Disaster insurance in New Zealand

L.B. Falck

New Zealand, recognizing that its economy could not absorb the heavy financial losses from a major disaster, reviewed its national system for insuring the public against disaster. Its national insurance commission has sought the maximum reinsurance protection the world market could provide and has considered ways to minimize the government’s contingent liability. New Zealand is not alone in understanding the need for a government-backed fund for disaster relief. As reinsurance pools shrink, international financial institutions such as the World Bank may be called upon to provide an underwriting facility that offers reinsurance at either a discount or an “average” cost.

New Zealand, which lies on the “Pacific Rim of Fire,” faces seismic hazards similar to those in Japan and California. But New Zealand, a small country with a small population, does not have the economic resources to withstand severe natural disasters. New Zealanders are fortunate that river floods tend to be localized events and that severe windstorms (tropical cyclones) have generally exhausted their energy before moving past New Zealand.

Earthquake is the most severe hazard the population faces. Each year about 800 are registered and between 150 and 200 felt. Typically one or two are of magnitudes above 6 on the Richter scale, 10 to 20 of magnitudes between 5 and 6, and the rest smaller (Seismological Observatory Bulletin 1983). A glance at any map of seismic events in New Zealand shows that no region is really safe from earthquakes. The need for mitigation measures is a concern to both government and the private disaster insurance industry.

The New Zealand Earthquake and War Damage Commission was established by statute in 1944 as a government agency with responsibility for the financial mitigation of losses from earthquake-related events. Speaking to the New Zealand Parliament, the then Minister of Finance Walter Nash (New Zealand National Society for Earthquake Engineering 1984) said that the endeavour had been to “work out a principle under which the whole loss is deemed to be a national loss, and under which those people who might be affected will subscribe towards a fund to meet losses which may come to any of them.” He added that “if the common fund is insufficient to meet the lawful claims thereon, the Minister of Finance shall, without further appropriation than this Act, pay such sums out of the Consolidated Fund as may be necessary to meet the deficiency.... this in effect is the guarantee behind this fund.” This act put into effect a nationwide insurance scheme that has provided for such losses since 1944.

Under that legislation, rates were determined by the government under delegated regulatory powers. (The initial rate of 5 cents per $100 indemnity-insured value continues to this day.) Private insurers, as agents of the commission, would collect premiums. Under these arrangements the commission was unable to identify its insured until a particular company lodged a claim and declaration of insurance. Property was insured for material damage to indemnity (current market) value only. (Insurance companies were permitted to provide “top up” replacement policies.) The New Zealand Government would indemnify the commission through loans for any deficiency in meeting its lawful claims. Any insurance policy with fire coverage immediately attracted earthquake and war damage coverage.

Since its inception the commission has built up a reserve of nearly $2 billion (New Zealand dollars). Revenues from annual premiums were $91 million at the end of fiscal 1989. In addition, the commission has reinsurance of $1 billion for a catastrophic earthquake (New Zealand Earthquake and War Damage Commission 1989a).

The effect of heavy losses

In 1987 a shallow earthquake of 6.3 on the Richter scale struck the area known as the Bay of Plenty, causing severe damage to domestic and commercial property. Losses for the commission, insurance companies, and government agencies were initially estimated as follows (in New Zealand dollars):

These losses were a shock, coming as they did in an area of low population density and poorly maintained housing stock. And domestic policy losses were disproportionate. Five thousand domestic claims cost the commission $20 million, and 10 commercial claims resulted in a payout of about $120 million. Over the many years the scheme had been working, inequities and inflation had distorted the basic purpose of the earthquake scheme.

Such heavy losses also caused concern about what would happen if a major loss occurred in one of New Zealand’s major population centers. Wellington, the capital city, lies astride the main active fault line. The last major earthquake there (in 1855) is estimated to have exceeded 8 on the Richter scale. Auckland, the main population center and New Zealand’s commercial capital, is situated on and near more than 60 dormant volcanos - the last of which erupted in the seventeenth century. New Zealand’s largest lake (Taupo) is also a dormant volcano which has the unfortunate habit of erupting explosively and ejecting the contents of the lake and the surrounding district 20 kilometers (12.5 miles) into the atmosphere.

If disasters were to happen in these areas, the New Zealand economy would be sorely pressed to cope with the financial repercussions. Confidential government studies showed that the current and future tax base would be unlikely to generate enough revenue to meet loan demands for needed reconstruction and rehabilitation, and the commission and private sector insurers would probably go bankrupt. So the New Zealand Government launched a review of how the commission and the disaster insurance industry function.

The review found that New Zealand’s economy could not absorb large financial losses as easily as the United States could. The California earthquake strained U.S. resources, but California and the federal government could cope with the situation without seriously jeopardizing the economic well-being of the rest of the country. New Zealand is not so resilient. The review identified the following problems in the current arrangements:

· The Commission, as a public service department, had not developed management and reporting structures that ensure efficient operations. For one thing, it had inadequate financial and accounting procedures. It has paid little attention to advances in information and telecommunications technologies in disaster and claims management. It has put little effort into promoting a corporate role for the commission.

· The composition of the Board was inappropriate, so the commission was too easily influenced by the government of the day. Clear rules had not been established for communication between the commission board and government ministers.

· The investment policies conducted by the New Zealand Treasury on the commission’s behalf were inadequate and took little account of the commission’s risk status.

· In the event of catastrophe, the current indemnification arrangements between the commission and the government were likely to place a debt burden on the commission that would cripple its operations and saddle it with debt far into the future. And the lack of reinsurance arrangements meant that the commission’s capital assets were totally exposed in the event of a disaster.

· The commission had not promoted and funded earthquake-related research. Among other things, there was an urgent need to review the position of other insurers in the market and their ability to meet large claims. And research was needed to determine agreed-upon estimated maximum loss figures for the government, the commission, and private insurers.

· The government had not reviewed its policy and management options for contingent liabilities in the event of a major disaster. Little attention had been paid to ensuring that there were effective economic contingency plans for dealing with such an emergency. And war coverage was inappropriate (New Zealand National Society for Earthquake Engineering 1984).

Agenda for reform

The board and government had a big agenda for reform and restructuring. The government decided it was appropriate to address these issues in two distinct phases: first, the complete restructuring and refocusing of the commission’s operation; second, comprehensive examination of the regulatory environment and industry operations as a whole. After consultation with the commission board and private sector interests, the government introduced permissive restructuring legislation that provided a new management structure for the commission (New Zealand House of Representatives 1988).

The government instituted the following changes by statute:

(1) The commission was reconstituted as an independent statutory corporation with the Crown of New Zealand as the sole shareholder. The minister of finance was invested with the rights of shareholder on behalf of the Crown. The commission now had the powers and opportunities available to corporations.

(2) The board was restructured, the minister of finance was no longer chairman, and the number of board members was increased to nine. This removed the last vestiges of political influence over the commission’s affairs.

(3) The commission’s financial assets were firmly vested in the commission and removed from Treasury control. Treasury now acted solely as agent for the board’s investments.

(4) The guarantee provisions of the 1944 legislation were revoked and the government assumed the role of “underwriter of last resort,” whereby in exchange for an agreed-upon premium the government undertook to grant to the commission such sums as it needed to meet its claims liabilities. This premium was loaded to encourage the commission board to seek reinsurance in the private world market.

(5) The government required the commission to adhere to the management, accountability, and reporting rules set out in the State Owned Enterprises Act (New Zealand House of Representatives 1986). These rules placed the commission’s management on the same basis as private companies (see appendix 1). To assure a level playing field, the commission was required to pay the same dividend and tax as other insurers.

Meanwhile, as a transitional provision, the government retained the right to set premium levels and to direct commission policy - requiring that when the minister directed the commission, such directives were to be in writing and published in the commission’s annual report. Since October 1988 the board has received only one such directive, about management of the commission’s financial assets (New Zealand Earthquake and War Damage Commission 1989b).

Once these amendments were enacted the commission considered its internal operations. The board rapidly refocused the management structure to give it a commercial ethos, balance sheet operation, and comprehensive claims management procedures. The board’s main concern was the lack of reinsurance. Under the previous statute, successive governments had resisted reinsurance because some people in government believed reinsurance would distort New Zealand’s foreign exchange market. This problem disappeared when the government floated the New Zealand dollar and gave the commission independent control of its financial resources.

New emphasis on reinsurance

The board moved with alacrity to establish a reinsurance program. With the help of three specialist reinsurance brokers it sought the maximum protection the world market could provide. After intensive negotiations the commission purchased a heavy layer of catastrophe protection: $1 billion in excess of $l billion - the largest program of this kind in the world. ¹ (Purchasing reinsurance of this magnitude allowed the commissioner to negotiate a lower market premium for such reinsurance than is usually available to private insurance companies.) This purchase of capital protection radically altered the commission’s ability to withstand losses, providing a guaranteed influx of funds should a disaster occur. The effects of such an influx of offshore currency funding is currently being carefully modeled by the Reserve Bank (New Zealand’s central bank), to ensure that when the inevitable occurs the Bank has suitable contingency plans to prevent rapid hyperinflation and associated effects.

The second phase of restructuring has been to examine New Zealand’s natural disaster underwriting industry and to consider ways to minimize the government’s contingent liability. Several proposals are being introduced or considered. They include:

· Making earthquake insurance compulsory for all domestic householders (whether or not their property is insured for fire) and not requiring that commercial property be insured.

· Deregulating the market. This would permit private companies to compete with the commission in all market sectors, thus ending the commission’s monopoly, facilitating the introduction of further capacity, and diversifying industry risk. Deregulation would also inevitably reduce the government liability, currently focused through the commission.

· Reducing Crown indemnity by requiring government departments, corporations, and agencies (such as schools and hospitals) to obtain suitable private insurance, financed through their operating budgets.

· Reducing assistance to local and municipal authorities by requiring them to take out adequate protection against disaster.

· Discouraging charity and government aid packages that provide more than immediate postdisaster relief assistance. In previous disasters uninsured property owners have had a comparative advantage over the insured, who had prudently paid premiums over the years. The uninsured have inevitably been helped in rehabilitation by the mayor’s, government’s, or private relief aid packages (New Zealand Government 1988).

Related policies will permit the commission to determine its premium rates on the basis of the risk profile (without government concurrence) and to devise an investment strategy that ensures that existing financial assets are placed offshore in a portfolio that ensures maximum growth yet provides access to extensive foreign currency reserves in time of need. The commission will also try to establish relationships with international banking agencies so it can eventually establish lines of credit and access to standby foreign currency borrowing facilities.

Worldwide implications

New Zealand is not alone in understanding the need for a government-backed fund for disaster relief. It is important to compare the New Zealand disaster insurance model with other similar disaster mitigation schemes operating elsewhere in the world. France, for example - where the major potential disasters are flooding and windstorms - passed a law in 1982 guaranteeing that all French citizens (including those in obviously risky areas) could obtain catastrophe coverage. Citizens pay an additional premium to insurance companies who then reinsure with the state-owned reinsurance company, CCR. Storms in October 1987 highlighted the value of this coverage. Up to half of the claims fell under the law’s auspices. Iceland, a nation whose seismic hazards are similar to those New Zealand faces and whose economic infrastructure is equally fragile, recently established a scheme for disaster underwriting modeled on New Zealand’s current scheme. The Japanese Government, jointly with all Japanese non-life-insurance companies, is setting up a fund and layers of reinsurance to ensure that funds are available to cover homeowners for earthquake insurance. All homeowner earthquake coverage provided by domestic and foreign insurers is wholly reinsured with the Japanese Earthquake Reinsurance Co. Ltd. (JER).

In the United States, there is currently no such government-backed disaster fund. But the U.S. insurance industry is pressing the federal government to take on up to $50-$60 billion (U.S. dollars) of earthquake risk in return for premiums that would build up the fund (the Earthquake Project). The total net worth of the U.S. insurance industry is about $134 billion. The industry would face irreparable damage if it had to make a $60 billion payment in the event of a major earthquake in Los Angeles. The Earthquake Project is basically a reinsurance program for which the federal government would assume most of the risk until a fund has been built up from premiums. This proposal is likely to go ahead, after the federal government completes its own research into the industry and calculates probable maximum losses. The government will probably require that a damage mitigation program be put in place as there would otherwise be no incentive to reduce risk (Price Waterhouse of New Zealand 1990).

The common purpose of all these schemes is to guarantee that insured domestic property owners are protected in the event of a severe natural disaster. Naturally they differ in philosophy, application, and underwriting risks but all propose a relationship between the government and the commercial insurance sector aimed at maximum mitigation of economic loss to citizens. All schemes also accept the basic tenet that such arrangements will not work without the government’s active and willing participation.

There would be nothing to prevent a group of small nations from jointly establishing a disaster underwriting agency and introducing - through an agreed-upon, uniformly compulsory regime - a scheme to provide basic disaster insurance for homeowners. Such a scheme is being considered by a group of small South Pacific island nations. In the past few years these nations have suffered severe economic dislocation from tropical cyclones - the latest example being the cyclone that devastated both Western and Eastern Samoa in 1989. The suggestion is that each participating nation take out a share (proportionate to its population) in the underwriting agency and commence building up reserves and reinsurance to protect against future losses. To effectively manage the loss, the agency would be given an initial “no-liability” period in which to build up a reserve fund and obtain reinsurance. In addition, it has been suggested that in future part of disaster aid could be financial help in meeting underwriting losses. It is important that the scheme make insurance of domestic dwellings compulsory and that some form of statutory authority be available to enforce this requirement. A similar scheme could provide some relief to the economies of the Caribbean nations that face the devastating effects of the hurricanes that pass regularly through the Caribbean.

All these schemes are predicated on the willing participation of commercial reinsurers. Their capacity to underwrite huge losses obviously depends on the extent of their asset bases and their own success in obtaining reinsurance. ² Potential customers of the reinsurers must always be aware that market capacity depends upon the current loss ratio the market faces collectively. In March 1990 the loss ratio London underwriters faced was about 550 percent after the British and European windstorms. As a result of these losses, together with all the other major losses reinsurers have faced in the last two years - Piper Alpha, Hurricane Hugo, San Francisco, Newcastle, and so on - the market is hardening and, more alarming, capacity is being withdrawn from the world pool. Premiums are rapidly increasing as reinsurers seek to generate revenue to offset what for many of them is currently a negative cash position.

Major international financial institutions could help underdeveloped countries by providing an underwriting facility that offers reinsurance at either a discount or an “average” cost. This would enable developing nations to establish disaster underwriting mechanisms that would not only alleviate distress but also mitigate the large injections of financial aid that are generally needed when these events occur. Through such arrangements the aid organizations could better provide planned assistance.

Governments can manage the economic effects of natural catastrophes or disasters effectively if institutions exist that have both the capability and the financial independence to manage the aftermath of these inevitable events.

Endnotes

1. One billion New Zealand dollars was the equivalent of US$620 million. Participation in the commission’s program has been as follows:

The New Zealand Earthquake and War Damage Commission provides only for catastrophic disaster. It does not cover such gradual events as New Zealand’s possible inundation (if the southern icecap melts) or the medical effects associated with the thinning of the ozone layer. According to New Zealand scientists, if a slab of ice the size of France broke off, sea level worldwide would rise one meter. If the entire ice cap slides off, sea level would rise 40 meters.

2. Reinsurance of reinsurers is facilitated through underwriters commonly known as retrocessionaires. Usually several layers of such reinsurance underwrite any primary reinsurers; the subsequent payment of claims is called the “Lloyd’s Spiral.”

Appendix 1 - Extract from New Zealand’s State Owned Enterprises Act Accountability provisions

PART III

ACCOUNTABILITY

14. Statement of Corporate Intent - (1) The board of every State enterprise shall deliver to the Shareholding Minister a draft statement of corporate intent not later than 1 month after the commencement of each financial year of the State enterprise.

(2) Each statement of corporate intent shall specify for the group comprising the State enterprise and its subsidiaries (if any), and in respect of the financial year in which it is delivered and each of the immediately following 2 financial years, the following information:

(a) The objectives of the group;

(b) The nature and scope of the activities to be undertaken;

(c) The ratio of consolidated shareholders’ funds to total assets, and definition of those terms;

(d) The accounting policies;

(e) The performance targets and other measures by which the performance of the group may be judged in relation to its objectives;

(f) An estimate of the amount or proportion of accumulated profits and capital reserves that is intended to be distributed to the Crown;

(g) The kind of information to be provided to the shareholding Minister by the State enterprise during the course of those financial years, including the information to be included in each half yearly report;

(h) The procedures to be followed before any member of the group subscribes for, purchases, or otherwise acquires shares in any company or other organisation;

(i) Any activities for which the board seeks compensation from the Crown (whether or not the Crown has agreed to provide such compensation);

(j) The board’s estimate of the commercial value of the Crown’s investment in the Group and the manner in which, and the times at which, this value is to be reassessed;

(k) Any other matters as are agreed by the shareholding Minister and the board.