Insurance bailouts

The New Zealand Government has provided a backstop guarantee to Christchurch-based insurer AMI. Nolan at TVHE hits the main issues. Too much of AMI's book was Christchurch-based for the amount of re-insurance cover it had for a sequence of major Christchurch events. Yes, two huge earthquakes in Christchurch was a low probability event. But it's relatively cheap to insure against low probability events.

Nolan rightly points out:

• This introduces serious moral hazard for other insurers
• The intervention was poorly targeted

Here's what I told the National Business Review yesterday, now in today's print edition:

University of Canterbury economist Eric Crampton said his biggest worry about the AMI bailout “is the signal it sends to New Zealand insurers. Why bother carrying reinsurance over and above the statutory minimum and why bother ensuring you have a balanced client base if the taxpayer will bail you out if anything really bad happens?”

He said the government was right to worry about systemic risks to reconstruction posed by an AMI collapse. “But I’m not convinced a bailout was the best option. AMI policyholders, myself included, enjoyed lower rates because AMI had underinsured against the risk of local disasters. And, as it was a mutual, we don’t really have anybody else to blame.

“News reporting suggests AMI had sufficient capital and reinsurance to cover the costs of the Christchurch disaster but then would have had nothing left against other adverse events.

“Under those circumstances, I could have expected a haircut to Christchurch claimants or a surcharge on AMI members to help in recapitalisation and to fund the purchase of additional reinsurance against other large events.

“It isn’t as though there would be no payouts to Christchurch claimants absent a bailout; rather, the company would likely have been wound down subsequent to paying out on claims.”

NBR left out my last line, which I think is an important one (culled due to space constraints I'd expect):

Transitional assistance during that wind down could have been enough to avoid systemic problems while keeping sharp incentives for other insurers, and their clients, going forward.

The NBR piece continues:

University of Auckland Business School BNZ chairman of finance David Mayes was skeptical about possible “moral hazard” from the bailout. “I’m very cagey on moral hazard – very few companies are running on the hope they will be bailed out.”

He said AMI’s mutual structure presented problems both in terms of raising capital and selling the company. Getting approval from policyholders was “more difficult than doing it through a shareholders’ meeting,” he said.

Reserve Bank spokesman Mike Hannah said the government bailout of AMI shouldn’t be seen as setting a precedent due to the unique situation. “This is not how you would deal with a distressed insurance company in normal circumstances. However, this is a very unusual set of circumstances.”

David is certainly right that few companies run on the hope of being bailed out. But they may underinsure in reinsurance markets against low probability events that would draw political sympathy. Here's the Sunday Star Times, HT Hickey:

Sunday Star-Times calculations show AMI invested 3.7% of premium income in reinsurance. Other insurers exceeded 10%, with Lumley General reporting 16.3%.

And the NBR reports elsewhere (subscription):

Rival insurers are privately fuming at the government’s decision to provide a support package to AMI policyholders in case the insurer’s reserves run out.

An insurance industry source told the NBR this morning that, when discussing with colleagues the possibility of an AMI bailout, there were two main responses.

“The first one was, the government is going to get into even more debt, and the second one was, what about moral hazard?”

However, the source said AMI’s rivals would be unlikely to speak out against the bailout because “they don’t want to annoy the government in case they need a bailout themselves one day.”

The source said AMI was understood to have had a lower level of reinsurance than other comparable insurers, meaning it was able to charge lower premiums than it would otherwise due to the reduced reinsurance cost.

AMI customers benefited from those lower premiums and, now that they were being backstopped by the government, other insurers with more prudent levels of reinsurance were being "punished."

What I most want to know is why AM Best gave AMI an A+ rating, about the same as the other folks insuring NZ property, when AMI had this kind of risk profile. I'm insured with AMI and have a claim sitting with them for damage to our swimming pool and sidewalks consequent to the February quake; EQC is likely covering the rest.

Here's what went through my head when we bought insurance after moving to New Zealand:

AMI has better rates than the other folks and the same credit rating. They seem to be mainly locally based, so they might be subject to problems if there's a big Christchurch event. But that kind of risk has to be cheap to lay off through reinsurance and, besides, if they haven't, there's no way the government would fail to bail out in the kind of local event that would take out the insurer. I'll go with the low rates.

I don't always like to have my expectations fulfilled.

I don't think that moral hazard problems generated by this would really hit the big insurers: anybody internationally based would have international resources to draw down in the event of a disaster and so wouldn't be bailed out. Rather, the industry as a whole winds up with too many locally-based mutuals that can lay off risk on the government.