Alister Cempbell
The COVID-19 global pandemic has tested the capacity and capabilities of governments worldwide to respond to extraordinary health care challenges, and at the same time manage and mitigate the devastating economic effects of the lockdown measures. In retrospect, governments of all stripes and in all parts of the world will be forced to reflect on how they could have prepared better for such a low-probability, high-impact scenario – known in the insurance industry as “tail risk.” If any good is to come from this awful global event, it is to be hoped that governments and societies would learn about the benefits of building better contingency plans. The COVID-19 pandemic powerfully illustrates the compelling benefits of having an “in-case-of-emergency-break-glass” plan for such tail-risk events.
Insurance leaders in Britain and the United States have recently published proposals for creating public/private pandemic pools, or other quota-sharing arrangements, structured to help mitigate the next challenges of the current pandemic and better respond to any future pandemic. In Britain they are, at least in part, modelled on the work already done there with reinsurers “Pool Re” and “Flood Re,” which have been put in place to address tail-risk events such as terror attacks, nuclear accidents or severe flooding. In the U.S., the starting point has been the lessons learned from the Terrorism Risk Insurance Act model – built in response to the terrible terrorist attacks of 9/11.
In Canada, however, with the exception of the decades-old Nuclear Insurance Association of Canada (a public/private insurance pool to cover nuclear-related events), we have neglected to expand our risk-transfer mechanisms to address the obvious tail risks we face as a country.
Certainly, our federal government needs to identify and implement the best solutions to address the pandemic. Recent media coverage of the insurance challenges facing businesses such as restaurants and bars, which are particularly exposed to COVID-19-related liability risks, helps amplify the importance, urgency and complexity of this challenge.
At the same time, Canada must use this opportunity to tackle some of the other long-standing, but as of yet unaddressed, tail-risk events that we also know are inevitabilities in our large and geographically diverse nation: earthquakes, wildfires and floods. It is a sobering and troubling reality that Canada remains the largest developed economy in the world with a large exposure to earthquakes and without a government mechanism to backstop the insurance sector and properly protect our country’s citizens when that inevitable event occurs.
The biggest challenge to achieving this broad objective is the very different underlying insurance problems represented by these very different events. The core principle of insurance is the pooling of risk. This is precisely why pandemic was, broadly speaking, excluded from insurance policies offered by our insurers in Canada and worldwide. It is impossible to diversify risk, either by time or by geography: a global pandemic strikes everyone, everywhere and at the same time.
So, if “pandemic pools” are to be constructed, the insurance industry can offer distribution and claims management capabilities but cannot put up material amounts of risk capital. In the end, the loss must largely be borne by government. Over time, modest tail-risk premiums can be collected and invested and, should there be a sufficiently long span of time without major events, a substantial pool can be accumulated. But such pools will never be adequate to make up for the economic losses of shutting down entire developed economies for months on end.
The situation with earthquakes (or wildfires, or floods in lower-risk zones, for that matter) is very different. Insurers are ready to respond to massive events without any need for recourse to government at all since many individuals and businesses already buy insurance to cover this risk. Certainly, there are issues around product design. And much work remains to be done to increase policyholder take-up for coverage in the earthquake-exposed Montreal- Ottawa corridor. But, unlike a pandemic, earthquake risk is diversifiable globally (the earth is very unlikely to shake at multiple spots simultaneously or burn everywhere at once). So, insurers can price, select and underwrite for earthquake as they do for flood or fire, and pay the claims when they happen.
Also, unlike pandemic, we know that the insurance industry could withstand a massive earthquake event. The Office of the Superintendent of Financial Institutions requires that insurers demonstrate that they could survive a modelled 1-in-500-year earthquake event in B.C. or in the Montreal/Ottawa corridor, utilizing their own capital and the backing of global reinsurers (yes – insurance companies buy insurance, too). Our country could experience such devastation likely without a single insurer failure. And, even if there was such a failure, the industry compensation fund (PACICC/SIMA) could and would respond effectively to protect policyholders.
But there remains the simple reality that for an earthquake event above a certain modelled risk level, the industry would see its capital and reinsurance capacity exhausted. And above that level, the design of the PACICC/SIMA backstop would prove to be problematic – levying charges on surviving insurers to fund the failures would bankrupt the rest in a serial contagion.
In 2016, PACICC/SIMA modelled that after an earthquake generating more than $35-billion of insured losses, the Canadian industry would face collapse. But the type of government support required is entirely different than in the case of pandemic. In a pandemic, the insurance sector could offer only minimal levels of coverage (at best) before having to have the risk transferred to government. By contrast, in the case of an earthquake, all Canada needs is a government backstop for a truly extreme tail risk – funds that could be repaid by the insurance industry after Canadians have their claims paid.
The challenge of flooding in higher-risk zones represents a different insurance problem again. Modest annual premiums can offset the potential losses for perhaps 80 per cent of Canadians insured. But, as our climate changes, we are seeing increasingly high concentrations of water falling on increasingly urbanized locations and there has been development in areas that are now proving to be prone to repeat flooding events.
Commercial coverage for flooding has been available for some time, and personal insurance coverage is also now largely available to most consumers. However, consumers in “higher-risk areas” face problems of both affordability and availability. This type of insurance problem is best addressed through some form of subsidization mechanism, but this problem also needs a firm government hand to ensure that subsidization does not encourage riskier behaviour (e.g. more building in known flood zones). The ultimate solution also requires government to invest public funds in mechanisms to support retrofitting and significantly enhance infrastructure in flood-prone zones.
Given the myriad problems represented by these diverse forms of tail-risk events, we are unlikely to find a single mechanism designed to solve all of these risk-transfer issues at once. But, if nothing else, the COVID-19 pandemic has forced a larger conversation around these kinds of events. It is a conversation we need to have now. Developing workable solutions to the tail risks to which Canada is most exposed is in the urgent national interest.