Tuesday, 21 September 2010

In which Seamus proposes a tidy solution

The lunchroom a few days ago discussed price gouging, among other earthquake related topics. Seamus proposed a very nice solution to a few linked problems; as he's been rather quiet here of late, I figured I might as well write it up on his behalf. All errors in the proposal as interpreted by me are, of course, attributable to him.

First, we know that the Earthquake Commission invests stupidly heavily in domestic assets - in particular, government securities. The appeal of investing these things domestically seems insurmountable, regardless of how much downside risk it exposes us to.

Second, we know that people hate profiteers. They get angry at the idea that anybody might earn excess profits because of somebody else's suffering, even if that's the most efficient solution to the problem and is most effective in making everybody better off in the long run. Better, they reckon, that everyone starve equally than that prices adjust to give an incentive for folks to bring food into the region, with richer folks potentially first in line. This gives governments a derived demand for stupid policies.

Seamus's tidy solution: get the Earthquake Commission out of government assets and reallocate investment to a portfolio of domestic stocks that we expect to jump in case of an earthquake. We could identify those reasonably easily just by looking at NZX data from the past couple weeks.

Now, who earns the rents when prices jump in the wake of a disaster? The folks who owned stock in the companies getting the rents prior to the price move. If the government's earthquake compensation portfolio is weighted towards assets that are likely to increase in value after an earthquake and are likely to increase most if nobody mucks around with prices, then government has stronger incentive not to give in to populist pressures to interfere with prices.

Problem with the solution: we have a very thin stock market. Total capitalization of the NZX building-sector stocks was about $5 billion end August (about $6 billion now) - not far off from the total purported value of the Earthquake Commission's holdings. And we'd hardly want EQC having more than a minority stake in anything lest we start seeing political interference in private companies through government stock holding.

But EQC taking a 5-10% stake in the building sector, across the board, to replace other parts of its domestic exposure, doesn't seem crazy. At least it's far less crazy than having those assets in the parts of the domestic sector expected to drop in value if the insured event transpires.

To be clear: I still can't see any case for EQC holding domestic assets, and I don't get why this isn't all just handled through reinsurance anyway rather than by having EQC hold an asset portfolio. But this would be better than status quo.


  1. Coming from somewhere else I can't see the point of EQC. Showing my ignorance, I initially expected that my insurance company would cover the house for earthquakes, reinsuring somewhere else as for any big risk.

    So what is the point of having this extra step/organization?

  2. It's hard to come up with great arguments for it. The best I can think of is that it makes it easier for the government to avoid bailing out people who don't have insurance: the government guarantee goes only to folks who have private insurance coverage.

  3. How cynical of you Eric :) From the EQC website:

    EQC was established by the Government in 1945 to provide earthquake and war damage cover for purchasers of fire insurance. Later, cover for other natural disasters was included and, later still, cover for war damage dropped. The modern EQC is a Government-owned Crown Entity.

    These days it is a helpful backup to regular insurance, as companies here are very quick to find cause to not pay out on claims. Often insurance companies include an "act of god" clause which allows them an out. Which came first however is debatable. I suspect insurance companies wouldfind it more difficult to justify weaseling out of paying out on act of god claims if the EQC didn't exist.

  4. Market demand for private insurance that includes natural disaster coverage may be somewhat attenuated by the existence of EQC; that said, pick up any issue of the paper from the last couple of weeks and check out the full page ads from pretty much every insurer telling their clients how to lodge claims. I'm not sure that "Act of God" is that big an out these days.

    I can buy that EQC can help facilitate really quick payment of small amounts prior to full assessment where private insurers may be reluctant to do so.

  5. Oh - the other obvious benefit of EQC is that where private insurance covers the cost of rebuilding your house, it doesn't cover the land value lost if you can't build on your property. So if the earthquake leads to rezoning such that you can't build where you were, you have to buy another section on which the insurance company would build a lot. EQC cover ought plug some of that gap. Again, though, it's unclear that the market wouldn't provide that kind of coverage at extra premium in the absence of EQC.

  6. Yep, agree it's likely that if demand for this sort of thing was sufficient we'd see private insurance companies offering land value cover in the absence of EQC. My take on the EQC is that it provides a single authority for dealing with large natural disasters and the like, a one-stop-shop if you will. It has virtually become part of the civil defense infrastructure in a way. I can see some value in having a single coordinated response to these sorts of events. Certainly private insurance companies could perform the same role for their customers, but my gut feeling is that the public has some distrust in private insurers, and that they get some peace of mind knowing that a govt backed insurer is in place during emergencies. However misplaced this may be, I don't think we can ignore the psychological benefits of having perceived secure guaranteed cover for the masses after a natural disaster.

  7. In the grand scheme of things, EQC is likely a neutral; I have a hard time seeing how it does either much harm or much good. Except if it is 1)compulsory and 2) ridiculous in its portfolio management.