Copyright 2001 FDCHeMedia, Inc. All Rights Reserved. Federal Document Clearing House Congressional
Testimony
October 24, 2001, Wednesday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 3224 words
COMMITTEE:HOUSE FINANCIAL SERVICES
HEADLINE:
INSURANCE AND TERRORISM
TESTIMONY-BY: PAUL H.
O'NEILL, REPRESENTATIVE
BODY: October 24, 2001
STATEMENT OF THE HONORABLE
PAUL H. O'NEILL SECRETARY OF THE TREASURY
BEFORE THE
SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE AND GOVERNMENT
SPONSORED ENTERPRISES
UNITED STATES HOUSE OF
REPRESENTATIVES
TERRORISM RISK INSURANCE
Mr. Chairman, Congressman Kanjorski, 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.
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.
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.
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.
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.
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.