The NZ Initiative calls for shareholders and policyholders, not taxpayers, to be made to take the hit if an insurer goes belly-up; Industry experts have their hesitations

Consider this scenario: Wellington is hit by a major earthquake that cripples one of the insurance companies operating in New Zealand.

It can either:

1. Find another company to buy it.

However if the insurer was large, one of the other major insurers already in the New Zealand market probably wouldn’t be able to make a successful bid for it.

Preventing Vero from buying Tower last year, the Commerce Commission has shown it won’t allow the general insurance market to become more concentrated.

2. Lobby the government to bail it out.

Taxpayers have footed a bill of nearly $1.5 billion to have Southern Response formed to settle AMI’s Canterbury quake-related claims after the insurer crumbled with the 2010/11 disasters. The rest of AMI’s business was sold to IAG.

3. Liquidate the company and leave policyholders with outstanding claims in the lurch; the government possibly stepping in to assist them.  

Life and health insurance policyholders might not be able to get replacement cover on similar terms, depending on their situations.

Right-wing economic think tank, The New Zealand Initiative, is calling for the Government to put a fourth option on table.

It wants to see a liability 'bail-in' regime imposed on insurers, similar to the Reserve Bank’s (RBNZ) Open Bank Resolution (OBR) for insolvent banks.

This would see a distressed insurer kept open for business, placing the costs of its failure primarily on its shareholders and creditors, rather than on the taxpayer.  

Mirroring the regime for banks, the insurer would come under statutory management. Some of its assets would be frozen to help resolve its issues, leaving policyholders to access a portion of its non-frozen assets.

Losses would be absorbed by shareholders first, then policyholders and other creditors, with the insurer potentially being recapitalised by a proportion of creditor/policyholder liabilities being converted to equity.

The NZ Initiative hasn’t gone into detail around exactly how it sees this working, but it would likely mean policyholders are forced to receive reduced pay outs on their claims.

They take a hit, rather than the taxpayer.

The NZ Initiative in a new report, Recipe for Disaster: Building policy on shaky ground, says an OBR-type scheme for insurers would encourage people shopping for insurance to put more weight on an insurer’s credit rating.

It also argues insurers might settle claims faster, as the government wouldn’t be legally liable for the shortfall between their assets and damages.

Does the OBR need to be fixed before a similar scheme is applied to the insurance sector?

Geof Mortlock, a consultant who has worked for domestic and foreign regulators, insurers, banks, financial service providers, and international organisations, supports the introduction of an OBR-type regime for insurers, but only if accompanied by other measures.

Fundamentally he maintains some gaping holes in the system would need to be filled before the regime is adopted by the insurance sector.

He believes an OBR-type regime for large insurers would have to be accompanied by a requirement for these insurers to have a tranche of subordinated debt that can be converted to shares, or written down, if their capital ratio fell below a certain level and they couldn’t raise further equity through their shareholders.

He wants banks to be required to do the same, noting this is what's done in other countries with OBR-type regimes. 

And in the same way Mortlock wants the Government to take the International Monetary Fund’s advice and introduce deposit insurance for banks, he believes an OBR-type regime for insurers would need to be accompanied by a policyholder compensation scheme.

If a bank was to run into trouble and come under statutory management under the OBR regime, there is a high risk that without depositors knowing their money is safe, they’d flock to withdraw it.

While this would only exacerbate the troubled bank’s problems, it could also encourage nervous depositors to withdraw their money from other banks. After all, if one bank was in trouble, the perception at least would be that the others would be too.

Mortlock believes that without deposit insurance, New Zealand's OBR regime poses a major risk to financial stability. 

A similar situation would pose less of a risk if an insurer went under. But likewise, knowing policyholders would be compensated for their claims may prevent them cancelling their policies on finding out their insurer would keep operating under statutory management.

Mortlock says that if well designed, policyholder compensation would enable long-term insurance policies to be transferred to another insurer, or continued in the failing insurer, and would provide protection for general insurance policyholders by guaranteeing prompt pay out on their insurance claims.

It would also provide continued policy cover to give policyholders time to get replacement cover.

This would reduce disruption to the economy - IE prevent people with mortgages getting into sticky situations with their banks when they say the properties their mortgages are held over aren't insured. 

Can policyholders stomach paying for a policyholder compensation scheme?

While there are different ways of administering a policyholder compensation scheme, the idea is that insurance companies - thus their customers - fund it.

Mortlock in 2016 told interest.co.nz that depending on their design, schemes in other parts of the world don’t necessarily have a major bearing on premiums.

Yet cost is what makes Insurance Council of New Zealand CEO, Tim Grafton, nervous.

While he would have to consult with his members to form a firm view on introducing an OBR-type scheme for insurers, he fears slapping another levy on top of insurance premiums to fund a policyholder compensation scheme could deter people from taking out insurance.

Policyholders have from 2017 already had to pay higher EQC and Fire and Emergency New Zealand levies.

However insurers have also been bumping up home and car insurance premiums, supposedly to compensate for the fact higher building and car repair costs are bumping up their claims expenses.

Are the other measures the RBNZ’s considering to strengthen the insurance sector robust enough?

Further to releasing an issues paper as a part of a review of the Insurance (Prudential Supervision) Act 2010 (IPSA), the RBNZ’s head of prudential supervision, Toby Fiennes, last year told interest.co.nz a policyholder compensation scheme wasn’t appropriate for New Zealand.

His view is that the insurance market and the risks it is exposed to are too concentrated.

So if there was an earthquake bad enough to see one insurer go under, it’s likely others would follow.

Fiennes maintains it would take too long to build up a fund to cope with so much exposure.

Mortlock disagrees. 

He says governments in other countries often top up funds in the event of a shortfall, only to later be reimbursed by industry levies.

Overall, he argues the RBNZ’s supervision of insurers is weak compared to that in other advanced countries, so it needs to up its game.

As a part of its IPSA review, the RBNZ is considering whether or not to require overseas insurers to hold a certain amount of assets in New Zealand or be locally incorporated.

While insurers are now required to hold more capital than before the Canterbury earthquakes, the RBNZ is also looking into applying a more graduated approach to overseeing insurers’ solvency levels.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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34 Comments

AMI ran into trouble because it did not have enough reinsurance. A crime in my view that should have led to jail time for much of the senior management. Except then, what they pulled off wasn't actually illegal, just sicko.
It's a dodgy time - we need insurance. We live on shaky isles, and the weather seems to be turning on us.
Of course there needs to be a standard. We need law that requires well spread reinsurance at very high levels.
Left alone the insurance companies will always cut costs (using low reinsurance) to keep customers and of course to keep dividends up.

You miss the point - the question is should tax payers bail out insurance companies or their shareholders be liable for their costs?

IMO it is the shareholders. The Boards should ensure that the companies are being run in sound way and to carry insufficient re-insurance, or have insufficient capital to meet the needs of a total collapse is criminal, I agree. But insurance companies play the risks, just like betting on the nags, and this failure only highlights the rort that insurance has become.

In my view, perhaps the Government could protect the public (by covering them when insurance companies fall short), but then be required to recover their costs from the companies and shareholders. After all it is they who have profited from the rort.

I understand the shareholders to already be liable in respect of the value of their shares. The new bank rules require despoit holders/creditors to effectively convert the debt owed to them by the bank into equity/shares thereby adding their funds to those available to the distressed bank.

I cannot see an insurance company having many depsit holders so I assume it will be creditiors of the insurance company that will be expected to convert their debt to equity so that they become forced shareholders (likely giving up any priority they had in respect of the assets of the insurance company). I do not think this will be as effective as the bank scheme due to the lack of deposit holders.

Actually i disagree with the rules around bank stress. I believe there is not enough pressure (regulation) on banks to protect their depositors funds. Indeed in law, once deposited, those funds become the property of the banks, and the depositor becomes an UNSECURED creditor. This is effectively legalised theft, particularly as bank lobbying has made it extremely hard to operate without a bank account. Even in recent times here there has been articles on the pressure on Governments towards moving towards cashless societies - more power to the banks! Try travelling in Europe and America with cash - not easy these days, as every one thinks you're laundering money, and the costs of a card that works on foreign currencies are not small - more power to the banks! Don't forget they are all privately owned, and bank shareholders profit hugely from them. Why shouldn't they have to shoulder the cost of the risks? Why should they be able to socialise those risks, while privatising the profits?

I struggle to see how insurance companies will have many if any creditors that can be drawn on in the event of a crisis. Besides if you are the cause of someone else's cost, which they make an insurance claim against, their insurance company comes to you looking to have their costs reimbursed. So in effect any claim, caused by another person or organisation, will effectively have no cost to the insurance company. So why should the insurance company be treated any different to the way it treats it's society base? Same for the banks?

I suggest that any Government protection for banks should be on the depositors funds, and that the Government in the event of having to act on that protection, should then seek reimbursement from the bank.

Welcome to Capitalism, mate.

Yes well we are currently going through a process that proves capitalism is as fraught as communism. Somewhere in the middle is where we should be I think. Regulation is required, but clear understanding and guidelines for Governments, and of course how we accept/deal with all forms of corruption.

You overlook the part played by Directors & Senior managers in assessing risk which they proved inadequate either through incompetence or a desire to improve profitability/Salaries/Bonuses so accountability is an essential part and stripping those involved of past bonuses/share allocations is a useful way of ensuring best business practice with Jail time for deliberate under re insuring.

No they report to the Board and therefore it is the responsibility of the Board to ensure their action and practices meet the required standards.

As to the comment below re overseas shareholders - there will be a way to ensure they cannot escape liability if they try. Some smart legislator will figure it out. It may be through capital requirements, but perhaps international law or legal agreements between countries will figure out a way?

Proposals that the government of tiny NZ could successfully impose a collapse liability on the offshore based shareholders of insurance companies operating here or 'recover' the cost afterwards, are unrealistic.

Being forced to hold more capital in NZ is feasible but the cost to the insuring public would be significant if long return events such as Christchurch or Rangitoto needed to be allowed for.

Yes murray86 - but. The point of my comment was that the first remedy for all of this was avoiding insurance company collapse at all by imposing some useful requirements on them. No collapses, no problem.
But yes, it should be shareholder and not taxpayers if the worst happens.

If a bank was to run into trouble and come under statutory management under the OBR regime, there is a high risk that without depositors knowing their money is safe, they’d flock to withdraw it.

While this would only exacerbate the troubled bank’s problems, it could also encourage nervous depositors to withdraw their money from other banks. After all, if one bank was in trouble, the perception at least would be that the others would be too.

Withdraw their "money" to deposit it at another bank? That is the only option given our banking system is cash starved.

Currently, $324,022 million ledger bound digital deposits are covered by a paltry $791 million cash. Moreover, bank creditors hoard $150,613 million hair trigger deposits at call. View graphic details here and here.

Objectively there is no money in banking.

Stephen, am I correct in thinking that when a bank finds itself under OBR it then after any haircut, it then becomes the safest place to deposit money? It essentially becomes Government backed. It's the other banks non OBR that come under scrutiny given the cash starved environment.

In theory, but reality may present itself differently to the government underwriting said bank's post OBR deposit rump.

I'm guessing that the Bank would be nationalised... ie.. Govt would take it over.
For an OBR event to happen a Bank would have to be insolvent... ie..bankrupt.. ( no pun intended).
Thru the RBNZ , the govt would have unlimited access to liquidity..

It would be far to generous if the Govt simply recapitalized the bank and allowed the existing shareholders to survive !!
Stranger things have happened... I recall "WallStreet" being showered with "gifts" during the GFC..

I would add.... If the govt did take over a bank , there would be a flight of money to that Bank as depositors all moved there money there., which would result in a liquidity crisis within the Banking system.
Obviously this would all happen , in troubled times, as the economy was tanking..

This is the unintended consequence of the OBR... It will create "Bank runs".

Thru the RBNZ , the govt would have unlimited access to liquidity.

At a heavy cost to the NZD/USD currency pair valuation.

yes.... the word "banana republic" comes to mind...
Thats', when we will learn what it means to be a small debtor nation..... not as wealthy as we feel..

Didn't the US come out of the GFC by doing exactly that, introducing unlimited liquidity ? Why won't it work for other countries ?

As opposed to the USD and Euro, the NZD is not a global reserve currency;

https://en.wikipedia.org/wiki/Reserve_currency

Better to open an account at the Perth Mint. Im saying that because trust that is hard earned is easy lost, and when it's lost it isn't coming back.

At least the Perth Mint has the guarantee of the WA government.

Surely a bank under OBR would become owned by the depositors who just got the haircut. The original shareholders would get the boot as their shares are now worthless but they aren't prepared to stump up more, and its the depositors who have just supplied the cash to carry own so they would be issued proportionate shares. The governments only involvement would be as regulator surely.
What Ive always wondered is what the status of the various bonds and other instruments concocted to circumvent the owners of said banks losing equity.

Covered bonds are guaranteed by houses with mortgages below %50 of the house value from memory. So wouldn't be a lot left.
Banks don't even own their buildings anymore.

Very few understand the effect of covered bonds and I am not aware of any practical experience of an OBR event on covered bonds. The point is depositors are unable to assess the real level of risk and therefore if the return offered adequately compensates. As the ex CEO of BNZ rightly comments the RBNZ is effectively not fit for purpose as a regulator of Bank and in my view insurers too. A firm statement on who would own the Banks following a OBR event would go some way to informing those interested . Whilst reserve Banks generally and Bank economists have been almost universally wrong on every prediction they have made this time it is different given the massive amount of derivatives issued and the insurance of them which in a GFCii and i doubt this is sufficient insurance capacity to deal with even a small fraction of derivatives collapsing and although derivatives are a zero sum game there are still losers. I do not know the answers but fear I may be about to find out.

"The point is depositors are unable to assess the real level of risk and therefore if the return offered adequately compensates" this statement alone exemplifies the degree of rort the banks have become to society. The have conned us all for far too long!

I thought Savers were the mugs in Saving any industry, lucky we have inflation to take care of that. daft approach.

Taxpayers and share holders and home owners and builders welcome calamity, it gives them a chance to rebuild their assets, when a GFC hits the ground, or another calamity. We bail out the wrong people with money, Insurances can spread the risk all around the World,, so ...they should what is known as
re-Insure...themselves. Might have to take a 'pay cut' to fund it. Like Savers have to do.

So basically we need to buy insurance to cover our insurance?
Precedent has been set with AMI, the Government will cover it, though I bet there are lots policy holders in Christchurch who reckon they'd have been better off with it wound up and cash paid out.

Exactly -self reinsurance - it would be cheaper to get the state to undertake that task on our behalf and stop contracting out to a failing private sector.

Matters in Britain surely suggest as much.

It’s not just Carillion. The whole privatisation myth has been exposed

yeah..
"Privatisation" was a mantra...
Foreign direct investment is another mantra..
free trade is another.

Next yr will be 40 yrs of the Thatcher/Reagan paradigm of neoliberalism
Dying a very slow death..

Surely time for real accountability with sharp teeth by stripping those involved of all assets acquired by way of Pensions/Bonus's/share allocations & salary above a reasonable level (3 times average wage perhaps) and Jail time for serious offending.

I think we should all live in State Houses, State owned Enterprises, State Insurance, State run Shops, State Banks, State Farms, State Fiddlers and State Parliaments all run by Robots.

To State one's case is the only answer, for mankind, I can think of.....As I cannot think for myself, nor plan for the Future.

Idiots have taken over from Common Sense.

Debt is now becoming farcical, expecting the State to fix anything is beyond belief....in 'money'

Let us try Robots...they can never be wrong in the Future and it is the Future we should be looking at.

Peace be with you all.

I Robot.

TBTF everywhere and everything...Next up, Kiwisaver becoming TBTF soon ?

The reason why AMI failed was that the profits that used to be built up in mutual insurance companies over time are paid out (demutualisation). If the profit had not been drained from these entities by the shareholders there would be no calamity, but the regulators and government think they can assign values and probabilities to events and then extrapolate the reserves needed and let boards determine risk vs reward and then everything else can be paid out. Nothing beats having lots of reserves. Why is it after the GFC that RBNZ raised the level of reserves required by financial institutions, its an acceptance that their previous calculations were wrong. And they are now right? If government can't regulate properly then they should take the hit, the average person should not have to take the risk when there is a regulator involved.

If we have any more failed insurers or banks we should send all of the executives and managers of the failed company to Manus Island. It would be a humane method of imprisonment according to Gerry Brownlee.

NO ? thats my answer the the rhetorical question .

I think this should have been standard policy from the get go! And enable the shareholders to vote on Management salaries as far to often we have overpaid CEO'S making stupid decisions but not held accountable!!!