Natural catastrophes like wildfires, storms and earthquakes threaten to empty the coffers of Canada’s property and casualty insurers, says a new report that calls on Ottawa to create a government-backstopped reinsurance scheme that would protect the country’s insurance industry and potentially drive down premiums for consumers.

A properly constructed government backstop would solve a long-identified weaknesses in Canada’s industry-only bailout regime and could also result in expanded insurance coverage and more affordable premiums, according to Thorsten V. Koeppl, a fellow-in-residence at the C.D. Howe Institute and the report’s author.

Taxpayers could be protected with a mechanism to recover public funds used to backstop risk, he added in the report published Thursday.

Canada’s current system for managing catastrophic events has been criticized for putting healthy insurance companies at risk via a shared industry-funded bailout fund. Limited government assistance is also among the factors blamed for rising insurance premiums amid increasing weather-related events and Canadians being left uninsured or under-insured against risk from catastrophic events such as earthquakes.

“A federal backstop for natural disaster risk is a sound economic idea and should be an essential feature of Canada’s P&C (property and casualty) insurance market,” Koeppl wrote in his report.

Under his proposed scheme, the government would use its capacity to borrow more cheaply than private insurers to cover extreme risks associated with natural hazards and would assume industry-wide losses above certain thresholds. In exchange, it would receive a premium that reflects the cost of backstopping the risk.

The reinsurance scheme would build up reserves over time by charging premiums to insurers that would be in proportion to their underwriting, and insurers would then pass these costs on to customers as they compete in the private market.

Koeppl proposed making insurance coverage against natural hazards mandatory or by default — with an opt-out only in exchange for giving up ongoing government assistance in the event of a regional disaster — and spreading it across the country regardless of where catastrophic events such as earthquakes might take place.

“More affordable premiums may follow as a result,” he wrote, noting that high-risk exposure has led private insurers to charge hefty premiums for coverage or withdraw insurance altogether.

“A string of tail events (such as) rare, extreme events with large losses can temporarily strain the capacity to underwrite insurance for the industry, leading to higher prices, tighter limits on coverage, and even possible withdrawal from certain perils.”

Under the current system, he added, many Canadians don’t have sufficient insurance to cover the risks where they live, such as earthquakes in British Columbia and Quebec.

“What complicates matters further is that insurance demand often does not internalize the full risk exposure,” he wrote. “As a result, the insurance premiums people are willing to pay do not necessarily reflect the underlying risk.”

The Canadian market’s “protection gap” is estimated at roughly 37 per cent, meaning only about two-thirds of disaster risk is covered by insurance, Koeppl said.

Canada stands alone among G7 countries in its lack of a built-in mechanism for government and financial regulators to intercede and stabilize the insurance industry in the event of a series of extreme natural or weather-related events or even a single catastrophe such as a major earthquake.

With damaging fires and storms on the rise, a handful of reports over the past decade have highlighted the risk that massive claims on some members of the industry-funded Property and Casualty Insurance Compensation Corporation could destabilize or even topple the entire industry.

In his report, Koeppl said the industry’s compensation fund is around $60 million, with the possibility to access up to $1.27 billion annually from its members, which represent about 95 per cent of the Canadian property and casualty insurance market. He noted that the federal government provides disaster relief only for large, geographically concentrated events and this assistance does not include a replacement guarantee for insured losses.

If the government were to decide to move forward with a backstop and reinsurance regime, he suggested that the Department of Finance take responsibility for developing a framework for mandatory insurance and building the infrastructure to price the reinsurance arrangement.

This should involve consultation with the insurance industry to comprehensively map out hazards across Canada and a build-out of expertise to ensure that the pricing of reinsurance trickles through to consumers, he said.

He also suggested creating a separate Crown corporation to operate the scheme and a special-purpose vehicle that would borrow from capital markets, with the federal government guaranteeing the debt issuance.

A key component of his proposed scheme is an audit function to scrutinize costs, actuarial soundness, and investment performance, ideally reporting back to Parliament.

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Koeppl acknowledged that selling the idea to the provinces and to Canadians forced to buy insurance might not be easy.

“The backstop deals with solvency issues where OSFI already has primary oversight. But costs need to be passed through to consumers, a matter that falls under the mandate of provincial regulation,” he wrote, adding that some provinces might also balk if there were varying costs per insured dollar across the country.

“Here, a broad backstop covering all natural disasters may be a selling point,” he suggested.

• Email: bshecter@postmedia.com