Copyright 2001 eMediaMillWorks, Inc.
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Federal Document Clearing House
Congressional Testimony
October 24, 2001, Wednesday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 3220 words
COMMITTEE:
SENATE BANKING, HOUSING AND URBAN AFFAIRS
HEADLINE: TERRORISM INSURANCE
TESTIMONY-BY: PAUL H. O'NEILL, SECRETARY OF THE
AFFILIATION: TREASURY DEPARTMENT
BODY: October 24, 2001
TERRORISM RISK
INSURANCE
Testimony of the Honorable Paul H. O'Neill Secretary of the Treasury
Department
Before the Committee on Banking, Housing and Urban Affairs
United States Senate
Mr. Chairman, Senator Gramm, and Members of the
Committee, I appreciate the opportunity to comment on
terrorism
risk
insurance. These hearings are extremely important. We
believe that there is a real and pressing need for Congress to act on this issue
now. As I will discuss in more detail, market mechanisms to provide
terrorism risk
insurance coverage have broken
down in the wake of September 11. Such coverage is now being dropped from
property and casualty reinsurance contracts as they come up for renewal, with
most policies renewing at year- end. If Congress fails to act, reinsurers have
signaled their intention to exclude such coverage meaning that primary insurers
may have to drop this coverage or institute dramatic price increases. As a
result, after January 1 the vast majority of businesses in this country are at
risk for either losing their
terrorism risk
insurance coverage or paying steep premiums for dramatically
curtailed coverage. This dynamic can in turn be expected to cause dislocations
throughout our economy, particularly in the real estate, transportation, and
energy sectors. 1. The Problem
The terrorist attacks of September 11
created widespread uncertainty about the risk and potential costs of future
terrorist acts. Since September 11, we have endured this uncertainty every day
as a country. It has permeated every sector of our economy.
A key part
of the government's response to the events of September 11 is to ensure that our
economic stability is not undermined by terrorist acts. Continued economic
activity is dependent on well functioning financial markets - where the
lifeblood of capital is provided to business enterprises. Financial markets
allocate capital based on the potential success of a business. In doing so,
financial markets rely on the insurance sector to mitigate certain types of risk
that are not directly related to the plans or operations of a business.
Insurance companies manage risk in economic activity and facilitate the
efficient deployment of capital in our economy by estimating probabilities of
possible adverse outcomes, and pooling risk across a large group. Since
September 11 the uncertainty surrounding
terrorism risk has
disrupted the ability of
insurance companies to estimate,
price, and insure the risk.
We learned on September 11 that, while
perhaps highly improbable, terrorists are capable of enormous destruction. Could
such an event be repeated? As a country and a government, we are doing
everything in our power to prevent a repetition of anything like the events of
September 11. But how does an insurance company assess this uncertainty? How
does an insurance company price for it? At the moment, there are no models, no
meaningful experience, no reasonable upper bound on what an individual company's
risk exposure may be.
Insurance companies do not "take" risks. They
knowingly accept and mutualize risks. They are private, for-profit enterprises.
If they do not believe they can make money by underwriting a particular risk,
they will not cover it. Because
insurance companies do not know
the upper bound of
terrorism risk exposure, they will protect
themselves by charging enormous premiums, dramatically curtailing coverage, or -
as we have already seen with terrorism risk exclusions - simply refusing to
offer the coverage. Whatever avenue they choose, the result is the same:
increased premiums and/or increased risk exposure for businesses that will be
passed on to consumers in the form of higher product prices, transportation
costs, energy costs and reduced production.
The consequences of
uncertainties surrounding terrorism risk are already evident in the airline
sector. The Department of Transportation's initial projection is that, as a
result of the September 11 attacks, airlines will pay nearly $
1
billion in premium increases for
terrorism risk
insurance in the next year despite a congressionally imposed
cap on third-party liability. Within the next few months, similar increases can
be expected for other forms of economic activity deemed "high risk" - if
coverage is available at all. Higher premiums will divert capital away from
other forms of business investment.
The need for action is urgent. From
our conversations with insurance company representatives, state insurance
regulators, policyholders, banks and other entities which provide financing for
property transactions, the next two months are critical. The insurance industry
relies on a complicated structure of risk sharing. Risk is shared among primary
insurers, reinsurers, and retrocessionairs (i.e., providing reinsurance to the
reinsurers). This structure has worked well in the past and greatly contributed
to widely spreading losses associated with the events of September 11 across the
insurance industry.
However, in light of the uncertainty created by
September 11, reinsurers have told us that they will no longer cover acts of
terrorism in their reinsurance contracts with primary insurers. And as I have
said, most property and casualty insurance contracts are up for renewal at year
end. This will create the following choices for insurers: assume all of the risk
of terrorism coverage and raise prices to cover all of the associated, unshared
costs; reduce coverage levels; or cancel coverage. Any of these choices has the
potential to cause severe economic dislocations in the near-term either through
higher insurance costs or higher financing costs.
2. Objectives
In grappling with this problem, we have had several objectives.
First and foremost, we want to dampen the shock to the economy of
dramatic cost increases for insurance or curtailed coverage. We also want to
limit federal intrusion into private economic activity as much as possible while
still achieving the first objective. And we want to rely on the existing state
regulatory infrastructure as much as practicable.
Note that none of
these objectives are directed at providing government assistance to the
insurance industry. The industry is absorbing the financial losses it contracted
for as a result of the September 11 attacks, and is fully capable of making good
on those losses. The industry is also capable of continuing to provide insurance
for non-terrorist hazards. The problem, as I have said, is one of uncertainty
about future terrorist risk. At the moment, there is no basis upon which to
price terrorism risk and no sense of the upper bound on the risk exposure.
3. Options
Over the past few weeks, a variety of proposals have
emerged to deal with the problem I have outlined. Before turning to the approach
we have developed, I will briefly discuss a few of the alternatives we
considered and some of the shortcomings we identified with each.
A case
could be made to treat
terrorism risk
insurance like war risk
insurance. During
World War II, the federal government provided property owners with insurance
protection against loss from enemy attack. Similarly, the Israeli government
provides
insurance for
terrorism risk. This
approach would recognize the terrorist threat as one made against all Americans
and would establish the broadest possible risk pool for insuring against this
risk. At the same time, such an approach implies a permanent federal intrusion
in the market so long as any terrorism risk remains.
A second approach,
one suggested in various forms by
insurance industry
representatives, involves the creation of a reinsurance company to pool
terrorism risk. This model follows an approach developed in the
United Kingdom in response to IRA terrorist activities. This approach has some
appeal, especially in providing a vehicle for pooling the industry's risk while
providing an upper bound on industry losses through a government backstop. With
more time, or in different circumstances, this approach may have been desirable.
In our judgement, however, it has several significant shortcomings.
First, the approach ultimately leads to the federal government setting premium
rates by establishing the rate charged to the pool for the government's
backstop. If the basic problem is that the
insurance industry -
whose business it is to measure and price risk - cannot currently price
terrorism risk without distorting markets, why would we think
the government can do a better job?
Establishing a pool would also take
time, and time is very limited since most policies expire at year-end. It is
unclear how long it would take industry to capitalize the pool. In the interim,
the government's exposure could be substantial, insofar as it would be liable
for 100 percent of losses that exceeded the pool's capitalization. In addition,
we question whether the government could move quickly enough on its end to
establish the contracts, the pricing structure, and the regulatory structure
needed to make the proposal work.
Finally, the pool approach creates a
federal insurance regulatory apparatus with some presumption of permanence, and
a potentially enormous pool of captive capital that we may never need to use. We
believe that there will be less uncertainty about terrorism risk a few years
from now and that uncertainty will be more manageable by the private sector than
is the case today. Given that, why undertake the effort to create a monopoly
reinsurer and give a new federal regulator the power to both set prices and
regulate insurance companies and their, activities?
A third option would
be to simply set a large industry deductible and let the federal government
cover all losses from acts of
terrorism past that point. For
instance, the federal government could require the
insurance
industry to cover all losses up to, say, $
40 billion in a given
year and the federal government would pay all losses above that amount.
This approach has two substantial drawbacks. First, it does not address
the fundamental problem: the industry has no basis for knowing - and hence
pricing - terrorism risk. A large deductible would require them to assess
premiums large enough to cover a large potential loss. In the absence of better
information, we might well expect companies to price insurance as if they fully
expected losses up to the deductible amount. Second, this approach makes it
difficult to control losses above the deductible as insurance companies would
have no incentive to limit costs once their deductible has been paid.
4.
A Shared Loss Compensation Program
After reviewing these and other
options, and discussing these issues with congressional and industry leadership
and the state insurance regulatory community, we developed an approach that we
believe best accomplishes the objectives I set forth. Let me say at the outset
that this approach reflects the current evolution of our thinking on this issue.
We want to work with Congress to achieve the best possible solution. As I have
said, the insurance industry can easily protect itself by eliminating coverage
or charging very high premiums. What we are trying to do is craft a plan that
will prevent the economic dislocations that will otherwise take place if private
insurers follow the course they are now on. It is imperative that we find a
solution that works in the marketplace. We must get it right, and we must get it
right now.
When terrorists target symbols of our nation's economic,
political and military power, they are attacking the nation as a whole, not the
symbol. This argues for spreading the cost across all taxpayers. Yet there are
also reasons to limit the federal role. If property owners do not face any
liability from potential attacks, they may under-invest in security measures and
backup facilities. In addition, the
insurance industry has
sufficient experience and capacity to price some portion of the risk associated
with
terrorism and has the infrastructure necessary to assess
and process claims.
Under the approach we are suggesting, individuals,
businesses, and other entities would continue to obtain property and casualty
insurance from insurance providers as they did before September
11. The terms of the
terrorism risk coverage would be unchanged
and would be the same as that for other risks.
Any loss claims resulting
from a future terrorist act would be submitted by the policyholder to the
insurance company. The insurance company would process the claims, and then
submit an invoice to the government for payment of its share.
The
Treasury would establish a general process by which insurance companies submit
claims. The Treasury would also institute a process for reviewing and auditing
claims and for ensuring that the private/public loss sharing arrangement is
apportioned among all insurance companies in a consistent manner. State
insurance regulators would also play an important role in monitoring the claims
process and ensuring the overall integrity of the insurance system.
Through the end of 2002, the government would absorb 80 percent of the
first $
20 billion of insured losses resulting from terrorism
and 90 percent of insured losses above $
20 billion. Thus, the
private sector would pay 20 percent of the first $
20 billion in
losses and 10 percent of losses above that amount.
Under this approach
the federal government is absorbing a portion -- but only a portion -of the
first dollar of losses, which we believe is important to do in the first year of
the program. The key problem faced by
insurance companies right
now is pricing for
terrorism risk. While this type of loss
sharing approach does not completely alleviate that problem, it does provide
insurance companies with the ability to evaluate potential losses on a policy by
policy basis, with clearly defined maximum exposures. For example, on a
$
100 million commercial policy the insurance company's maximum
exposure would be $
20 million. If industry losses were greater
than $
20 billion that exposure would be reduced even further.
More importantly, price increases to policyholders should be lower under
this approach than under an approach that requires companies to absorb 100
percent of losses up to a large, aggregate industry loss deductible. Under this
approach, if an insurance company's maximum exposure was defined at
$
20 million on a $
100 million policy, the
insurance company could then price that $
20 million exposure on
the probability of a complete loss event occurring.
Suppose instead that
the insurance industry had to absorb $
20 billion in losses
before any government loss sharing began. Then, in our example, the insurance
company's maximum loss exposure would be $
100 million on that
policy, not $
20 million. Pricing to this maximum loss would
create the economic dislocation we are trying to avoid.
The role of the
federal government would recede over time, with the expectation that the private
sector would further develop its capacity each year. As private sector capacity
increases, the nature of the government's loss sharing agreement would also
change. Given more time and experience, we believe that the insurance industry
could reestablish robust risk-sharing arrangements such as reinsurance that
would enable the private sector to insure losses from terrorism before the
government loss sharing commenced.
Thus, in 2003, we would have the
private sector be responsible for 100 percent of the first $
10
billion of insured losses, 50 percent of the insured losses between
$
10 and $
20 billion, and 10 percent of the
insured losses above $
20 billion. The government would be
responsible for the remainder.
In 2004, the private sector would be
responsible for 100 percent of the first $
20 billion of insured
losses, 50 percent of the insured losses between $
20 and
$
40 billion, and 10 percent of the insured losses above
$
40 billion. The government would be responsible for the
remainder.
To preserve flexibility in an extraordinary attack, combined
private/public liability for losses under the program would be capped at
$
100 billion in any year. It would be left to Congress to
determine payments above $
100 billion.
The federal
government's involvement would sunset after three years. It is our hope, indeed
our expectation, that the market problem we face today will have been corrected
by then so that the private sector will be able to effectively price and manage
terrorism risk
insurance going forward. Of
course, should that prove not to be the case, Congress and the President can
reevaluate the program in place and decide at that time on an extension of the
program or establishment of some other approach.
This approach would
also provide certain legal procedures to manage and structure litigation arising
out of mass tort terrorism incidents. This includes consolidation of claims into
a single forum, a prohibition on punitive damages, and provisions to ensure that
defendants pay only for non-economic damages for which they are responsible. It
is important to ensure that any liability arising from terrorist attacks results
from culpable behavior rather than overzealous litigation. These procedures are
important to mitigating losses arising from any future terrorist attack on our
nation, and are an absolutely essential component of the program I have
outlined.
Finally, this approach requires a clear definition of an "act
of terrorism." We suggest that the Secretary of the Treasury, with the
concurrence of the Attorney General, and in consultation with other members of
the Cabinet, be given authority to certify that a terrorist act had taken place
for purposes of activating the shared loss compensation arrangement.
We
believe that this approach dampens any adverse economic impact from a sudden
increase in the cost from
terrorism risk
insurance over the next 12 months. The imposition of a
deductible in the second year, and an increase in the deductible in the third
year, permits the federal government to gradually withdraw from the market as
the private sector adapts to measuring and pricing terrorism risk.
5.
Conclusion
Mr. Chairman, for the reasons I have set forth, the
Administration believes that the economy is facing a temporary, but critical,
market problem in the provision of
terrorism risk
insurance. Keeping our economy moving must be our overriding
concern. Leaving this problem unresolved threatens our economic stability. The
approach I have outlined limits the
government's direct involvement,
retains all those elements of our private insurance system that continue to
operate well, and provides a transition period to allow the private sector to
establish market mechanisms to deal with this insidious new risk that confronts
our nation.
There are no perfect solutions to this problem. We have
developed what we believe is a sound approach. As I explained earlier, we do not
believe that creation of a reinsurance pool can be accomplished under the time
constraints we face, but we would be glad to explore modifications to our
approach with the Committee.
I would be pleased to answer any questions
the Committee may have.
LOAD-DATE: October 25,
2001