Canada not prepared to deal with financial impact of a major earthquake

A massive earthquake off the coast of British Columbia has the potential to cause widespread failure among insurance companies and trigger a domino effect across the financial sector, according to a new Conference Board of Canada report, Canada’s Earthquake Risk: Macroeconomic Impacts and Systemic Financial Risk.

“As the earthquake in New Zealand earlier this month reminds us, we cannot prevent massive earthquakes from happening. However, we can lessen the impact of a massive quake on the economy by putting in place additional backstop measures to protect the insurance industry and the financial sector more broadly,” said Pedro Antunes, Deputy Chief Economist. “At the industry’s current levels of capitalization, Canada is not prepared to deal with the macroeconomic and fiscal consequences of a large earthquake. It is important for Canadians, businesses and government leaders to understand that the current regulatory regime may not be able to protect our economy from a major disaster.”

Highlights

• Canada is not prepared to deal with the macroeconomic and fiscal consequences of a massive earthquake.
• A large-enough earthquake would overwhelm the Canadian economy, leading to financial contagion that would delay rebuilding and result in additional long-term economic loss.
• The government can play a role in mitigating these economic and fiscal costs.

In this analysis, the Conference Board tests the ability of the Canadian economy to deal with earthquake risk. It estimates the macroeconomic and financial impacts of a major earthquake off the coast of British Columbia and the 10-year period that follows. A massive earthquake, similar to the 2011 earthquake and tsunami in Japan, is considered to be a rare event. Natural Resources Canada estimates the probability of a significant earthquake in Western Canada over the next 50 years at 30 per cent, and between 5 per cent to 15 per cent in Eastern Canada.

The analysis indicates that the fiscal and macroeconomic impacts of such an earthquake would be devastating. Insured losses that exceed $42 billion would surpass the level at which the industry is currently capitalized. Such an earthquake would result in $127.5 billion in total economic losses and could result in approximately 15,000 deaths.

An earthquake of this size would inevitably cause insurance companies to fail. And the existing industry compensation mechanism created to protect policyholders would cause failures to snowball. This would trigger a chain of systemic financial contagion resulting in insolvencies across the industry and the broader financial service sector, while delaying the rebuild and recovery efforts by an estimated two years.

The Conference Board estimates that the earthquake and fallout from financial contagion reduces real gross domestic product (GDP) by a cumulative $100 billion and costs an estimated 437,000 person-years of employment—equivalent to the loss of 43,700 jobs over the 10-year period.

Real GDP losses peak at nearly $38 billion in the third year after the earthquake, and the rebuild effort would not contribute positively to growth until 6 years after the earthquake.

Stringent capital requirements for insurers, while contributing to making the Canadian insurance industry one of the soundest in the world, are not enough to address the very low-frequency, high-severity probable events.

In addition to the $42-billion cost to Canada’s property and casualty insurers, the rebuilding effort would take an enormous toll on all levels of government finances. Taxpayers would have to absorb the costs of losses to both public assets and infrastructure, as well as uninsured private losses. But the financial contagion is also very costly. Reduced revenues and increased government spending add $122 billion in net new public debt to government coffers—nearly double the $63 billion in government borrowing that would be necessary if Canada had a mechanism in place to avoid financial contagion following the earthquake.

While an earthquake this size is an extremely rare event, governments could establish an emergency backstop mechanism that prevents financial contagion and would mitigate economic and fiscal costs.