Unlike individuals or companies, governments in Canada and elsewhere commonly self-insure against risk. This means rather than purchase insurance externally, most governments accept the risks and associated costs. While this can be the most effective way for government to manage day-to-day risk, as we have seen from recent earthquakes in Japan and New Zealand, catastrophic events are another matter altogether.

Canada faces a very real risk of a major earthquake. A recent paper by the Toronto based Institute for Catastrophic Loss Reduction estimates a 30 per cent chance that an earthquake strong enough to cause significant damage will strike southwestern British Columbia in the next 50 years, a region that includes Vancouver and Victoria. There is also a five to 15 per cent chance that a damaging earthquake will strike southern Quebec or eastern Ontario in the same time frame, a region that includes Montreal, Ottawa and Quebec City.

If we assume that a major earthquake is likely in Canada, then it logically follows that the federal government needs to take a more pro-active approach to managing the financial risks associated with a major earthquake in a densely populated area.

The first step in risk management is measuring the potential costs. For Ottawa, this includes an examination of the repair costs to buildings and infrastructure such as airports, bridges and ports.

However, several other significant costs also need measurement, such as disaster relief. This includes not only the immediate costs of food, shelter and medical assistance, but also Ottawa’s share of disaster financial assistance provided through an existing cost-sharing arrangement with the provinces.

Loss of tax revenue would be another cost. The economic disruption caused by an earthquake will result in lower business and personal tax receipts. For instance, New Zealand’s Treasury Department expects the Christchurch earthquake will result in a loss of tax revenue by as much as NZ$5 billion (CDN$3.6 billion) over five years.

Lastly, there is the exposure of numerous federal programs (or backstopped programs) that might take a hit on their existing loan portfolio or guarantees. A few examples are the Business Development Bank of Canada, the Small Business Loans Administration, and the Western Diversification Fund.

Once measured, it is possible to consider whether measures should be taken to reduce or transfer earthquake-related risk. For instance, for the various programs noted above, it might be sensible policy to require recipients of government loans in vulnerable areas to have insurance coverage against earthquake damage.

The disaster financial assistance provided by the federal government is paid to the province to help defray the province’s costs in returning infrastructure and personal property to pre-disaster condition. Although take-up rates vary, private earthquake insurance is available even in Canada’s most earthquake prone areas. Adopting a policy of restricting eligibility for the federal disaster financial assistance program where private insurance is available, such as restoration of principal residences, and communicating this policy to the public would both help control exposure and reduce moral hazard. The moral hazard is the disincentive to purchase earthquake insurance because of the potential for government financial assistance. It’s similar to government guaranteeing to pay the replacement cost of one’s car. If that was widely assumed, few would bother with their own automobile insurance.

By measuring its total earthquake exposure, the federal government will be able to assess the merits of transferring some of its earthquake exposure through a mechanism such as a catastrophe bond. These bonds transfer risk to investors in exchange for a rate of return that compensates them for that risk. In the event of a pre-defined catastrophe, investors are exposed to a loss of interest and principal. An example of this type of transaction is a Mexican government catastrophe bond issue set up to help finance the costs incurred to its Natural Disasters Fund in the event of an earthquake. There is a cost to this type of transaction as investors want a premium for taking on catastrophe risk. In Canada’s case, it may be worth it; it may not be. But the question cannot be answered without a measurement of the federal government’s total exposure.

In fact, until total financial exposure is measured, it is impossible to understand the potential size of the problem. However, the recent earthquakes in New Zealand and Japan show the costs associated with an earthquake can be staggering. By taking a pro-active approach to understanding and managing the financial risk, the federal government would be better positioned to deal with the economic recovery after the event should a major tragedy, such as just occurred in Japan, happen here.