31 January 2012 Duncan Anderson Acting Assistant Secretary Disaster Recovery Policy Taskforce National Security Resilience Policy Division Attorney-General's Department 3-5 National Circuit BARTON ACT 2600 By email: Duncan.Anderson@ag.gov.au Dear Mr Anderson NDRRA Submission The Actuaries Institute is the sole professional body for actuaries in Australia, providing independent, expert and ethical comment on public policy issues where there is uncertainty of future financial outcomes. It represents the interests of over 3,800 members, including more than 2,000 qualified actuaries. Some of the principles that guide the Institute s inputs into public policy are:» acceptance of public sector involvement where the market does not meet societal needs,» the need to take a long term policy view, with appropriate transitional arrangements,» ensuring that consequences of risk taking behaviour are borne by the risk taker,» issues of intergenerational equity, and» clear and reliable information available for decision making. The Institute has met with the Attorney-General's Department (AGD) and has offered to provide some high level thoughts on ways to reform the Natural Disaster Relief and Recovery Arrangements (NDRRA). We have not carried out any technical analysis in the preparation of this submission. Revising the NDRRA will require extensive analysis of past claims and expected future claims under different potential structures. Current NDRRA Structure The NDRRA sets out the basis for the Commonwealth to provide financial assistance to the states to relieve the burden of the impact of natural disasters. There is a range of criteria which must be met and specified formulae for the financial assistance.
There are two key principles: The assistance is not to supplant, or operate as a disincentive for, self-help by way of either insurance or appropriate strategies for disaster mitigation, and As far as practicable, its assistance is to be designed to achieve an efficient allocation of resources. The current minimum state 1 assistance is $240,000. expenditure in order to be eligible for access to financial Under the current NDRRA structure, the Commonwealth effectively insures the states against natural disaster losses via the NDRRA, albeit that no premium is charged for the cover provided. Adopting Insurance Principles into the NDRRA We encourage the AGD to examine the typical process of insurance placement and management for a large organisation, and the placement of reinsurance for an insurer in respect of its property risks, including aspects such as: the information that is provided by the states under the NDRRA, and how that information request impacts risk understanding and management; the financial incentives involved with charging premiums (and facilities to track cost relative to assets insured); and the expertise brought to the fore from the various parties involved, including brokers, insurers and reinsurers, risk managers, engineers and other analysts. In particular, we encourage the AGD to:» Structure NDRRA compensation in a way that encourages the states to understand, manage and mitigate risks. Traditional insurance (whether formally structured selfinsurance with financial risk management feedback systems or standard insurance to a third party) introduces important rigours and disciplines such as a visible charge for risk, a control cycle, and a process, such as the collection of exposure data and analysis of risk scenarios, by which the understanding of risk is improved. The current structure of the NDRRA has few such structures. For example, the lack of any charge, actual or notional, for the support offered under the NDRRA gives no visibility to the states of the cost of the federal support and no feedback to encourage risk management and mitigation until after an event has occurred.» Consider the Natural Disaster Insurance Review s recommendation that federal compensation to the states under the NDRRA be based on gross rather than net losses (i.e. losses prior to recoveries from any insurance that the states have taken 1 In this submission, state has the same meaning as it does in the NDRRA documentation Page 2
out). This will give the states a clearer financial incentive to manage risks. Under the current arrangements the states are penalised for taking out reinsurance. Basing NDRRA compensation on gross losses means that the portion of losses payable by the Commonwealth under the NDRRA will need revision. The states third party reinsurance arrangements would need to reflect a gross basis of NDRRA compensation to avoid double payment.» Consider revising the NDRRA excess or attachment point (i.e. the level of losses which triggers compensation), which is much lower than would be applied in a reinsurance context.» Consider the barriers in place which discourage states from managing and mitigating risks. Without having reviewed actual payments to the states, it appears that the current equal treatment of states in respect of thresholds defined relative to revenue may not take account of the significant differences between states in the size and impact of natural disasters and in the significant differences in assets exposed to risk. This may be a barrier to the NDRRA having embedded feedbacks which encourage states to manage and mitigate risks. The financial exchange between state and federal governments needs to be sufficiently sensitive to the underlying risks of each state in order to create an incentive for state level focus and ensure that state level action (or inaction) forms part of the state level political agenda. If the NDRRA attachment point was increased and/or the Commonwealth s portion of losses reviewed to allow for a gross loss basis or other changes, this could lead to lower expected NDRRA payments than would apply under the current structure. This could give the Commonwealth the option of maintaining theoretical revenue neutrality by providing upfront monies to the states to fund mitigation and risk management activities. That is, the Commonwealth could consider making available to the states the difference between current expected NDRRA compensation payments and those lower payments modelled to occur after NDRRA revision, as long as certain conditions are met on the use of funds. This payment to the states could fund mitigation and risk management activities. Basing Recoveries on Gross Losses Basing federal compensation to the states under the NDRRA on gross rather than net losses may encourage more effective risk management by the States. Applying the NDRRA to net losses may provide a disincentive to states to establish relationships with reinsurers. Under the current NDRRA, following an eligible disaster the Commonwealth provides funds to the states after allowance for (i.e. net of) any other (re)insurance 2 recoveries. This means 2 Reinsurance is the insuring of an insurer. A state taking out catastrophe insurance would almost always do that with a (international) reinsurer. This would strictly be insurance (not reinsurance), but in this case the terms are interchangeable. Page 3
that states are not rewarded but rather penalised for taking out insurance. The less insurance a state has, the higher the recoveries available under the NDRRA (even if the same amount is recovered via the insurance arrangements, the state is out of pocket to the extent of the insurance premium). Reinsurers will typically determine their portion of losses net of known (preceding) reinsurance arrangements. Once reinsurance arrangements are in place, the insurer has limited incentive to purchase additional reinsurance which reduces the loss to the reinsurer this is because the insurer will bear the full cost of the reinsurance but only receive a proportion of the benefit. However, reinsurers will not contemplate a situation where a state is indemnified twice for a loss. Rather, the part to be played by the private sector needs to be integrated into the NDRRA arrangements so that the cost of any catastrophe loss is met partly by the Commonwealth, partly by any private sector reinsurer, and partly by the state. The integration has to occur in a way that does not inhibit the states from effecting private insurance or mitigating risks. There are many examples of governments partnering with reinsurers for cover of unpredictable and/or costly risks, including earthquake insurance in Japan, Taiwan, Turkey and California, and terrorism insurance programmes (TRIA in US, GAREAT in France and NHT in the Netherlands). Such programmes need to be carefully designed in order to be successful. In particular, it is important that the design of the programmes allow for appropriate pricing of risk. Interaction by states with reinsurers could be encouraged not only for financial reasons, but also to assist states to develop an understanding of exposures and risk management procedures expected in a conventional private sector reinsurance arrangement. For example, private sector insurers and reinsurers have skills in claims administration which could also be of assistance to governments. Attachment Points, Deductibles and NDRRA Reimbursement Proportions The loss amount triggering NDRRA recoveries (the excess or attachment point) is much lower than would be applied in a reinsurance context. The attachment point could be increased to a level which encourages states to take out appropriate reinsurance arrangements and also to carry out other cost-effective mitigation measures to protect themselves and their inhabitants against the impact of natural disasters. The table below provides a broad comparison of the attachment point on insurance or reinsurance policies with each insured s assets. The figures shown are indicative estimates of current practices and asset levels in Australia. Page 4
Indicative excesses as a proportion of assets for different insureds Insured Excess 2 Assets Excess % Individual $500 $750,000 0.067% Small Insurer $1,000,000 $150 million 0.66% Large Insurer $25 million $5 billion 0.50% Large Insurance Group $100 million $20 billion 0.50% State 1 $240,000 $150 billion 0.00016% 1 States retain a proportion of losses above this amount so the excess % is not directly comparable. 2 The qualifying threshold under the NDRRA is not directly comparable to the insurance attachments shown in the table, but serves to illustrate the relative levels of risk retained and transferred. The NDRRA could be both more effective and provide better disaster resilience incentives if the level at which financial assistance is provided is increased significantly. In theory, the states should be able to withstand a greater deductible (the amount below the attachment point) than insurance companies. The low attachment point in the present NDRRA arrangements effectively means that the NDRRA is subsidising infrastructure in high risk areas. Transferring a higher proportion of the cost of the more frequent catastrophe events back to the states and increasing private sector participation could be expected to produce a stronger focus on risk management on the part of the states. Although the states could readily absorb more of the small losses, the impact of large natural disasters can be considerable. The Commonwealth should not necessarily be exposed to the full cost above the deductible, and there are greater incentives for the states to implement disaster mitigation strategies if they bear a proportion of the costs above the deductible. In essence, this is similar to the current NDRRA but is triggered after a large natural disaster event. Once an attachment point has been breached, there are a number of alternatives for determining the proportion of losses which fall under NDRRA recoveries (NDRRA reimbursement proportions). Given the magnitude of the assets of the states, particularly in comparison with the larger insurance companies in Australia, a deductible between $200 million and $1 billion may be considered. With a higher deductible it may be possible for the Commonwealth to accept a higher proportion of the costs of events above a certain magnitude. The table below sets out a hypothetical structure. Page 5
Example of state/commonwealth cost proportions by layer Layer Proportion of Layer 1 State Commonwealth $1 million to $200 million 100% 0% $200 million to $1 billion 50% 50% $1 billion to $5 billion 25% 75% $5 billion to $10 billion 10% 90% 1 These percentages are for illustration only and are not based on any analysis. Determining appropriate attachment points and NDRRA reimbursement proportions requires a comprehensive modelling exercise, incorporating both analysis of past losses and projection of future possible losses, to estimate the cost neutral trade-off function between a higher attachment point and higher reimbursement proportions. (It is not necessary for the restructuring of the NDRRA to be cost neutral.) With a higher attachment point, a cost neutral re-design of the co-insurance arrangements could see the states picking up more of the lower layer costs and the Commonwealth picking up more of the higher layer costs. This could provide some incentive to states to manage lower layer costs. Alternatively, the NDRRA co-insurance portion could be re-arranged so that the states are responsible for a higher overall share of losses above the attachment point than currently applies, in addition to the higher level of deductible. The states could then be compensated with an up-front payment from the Commonwealth. The states could use these monies paid by the Commonwealth to meet annual loss costs, apply it to mitigation, use it for insurance, etc. This could give the states financial incentive to mitigate and manage risks, and provides upfront monies to fund these efforts. In effect, the Commonwealth could be paying up-front monies to the states to reflect the part of the NDRRA from which the Commonwealth is withdrawing support. To achieve cost-neutrality, the premium could be determined as equal to a proportion of the shortfall (compared to the present NDRRA) in the expected annual disaster recoveries from the Commonwealth under the new arrangements. This proposal could remove the distortion implicit in the present NDRRA which impairs the states incentive to take cost-effective risk mitigation actions. The Commonwealth s cost under the NDRRA could become the annual transfers to the states, plus a lower share of the costs of natural disasters. Even if NDRRA recoveries continue in much the same form as at present, and the reimbursements to the states continue to be determined on a "net of insurance recoveries" basis, a review of attachment points and reimbursement percentages to increase the incentive for states to implement mitigation actions is encouraged. Page 6
There are a number of options for determining an appropriate attachment point. For example, if the attachment point is set as a percentage of state revenue, it would be insensitive to the accumulation of assets over time which could, dependent on infrastructure investment levels, depreciation and inflation, typically exceed growth in revenue. State Governments Funding Options Traditional reinsurance providers are not the only source of non-ndrra recovery for states. States (and the Commonwealth) may be able to access capital markets via catastrophe bonds and similar instruments, which could be an effective funding mechanism for natural disasters. Catastrophe bonds allow monies to be raised from the private investment sector, at a certain interest rate, in advance of an event. These funds are then released when a defined catastrophe occurs. The net interest payable, less any recoveries, is the cost of catastrophe bonds. The higher interest rate payable on these bonds by comparison with conventional bonds of the same duration from the same issuer represents the additional cost associated with the cost of the catastrophe risk. From a catastrophe bond investor's perspective, this additional interest is compensation for the greater risk of loss of capital (in the event that a natural catastrophe which meets prescribed parameters occurs). Following a prescribed catastrophe, a bond s face value falls, possibly to zero, meaning that the money raised by the sale of the bonds does not need to be repaid to the private sector investors, therefore freeing it up for use in meeting the costs of the catastrophe. Catastrophe bonds work like reinsurance, and allow capital and debt markets to participate directly in insurance profit and losses. Catastrophe experience is often seen as uncorrelated to the substantive part of investment portfolios, and the contingent nature of reinsurance financing (pre-event) and the relative magnitude of potential losses involved can make these instruments attractive investments for capital and debt markets. The size and nature of government exposures make catastrophe bonds worthy of further investigation. Such financial instruments may provide a viable source of funding for state governments, which have a credit rating that typically allows access to capital and debt markets at a lower cost than applies for the private sector. There is also the option for the Commonwealth to issue catastrophe bonds to states or insurers. Catastrophe bonds may become relatively more economical if reinsurance rates charged by international reinsurers for Australian disaster risk increase significantly. We suggest that keeping the NDRRA framework as simple as possible, and widely distributing and clearly explaining the framework, would help the public understand where financial responsibilities lie. Page 7
In closing, we note that a lot of natural disaster exposure in Australia arises from inappropriate development around major cities. Further, there is potential for climate change to exacerbate the cost of inappropriate development. However, it is possible to see this as an opportunity to encourage appropriate regional development, a policy supported by every level of government in Australia. The Institute would be pleased to discuss the issues raised in this submission or to respond to specific questions to assist the Attorney-General's Department in the course of its work. Please do not hesitate to contact our Chief Executive, Melinda Howes, on (02) 9239 6106 if there is any way we can assist. Yours sincerely David Goodsall President Page 8