Quirky EQC self-insurance

Hoisted from the comments, here's some sensible comments from one of my former students, Tom Quirk, on the National Disaster Fund:

Hi Eric,

Part 1 – on the NDF and sovereign risk management
I wonder whether you’ve framed your analysis on sovereign catastrophe risk management in the wrong light. Let's start with a bastardized-but-useful adaption of your summary:

"Suppose that your wife tells you that you could save a lot on house insurance if you just paid her the premiums every month and she'd pay you if the house burned down. Seems like a good idea - keep the money in the family. She invests the premiums you pay her in getting the kitchen redone.....

[insert my bit]....

But before you tell her to put away new the kitchen plans and to think carefully about her risk-management shortcomings, you realize that it’s you who have forgotten something important: your wife is extremely wealthy - she owns 100 houses! Each house has its own, reasonably independent, risk (most of the houses are in different neighborhoods).
Now you could put the premiums towards offsetting the specific risk on your current house, which may now seem expensive (do you really need insurance given your enlarged portfolio)? Or you could put the premiums into an account to cover losses and risks across your wife's (and your) whole portfolio, which may sensible and efficient. Or, if the kitchen is going to save you a bunch of money in the long run, and your wife's housing portfolio has been performing well, maybe you should just spend it. [finish my bit]"

My point is that we need to take a “helicopter perspective” when thinking about government risk. The government’s comprehensive balance sheet is exposed to a plethora of risks and possible shocks: potential government losses from biohazard shocks (foot and mouth), bailouts of non-bank deposit taking instructions (South Canterbury Finance), bailouts of banking institutions (hopefully not!), leaky buildings, solid energy - and the list goes on. We should factor in all of these risks when managing and financing any individual specific risk.

It would be silly to have a large build-up of assets in a bio-hazard risk fund while at the same time the government has to finance costs from bailing out South Canterbury Finance. It would be equally silly to have the NDF busting at the seams while at the same time that the government is heading to international markets to finance huge costs stemming from a serious foot and mouth epidemic. The idea is that an NDF-type fund invested in real, non-NZ government assets will ignore diversification across the government's portfolio, unnecessarily ring-fencing risks.

What you really want is a pool of assets on hand to cover the potential losses from all shocks/risks across the government’s entire portfolio. And luckily, the government has one of these - its call the fiscal anchor (net debt, or whatever you want). Would you care if the government did not have NDF if, when it came to funding the EQC’s earthquake liabilities, net debt was at 10% of GDP? (maybe you’d want some liquid cash to finance immediate expenditures and avoid f/x crisis. But taking the Canterbury earthquakes as one data point, the exchange rate and Govt debt YTM dynamics weren’t that bad post February 2011).

So when we talk about sovereign risk management we need to keep in mind that the level of net debt is probably what matters most at the end of the day. The NDF and other asset accumulating instruments are, at best, a good political instrument that encourage people to compensate government for the risk it assumes (think of the NDF as a vehicle used by the government to convince people that the EQC levy it collects doesn’t go directly to the government coffers and government expenditure). At worst, NDF type instruments constrain governments’ ability to efficiently manage risk.

We should be asking government to explain and justify whether its net debt target builds in an adequate and appropriate buffer for the risks to which it is exposed, and not whether the NDF’s asset allocation is appropriate. My personal view is that the NDF actually matters diddly-squat, even if it holds tons of real assets. This is because the government can always increase its debt in line with NDF asset growth, nullifying it the net impact of the asset accumulation, while still at the same time still achieving the net debt targets it actually cares about. The NDF holding non-tradable NZ government assets is a cleaner and more efficient way to achieve this global optimal debt level.

Now there could be a good political economy justification for the existence of a real–asset NDF. If the MoF is worried that she/he is not going to be able to constrain her/his colleagues’ expenditures in the future, then the NDF – actually quite like the NZSF - could be a good way to put the money into a safety deposit box, politically and maybe even legally out of reach of prying hands. But let’s be clear, this is not the usual financial risk management argument for having a real asset NDF.

So in summary, what’s my point? It is this: you can have an NDF, and you might actually want one for political economy purposes. But don’t kid yourself that you should have one based on vanilla principles of efficient risk management.
There are a few caveats and alternative strategies that would justly refute what I’ve said so - asset-liability matching is a good example. But I’m lazy ad will leave these for another day.
Part 2 – on the EQC

I wonder whether our views of Govt earthquake risk management may also stem from differences in our views of the EQC.

The EQC is not a private entity where the residential risk it assumes through its Act is ring-fenced, insulating the government from losses. In other countries EQC equivalents do follow a more private model. In such countries your arguments re holding appropriate real assets would have some fair bite.

But the EQC act clearly places the Minister of Finance (or maybe now the EQC Minister? - can't remember) with ultimate power concerning the EQC's finances. From purchasing reinsurance and deciding on the strategic asset allocation of the NDF to pricing the EQC's levy premium, the MoF “wears the pants” relative to the EQC's board and CEO. And because the government is guaranteeing the whole thing at the end of the day, this is exactly the way you'd want it.

The heuristic I use to think about the EQC is that it is really just an acknowledgement that in the wake of a disaster the government would not be able to turn down a bailout of badly damaged and uninsured residential property (and that without the EQC buffer, for a number of commercial and behavioral reasons, levels of domestic catastrophe insurance penetration would likely be much lower). Instead of simply dealing with this problem after the fact – and its likely to be a much bigger problem after the fact - the EQC lets the government collect some money and compensate itself in advance.

Part 3 - some thoughts on the government’s procurement of reinsurance

If you assume the government is the final funder of the EQC, all but the most tail-risk target reinsurance will be relatively expensive. From a value-for-money perspective NZ citizens should be wary of huge reinsurance premiums.
Reinsurance layers/tranches are generally priced based on the expected value of losses (with adjustment for risk preferences and tail risk, operating costs, market conditions, returns/costs of capital, etc). As a result, lower layers with low excesses will be highly priced, and higher layers with large excesses will be priced relatively lower. (The price metric used is the “rate-on-line”, the premium costs as a per cent of the total risk transferred).

Should the government pay high rates-on-line for relatively to get coverage at a low excess level? I think this would be silly: the government has a deep and diversified portfolio; it has buffers and financing flexibility. Paying NZD 100million+ per year to cover the EQC risk (or other earthquake risks) at a low excesses (less than a good few NZD billion) is crazy.

The government can also likely finance losses at low excesses at a far lower rates than reinsurers, especially over the long run. Self-insurance would seem to me to be the first option government should examine in its risk management, especially given its risk profile, likely risk preferences, funding costs, revenue stream variability, etc. Governments can take a long-term time horizon that reinsurance business models simply cannot match; I imagine that Government financing costs across the entire yield curve will be lower than even the gargantuan reinsurers.

If the government can buy reinsurance attaching at a level high up the EQC loss distribution, it might make sense as a “tail-risk” management strategy. But, eeeekkk, I’d need to see some pretty good CBA to justify it. You’d need a strong argument as to why we’re not better putting the financing into building a bigger buffer in the net debt anchor.

It’s hard to be scientific around what appropriate reinsurance purchases might look like without doing the modelling or analysis. But I’d say - very unscientifically, and given NZ’s current debt levels - a reinsurance program attaching at over NZD 6-7 billion and going up from there might be worth considering. At least in a huge earthquake this might make a difference to our financial position. But how many years of forgone accumulated premiums, and consistent and building self-insurance, is this risk transfer worth? We’d need some modelling that I’m not sure has been done.

I do accept, however, that reinsurers may have some cost advantage compared to government; for one example, they can achieve cross-country diversification that governments cannot achieve. But I’m just not sure that these advantages outweigh the government’s self-insurance capacity and inherent diversification. It’s an empirical question for someone smarter than me to answer.

I agree with much of this as far as it goes, but think of the incentives then created.

Every homeowner taking out house insurance is forced to take on EQC insurance as well. In small events, all's well - the government's self insurance for the excess prior to reinsurance kicking in covers things without imposing noticeable burden on public finances. And the same holds if it is reinsurance all the way up.

Large events like the Canterbury quake, or a future Wellington one, strain government finances appreciably. There is no actual NDF on which to draw, as it all comes out of government borrowing. Under Tom's proposal, there might not be reinsurance on which to draw either; in the Canterbury quake, the government was on the hook for anything above the reinsurance draw.

EQC behaved, after the February earthquake, as though its purpose were to minimise costs to the Crown rather than to make good on its contracted commitments to policy holders. It is difficult otherwise to make sense of the numerous claims where EQC believed the house was well under-cap but the private insurers called it a complete rebuild.

And as good as the proposal from the Crown has been to increase the EQC cap to reduce the coordination failures between private insurers and EQC, that also makes it less likely that you'll be able to trigger assessment from your private insurer where you might get a fair shake.