AMI and moral hazard

So when a disaster hits, the government is willing to bail out domestic insurance companies to “provide certainty for claimants”.  Ok.

As a result, insurance firms will discount these large scale low probability events – and take on more risk when providing loans.  Their willingness to take on more risk than is socially optimal will be paid for by tax payers.

I wonder how big this effect is – and I wonder why it hasn’t been raised in conjunction with these movements.  If we are determined to provide a backstop for a number of New Zealand industries we will probably need higher taxes – this is something that the government should probably articulate to people if it wants to be transparent – then if society is willing to socialise losses they can …

  • http://www.sustento.org.nz raf

    I don’t think the government can articulate something they don’t understand. They want to privatize and underwrite at the same time. Make your mind up time.

    How are people ever going to learn about risk when they are always covered?

    AMI (as much as I like the company) should pay out what they can and then wind up or be bought out.

    Government has no role in this at all.

    Polanyi would be having a laugh about this, Hayek would be choking…..

  • http://www.tvhe.co.nz Matt Nolan

    @raf

    I’m fairly unhappy. I don’t think people are averse to the idea of giving people in Canterbury some support – but backstopping insurance companies is a funny way to go about it IMO.

    I am sure the case could be made, I just wish it was being made instead of assumed :(

  • http://www.sustento.org.nz raf

    I think you are right to be unhappy. The problem they have now is where is the line in the sand?

    Everyone should now rush to the best capitalised insurance company. Insurance is a risky business (ask anyone who’s been in a LLoyd’s syndicate or AIG for that matter) but I think we all assume insurance is some magic system to cover us all. Well it isn’t. It’s a mathematically driven business and you always hope you have enough money to cover yourself in the event of a major claim situation.

    Now as we have seen in many businesses, financial ones mainly, there is a temptation to run “stocking” levels as tight as you can, whether that’s food or petrol supplies or capital reserves. That’s where regulation comes in.

    But if you get it wrong sorry…….that’s business, that’s capitalism at its most basic form.

    We’re on a slippery slope and probably have been for sometime. Some would argue the neo-liberal agenda is always about protecting business and the wealthy rather than ensuring a highly transparent and efficient market system.

    On the evidence to hand, they may be right.

  • http://www.tvhe.co.nz Matt Nolan

    @raf

    “Now as we have seen in many businesses, financial ones mainly, there is a temptation to run “stocking” levels as tight as you can, whether that’s food or petrol supplies or capital reserves.”

    And many of the firms would have been doing this because they felt they had a backstop in government.

    “We’re on a slippery slope and probably have been for sometime. Some would argue the neo-liberal agenda is always about protecting business and the wealthy rather than ensuring a highly transparent and efficient market system.”

    I’m not sure if I’d say that this is the “neo-liberal agenda” – however, this could all stem down to how we define neo-liberal. There are a set of vested interest groups that have an impact on regulatory policy – that is undeniable – and those sorts of public policy issues vex me. However, I also think it is undeniable that a lot of policy that has been put in place was on the basis of improving outcomes – its just that it wasn’t thought through enough.

    IMO the best way to protect against such things is to increase economic literacy, so that the public can recognise when this happens – and recognise the costs and benefits of policy. As always, its about information.

  • JAGNZ

    Firstly, I have MANY friends in Christchurch and my heart goes out to them in this horrible situation. There is no easy answer here. I didn’t want to post my thoughts for fear of sounding insensitive but I feel I must.

    This bailout just goes to prove that ‘Too Big to Fail’ has infected NZ just like the rest of the world. These situations are why we have bankruptcy laws! To re-structure an unsustainable debt load.

    Why some private businesses qualify for bailouts (like AMI, Air NZ, BNZ, the finance companies etc etc etc) whilst others do not (like small mom and pop shops hit hard by the recession such as my business which I recently sold) is just another example of socialism at work. The government is not bailing out AMI – the TAXPAYER is. And that is wrong if we want true capitalism in this country.

    You simply CANNOT have capitalism on the way up and socialism on the way down, it simply does not work and this has been proven over and over again worldwide. And these bailouts always happen at 100c on the dollar. WTF? Should there be no risk in the world these days? Risk/reward is what makes capitalism work in the first place and when you remove the risk component all hell breaks loose in the markets through insane risk taking for short term business gains.

    All NZ’ers are going to wear these bailouts in the form of higher premiums, higher taxes and rampant inflation. In life you never get something for nothing.

    The government tries to play it down by saying they’ll do a cash for equity swap like they did with AirNZ. If this was such a great deal then PRIVATE investors the world over would be chomping at the bit for some of that action. They obviously are not. So, if it’s not a good deal for business people and investors WHY is it suddenly a good deal for the taxpayer?

    This bailout totally harms AMI’s competitors too, you know the ones who did not take the geographically concentrated risks AMI did in the market? What SHOULD happen is that policy holders flee AMI for their competitors, meaning they pick up market share through wise business practices. Now, instead, poor risk management is being rewarded and their competitors do not derive the benefit from free market dynamics. If I was an AMI competitor I would be PISSED right now. But then again it sets a nice little precedent for them in case they are ever in the same position so I doubt they will make too much noise about it.

    Since NZ is and always has been left/socialist leaning (and as such bailouts will most likely occur until we’re broke), at the very least AMI should be forced into liquidation/bankruptcy and closed up with the directors not allowed to run a business again (or at least for the normal statute period under bankruptcy law).

    If the government chose to honour historic claims against the company then so be it but they should not be allowed to continue to operate to the detriment of the country (taxpayers), the industry and their competitors. This is the only thing that will help prevent the moral hazard that bailouts create in the first place.The current bailout package is just a bandaid on a very broken system.

  • Miguel Sanchez

    I wonder how many of those fuming about the AMI bailout are also opposed to the Government blowing millions of dollars on subsidies for employers (including those small mom and pop stores), job loss cover for workers, meet and greet functions for exporters, and so on. That stuff only encourages people to keep living and working in a city that’s much more of a quake risk than previously thought. And when the next one hits, who’s gonna wear the cost? The taxpayer again, of course.

  • Greg

    Miguel has it right. This is Mr “Nice Guy” Key making sure that AMI”s customers don’t lose out. So there’s an indirect moral hazard of encouraging people to rebuild the parts of Christchurch that are on liquefaction-prone soils, without the necessary thirty-metre piles and other safety measures.

    I’m not sure that there’s necessarily a direct moral hazard, though. That would only be the case if AMI’s (soon-to-be-former?) owners are not made to bear losses. The jury’s still out on that.

  • http://www.tvhe.co.nz Matt Nolan

    @Miguel Sanchez

    I’m fine with policies that are direct and transparent – it just vexed me that this was being sold as “helping Christchurch” when it is a loan/equity purchase to prevent a firm from failing.

    Hell, if they made a nice argument as to why they did it – I’m sure there could be some justification (although I’ve heard enough in this case where I don’t agree with government intervetion), but we didn’t get that.

    @Greg

    Good point regarding the moral hazard – it indicates that I was unclear in my post (like usual) ;)

    The moral hazard issue I’m talking about stems from peoples choice to get insurance – the individuals getting insurance should have taken into account the potential for failure given a large low probability event (especially given the exposure of the firm). However, now they know the taxpayer will pick that up – so they will be willing to move into riskier insurance firms for cheaper premiums. As a result, insurance firms are also willing to take on more risk, as they know that when an event that causes a large claim comes in they have a society that will pay for them …

  • MrV

    @Matt Nolan
    Agreed there is moral hazard involved on the company side etc.

    However the idea that individuals getting insurance should have to analyse financial statements of multiple companies, ensuring that said statements are comparable in the way financial data is reported and that reinsurance information is even disclosed to those same individuals makes it absurd that the general public should do this or are even qualified to do so.

    Perhaps there could be a role for a ‘consumer protection agency’ to ensure standardised contracts, equivalent comparison of underwriting standards and provide simple info to consumers of insurance products etc.
    You could suppose a private business model could provide this service, however as we have seen with S&P, Moodys etc they can also be conflicted as the question is always ‘who pays?’ for the service

    Perhaps we need to assess the presumption that a general insurer even has the requisite skill base to offer natural disaster insurance products, given such events by nature are more difficult to model than run of the mill auto-accidents etc. No doubt AMI will say they relied on independent advice or some ‘model’ as to appropriate reinsurance levels etc. However given that Western civilisation has only lived on these islands for say 200 years, we really don’t know what geological time has in store for us.

    We should also reflect on the other ‘moral hazards’ created on the consumer side.
    Maybe there should be a large excess (say $5000) on contents for large disasters to discourage frivolous claims and encourage savings for said events. Is it reasonable after the first earthquake that contents should be covered for aftershocks if consumers don’t take care to protect their own contents to a higher degree. Not to mention additional things that get claimed as ‘earthquake related’ but are marginal at best.

    We also see the folly of expecting insurers who have to hold generally more liquid
    instruments (hence generally earning lower yields) to cover the incentives created by government policy toward housing which has generally been inflating at a faster rate. At some point the math fails as there is a gap between interest earned on assets not being aligned with the increasing value of property. I suppose you could argue that insurers should be able to account for this with premium increases, however at what point would this make said cover not affordable. Logically the firm should refuse cover but the incentives in the market as it is today would make this difficult without something binding on all market participants.

  • Greg

    Matt Nolan :
    @Greg
    The moral hazard issue I’m talking about … insurance firms are … willing to take on more risk, as they know that when an event that causes a large claim comes in they have a society that will pay for them …

    Again, that applies if AMI’s owners don’t bear their losses in full. If they do bear the losses in full (i.e.without benefit of bankruptcy, etc), we avoid moral hazard. But perhaps you are operating in the real world … ;-)

  • Greg

    After some pondering, I’m back where I started. The knowledge that their claims will always be paid will lead customers of insurance companies, house buyers, to be imprudent. If an insurer knows that she can’t make money from a bailout, i.e. that she has to face the true risks, she will not fall prey to moral hazard.

    The moral hazard lies definitely with the householder and only possibly with the insurer; it is the householder who has taken on excessive risk and is now being bailed out.

    I guess we’ll see. If insurance premiums do not rise differentially for property in liquefaction-prone areas, now that the risk has been made plain, then that would be prima facie evidence of moral hazard in insurers.

  • Miguel Sanchez

    Greg :After some pondering, I’m back where I started. The knowledge that their claims will always be paid will lead customers of insurance companies, house buyers, to be imprudent. If an insurer knows that she can’t make money from a bailout, i.e. that she has to face the true risks, she will not fall prey to moral hazard.

    No, that’s a false distinction, and funnily enough in this case it’s easy to demonstrate why. AMI is a mutual; the customers ARE the owners.

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  • Miguel Sanchez

    I just realised that we haven’t even touched on the worst aspect of this moral hazard. Bailing out AMI – but not Western Pacific – tells insurers to go for growth at all costs, until they’re big enough to be “too big to fail”. Never mind that that rapid growth will probably sow the seeds of their own demise. It worked for South Canterbury Finance – ten years ago they wouldn’t have been large enough to warrant a bailout.

  • Dismal Soyanz

    Not being an AMI policyholder (I narrowly avoided that one by actually finding a cheaper quote from a competitor whom I knew something about their balance sheet health to be comfortable), I have a question. How much information was given to prospective and actual policyholders regarding the risk allocation of AMI? There is certainly none obvious on their website

  • Dismal Soyanz

    MrV :
    However given that Western civilisation has only lived on these islands for say 200 years, we really don’t know what geological time has in store for us.

    Not quite true. I have a couple of geologist friends who explained how the geological record can provide evidence of major seismic events stretching back megazillions of years. Whether we a) researched, b) interpreted ans c) applied the geological record correctly is another matter.

  • MrV

    @Dismal Soyanz
    I don’t doubt that the geological record holds many as yet undiscovered clues. But whether we will ever be able to a) research b)interpret and c) apply it, and d) do it a timely manner is certainly an open question.

    In relation to this situation perhaps it should only be insurers with significantly diversified global resources to draw on that should be able to insurer these sorts of risks. That would provide a natural barrier for mutuals getting too large, given that if people want the fully comprehensive cover that includes natural disaster they would have to get at least some of their policy from a more diversified insurer.

  • Fed Up

    Miguel Sanchez :I just realised that we haven’t even touched on the worst aspect of this moral hazard. Bailing out AMI – but not Western Pacific – tells insurers to go for growth at all costs, until they’re big enough to be “too big to fail”. Never mind that that rapid growth will probably sow the seeds of their own demise. It worked for South Canterbury Finance – ten years ago they wouldn’t have been large enough to warrant a bailout.

    I totally agree with this and it is something that seems to have been missed in the media.
    There is a lot behind this decision, nor did it surprise me that it was made, I know that not all government members were supportive of this bailout for the very reasons mentioned here, but senior members made the decision.
    NZ Prudential Regulation is currently weak and the Reserve Bank was in the process of increasing the controls, more will come out of this in the next 6 months and insurance companies will not squeal too much when it is accelerated, knowing that potential Government support is at stake.

  • Mary

    What is the moral difference between insured by AMI or Western Pacific? Unless govt thinks there are lots more shonky insurance companies out there, why are they not treating like for like? AMI policiy holders are no more deserving than WPI policy holders. They are both victims of a shonky insurance environment where cowboy brokers take excessive commissions to place insurance with companies set up by people blacklisted in Australia (i.e. McNally). Both govt (MED) and the insurance industry (Insurance Council and brokers) have known for months that there was a problem but they did nothing to alert the public or look after anyone but themselves. Now us poor sucker have to carry the can.