Major Canada Earthquake Could Lead to Widespread Insurer Insolvencies: Report

A massive earthquake off the coast of British Columbia has the potential to cause widespread failure among insurance companies and trigger a domino effect across the financial sector, according to a Conference Board of Canada report.

“As the earthquake in New Zealand earlier this month reminds us, we cannot prevent massive earthquakes from happening. However, we can lessen the impact of a massive quake on the economy by putting in place additional backstop measures to protect the insurance industry and the financial sector more broadly,” said Pedro Antunes, Deputy Chief Economist, Conference Board.

“At the industry’s current levels of capitalization, Canada is not prepared to deal with the macroeconomic and fiscal consequences of a large earthquake. It is important for Canadians, businesses and government leaders to understand that the current regulatory regime may not be able to protect our economy from a major disaster,” Antunes added.

The Conference Board’s report tests the ability of the Canadian economy to deal with earthquake risk, gauging the macroeconomic and financial impacts of a major earthquake off the coast of British Columbia and the 10-year period that follows. The funding for this research was provided by Insurance Bureau of Canada.

A massive earthquake, similar to the 2011 earthquake and tsunami in Japan, is a rare event. Indeed, there has not been a devastating earthquake since 1700, said the report titled “Canada’s Earthquake Risk: Macroeconomic Impacts and Systemic Financial Risk.”

Natural Resources Canada estimates the probability of a significant earthquake in Western Canada over the next 50 years at 30 percent, and between 5 percent to 15 percent in Eastern Canada.

The report indicates that the fiscal and macroeconomic impacts of such an earthquake would be devastating, with $127.5 billion in total economic losses and possibly as many as 15,000 deaths.

Under such a scenario, insured losses could exceed $42 billion, surpassing the level at which the industry is currently capitalized, although the report emphasized that an earthquake generating losses above the insurance industry’s capacity would be “exceedingly rare.”

“[A]n earthquake of this size would inevitably cause insurance companies to fail,” the report cautioned. “And the existing industry compensation mechanism created to protect policyholders would cause failures to snowball, triggering a chain of systemic financial contagion resulting in insolvencies across the industry and the broader financial service sector.”

Canadian policyholders – both homeowners and businesses – would be unable to rely on claims payments from their insurers, which would act to delay rebuild and recovery efforts by an estimated two years.

The Conference Board estimates that the earthquake and fallout from financial contagion would reduce real gross domestic product (GDP) by a cumulative $100 billion and cost an estimated 437,000 person-years of employment – equivalent to the loss of 43,700 jobs over the 10-year period.

Real GDP losses peak at nearly $38 billion in the third year after the earthquake, and the rebuild effort would not contribute positively to growth until six years after the earthquake, the report continued.

Stringent capital requirements for insurers, while contributing to making the Canadian insurance industry one of the soundest in the world, are not enough to address the very low-frequency, high-severity probable events, the report cautioned.

“In addition to the $42-billion cost to Canada’s property and casualty insurers, the rebuilding effort would take an enormous toll on all levels of government finances,” the report said. “Taxpayers would have to absorb the costs of losses to both public assets and infrastructure, as well as uninsured private losses.”

But the financial contagion is also very costly, the report confirmed, noting that reduced revenues and increased government spending would add $122 billion in net new public debt to government coffers – nearly double the $63 billion in government borrowing that would be necessary if Canada had a mechanism in place to avoid financial contagion following the earthquake.

Emergency Backstop

Indeed, the report emphasized that the government has a crucial role to play in preventing largescale insurer failures, and subsequent financial contagion, by setting up a last-resort emergency backstop mechanism for extreme disasters such as a major earthquake.

This would be similar “to what is already in place domestically with other industries and internationally between governments and insurers for a number of catastrophic perils (e.g., earthquakes, hurricanes, terrorism),” the report said.

The Conference Board noted that Nicholas Le Pan, former federal superintendent of Financial Institutions, recently recommended such a mechanism. In Canada “there is a strong case for establishing a federal government/industry backstop arrangement that could be activated to deal with … catastrophic [earthquake] risk.”

Source: Conference Board of Canada