by Rob Hosking
The fate of the Earthquake Commission (EQC) might not seem the most likely issue to generate powerful passions. However, it has seen annual reports ritually ripped up in front of select committees, heated arguments over whether the politicians are "raiding" the fund, and dire warnings that the commission’s funds are leading the country into a "Japanese government bond trap."
The government is at present moving to diversify the EQC’s investment arm, the Natural Disaster Fund (NDF), out of government stock and New Zealand bank bills into other assets. The move could prove to be a sort of ‘dry run’ for Minister of Finance Michael Cullen’s dedicated superannuation fund.
The EQC has, in recent years, been required to put its funds in government stock. It was this policy which led to an executive from the commission ripping up the annual report in front of MPs reviewing the commission’s financial performance, and telling them the information on the balance sheet was next to worthless.
And last year, according to papers obtained under the Official Information Act, commission chairman Neville Young told Treasury officials that at current interest rates the money in the Natural Disaster Fund would double every 12 years.
"Are we slipping into the Japanese Government Bond trap?" he asked officials.
At issue is a policy to allow the government to pool its uncorrelated risks – which includes disaster insurance – and thus prepare more cheaply for such disasters. If the NDF remains a dedicated fund this will prevent the government from pooling those risks, runs the Treasury argument.
This view holds that the government can manage its investment portfolio better if it is centralised and run according to broad financial objectives, rather than by way of an entity such as the EQC. The disadvantage of the dedicated fund is seen as being that its contingent liabilities – ie natural disasters – are highly unpredictable. Moreover, its investment objectives are not in line with the overall financial objectives of the government.
The commission’s investment policy is described as "misaligned" because its aim is to minimise the probability of it having to call on the Crown guarantee – what is called "the probability of ruin" policy.
The EQC’s governing statute, passed in 1993, requires the commission to use the NDF as first source of funds, and Treasury argues that if the fund is diversified and a large earthquake hits, the commission would have to sell its diversified portfolio even if the government wanted to keep those assets, particularly if they are not at an optimal selling price.
It is this argument which Young calls "a red herring of the fattest and juiciest kind".
"If the Crown is ever to make use of any funds it is investing at any particular time, that fund will always have sell-down risk attached to it." The argument applies to any investment the Crown makes, he says.
Moreover, the ‘mirror image’ argument also applies to any borrowing the government might have to make following a natural disaster.
Such a risk has already been factored into the NDF’s polices, he maintains.
According to Treasury papers the Crown manages all differently, whether it's accident insurance, Crown debt, or superannuation liabilities.
Because of this central pooling system, the government need hold fewer reserves to finance contingent risk than if it financed each of those risks separately.
This is, notes one Treasury paper dryly, the principle underlying all insurance.
The problem currently facing the government has only arisen, he argues, because successive governments have "raided" the fund for other purposes.
"If the fund had been independently invested since its inception" – ie in the way that Dr Cullen promises his superannuation fund will be – "the Crown in general, and future taxpayers in particular, would not carry such a catastrophic risk."
In other words, he argues, the only reason the Crown is carrying the risk of a natural disaster in the first place is because it effectively "borrowed" that risk when the money was pulled out of the fund by earlier regimes.
Rob Hosking is a Wellington-based freelance writer specialising in political, economic and IT related issues.
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