An examination of catastrophes, insurance guaranty funds and contagion risk

Abstract

Many countries have formalised solvency insurance programmes that provide payments to policyholders of insolvent insurers. Like most insurance schemes, these programmes operate most effectively when failures are firm-specific. Using Canada as a case study, we examine the issue of using ex post guaranty fund assessments following a peak peril loss resulting in the simultaneous failure of multiple insurers. In this case, the guaranty fund assessment levied on surviving insurers is so large that it causes a contagion effect: several insurers fail because of the assessment, and the end result is the collapse of the entire industry. We conclude with a discussion of possible policy alternatives to address this issue, including increasing prudential requirements, changing the ex post funding mechanism, prefunding the guaranty fund for a peak peril loss, using the government as the insurer of large catastrophic losses, or developing public–private partnerships. We highlight both prudential and public policy implications of each of these alternatives and make recommendations for countries that face a large peak peril relative to the size of the private insurance industry.