This is a repost of a article originally published on pundit.co.nz. It’s here with permission.
Suppose you are exposed to a risk from which you cannot protect yourself. You could build capital to cover the loss if the event occurs. But if the loss was your home in an earthquake, you’d have to set aside all of its value, doubling the cost of the home even if the likelihood of total obliteration is low (or so you hope).
Instead, we use insurance to cover the eventuality. Basically, there are two types of insurance that sometimes go back to two cases (illustrative, but not entirely historically accurate).
One involved a group of Swiss farmers who had agreed that if one of them lost a cow, the loss would be shared by all. Observe that such social sharing can only work if the shock does not affect a large part of the group.
The second type of insurance would have led to the development of Lloyd’s of London. It involves paying a fixed sum to someone to take the risk of an event occurring. The counterparty covers many similar events and bets that only some will occur, in the hope that the total claims will be less than the fixed sums paid to them; if not, they suffer a loss. Typically, they, often a corporation, assume a portfolio of such bets in the probability that an earthquake in Wellington will not occur around the same time as those in San Francisco and Tokyo. It is possible that the insurance company will not be able to cover its losses and will go bankrupt. (AMI was aided by the state to prevent it from sinking when it was too exposed to the Canterbury earthquakes. The world’s largest insurer, AIG, had to be nationalized by the United States during the GFC.) In this case, the insurer would lose its coverage.
It’s much more complex than that, but the important thing here is that there are these three answers: auto, share (or social) and quarter insurance. Of these, ‘share’ and ‘change’ are the important policy options (although if there is a surplus to his insurance, it is ‘self’).
In 1993, New Zealand’s Earthquake Commission Act made a dramatic change to its earthquake insurance by altering the balance between share and transfer. I’m focusing on housing – there have been changes in commercial buildings too – and I’m simplifying.
Previously, the essence of home earthquake protection was a shared system where the risk was covered by the New Zealand government. Insurance contributions were paid to the Earthquake and War Damage Commission; if there were damages, the EWDC paid for them. If the EWDC had insufficient reserves, the government (taxpayer) covered the deficit. Thus, the residual individual seismic risk was shared by the entire New Zealand community.
After 1993, only the first $100,000 of damage was covered by the new Earthquake Commission (EQC) to which insurance was paid. (The government recently raised the level to $300,000. The $100,000 from 1993 would buy about $200,000 of building construction today.) The rest of the earthquake protection must be purchased from insurers private. Basically, since 1993 there has been a rebalancing from sharing to transfer – a privatization of earthquake protection.
(EQC insurance also covers other major disasters such as natural landslides, volcanic eruptions, hydrothermal activity, tsunamis, and the impact of storms and floods on residential land.)
There were many reasons for this change. The minister responsible for the bill was Ruth Richardson, so there would have been a neoliberal-minimalist state element among them. (The change was discussed by the Rogernomics government.)
The end of the partition state was happening in other policy areas. The Richardson-Shipley “welfare reform” was a return to the charitable aid that had predated the Pensions Act of 1898, New Zealand’s first major social insurance.
The notion of social insurance, where certain burdens are shared across the nation, barely appears in today’s rhetoric, even from the Labor Party. When was the last time he used Nash’s statement “the young, the old and the sick will be the first to call upon the state”? An exception is the social insurance offered for the laid-off unemployed. It is striking how much of the mainstream criticism comes from minimalists who see levies as a tax rather than a way to share the burden of adjustment among all workers. (I guess they wouldn’t mind if private insurance did this, but they won’t.)
Another rationale for the 1993 earthquake legislation was that the Treasury was trying to minimize its exposure to risk because it felt the taxpayer was over-committed. She feared she would not be able to fund other costs associated with a major disaster, such as social benefits and the restoration of government facilities.
Following the Canterbury earthquakes, the key English government chose to fund its reconstruction from current revenue rather than impose a special levy, for example on income tax, justified by burden sharing by the whole nation. This would have been the traditional welfare state approach. (The consequence has been that public spending has been squeezed; we are paying the cost of the social damage it has caused to this day.)
My view is that the role of government is to do things that the private market cannot do effectively. There were private insurance companies willing to sell earthquake insurance – take the risk – so there was a need to change the rotational share balance. It should be noted that the insurance companies do not take all the risk but postpone part of it by reinsuring themselves with others abroad, as the EQC does.
Thirty years later, the system is not working well. The Canterbury and Kaikoura earthquakes have indicated that severely damaging earthquakes are more likely than we once thought. Apparently, a period of seismic quiet has come to an end; the future risks of these disasters are increasingly uncertain and reinsurers are becoming more suspicious. (Climate change is another source of heightened uncertainty.)
The situation is further complicated by the fact that there are only three major private insurers, which means that the market is not fully competitive and may function less well.
Either way, private earthquake insurance is getting more and more expensive. For example, Wellington apartment buildings of a certain age and height are experiencing extraordinary increases. In one case I have seen, private earthquake insurance costs have increased more than eight times since the Kaikoura earthquakes.
It’s not the fault of the private insurers; they cannot find cheap reinsurers. Risks since the Canterbury earthquakes have become much more uncertain. They may be able to find a reinsurer, but not at an acceptable price, while the local national insurer may fear being too concentrated – as the AMI experience has shown. The best approach in such circumstances is prevention, but retrofitting older buildings can be very expensive.
Perhaps we should reconsider the 1993 decision. Should we shift the balance, returning to greater use of risk sharing across the country rather than depending on transferring it all offshore?
Insurance is a complex field. We’ve had many inquiries about how the EQC works, but not one regarding the car-sharing-change balance. Hopefully we will get there before the next big earthquake.
*Brian Easton, independent researcher, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a repost of a article originally published on pundit.co.nz. It’s here with permission.
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