Appendix D:
Managing the Cost of Damage to Road Infrastructure Caused by Natural
Disaster - National Pool Approach - August 2012Disaster
APPENDIX D | NDRRA PHASE 2 REPORT
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This work must be attributed as: “Commonwealth of Australia, Department of Finance and
Deregulation, Review of the Insurance Arrangements of State and Territory Governments
under the Natural Disaster Relief and Recovery Arrangements Determination 2011”
MANAGING THE COST OF DAMAGE TO ROAD
INFRASTRUCTURE CAUSED BY NATURAL DISASTER
- NATIONAL POOL APPROACH
TABLE OF CONTENTS
1
INTRODUCTION ..................................................................................... 3
2
SCOPE OF TASK ................................................................................... 3
3
PRELIMINARIES .................................................................................... 4
4
COST SHARING – EQUITABLE CONTRIBUTIONS.............................. 5
5
FUNDING .............................................................................................. 10
6
MEMBERSHIP BASIS – COMPULSORY OR VOLUNTARY? ............. 11
7
GOVERNANCE ..................................................................................... 12
8
CONCLUSION ...................................................................................... 13
Managing the cost of damage to road infrastructure caused by natural disaster national pool approach
1.
1.1
Introduction
The Queensland floods of 2011 resulted in expenditure of hundreds of millions of
dollars related to the repair of damaged road infrastructure. The direct costs
associated with
Commonwealth.
1.2
this
event
were
shared
between
Queensland
and
the
At the time, Queensland did not have commercial insurance cover for its road
infrastructure. We believe that Queensland has approached the commercial
insurance market subsequently. Although it has purchased commercial insurance
over elements of essential public infrastructure, we believe that it has not been able
to secure insurance over its road network.
1.3
Swiss Re has confirmed that it can be difficult to insure road infrastructure for
damage from natural disasters in the commercial insurance market.
1.4
It would be risky to assume, therefore, that commercial insurance will present a
sustainable solution to the problem of damage to road infrastructure caused by
natural disaster. Rather, it would be prudent to consider what other options might be
available to manage the risk associated with the cost of damage to road
infrastructure caused by natural disaster, on the assumption that commercial
insurance is unlikely to be a sustainable solution.
2.
1.5
Scope of task
AGA has been asked to prepare a brief paper that considers a consolidated pool
approach, whereby the Commonwealth, together with states and territories, would
operate a ‘road insurance pool’.
1.6
AGA has been asked to consider the following issues:
•
How a pool could operate
•
Compulsory or optional membership
•
Governance
•
Funding
•
Equitable contributions
•
Pros and cons
1.7
The intention is that this paper is at a high level. It discusses principles, but not
items of detail.
1.8
This paper does not consider any other options. This should not be taken to imply
that other options are not available or should not be considered.
3
1.9
AGA’s starting point was to look at the possibility of a designing a road pool model
which does not result in cost shifts from the Commonwealth to states and territories
or vice versa but which, at the same time, delivers appropriate risk management
signals to the owners of road assets.
1.10
This is not intended to imply that AGA favours or recommends a cost-neutral model.
AGA is indifferent on this. The only point that we would make is that there does not
seem any reason for an increase in expected Commonwealth costs, relative to
existing NDRRA arrangements.
3.
Preliminaries
1.11
Many design issues need to be considered but, first, it is helpful to try to identify a
set of principles which should underpin the design of any model.
1.12
Useful principles are likely to include:
•
practicality
•
robustness
•
reasonableness
•
efficiency
1.13
Practicality refers to ease of implementation and administration.
1.14
Robustness refers to vulnerability to manipulation. It also refers to the extent to
which the arrangement provides sound behavioural incentives. A system which can
be manipulated by either states and territories or the Commonwealth to their own
benefit is not robust. On the other hand, a system which naturally results in sound
risk management behaviours by all contributing governments is more likely to be
robust.
1.15
Reasonableness refers to the relative contributions required of each party.
1.16
Efficiency refers to the extent to which available resources are used productively.
For example, setting aside and quarantining large reserves to fund contingent
liabilities which only have a small probability of being crystallised might not be
efficient. This is akin to having a ‘lazy’ balance sheet in a business context.
1.17
Candidate models could helpfully be assessed against these principles.
1.18
Under a pool model, all jurisdictions would share in the direct costs associated with
road damage arising in any given jurisdiction due to natural disaster.
1.19
A pool model can be thought of, at least in this regard, as an extension of the
current NDRRA arrangements where the only explicit cost sharing is between the
Commonwealth and the jurisdiction that the damage occurs in.
1.20
Key design issues for a pool include:
4
4.
1.21
•
the basis of the cost-sharing/contribution arrangements
•
the funding model
Cost sharing – equitable contributions
It is helpful to consider two different ways that costs can be shared between parties.
These can be described as:
•
proportional
•
non-proportional
Proportional
1.22
Under a pure proportional cost-sharing arrangement, each party would be
responsible for a pre-determined proportion of the costs of road damage in a
jurisdiction, regardless of where the damage occurred.
1.23
1.24
In respect of a possible pool model for road damage, the factors that might be taken
into account in determining proportions include:
•
revenue base of each jurisdiction
•
relative exposure to natural hazard risk of each jurisdiction
A graphical depiction is presented below. This depiction has the Commonwealth
meeting the majority of the cost of any natural disaster because of its relatively large
revenue base. The remainder of the costs are shared between the other
jurisdictions, having regard to both the revenue base and relative exposure to
natural disaster risk of each jurisdiction.
1.25
In principle, it would be possible to calibrate a proportional cost-sharing
arrangement in a way that resulted in the expected costs for each jurisdiction being
the same as under the existing NDRRA arrangements. However, this would be
difficult to do in practice.
5
WA
SA
NT
Tas
ACT
Vic
NSW
Commonwealth
Qld
Non-proportional
1.26
Under a pure non-proportional cost-sharing arrangement, the costs would be shared
between participants on the basis of ‘layers of cost’, rather than proportions. For
example, the jurisdiction in which the damage occurred might meet the first $x of the
repair cost, with at least part of the excess, if any, being met by other jurisdictions.
$x is referred to as the first layer of cost.
1.27
In practice, a non-proportional model for this purpose is likely to involve both layers
and proportions. For example, if the first $x is met by the jurisdiction in which the
damage occurs, the next $y might be shared between jurisdictions in fixed
proportions. $y is referred to as the first excess layer of cost.
1.28
One of a number of possible non-proportional structures would see the ‘first layer’ of
cost being met by the jurisdiction in which the damage occurs, the ‘first excess layer’
being shared between jurisdictions (other than the Commonwealth) in fixed
proportions, and any additional cost being shared between the Commonwealth and
the owner jurisdiction.
1.29
A graphical depiction of how such an arrangement might operate is provided below.
6
1.30
1.31
Increasing Cost
ACT
TAS
VIC
FIRST LAYER
Owner
Jurisdiction
funds individual
retention level
$x of
NT
Pool funded by non-Commonwealth jurisdictions
SA
FIRST EXCESS
LAYER
Pool funds next
$y
WA
Shared between Commonwealth and owner
jurisdiction
NSW
Cwth shares
expenditure in
excess of $x + $y
QLD
Increasing Cost
Cost sharing under non-proportional funding arrangement
In respect of such a non-proportional pool model for road damage, the factors that
might be taken into account in determining layers and proportions might include:
•
jurisdiction in which the damage occurred
•
revenue base of each jurisdiction
•
relative exposure to natural hazard risk of each jurisdiction
If the owner jurisdiction were required to fund a relatively large first layer of costs, an
increased emphasis on risk mitigation would be encouraged. The objective would be
that, over the long run, costs would reduce.
1.32
In principle, it would be possible to calibrate this non-proportional cost-sharing
arrangement in way that resulted in the expected costs for each jurisdiction,
including the Commonwealth, being the same initially as under the existing NDRRA
arrangements. This would be the case even if the owner jurisdiction were required
to fund a relatively large first layer of costs. However, it is important to note, again,
that this would be difficult to do in practice.
Comparison of proportional and non-proportional models
1.33
Under a pure proportional model, each jurisdiction is involved from the ‘ground up’.
This means that the cost of a natural disaster is shared between all jurisdictions,
regardless of how low the cost is (how small the disaster is).
1.34
As well as this, each jurisdiction’s exposure is, in effect, open-ended in respect of
any natural disaster event under a pure proportional model.
7
1.35
Under a non-proportional model the ‘owner jurisdiction’ covers first layer costs in full.
Other jurisdictions do not participate unless the relevant threshold has been
exceeded and the total cost exceeds the first layer. Under the non-proportional
arrangements described here, the Commonwealth would not participate in any claim
unless the total costs exceeded the first excess layer.
1.36
Under the non-proportional model described here, the Commonwealth’s exposure is
uncapped in respect of any natural disaster event. The owner jurisdiction also has
an open-ended exposure. Other states and territories would share the costs of the
first excess layer. Their exposure is therefore capped at this level.
Per-event or per-year basis?
1.37
Either model could be implemented on a per-event basis or a per-year basis. For
example, on a per-event basis, either model would see the costs of each event
shared according to the governing formula. On a per-year basis, the costs
associated with natural disaster events that occurred during the year would be
shared according to the governing formula.
1.38
A per-year basis would be better linked to financial reporting cycles than a per-event
basis. Further, a per-year basis might avoid a number of definitional difficulties that
can be associated with a per-event basis. These difficulties can manifest
themselves in a non-proportional arrangement (rather than a proportional
arrangement). For example, it is not always apparent when one disaster stops and
another starts. It can also be difficult to know whether damage has been caused by,
say, a cyclone or by a flood happening around the same time. Under a nonproportional model, the owner jurisdiction must meet the first layer of cost. If this is
applied on a per-event basis, then either of the two examples described above could
lead to disputes around whether the owner jurisdiction was liable for one or two first
layers of cost in some cases. Using a per-year basis largely avoids these issues.
1.39
To operate on a per-year basis, it would be important, however, to ensure that the
underlying costs (to be shared) were assessed on an ‘incurred’ basis and not a
‘paid’ basis. That is, a per-year basis would relate to the cost of damage arising due
to natural disasters that occurred during a given year. It would not be based on the
level of repair payments that were made during a particular year.
Assessment
1.40
The table below assesses the two models against the criteria suggested above.
5.
Practicality
Proportional
Non-proportional
Reasonably easy to describe.
However, all jurisdictions are
The
‘owner’
jurisdiction
is
responsible for small claims. Other
8
involved in all claims, including
small ones.
Some practicality issues when
multiple jurisdictions suffer damage
in the same event.
jurisdictions participate on larger
and very large claims. The
Commonwealth only participates
on very large claims.
Some practicality issues when
multiple
jurisdictions
suffer
damage in the same event.
Robustness
Based on the principle of ‘solidarity’
so can be vulnerable to moral
hazard. Specifically, this model
does not send strong risk
management price signals in
respect of small claims.
If a suitably high threshold is set,
this model can deliver sound risk
management behavioural signals
to jurisdictions. This is because
‘owner
jurisdictions’
are
responsible for first layer costs.
Reasonableness
Will need to be calibrated carefully
Will need to be calibrated carefully
Efficiency
Depends more on funding model –
not related to pool concept.
Although, in principle diversifying
risk enhances efficiency
Depends more on funding model –
not related to pool concept.
Although, in principle diversifying
risk enhances efficiency
1.41
This simple analysis suggests that a non-proportional model is to be preferred.
1.42
The main reason is that the non-proportional model is more robust because it is
better aligned with sound risk management behaviours. As well, it is more practical
because cost-sharing only applies when the cost exceeds a defined threshold,
rather than from the ground up as in the proportional model.
1.43
It is noteworthy in this regard that commercial catastrophe reinsurance programs
operate on a non-proportional basis.
1.44
The Australian Government scheme to deal with the insurance of commercial
property against terrorism risk also operates on that basis. The commercial
insurance industry picks up the first layer of costs following a terrorism event. A pool
of funds is available to fund costs in excess of this first layer. Contributions are
made to the pool by all participating insurers according to a pre-determined formula.
An insurer’s contributions are, in effect, a function of the insurer’s commercial
property insurance premium revenue and its relative exposure to terrorism risk. The
Commonwealth is responsible for very high layer costs. The terrorism scheme also
accesses the commercial insurance market to provide further protection. The
possible role for commercial insurance in the road pool context is discussed further
below.
Risk management
1.45
Under the non-proportional model described here, first layer costs are met in full by
the ‘owner’ jurisdiction.
9
1.46
The level of the first layer should be set so that it represented meaningful
expenditure relative to the revenue base of the jurisdiction and the value of its road
assets. The level would be set with a view to encouraging jurisdictions to undertake
effective risk management practices (through this price signal).
1.47
Notably, first layer costs are likely to be associated with relatively small natural
disasters (as well as large disasters). In turn, relatively small natural disasters are
likely to occur more frequently than larger disasters. In principle, therefore, by
requiring jurisdictions to meet first layer cost in full, a price signal is sent which is
intended to encourage jurisdictions to consider risk management possibilities for
those roads which are most exposed to natural disaster risk. By way of example,
jurisdictions might be encouraged to think carefully about whether to construct roads
which will be exposed to frequent flooding. Where a jurisdiction judges that it is
necessary to construct a road in a particular location despite the flood risk, it would
then be encouraged to think carefully about how that road is constructed.
6.
Funding
1.48
There is a question around whether a reserve (dedicated pre-funded pool of money)
should be created or whether costs should be met on a PAYG basis.
1.49
The discussion below follows from the earlier analysis which suggested that a nonproportional model might be preferred to a proportional model.
1.50
Under the type of non-proportional pool model described in this paper:
1.51
•
first layer costs would be picked up by the owning jurisdiction
•
first excess layer costs would be shared between non-Commonwealth
jurisdictions (including the owner jurisdiction)
•
the Commonwealth would share costs in excess of the first excess layer with the
owning jurisdiction
Under this structure, ‘owner’ jurisdictions meet first layer costs. It would be up to
individual jurisdictions to decide whether or not to set aside reserves for this
purpose.
1.52
The next layer of costs would be shared between all the non-Commonwealth
jurisdictions. Under this structure, there is an effective cap on the second layer
exposure. The size of this second layer, of course, depends on how the model is
calibrated. However, it could easily be several hundreds of millions of dollars.
1.53
There would be a sound argument for funding this layer. Contributions would be
from all participating jurisdictions in agreed proportions. A pool of several hundred
million dollars could not reasonably be funded overnight. Rather, it is more likely that
the pool would be built up over a period, perhaps of several years.
1.54
If the reserve was drawn down following a sufficiently large disaster, then it would
need to be topped up, again with contributions from all jurisdictions in agreed
10
proportions. Again, the pool would not need to be replenished immediately. Rather it
could be replenished over a period of years, if required. This is obviously a matter of
design detail which is not considered further.
1.55
The Commonwealth’s exposure is uncapped under this structure. There would be
little merit in the Commonwealth pre-funding its exposure.
Commercial insurance
1.56
Even though there is little merit in the Commonwealth pre-funding its exposure,
there would be a possible case for the Commonwealth seeking to partially reinsure
its exposure in the commercial market.
1.57
The Australian Government’s terrorism insurance scheme (mentioned earlier) was
developed because of a withdrawal of commercial terrorism insurance capacity. The
Commonwealth (through the Australian Reinsurance Pool Corporation [ARPC]) has
sought, in recent years, to enhance the protection offered under the scheme by
purchasing commercial terrorism reinsurance in the commercial market. ARPC has,
for the last few years, purchased about $2bn in cover, excess of around $300m.
Thus, the first $300m of losses on any event would be retained by the ARPC with
the commercial cover only responding if losses from a single event exceeded this
amount.
1.58
The motivation for seeking commercial reinsurance has been, in part, to try to
stimulate, to the extent possible, the commercial market for terrorism insurance. In
fact, the ARPC provides a degree of efficiency in this process by ‘bundling up’ all of
the terrorism risk into one place. It is arguable that the offer of a large chunk of
terrorism business to the commercial market is ‘more attractive’ than an offer of
many small chunks of business (which would be the case absent the ARPC).
Similarly, by maintaining a reasonable first layer to its own account (around $300m),
the ARPC manages to ensure a level of price efficiency (high layers of cover cost
less than low layers of cover, all else being equal).
1.59
It is possible to draw some analogies with the current situation. Part of the
motivation for this current paper relates to the apparent difficulty in obtaining
commercial insurance for road assets. It is possible (but by no means certain) that
the offer of a large chunk of road insurance business to the commercial market
might be ‘more attractive’ than an offer of a number of small chunks of business
(which would be the case if each jurisdiction sought its own insurance individually).
It is also possible that the attractiveness of this approach would be enhanced if
there was a reasonably large retention involved (of several hundred million dollars).
1.60
Taking all of the above together, there might be a case for the Commonwealth
seeking to reinsure part of its exposure in the commercial market, in order to
‘encourage’ commercial participation in this risk.
7.
Membership basis – compulsory or voluntary?
11
1.61
A pool model would work better if all jurisdictions participated. This would diversify
the risk to the greatest extent.
1.62
With less than full participation, the model could easily be ineffective. For example, if
the only participating jurisdictions were, say, Queensland and the ACT, then there
would be little benefit from diversification and little reason to operate a pool.
1.63
This suggests that compulsory membership might be required. Alternatively, strong
incentives to participate would be needed.
1.64
Currently, road relief forms part of the NDRRA arrangements. While this situation
continues, the incentives for jurisdictions to voluntarily join a ‘road insurance pool’
are unlikely to be strong. This might be particularly the case if a non-proportional
model is adopted, since the owner jurisdiction would be required to fund first layer
costs in full while under current NDRRA arrangements, Commonwealth funding is
available in the event of relatively small scale losses.
1.65
As noted above, a non-proportional model can (in theory) be calibrated so that the
expected costs for a jurisdiction are the same as they are under the NDRRA but this
would not, of itself, provide a strong incentive for states to join. Indeed, while road
relief remains a part of NDRRA relief arrangements, a road insurance pool would
only be attractive to all jurisdictions if their expected costs, individually, were all
lower under the road pool than under NDRRA. The only way that this could be
achieved is for the Commonwealth’s expected road relief exposure to be higher
under the road pool than under the NDRRA. There would seem little reason to seek
to establish a road pool where the Commonwealth’s expected exposure was higher
than it is under the NDRRA.
1.66
A pool model would, therefore, only be likely to work if road relief was excluded from
the existing NDRRA funding. In this circumstance it would be theoretically possible
to calibrate the model in a way that ensured the Commonwealth’s exposure was no
higher than it is under the NDRRA and, at the same time, provided meaningful
incentive to jurisdictions to elect to participate. Jurisdictions would then have the
choice to participate in the pool model or manage their road exposure in other ways
(either full self-insurance or partial self-insurance and partial commercial insurance).
8.
1.67
Governance
Jurisdictions would need to be involved in, and agree to, the calibration of any costsharing formula.
1.68
However, once the cost-share basis had been determined, the Commonwealth
would probably be best placed to administer a pool.
1.69
Key governance requirements would include:
•
accepting and reporting on contributions (assuming the second layer is funded)
from jurisdictions
12
9.
1.70
•
informing jurisdictions of their contribution obligations
•
ensuring that claims for assistance are valid
•
paying valid claims and reporting on payments
•
maintaining a proper database on claims and exposures, to ensure ongoing
enhancement of understanding of the risks involved
•
revising the cost-share basis from time to time with the involvement of all
participating jurisdictions, in order to ensure that the system remained robust
and reasonable
Conclusion
One possible benefit of a pool concept relates to the diversification of natural
disaster risk in circumstances where commercial insurance is unlikely to be readily
available.
1.71
Under current NDRRA arrangements, risk is in effect shared between the owner
jurisdiction and the Commonwealth only. Under a pool arrangement, risk would be
shared between all jurisdictions, including the Commonwealth.
1.72
1.73
More specifically, under a well-designed non-proportional pool model:
•
Sound risk management behaviours would be encouraged and so, over the long
run, costs would be expected to reduce
•
Costs would be shared equitably between jurisdictions
•
States and territories could have their exposure effectively capped in any given
year1
•
The Commonwealth would only participate in very large claims
•
It would be possible, in principle, to calibrate the model so that the expected
costs for all jurisdictions, including the Commonwealth, would be no higher
initially than they are under the NDRRA
•
It might be possible to stimulate (to a degree) the commercial insurance market
It is likely that a pool model would only work if road relief was excluded from the
existing NDRRA funding. Jurisdictions would then have the choice to participate in
the pool model or manage their road exposure in other ways (either full selfinsurance or partial self-insurance and partial commercial insurance).
1
This would be the case if the Commonwealth picked up 100% of any additional cost over and above
the first excess layer.
13
1.74
The main challenge for a pool model relates to the calibration of the cost-sharing
basis. This challenge should not be underestimated. Care would be needed to
ensure that shares are reasonable and equitable. There is an inevitable risk that
individual jurisdictions might be sceptical about this type of arrangement.
Peter Martin
Australian Government Actuary
22 August 2012
14