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Federal Document Clearing House
Congressional Testimony
October 24, 2001, Wednesday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 7006 words
COMMITTEE:
SENATE BANKING, HOUSING AND URBAN AFFAIRS
HEADLINE: TERRORISM INSURANCE
TESTIMONY-BY: THOMAS J. MCCOOL, MANAGING DIRECTOR,
AFFILIATION: FINANCIAL MARKETS AND COMMUNITY INVESTMENT
BODY: United States General Accounting Office
GAO
Testimony
Before the Senate Committee on Banking,
Housing and Urban Affairs United States Senate
October 24, 2001
TERRORISM INSURANCE Alternative Programs for
Protecting
Insurance Consumers
Statement of Thomas J.
McCool Managing Director, Financial Markets and Community Investment
GAO-02-199T
Statement
Terrorism
Insurance: .Alternative Programs for Protecting
Insurance Consumers
Mr. Chairman and Members of the
Committee
The tragic events of September 11, 2001, bring to light
numerous areas of concern within the financial services sector, especially as
threats of future terrorist attacks continue. One area of concern voiced by
various industry groups and the Congress is how the insurance industry should
respond to risks posed by potential terrorist attacks and the extent to which
the government should play a role alongside the industry to address these risks-
We appreciate the opportunity to discuss this issue. Prior to September 11th,
insurance coverage for losses from
terrorism
was included as a normal feature of
insurance contracts.
According to industry analysts, thus was because insurers' experience suggested
that domestic exposure to
terrorism, both in the number of
occurrences and the magnitude of losses, was limited. The September 11" attacks
have changed insurers' perception of their potential risk exposure. Insurance
companies have indicated that they will pay their share of the losses from these
tragic events. However, both insurers and the reinsurers who share the
industry's asks, have indicated that they don't know .how much to charge for
this coverage going forward because they cannot predict future losses- As a
result, it has been reported that industry leaders may exclude
insurance for
terrorism from future
insurance contracts unless the federal government provides some
form of assistance to the industry.
A financially strong insurance
industry is essential to the smooth functioning of the economy. Industry
officials have indicated that insurance coverage for catastrophic events such as
a major terrorist act is necessary for investors and other financial
decision-makers to be willing to provide capital to promote continued economic
growth and stability. If the federal government chooses to provide financial
backing to thus industry, the primary driving force should be to safeguard the
economy's access to necessary insurance protection. At the same time, care reeds
to be taken to ensure that the interests of both the federal government and
American taxpayers are safeguarded, and that the industry is assuming its fair
share of risks.
Any mechanism established by the federal government to
support the ability of individuals and businesses to get insurance for terrorist
acts should address several significant concerns. Most importantly, the program
should not displace the private market. Father, it should create an environment
in which the private market can displace the government program. Second, it
should be temporary, at least initially. Finally, any program should be.
designed to ensure that private market incentives for prudent and efficient
behavior are not replaced by an attitude that says, "Don't worry about it, the
government is paying."
In the aftermath of -the September l1"' terrorist
attacks, the Congress is considering whether and how to provide financial
backing to the insurance industry so that insurance is available for losses due
to terrorist acts. As requested, we will present (1) features of several
existing insurance programs, both domestic and international; (2) alternative
mechanisms for funding insured losses; and (3) some broad principles or guidance
that the Congress may wish to bear in mind as it considers possible ways to
support the insurance industry in case of future catastrophic loses due to
terrorist acts. My observations are based on publicly available information on a
variety of insurance programs within the United States and other countries and
from prior GAO work.
Features of Selected Insurance Programs Covering
Catastropic or Terrorist Events
Today, a number of insurance programs
exist in the United States and other countries to help ensure that insurance
will be available to cover risks that the private sector has been unable or
unwilling to cover by itself, including losses from catastrophic events and
terrorism. Certain
insurance programs are
completely controlled and managed by the government, while others have little or
no explicit government involvement. Likewise, in many programs the public and
private sectors share risks, though in several different ways.
For this
testimony, we are highlighting features from selected insurance programs,
including some established by the federal government as well as some from other
countries, the states, and others- For example, the federal government insures
individuals and firms against natural disasters under the flood and crop
insurance programs and bank and employer bankruptcies wider the deposit and
pension insurance programs. Some federal programs cover political risk insurance
for overseas investment activities, third-party claims for nuclear accidents,
and protection against war-related risks. Other countries and organizations have
also developed insurance programs covering catastrophic or terrorist events.
These programs can provide useful insights in developing an appropriate
insurance mechanism to cover losses from terrorist acts.
For government
insurance programs, the question of long-term cost and program funding needs to
be addressed before the program is established. Some federal insurance programs
have the statutory intent to provide subsidized coverage, while others are
intended to be self-funding. As noted in some of GAO's previous work, whatever
merits the federal government has as an insurer, the same characteristics that
inhibit private insurance firm:; from covering certain events could also make a
federally sponsored insurance program a costly undertaking.
In some
cases, the federal government subsidizes insurance programs in order to achieve
a public policy objective. For instance, catastrophic coverage under the crop
insurance program is subsidized in an attempt to reduce reliance on ad hoc
disaster assistance. In other cases, the federal government may set up premium
and fee structures intended to cover the full cost of providing insurance.
However, regardless of statutory intent, if federal insurance is underpriced
relative to its long-run costs and the federal government pays the difference, a
government subsidy results. For example, under, the Flood Insurance Program,
program operating losses have been financed through borrowings from the U.S.
Treasury or covered by appropriated funds
Selected Insurance Programs
Established by Federal Statute
The federal government's size and
sovereign power provide it with the unique ability to offer insurance when the
private market is unable or unwilling to do 50. Currently, the federal
government has a variety of mechanisms, including insurance programs, to cover
risks that the private sector has traditionally been unable or unwilling to
cover. Appendix I, table 1, highlights key features of several selected
programs. We will describe some of them further today.
Insurance for
Catastrophic Nuclear Accidents
A system that limits liability and
provides indemnification for operators of nuclear reactors was established
through the passage of the PriceAnderson Act of 1957. Specifically, the act
limits the total liability of individual reactor operators for any accident.
First, the operators must obtain insurance up to the maximum amount of private
insurance available to the operator, which is currently about
$
200 million per reactor per accident. In addition, in the
event of an accident at any single reactor that results in losses exceeding
$
200 million, all operators of the 106 commercial nuclear power
reactors in the United States would be required to provide additional protection
by paying into a secondary insurance fund. Depending on the amount of the
claims, these contributions could be as high as $
88.1 million
per reactor, per accident. Following an incident, the operator; of commercial
power reactors would be required to pay as much as $
10 million
annually for 9 years to complete the secondary insurance fund. For the 106
reactors in the United States, the nuclear industry's current exposure to
third-party liability claims would be approximately $
9,5
billion before the Congress intervenes.
In the event of an accident that
involves damages that exceed the amount in the secondary insurance fund, the
government is not explicitly required to fund the balance. Rather,
Price-Anderson commits the Congress to investigate the accident and to take
whatever action it deems necessary. This action could include, among other
-things, appropriating funds or requiring the nuclear industry to provide
additional funding to satisfy remaining claims. No nuclear accidents have
occurred since PriceAnderson was enacted that cost more than was provided by the
available private insurance. As a result, the industry has never had to pay into
the secondary insurance fund, nor has the Congress been required to take action
on excessive losses.
Insurance Against Overseas Political Risk
The Overseas Private Investment Corporation (OPIC), which began
operations in 1971, was established to facilitate private investment by U.S.
investors in developing countries and countries with emerging markets. OPIC
insurance; programs reduce the risk to U.S. investors in these countries by
offering protection against several political risks. To general, the coverage
offered by OPIC is more comprehensive both in scope and duration than the
coverage currently available from private sector insurers. OPIC operates as a
self-financing government agency. A significant portion of its income is derived
from premiums and fees, but the program is also backed by $
100
million in borrowing authority from the U.S. Treasury. Premium rates are based
on a standard pricing table for different business sectors, with adjustments for
project-specific risks. The risk assessment methods OPIC uses to establish
insurance reserves and set premium rates rely heavily on expert judgment and are
not highly quantitative. According to OPIC officials, no standard actuarial
model exists for quantifying political risks.Over the life of OPIC, the
government has made money on the insurance provided.
Insurance Against
Urban Riots and Civil Disorder
Features:
Voluntary participation
Encouraged. states and the private sector to provide insurance in urban
areas
Offered federal reinsurance for insured property in urban areas
The National Insurance Development Program was established by the
Housing and Urban Development Act of 1968 (P.1.. 90-448). The program sought to
ensure the availability and affordability of fire, crime, and other property
insurance to residential and commercial owners located in highrisk urban areas.
The act created a Federal Insurance Administrator within the Department of
Housing and Urban Development to administer the reinsurance program, but
responsibility was later transferred to the Federal Emergency Management Agency.
The program was a response to the urban riots and civil disorders of the 19605;
when many of America's cities suffered major property losses.
As a
result of these losses, insurers became reluctant to underwrite property
insurance in communities considered to be at risk for such events. The program
had two purposes. First, the program encouraged state insurance regulators and
the industry to develop and carry out programs to make property coverage more
readily available. Second, it provided a voluntary federal program of
reinsurance for urban property owner relief against abnormally high property
insurance rates in private markets- Under this program, federal reinsurance was
made available to property insurance companies operating in states that
voluntarily adopted Fair Access to Insurance Requirements Plans. Insurers were
required to retain a small portion of the liability,, which had to be paid first
in the event of a claim. Insurers could transfer most of the remaining risk by
making a premium payment to the federal government, which then assumed the
remaining liability. This liability ranged from 90 to 98 percent of the
remaining insured amount, and coverage increased as losses grew. The program was
backed by $
250 million in borrowing authority from the U.S.
Treasury.
The program also included a requirement that states share in
program losses with the federal govenunent.3 According to a former program
official, state sharing of program losses was a feature designed in part to keep
states from setting property insurance premiums too low. At the program's
inception, federal reinsurance was to last less than 5 years, However, former
officials reported that the program made money because claims never reached the
anticipated levels and, beginning in the early 1970s, the program premiums were
used to subsidize a crime insurance program- Reinsurance was discontinued in
1984 because of the small number of insurers participating_
Insurance
Against Floods
Features:
Voluntary participation
Federal
government is the insurer for f ood risk
Subsidized rates offered to
encourage mitigation
The National Food Insurance Program, which was
established by the National Flood Insurance Act of 1968, makes federal flood
insurance available to property owners living in communities that join the
program. Same of the key factors that led to the program's establishment were
private insurers' reluctance to sell flood coverage, increasing losses from
floods because of floodplain encroachment, and high federal expenditures for
relief and flood control. This program, which is financed primarily through
premiums, fees, and interest income, aims to reduce federal spending on disaster
assistance. By design, this program is not actuarially sound, because it does
not collect sufficient income from premiums to build reserves to meet long-term
expenditures on flood losses. Though the Federal Insurance Administrator is
authorized to subsidize a significant portion of the total policies in force,
its annual appropriations do not cover these subsidies. As a result, the
Congress has appropriated funds for the program from time to time. In addition,
the Federal Insurance Administration bas periodically borrowed from the U.S.
Treasury to finance operating losses. The program is backed by
$
1 billion in borrowing authority from the U.S. Treasury.
Selected Insurance Programs of Other Countries
Many other
countries have government-sponsored insurance programs that cover catastrophes,
terrorist. events, or both. Some of these programs are essentially run by the
government, while others have little or no government backing. Appendix I, table
2, highlights key features of such programs in Israel, Japan, Switzerland, and
the United Kingdom. We will briefly discuss these programs.
Japan's
Insurance Against Earthquakes
Japan's earthquake insurance program,
originally conceived in 1966, arose out of a major earthquake in that country in
1964. The insurance is purchased as a supplement to residential fire insurance
and covers homes and household goods. Private insurers and the government share
in any Features:losses that result from a disaster according to a three-tiered
payment system. Under the first tier of coverage, private insurers are
responsible for the first $
625 million' of damages before
government assistance is participation triggered. This initial amount
effectively acts as a deductible. Losses above this amount trigger a second tier
of coverage, for damages up to $
6,821 billion. The Japanese
government pays 56 percent of the losses in this second tier, The third tier of
coverage involves losses of between $
6.821 billion and
$
34.166 billion, with the government paying 95 percent as
losses increase of losses exceeding $
6.821 billion. The
Japanese government receives reinsurance premiums from primary insurers, but its
total liability is not necessarily limited to the total amount of premiums
received.
Japan's program has several distinguishing features. First,
the private sector is responsible for the initial portion of losses. This
feature helps to ensure the development of a private market for earthquake
insurance that is unencumbered by a monopoly. Additionally, industry pool
arrangements are mandated under the program. The government takes on an
increasing share of losses as they rise, up to a maximum cap on the total amount
of exposure, but the private sector still bears some cost even at higher levels,
This feature helps to ensure that risk of disaster is spread throughout the
entire country and economy. Finally, the Japanese program was not established to
provide coverage for all potential losses, but rather as a :first step toward
providing some level of coverage, with the government and private sector working
together.
United Kingdom's insurance Against Terrorist Events
Features:
Voluntary participation
Created because of
withdrawal of private insurance
- Insurers pay 110 percent of premium
received before government pays
The United Kingdom's Pool Reinsurance
(Pool Re) program was established in 1993 to provide insurance against losses
and damages caused by terrorists attacks on industrial, commercial, and
residential properties located within the British mainland. There are several
distinct layers of coverage. All policyholders who buy basic property coverage
from insurers have the option of buying additional coverage from the same
insurers to protect against terrorism. Insurers are responsible for the first
100,000 pounds of coverage per coverage type, with no reimbursement from the
government Claims exceeding 100,000 pounds are paid from premiums accumulated
within a pool made up of insurance companies and Lloyd's syndicates. (1' he
British government and the
insurance trade group established a
mutual company from these companies and syndicates to provide
terrorism reinsurance.) If the pool of funds is exhausted, all
participating insurers face a call of up to 10 percent of the premiums they have
collected during the year. Beyond the 10 percent call, the pool investment
income is tapped, and the government meets any claims in excess of this-
According to United Kingdom officials familiar with the program, the government
has not yet had to bail out the pool as the reinsurer of last resort.
Israel's Insurance Against Terrorist Attacks
Features:
-Mandatory participation
-Government bears all risk
-Funded by tax revenues
Israel has two programs for covering
losses resulting from a terrorist attack. The first is the Property Tax and
Compensation. Fund, which covers property, and casualty insurance. The second is
the Law for the Victims of Enemy Action, which covers life and health insurance.
The Israeli government funds and administers both programs. Under the Property
Tax and Compensation Fund, the Israeli Income and Property Tax Commission levies
a national property tax predominantly on Israeli businesses. The con- Commission
pays claims on property damages that are the direct result of a hostile
terrorist attack (including losses of business inventory), on the basis, of the
market value of a property immediately before the attack. All indirect damages,
including those for business interruptions, must be covered through private
insurance. Private supplemental coverage or additional state coverage can be
purchased to cover the difference between a property's current market value and
the cost of rebuilding (known as the replacement value). State coverage is
capped by implementing regulations.
The second program, the Law for the
Compensation of Victims of Enemy Action, is a state in program administered by
the National Insurance Institute (NU) and is also funded by the government. The
NII is similar to the U.S. Social Security Administration. Coverage is provided
for medical care, lost wages, extended payments to the families of attack
victims, and personal injury.. Coverage also extends to visitors and tourists
who are in Israel- Coverage amounts for this program are again determined by
implementing regulations.
Switzerland's Insurance Against Selected
Catastrophic Events
Features:
- Mandatory Participation
- NO government risk exposure
Switzerland's Catastrophe
Insurance program was established to insure against natural disasters, including
storms, hail, floods, landslides, and avalanches. Earthquakes are not covered
under this program.. This program does not set up a separate catastrophic
insurance fund, but instead obliges insurers to include coverage for specified
catastrophes in fire insurance policies for buildings and their contents at a
statutorily fixed rate. These compulsory premiums are the sole means of
financing the catastrophe insurance program. Although this scheme does not set
up a separate catastrophe insurance fund, Swiss insurers have created a
reinsurance pool where these additional premiums are deposited. Membership in
this pool is optional for insurers, but currently 85 percent of claims are ceded
to it. Should claims exceed the funds in the pool, the difference would be
payable from the insurers' capital and assets, There is no government
involvement or exposure a9sodated with the operation of the program, since the
Swiss government does not provide any guarantee. For this reason, the private
sector has an incentive to reduce risks. Insurers that participate in the pool
are also subject to a cash-call in proportion to their participation in the pool
to cover claims that exceed pool capacity.
Insurance Programs Sponsored
by States or Other Entities
Other insurance programs that may provide
useful insights in developing insurance coverage for terrorist acts include
those established by state governments and private sector entities. Appendix T.,
table 3, highlights the features of several state and private sector insurance
programs, and I will describe these programs here.
State
Insurance/Guarantees Against Insolvent Insurers
Features:
Mandatory participation
Funded by postevent assessments
-Operated by industry
-No explicit subsidy
Every state
has guaranty funds to protect policyholders when an insurance company fails.
These funds exist for property-casualty as well as lifehealth insurers. While
there are differences between the funds for the two insurance sectors, in
general they operate similarly. Insurance guaranty funds are not really funds.
In nearly all states, the money used by guaranty funds to pay policyholders of
failed insurers is collected through post, failure assessments. After an
insurance company is found to be insolvent by a state regulator, the regulator
and the guaranty funds in each state where policies were sold determine by how
much the failed company's policyholder claims exceed the value of the company's
assets- The guaranty funds then provide sufficient funds to ensure that all
claims are paid (up to each state's statutory limits). Guaranty funds are not
operated by state governments, nor are they funded by public money (i.e., there
is no explicit subsidy).
However, the hands were created by statute and
operate as part of the insurance regulatory system. Even though no appropriated
funds are used to fund the guaranty funds, insurers do not bear the entire cost
of guaranty fund assessments. While tax treatment varies among states, many
states allow the insurers to offset their premium taxes for assessments paid to
guaranty funds- Where this tax credit is permitted, insurers can usually reduce
their premium tax bill, by 20 percent each year for d years. Other states allow
in:3urers to recoup assessments by increasing or adding a surcharge to
policyholder premiums.
California's Insurance Against Earthquakes
Features:
- Participation based on statutory requirements
-Funded by assessments on insurance companies
No public funding
The California Earthquake Authority was established to insure California
residents against losses caused by earthquakes. The Earthquake Authority was set
up by state statute. The state of California, however, does not contribute any
funding to the authority. After the Northridge, CA earthquake in 1994, insurance
companies determined that the premiums they had been charging for earthquake
coverage were inadequate. Furthermore, the companies did not know how to set an
actuarially sound price. Insurance companies attempted to stop selling insurance
against earthquake damage, but were opposed by the state. After negotiations,
insurers were permitted to exclude earthquake coverage from their
property-casualty policies if insurance companies representing at least 70
percent of the market agreed to participate in the Earthquake Authority_
Participation meant agreeing to pay an initial assessment totaling
$
717 million plus two additional assessments of
$
2.15 billion and $
1.434 billion after certain
levels of earthquake- related losses occurred. Thus, potential Earthquake
Authority losses are to be funded by a multilayered financing arrangement
involving insurer contributions, premiums, conventional reinsurance, anti
pre-established debt financing. In early 2000, these layers totaled about ,$ r
billion. In the event that all authority funds were expended, claims payments
would be prorated. The Earthquake Authority currently provides virtually all of
the earthquake insurance available in the state of California.
Ship
Owner Insurance For Ocean Pollution
Features:
-Voluntary
participation
-Risks are pooled and, funded by pre and post assessments
-No government involvement
The International Group of Protection
and Indemnity Clubs (Group) includes the 14 protection and indemnity
associations or "clubs" that insure about 90 percent of the world's seagoing
tonnage. The individual clubs are nonprofit-making mutual insurance
organizations that cover third-party risk,; of shipowning members. The American
Steamship Owners Mutual Protection and Indemnity Association, Inc., known as the
American Club, was established in New York State in 1917 and is the only U'. S.
domiciled member- 6 The American Club has no government subsidy.The Group
arranges collective insurance and reinsurance that covers risks such as those
arising from oil spills and other polluting substances. The program uses
primarily a prefunded approach to pool funds through advance calls of premium.
The advance premiums paid by shipowners are 80 percent of e3timated claims for
the policy year. Premiums are invested by the Group. Should loss experience
prove higher than anticipated, the program also encompasses other reinsurance
and a post assessment call feature.
The pooling arrangement is a
four-layered system. Claims of less than $
5 million are
essentially risk of loss retained by the club member shipowners. The program
then enables the pooling of claims from $
5 million to
$
30 million between clubs based on a formula incorporating
tonnage size, premium income, and claims record. The next layer, called "excess
of loss reinsurance," is reinsurance purchased by the Group for third-party
claims incurred in a single incident in excess of $
30
rnillionup to , billion in the case of oil pollution liabilities and up to
$
2 billion for all other liabilities. Finally, the program
encompasses an "over spill' layer to cover claims in the $
2
billion to $
4 billion range. This layer is funded through a
post assessment of club members.
Alternative Mechanisms for Funding
Insured Losses
In order to pay claims when an insured event occurs, a
mechanism must exist to ensure that the funds will be available when they are
needed. Currently, there are two possible models for such a mechanism. Fast,
insurers can prefund for expected losses by estimating potential liabilities
(establishing a reserve liability) and collecting assets (premiums) to pay
claims when an insured event occurs. Alternatively, under certain circumstances,
after an instated event when losses are known with certainty, assessments can be
levied to provide the necessary funds. Both models, and in : new cases a
combination of the two, are widely used in the insurance industry.
Prefunding Versus Post Assessment
The deposit insurance provided
by the Federal Deposit Insurance Corporation (FDIC) is an example of a prefunded
system. Banks pay premiums into a fund. When a bank fails, the deposit insurance
fund is used to make up the difference between the bank's remaining assets and
customer deposits, up to a legal limit. Of course, if the deposit insurance fund
falls below a certain level because of large payouts, banks must pay additional
amounts into the fund to ensure that sufficient funds are available for future
failures- In contrast, most of the state insurance guaranty funds described
earlier are examples of post assessment plans After an insurance insolvency, the
remaining insurance companies in each state where the company operated are
assessed the difference between the failed insurer's legal obligations to its
policyholders and its assets. Some of the programs described earlier in this
statement include a combination o both pre-funded and post assessment
mechanisms, including the British Pool Re and the California Earthquake
Authority.
For ordinary, noncatastrophic events, insurance companies set
up reserves (liabilities) that measure their expected losses, and set aside
assets to offset those liabilities. For catastrophic events, when both the
timing and magnitude of losses are difficult or impossible to predict, insurance
companies generally do not set up reserves. These losses are generally paid out
of the company's ongoing premium stream, the company's capital, or both. If
income from premiums is too low or losses are too high, an insurer's capital can
be depleted, and the insurer may become insolvent. In the long run, if an
insurer does not become insolvent, it can recoup catastrophic losses by
adjusting the premium rates charged to policyholders. Thus, even insurance
companies postfund some of their insured losses. Both prefunding and post
assessment are reasonable ways to fund the exposure to losses from large
catastrophic events, including terrorism. Both mechanisms have advantages and
disadvantages. Used together, they could provide a multilayer mechanism for
funding levels of risk exposure that otherwise could limit the availability of
needed insurance.
Reinsurance: A Further Means of Protection
Insurance companies that insure catastrophes can also reduce the
potential for insolvency by purchasing reinsurance. The insurer remains liable
for any claims when they are presented, but is later reimbursed by the reinsurer
for the portion of the liability that was reinsured. The problem for the insurer
then becomes one of liquidity rather than solvency. Of course, over time both
the insurer's and the reinsurer's solvency depend on a reasonable correspondence
between premium income (plus investment income) and losses.
Reinsurers
remain in business if the direct insurer can charge premiums that provide
sufficient income to pay claims, and related expenses and to record a profit, if
a reinsurer does not believe an insurer is capable setting a price commensurate
with the risk, or of generating enough premium income to pay those risks, it
will not reinsure that business. According to the insurance industry, it is now
facing that situation in the aftermath of the September attacks.One possible
solution would be for a group of insurers to establish a pool to take the place
of the unwilling reinsurers. In this case, losses from any terrorist event that
affect only one or a few members can be spread across the entire pool, reducing
the likelihood that individual members will become insolvent. however, while the
pool may take the place of the reinsurers, the pool faces the same difficulties
in establishing catastrophic (contingency) reserves as the individual insurers.
It would also be holding the same risks that the reinsurers were unwilling to
accept. Hence, the desire to add the government to the equation.
How the
Federal Government Can Support Insurers Facing Catastrophic Losses
The
federal government could help the insurers in a number of ways. It could allow
the pool to build tax-free, multiyear reserves for potential losses that do not
have a measurable probability or estimable value. Such a pool arrangement has
been used in Britain for the purposes of increasing pool assets for catastrophic
losses. This tax-free status would increase the pool's ability to pay for future
terrorist events. However, if the insured event occurs before the pool builds up
substantial reserves, or if the prices insurers are charging for coverage run
out to be too low, the pool's reserves would still. be depleted. If so, the
member insurers would still risk insolvency, since they would be obligated to
pay all legitimate claims whether they could recover the funds from the pool or
not. To alleviate this possibility, the government could also stand behind the
pool as a riskbearer. In this case, if the pool's assets were depleted, the
government would assume the contingent liability, using its resources to pay
additional losses and reducing the risk of insolvency for the insurance
companies.
The government could also fund its contingent liability to
the pool in a variety of ways. It could charge the pool a premium for the
reinsurance like protection it provides, accumulating a fund it could use to pay
for losses. Of course, any premiums charged to the pool would reduce the pool's
assets and accelerate both the time when the government would have to begin
covering losses and its total exposure. Alternatively, the government could fund
its losses out of tax revenues, either with or without repayment requirements.
Given that the problem currently facing the insurance industry is an
inability to co,1'rectly price the risk of a terrorist act, prefunding may not
generate sufficient funds to fully pay potential insured losses from major
terrorist events. A postfunding (post assessment) mechanism could be used either
to substitute for or to augment, a prefunded reserving mechanism. Postevent
assessments could be a feature of the pool, of the government mechanism, or
both. Pool Re, the British plan for public/private sharing of terrorism risk,
includes a call on each memberinsurer after the private pool is exhausted, in an
additional amount equal to 10 percent of the total premium that insurers
collected for terrorism coverage. Alternatively, the government could pay that
portion of the losses that exceed the pool's resources and then assess the
member companies over true in order to recoup part or all of its expenditures.
In this valiant, the government would be lending the insurance companies part or
all of the cash needed to meet liquidity demands resulting from the terrorist
event, but not bailing the industry out.
Principles to Consider When
Pro-,viding Financial Assistance
At this point, we would like to discuss
some broad principles that we have drawn from lessors learned over several
decades of supporting congressional efforts to assist industries and firms in
moments of crisis, including the servings and loan industry and, most recently,
the aviation industry-' These principles may provide guidance as you consider
whether the government should take actions to ensure the continued availability
of insurance and reinsurance for terrorist-related acts. We believe that the
following three principles are key to such efforts:
Clearly define the
problem to be solved.
Ensure that the program protects the government
and taxpayers from excessive and unnecessary losses.
Avoid a
self-perpetuating program, that is the government's involvement should be
temporary.
Defining the Problem the Industry Faces
The industry
and federal government need to work together to clearly define the specific
nature of the problems confronting the industry, separating shoat-term. needs
from long-term challenges and wants from genuine needs. 1t. seems clear, given
insurers increased recognition of their exposures in the aftermath of the
unprecedented events on September 11, 2001, that coverage for terrorist acts is
not now amenable to normal insurance underwriting, risk management, and
actuarial techniques. A.,, a result, insurers and reinsurers are concerned about
their ability to set all appropriate price for insurance coverage for terrorist
actsGiven this uncertainty if this kind of insurance were to be offered at. all,
it is likely that either the prices insurers set would be prohibitively high or
so low as to invite insolvency. However, even if we conclude that insurers
cannot price and, therefore, cannot sell this kind of insurance, defining the
nature of the problem facing both the economy and the insurance industry is a
critical first step. Many important questions need to be addressed. Among them
are:
What is the appropriate definition of a terrorist act?
Now
would the lack of insurance coverage for terrorist events affect other sectors
of the economy?
-What are the public policy objectives to be achieved by
an assistance program?
Protecting the Government From Excessive Losses
Whatever program or mechanism is put in place, protecting the government
and therefore, taxpayers---from inefficiency and excessive costs needs to be a
primary objective_ When the government becomes involved in providing insurance,
it is usually because the private insurance market is having difficulty
underwriting and pricing certain risks. For instance, some risks are difficult
to predict and can be catastrophic in size. Additionally, some risks may not be
independent-that is, the losses may strike a large number of 'ensured
individuals or entities at the sane time. Farthermore, spreading the risk to a
large and diverse population may be difficult, This difficulty sometimes results
from adverse selection, which occurs when those with the highest probability of
loss tend to purchase insurance, where those with the least risk opt out.
While these factors may provide a basis for government intervention in
the market, they also complicate efforts to measure the government's exposure to
loss. Nevertheless, the government can take steps to control and limit losses.
For example, any program should have keep market incentives where they
belong--with private firms. As long as private firms have their own money at
risk; the private market is a better choice than the government for handling
traditional insurance functions such as setting prices, underwriting policies,
and handling and adjusting claims. If the government is bearing all or most of
the risk, private funds will not have the same incentives to maximize
efficiency.
Thus, any government program must be structured to ensure
that private insurers have the same incentives they would have if the government
were not involved. For example, firms should have an incentive to set the best
prices they can (even in an environment of insufficient information), to require
risk ,mitigation on the part of their customers in exchange for a reduced
premium, and to carefully investigate losses to ensure that claims payments are
appropriate. Creating a mechanism that places part of each company's capital at
risk-as well as premium income-could serve to maintain the correct incentive
structure. If insurance companies believe that their own exposure to losses is
insignificant, they are not likely to behave the same way they would if their
own money was at stake.
Reevaluating Future Government Involvement
Finally, in the current crisis environment any government solution
should be temporary and needs to be revisited periodically. Congress may decide
that ensuring the continued ability of the insurance industry to serve all its
customers is in the national interest. However, given the lack of information
about the scope and nature of the long-term problem, it does not seem prudent to
establish such assistance in a program that may become permanent. However,
government programs that are not carefully designed tend to become
self-perpetuating. We can find examples of such programs in our own government
experience and in some of the foreign programs we have described today.
Fortunately, several strategies are available to minimize the possibility that a
program will perpetuate itself. First, government bureaucracy should be kept to
a minimum. An established bureaucracy tends to find reasons for its own
continued existence. Second, any program should have an exit strategy from the
beginning. An Exit plan will provide the insurance industry and program
administrators with congressional guidance on how the industry should emerge
from the assistance program. Finally, a primary goal of any federal insurance
program must be to create an environment in which the private market can and
will be reestablished.
Conclusions
The government may have an
important role to play in helping the insurance industry establish insurance
coverage for losses from terrorist acts. GAO believes that should any assistance
program be established it would be most successful if based on the principles we
have described today. Following these principles will help ensure that
assistance addresses market problems, protects taxpayers from excessive and
unnecessary losses, and does not displace the private market for providing such
insurance coverage.
Mr. Chairman, this concludes my statement. We would
be pleased to respond to any questions that you or other members of the
Committee may have.
LOAD-DATE: October 25, 2001