious: based on the soft reinsurance market conditions of the past year, and within the allowance of the OSFI earthquake guidelines, insurers have rather opted to cover their exposures through reinsurance facilities than topping up reserves. In addition, as Kovacs notes in a speech presented to the International Association of Insurance Supervisors at their recently held annual meeting, the incentives built into OSFI’s guideline for voluntary reserving is presently inadequate. Simply put, there is no financially sound reason for an insurer to go the voluntary reserving route rather than offsetting the risk exposure through reinsurance and other mechanisms allowed under the guideline. “I understand that few insurers used the premium reserves during this first year, as traditional reinsurance coverage is the preferred approach at this point in the reinsurance cycle, also there are relatively few incentives found in the current design of the earthquake premium reserve.”

Kovacs points out, however, that the industry is fully covered in terms of its current estimated earthquake liability, that being to meet the insured cost of a potential 250-year event which translates into a 0.4% chance of an earthquake of such magnitude occurring in the coming year. It is estimated that the insured loss of a 250-year earthquake in Vancouver would, in today’s terms, be around $9-$10 billion with a similar event in Montreal costing $3-$4 billion. The overall damage cost of a 250-year earthquake in either Vancouver or Montreal is estimated at $30 billion (The OSFI earthquake guideline currently only applies to exposures in British Columbia and Quebec).

In contrast, Kovacs refers to an industry estimate of around $11 billion in insurance capacity currently available to meet an earthquake loss. “The regulator is presently evaluating the results [of the guideline] of the first year of the program…few insurers had difficulty demonstrating that capacity was in place to handle a 250-year return period earthquake, and many could already show that they could fully address an even larger exposure.”

Although Kovacs would not be in a politically-correct position to state this, the real issue which seems to come to the fore over the haggling position being taken by OSFI is whether the regulator itself is sufficiently confident in the earthquake system implemented. If not, and should dramatic change such as prescriptive reserving be introduced now, the spirit of long-term planning to handle exposure would be defeated by a “shifting of the goal posts”.

When the OSFI earthquake guideline was first introduced, including the tax-exempt allowance for voluntary reserving, the legislation drew criticism from the industry for the restrictions placed on the tax-free incentive. And, as Terry Squire of the Co-operators Group recently observed, the legislation is even unclear to whether voluntary reserves made are regarded as being part of an insurer’s overall capital surplus, essentially, earthquake reserves are seen as “dead money” in the bank. If the regulator plans on revising the existing legislation on earthquake risk management, it would perhaps better serve its energy by re-addressing the tax-free incentives and providing accounting clarity on the status of reserves allocated.