FINANCIAL FAULT LINES
It would be the biggest natural disaster in Canadian history – and scientists say there's a one-in-three chance it will happen in the next 50 years. If 'the big one' hits, who would pay the bill?
A massive earthquake off the British Columbia coast could plunge the Canadian economy into a deep financial crisis, Canada's former top financial regulator is warning in a new report.
Catastrophe-modelling firms depict an earthquake and ensuing tsunami that could cause thousands of casualties in coastal British Columbia, liquefy inhabited land and damage homes and infrastructure in Vancouver, Victoria and Nanaimo.
While the province and country would first address the human toll in the aftermath of a disaster, a chain of subsequent events with "potential grave systemic financial effects" could further devastate the economy, Nicholas Le Pan, former superintendent of financial institutions, said in a report to be released by the C.D. Howe Institute on Wednesday.
Scientists predict a one-in-three chance that an earthquake strong enough to cause significant damage will hit the North American West Coast in the next 50 years. At its worst, key ports and the Vancouver airport would face months of incapacitation, disrupting global supply chains and crippling Canada's gateway to Pacific markets. The value of land and many homes would crater, particularly in built-up areas expected to sustain the most damage in the Fraser River Delta. Insurers would be forced to stretch to cover billions in insured losses, while mortgage insurers and banks could be sideswiped by credit losses.
Although this risk has been known for many years, recent worse-than-expected earthquakes – such as those that struck Japan and New Zealand in 2011 – have put the issue back in the spotlight, prompting new studies of preparedness in Canada and elsewhere. The federal government has pledged to plan better for natural disasters in the wake of recent dramatic flood and wildfire events. This year's fires in Fort McMurray, Alta., rank as the costliest natural disaster in Canada's history, but would represent just a small fraction of the potential cost of an earthquake.
Also sounding the alarm have been the private enterprises most likely to feel the financial pain of earthquakes on a large scale: insurers. "Earthquake is the one risk that is so much larger than anything else that Mother Nature can throw at us," said Don Forgeron, chief executive officer of the Insurance Bureau of Canada.
Property and casualty insurance companies are trying to put the issue on the public agenda, part of a larger effort to engage institutions and lobby the government to make sure that their industry is not wiped out by a natural disaster.
If an earthquake were to hit at a higher magnitude than the models show, as happened in Japan and New Zealand, "the impact gets magnified. It's a classic systemic risk knock-on effect – across companies to other companies that might otherwise be healthy," said Mr. Le Pan, who helped to develop some of the first earthquake capital testing rules for insurers while at the Office of the Superintendent of Financial Institutions from 1995 to 2006. He said his report is "about preventing that knock-on effect that would potentially impact auto insurance, home insurance, business interruption insurance far beyond the earthquake zone."
The risks are not limited to British Columbia. Another active seismic zone stretches from the Ottawa Valley past Quebec City, where a significant earthquake could also have crippling economic consequences. All told, two in five Canadians live in homes tucked in these two seismic pockets separated by more than 4,000 kilometres.
Simplified seismic hazard map for Canada
From Natural Resources Canada: The map below provides an idea of the likelihood of experiencing strong earthquake shaking at various locations across the country. This map shows the relative seismic hazard across Canada for single family dwellings (1-2 story structures).
The insurance industry has been analyzing earthquake-linked risk for more than two decades, and some insurers calculate that the economic losses from either the eastern or western scenario could top $100-billion.
"We sailed through the financial crisis with no issues. And this led us, at the time, to say: 'What is a big issue for us? What is the systemic risk for the industry?' There was one in my mind. And it was quake," said Charles Brindamour, CEO of Intact Financial Corp., the country's largest property and casualty insurer. "As far as I'm concerned, this is the risk that could take the industry down, and could have a significant macroeconomic impact for the country, as we've seen in other countries."
Insurers say that if Canada acts now, it can help mitigate the risks to the financial system. With the post-earthquake experiences of other nations fresh in their memories, Canadian insurers, regulators and governments have collectively begun to rethink their strategies and approaches to account for earthquake risk and limit the potential impact.
Still, troubling questions hang in the air: When the "big one" comes, how will we recover – and who will be left with the bill?
One month of quakes
Canada experiences thousands of earthquakes every year, but most aren't felt. Here's a snapshot of seismic activity in B.C. and surrounding areas during July – all 319 quakes. (Circle size represents magnitude.)
Tom Cardoso/The Globe and Mail Source: Natural Resources Canada
O n a late-November Sunday evening, nine-year-old Veronica Scotti was building a wooden dollhouse with her father on the family's kitchen table in Naples, Italy. Suddenly, her world was in motion.
Wood clattered to the floor and kitchenware slid from shelves as her engineer father pushed her to safety under the table – a swift reaction to the magnitude-6.9 earthquake that shook the region on Nov. 23, 1980.
Her family lived out of their car for a week, while the economic and political ramifications affected the region for many years.
Feelings of vulnerability lingered. "People [who] haven't experienced it don't know how quickly it goes, and how very devastating it can be," said Ms. Scotti, who now lives in Toronto and works as Canadian chief executive of Zurich-based Swiss Reinsurance Co., which insures other insurance companies.
She said a significant earthquake is among Canada's most potentially devastating perils, and one of the least insured.
At greatest risk is the southwestern coastal region of B.C. that includes Canada's third-largest metropolitan area near the Cascadia subduction zone, where two tectonic plates, locked against one another for hundreds of years under the ocean, will one day violently give way – a scenario illustrated in a Pulitzer Prize-winning 2015 New Yorker story, which examined the potential devastation a cataclysmic quake could cause if it hit off the coast of the western United States.
Two years before that story, a study by the Insurance Bureau of Canada (IBC) and catastrophe-modelling firm AIR Worldwide sounded the alarm for Canadians, estimating the impact that a magnitude-9 earthquake on a late July weekday would have. The last time the region sustained something similar was in 1700, before European colonization and the building of Vancouver and Seattle, and their skyscrapers, bridges, pipelines and sewage systems. Today, the quake and subsequent devastation could cause $75-billion in economic damage in Canada. Less than one-third of that would be covered by insurance.
AIR's report also pointed to the Charlevoix zone in the East, where the shaking could feel more violent than on the West Coast, despite registering far lower on the Richter scale. There, a quake at a magnitude of 7.1 would ruin architecture and structures in Montreal and Quebec City much older than Canada itself and cause about $61-billion worth of damage. There is a 5- to 15-per-cent chance that such an event will strike in the next 50 years, the study noted.
The last major earthquake in this area – on Feb. 28, 1925 – predated the Richter scale, but researchers would later rank it as a 6.2 event. The quake damaged churches and statues and wrecked plumbing and chimneys.
There's more at stake now.
Fewer than half of B.C. residents have bought earthquake insurance, according to the IBC, although take-up rates in Victoria and Vancouver are 70 per cent and 55 per cent, respectively. In Quebec, fewer than 5 per cent of people have earthquake insurance.
"A lot of people might think they are covered. They think: 'I have homeowners insurance,' you know? 'What else am I paying for?'" said Gerry Glombicki, who oversees North American insurance at Fitch Ratings. "Turns out, not."
Businesses tend to plan better for such events: About 85 per cent of B.C. businesses and roughly 60 per cent of Quebec businesses have earthquake coverage, the IBC said. There are more than 200 companies that provide property and casualty insurance in Canada, an industry separate from life and health insurance coverage offered by Manulife Financial Corp., Sun Life Financial Inc. and others.
Earthquake insurance is sold by the private sector with an expectation that a lot of people – but not everyone – will need to be paid a claim at once. That is unlike other types of insurance such as automotive, where accidents and damages happen in a less concentrated way. As with all types of insurance, however, there is a risk that losses will exceed what the insurers have foreseen. But when that happens on a large scale in an earthquake, companies can get into trouble.
The Office of the Superintendent of Financial Institutions (OSFI) requires insurers to hold enough capital to ensure that they can cover claims from a significant earthquake and many have added financial cushions on top of that. Insurers also spread risk around globally through deals with reinsurers. All told, the industry should be just be able to manage a collective $30-billion loss event triggered by a very, very large earthquake.
Mr. Le Pan's concern is that this preparation does not go far enough, and he said an emergency backstop agreement with the federal government should be put in place so that money is quickly and clearly available to fund losses and prevent financial shocks to the economy.
Such a large earthquake would cause the bankruptcy of some insurance companies, shifting the responsibility for paying their claims to an industry group called Property and Casualty Insurance Compensation Corp. (PACICC), which insurers are required by law to join. It is PACICC's job to wrangle surviving insurers to help absorb costs, all without receiving any government funding.
But PACICC has its limits. If multiple large insurance companies were to become insolvent, its demands on the remaining companies would cause them to fail their own regulatory solvency tests, threatening the survival of the whole industry. That would be a huge hit for an industry with nearly $160-billion in assets that employs more than 120,000 people.
"You'd start having all the companies in trouble all at the same time," PACICC head Paul Kovacs said. "The insurance industry has a limited amount of money. At some point, it's paid everything it's got."
An insurance industry in crisis would limit other kinds of coverage on which people rely. Without that insurance, people would not be allowed to drive their cars, get a mortgage or operate businesses.
Mr. Kovacs supports a deal that addresses this risk. "The government of Canada doesn't immediately have $60-billion, but it can handle it on a better scale than the 100 or so insurance companies that would get this bill."
And there is a precedent for emergency backstop arrangements with the private sector that protect against such disasters, since nuclear power operators and offshore oil drillers both have emergency funding plans, Mr. Le Pan said. If the government could pledge to pay outsized damages to the insurers in the wake of an earthquake, it could "minimize the systemic financial impact resulting from such a catastrophic and likely an uninsurable event on those affected and on the economy at large," his C.D. Howe report said.
The Department of Finance said in a statement that insurers are expected to "assist their clients by settling policy obligations," but it also noted that it works with the OSFI to foster "a framework that is robust enough to protect policyholders and preserve financial stability in the event of insurance company failures." The statement said officials would review the C.D. Howe Institute's recommendations.
Given the spotty insurance coverage in parts of Canada and the volume of unprotected public infrastructure, a large earthquake would require a government intervention anyway. The federal Disaster Financial Assistance Arrangements program for providing provincial and territorial governments financial relief has never been tested at such a large scale. The costliest natural disaster in Canadian history happened this year when Fort McMurray was struck by wildfires and insured losses climbed to $3.6-billion. Ottawa stepped in with an initial aid payment of $300-million.
Governments have never had to manage the delicate question of how to fund a recovery from a catastrophic disaster where some people have purchased insurance to protect themselves while others have opted not to and would be left, at worst, with a large mortgage on a home that has been destroyed.
"In the extreme [earthquake] scenario that I'm concerned about … I think that it is not a stretch of the imagination to think that an economic area could lose a decade rebuilding," Mr. Brindamour said.
The C.D. Howe Institute is part of a growing chorus calling for actions to mitigate this systemic risk.
The Conference Board of Canada is due to release a report on earthquake risk this year. The IBC is working on a more detailed economic-impact report. In British Columbia, some municipalities are considering banding together to purchase earthquake insurance to cover repairs of public infrastructure.
And the federal government has been increasingly focused on disaster relief as it prepares to spend billions on new infrastructure and heightens climate-change awareness.
Last year, Canada Mortgage and Housing Corp. – the Crown corporation that backs more than half of Canadian properties with mortgage insurance – began stress-testing for earthquake risk for the first time, at the OSFI's request. The CMHC found that a major quake would slash profits by $2.4-billion over the five-year period from 2015 to 2020. But it would not be on the hook for default losses, since mortgage loan insurance does not protect lenders against unexpected major events – often called acts of God, or force majeure.
"If someone's house was destroyed in an earthquake, and they did not have earthquake insurance, then the next institution that is exposed to the loss is their financial institution," said Brad Fischer, director of insurance and guarantee risk at the CMHC.
Canadian banks do internal reviews of credit and business continuity risk to satisfy both the OSFI and their own internal standards. But the results are not disclosed publicly. "Generally speaking, from a lending perspective, banks are aware of the risks that natural disasters can pose," said Maura Drew-Lytle, a spokeswoman for the Canadian Bankers Association.
Regulators have also been tightening their insurance requirements. By 2022, insurers with exposure to British Columbia and Quebec will have to show that they can cover the probable maximum loss stemming from a one-in-500-year earthquake, which many are already doing.
The Department of Public Safety said in a statement that it is "shifting from a reactive model to one that allows us to better identify risks, plan for and prevent natural disasters and the economic disruption that comes with them," and has many initiatives with provincial and territorial governments under way. The Department of Finance said the potential economic impact of an earthquake is uncertain, but added that the effects have been "limited" in other industrial countries as reconstruction efforts offered a boost.
Even as insurance companies push other institutions to increase awareness and season the public about the risks, they are wary of sounding the alarm too loudly. Some do not really want to sell more earthquake insurance, and have tightened their sales in areas of Vancouver, or cut them off completely.
"I don't want to be making a black cloud everywhere," said Philipp Wassenberg, Canadian chief executive officer of Munich Re Group, who is largely critical of Canada's level of preparedness and attention to quake risk. "You see a lot of risk mitigation efforts [in British Columbia], by the IBC, by insurers, by municipalities," he said, adding that in some countries that are well prepared, the economy can actually get a boost in the aftermath of an earthquake, as insurance money pours in.
Mr. Kovacs said the Canadian insurance industry is much better prepared than the industry in other countries. "But, again, there is a threshold," he said. "At some point, there is the potential for an earthquake that is bigger than what we've prepared for. Big enough to be really a serious problem."
Illustration and map by John Sopinski / Source: Natural Resources Canada