The Australian Reinsurance Pool Corporation (ARPC)

 There are some ideas that are so absurd, George Orwell once famously said, that only an intellectual could believe them.

If reports in the Sydney Morning Herald (1 March 2013) and the AFR (11 April) are to be believed, the Government’s plan to “raid the funds” of The Australian Reinsurance Pool Corporation (ARPC), which I had the honour to chair from inception until the end of last year, is one such idea.

Let me explain why.

After 9/11, not surprisingly, it became impossible or prohibitively expensive, for the owners of commercial property to obtain insurance cover against terrorism

Adopting best practice, after reviewing various schemes then in operation or under discussion internationally, the previous government (with bipartisan support) adopted the best elements: it made the provision of terrorism cover compulsory for insurers , but set premiums whereby the risk could be laid off with the government’s reinsurer, the ARPC. A majority of insurers availed themselves of the reinsurance, and the “pool” of funds thereby accumulated steadily grew and available to meet claims. As yet, thankfully, there have been no claims

The scheme was designed to be temporary; indeed its very existence is subject to review every three years. It was designed to address market failure and anticipated that in the future terrorism cover could be provided by the private markets and the government could step back from the risk.

As the private markets recovered, Australia adopted a unique approach, which was to acquire retrocession ( a term of art whereby reinsurers themselves reinsure) for the excess over and above the mandatory industry retention and the ARPC’s cash reserves. As at the end of last year, with some tweaks, the government was “off risk” for a terrorist incident or series of incidents up to a loss of almost $3 billion

Simply put, were there to be a 9/11 type incident in Australia, the insured parties could claim up to $3 billion without the taxpayer having funded any part of the loss; the claim would be met by the insurers, the insureds and the retrocessionaires (the international reinsurers). The Government’s role would have been to act as a facilitator (legislating and administering the scheme) and a provider of a layer of protection ($10 billion) beyond the capacity of the private markets

Almost a perfect example of government doing what it does best: facilitation of the private markets; providing a legislative framework and only taking on risks which the private sector simply cannot manage. The idea was that as the private sector appetite for terrorism risk increased, so the government would step back from the risk

The success of Australia’s scheme has been internationally recognised. Australia is probably the largest single purchaser of terrorism retrocession in the world and Australia’s blend of private/public partnership is considered a model. Most importantly, Australia has been able to purchase retrocession at rates which are competitive with or better than that available to other markets as to the way in which its organised

The ARPC has twice now co-sponsored with the OECD an international conference on terrorism insurance which is co-chaired with a leading academic from the Wharton School of Risk Management.

As part of its 2012 review of the Act, the government decided to require the ARPC to pay it a dividend: $100 million per annum for four years. The $400 m thus “raised” has apparently been booked as part of the 2012-13 budget, which it was hoped would provide a surplus. The decision to require a dividend is debateable. The idea of the pool was to meet claims; its surplus is not a profit. Governments in other jurisdictions have levied a fee on the provision of its guarantee; this seems conceptually more sound although practically, the cash effect may well be the same.

In response to the Queensland floods in late 2011, the Trowbridge report recommended that a scheme modelled on the ARPC : the compulsory provision of cover; the creation of a premium reserve; laying off risk with the government and the purchase of a retrocession – may solve the difficult position the government found itself in with the its joint sharing arrangement with the various State Goverments.

In fact ARPC offered its expertise in formulating and administering such a scheme.

Clearly, the risks – terrorism and flood – are different and the solutions need to be different.

The Fin Review yesterday confirmed that the ARPC’s retrocession purchase is to be cancelled for the next two years and, apparently, $100m of the $150m thus “saved” is to applied by the National Insurance Affordability Council to fund flood mitigation works in Queensland and New South Wales.

This is policy folly; it’s arguably tantamount to gambling. Should there be no terrorist incident in 2014 or 2015 (the current cover expires at the end of this calendar year), then worthwhile works will have been funded in Roma Ipswich and Warragamba, albeit out if insurance premiums paid by commercial building owners for terrorism cover. If (and let’s hope not) a major incident should occur, Australian taxpayers will be out if pocket up to $3billion, which would otherwise have been picked up by international reinsurers. That’s $3 billion added to the budget deficit on the downside, with up to $100m of flood mitigation works as the upside.

Don’t like the odds? Neither do I. Nor do I like one group of insured’s premiums being used to alleviate another’s potential risks

There is a view abroad in certain circles that retrocession should never have been purchased as the Government’s balance sheet will always provide the least expensive form of funding. This is one of those intellectual ideas to which I above referred

As a matter of principle, the Government should assume risk only where the private sector is unable to do so. It’s balance sheet is not unlimited ( as recent global experience has demonstrated) and can only be funded from borrowings or tax increases, neither of which is to be encouraged and in this case and neither of which is here necessary.

There is another practical issue here. It goes to Australia’s international commercial reputation. The ARPC and its advisors have invested a great deal of energy in fostering the international retrocession markets: together with other government agencies providing leading edge risk modelling and analysis and thought leadership.

It should not be assumed that if Australia ceases to purchase reinsurance from the international markets for two years, that the extent of cover currently available will be there; or the rates currently enjoyed. The market is limited and Australia has been able to enjoy the advantages of being a well organised scheme, low risk environment and consistent customer. It is this reputation for consistency that is at risk, and may favour other markets should Australia wish to reinstate its cover after two years.

Joseph Gersh AM is Executive Chairman of Gersh Investment Partners Limited and was inaugural Chairman of the ARPC (2003-2012). He is the longest serving Director of Reserve Bank of Australia Payment Systems Board