The Role of Government in Financing Catastrophes

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1 The Geneva Papers on Risk and Insurance Vol. 27 No. 2 (April 2002) 283±287 The Role of Government in Financing Catastrophes by Frank W. Nutter While exposure in the United States to natural catastrophes has been widely documented, and the events of September 11 exposed the U.S. insurance industry to a truly unknown level of catastrophe, the role of government in nancing catastrophes lacks a clear policy direction. Some of this failure can be attributed to the multiple levels of government that have addressed catastrophe exposure; yet the industry's own disagreements over the proper course of action can account for this as well. It is not for lack of effort on the part of both in trying to craft approaches over the last ten years, however. 1. The role of the states Because of the enormous coastline and exposure to hurricanes in the U.S., nearly every coastal state has a combination of mitigation, coverage mandates and residual market pools to address insurance availability and affordability. States view their role as one of assuring access to insurance protection on an affordable basis for consumers. Thus, form and rate approvals generally remain in place for personal lines as a means to require coverage and assure insurance at rates deemed affordable in the context of exposure analysis. For this reason, changes in deductibles or other coverage limitations as a means to shift nancing remain sensitive. The hurricane-exposed states all have residual markets for homeowners who cannot nd coverage in the voluntary market. If states believe rates are too high, they suppress rates knowing that the business will ow to the residual market. South Carolina is an example of a state that has a small residual market due to the regulator's willingness to let rates rise to competitive market levels. Texas and Florida are examples of states with large hurricane exposed residual markets. By managing rates and the use of residual market, states are nancing catastrophes by using the resources of private and voluntary insurance capital. Following Hurricane Iniki (1992), Andrew (1992) and the Northridge earthquake (1994), Hawaii, Florida, and California enacted legislation to create a state fund or pool as a means of nancing catastrophe risk. Although states have been reluctant to create state catastrophe funds, each of these states created a different mechanism re ecting its own market crisis and the state's role as a laboratory. The Hawaii fund was a direct provider of hurricane risk insurance. That market has since returned and the Hawaii fund no longer writes business. It exists in the statutes and can be recreated when necessary. The Florida fund is a reinsurance pool. It serves to provide reinsurance capacity but also serves to affect rates in the private market. In the event of the loss, it would assess on a statewide basis most President, Reinsurance Association of America, 1301 Pennsylvania Avenue, NW, Suite 900, Washington, D.C , Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK.

2 284 NUTTER policyholders, for the losses in the property lines. The California Earthquake Authority is a voluntary direct provider of earthquake coverage. About 70 per cent of the insurance market offers their customers earthquake coverage through this fund. The CEA market share is declining, as is the historical experience in California: as time passes and memories of recent quakes fade, the consumer's interest in protection declines. New York, South Carolina, Georgia, Louisiana, Texas, Maryland, Virginia, and New Jersey have all discussed the creation of state catastrophe funds. Efforts to establish them failed largely because insurers in the state were not in agreement. Insurers recognized that a state fund and its inherent market subsidies should be created only as a last resort. Instead, insurers advocated mitigation, rate and form exibility before resorting to state funds. Legislators were also concerned about cross-market subsidies, and regulators were inclined to see if the market could sort out the problem. In these states, these considerations have all prevailed. Looking at the role states have played, a consistent theme of taking advantage of the insurance markets' desire to write coverage for catastrophe exposed risks or risks related to them is evident. Insurers in coastal states and in highly populated states have been willing to submit to subsidized, involuntary mechanisms such as residual markets and creative state solutions that require private capital commitments and post-event assessment schemes such as the California Earthquake Authority rather than withdraw from other market opportunities. The state programs may also purchase private reinsurance or capital market products as a further means of tapping private market capital. With this trade-off, states can nance catastrophe exposure largely through private capital sources without exposing taxpayers. This approach is not without its critics, however. Insurers have been consistently subjected to the use of residual markets to in uence voluntary market rates. By lowering windstorm and residual market mechanism rates to below private market rates, states effectively appropriate private capital to subsidize catastrophe risks. In states where quasiprivate/public mechanisms have been used (e.g., the Florida Hurricane Fund or the California Earthquake Authority), some insurers have more aggressively used these funds than others, thereby creating a winners and losers tension between market participants. Lastly, the various approaches by the states have been criticized as untested and underfunded. It remains to be seen whether these public/private programs are a house of cards or even renewable after a major event. 2. The role of the federal government Federal policy with regard to nancing catastrophes has largely been limited to response and recovery efforts funded by taxpayers. Over the past ten years, federal agencies have spent enormous sums to provide victims of catastrophes with immediate assistance, housing and low interest grants and loans. Other than several very targeted programs mentioned below, federal policy on nancing catastrophe risk has been the allowance to insurers of carry back (two years) and carry forward (15 years) for losses against federal tax liability. Over time several federal programs have been enacted to address speci c catastrophe exposures. The National Flood Insurance Program In 1968 the National Flood Insurance Program was adopted to provide insurance to residential and small commercial risks. The program operates much like an insurance company with some subsidization of risk premium but a stated goal of reducing disaster

3 THE ROLE OF GOVERNMENT IN FINANCING CATASTROPHES 285 assistance by requiring those at risk to ooding to bear the cost of insurance. The nancial backing of the federal government does permit the program access to below market federal funds in the event it cannot meet liquidity needs. Insurance for catastrophic nuclear accidents The Price±Anderson Act of 1957 limits the total liability of individual nuclear 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 the event of an accident at any single reactor that results in losses exceeding $200 million, all operators of commercial nuclear power reactors would be required to provide additional protection by paying into a secondary insurance fund. Following an incident, the operators would be required to pay as much as $10 million annually for nine years to complete the secondary insurance fund. 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 appropriating funds or requiring the nuclear industry to provide additional funding to satisfy remaining claims. Insurance against urban riots and civil disorder While not speci cally targeted as catastrophes, the National Insurance Development Program was established to ensure the availability and affordability of re, crime, and other property insurance to residential and commercial owners located in high-risk urban areas. The program was a response to the urban riots and civil disorders of the 1960s, when many of America's cities suffered major property losses. 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 inactive 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 rst 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. The program also included a requirement that states share in program losses with the federal government to keep states from setting property insurance premiums too low. Recent initiatives The industry has repeatedly sought the involvement of the federal government in nancing catastrophe risk over the last ten years. Even before Hurricane Andrew in 1992 and as recently as the months following the World Trade Center catastrophe, the industry has promoted various approaches to secure federal backing. Early efforts focused on the creation of a government sponsored enterprise (GSE) that would be privately managed but would have the backing of the federal government. The rst effort involved federal loans to the corporation in addition to favorable tax treatment.

4 286 NUTTER Although later efforts expanded the authority to include insurance to consumers as well, the corporation would be authorized to provide reinsurance to insurers. Resistance to the concept included the concern that insurers bore no direct risk to their own insurance portfolio and therefore had little incentive to underwrite appropriately. Even suggestions to require the corporation to quota share the loss were met with opposition from those viewing GSEs as a subsidy to corporate America that could not be justi ed by the promise of more affordable or available insurance for catastrophe exposure. The idea of a public±private partnership evolved to a proposal for a federally backed reinsurer of state funds. This was advanced following the creation of the Florida and California funds as a means to give them greater nancial support. Opponents of this approach noted that state funds had been rejected by many states and that such funds exposed the federal government to actions by the states regarding rates and coverage with no federal regulatory authority over state action. The industry eventually settled on an approach that involved the federal government in the auction of reinsurance contracts to quali ed bidders. Under this approach the government could control and limit its exposure, the industry would have additional reinsurance protection and taxpayers would not subsidize the risk. Such contracts could be divisible and resold on a secondary market. It was also thought that this action would stimulate capital market products that would provide additional catastrophe capacity. State funds, private investors and insurers could bid on the contracts. This approach fell victim to a lack of industry consensus. Reinsurers argued that such a program was attractive if the federal contracts attached at a point above private sector capacity. Some insurers argued, however, that the attachment point should be low ($2 billion of insured loss) to improve capacity and pricing at the consumer level. The debate tended to be between commercial insurers and reinsurers on one hand and personal lines insurers on the other. The proposal saw limited Congressional action. One must wonder what the argument over the attachment point would be in light of the estimated $40 to $70 billion of insured loss from the events of September 11 with no federal or state program in place and the industry committed to pay its full liability. Some insurers have promoted catastrophe reserves for insurers that would accumulate funds tax free or tax deferred for future catastrophe events. Such proposals have not received much Congressional attention. While proponents argue that offshore insurers have the bene t of such reserves, tax and accounting professionals express concern over the potential misuse of such tax advantages for events that are unknown and perhaps unknowable. Similar proposals have been made to allow state-sanctioned special purpose reinsurers to be tax exempt. Proponents argue that offshore tax havens have used these to create additional catastrophe capacity. The Congress has not yet addressed these proposals which may suffer from the same concerns over tax shelters for corporate insurers. 3. The terrorist events of September 11 The insured losses from the terrorist acts of September 11 fall under many traditional coverages because of the lack of policy exclusions for terrorism. They also fall under the same catastrophe coverages in reinsurance contracts as natural catastrophes. As with several other federal programs aimed at speci c risks mentioned above, the industry approached the federal government for assistance on insured coverages going forward (the industry sought no assistance for losses from September 11). As had been the case in the U.K., the industry proposed the creation of a pool of insurers having assistance

5 THE ROLE OF GOVERNMENT IN FINANCING CATASTROPHES 287 from the federal government in the form of reinsurance and possibly a liquidity mechanism such as a letter of credit. While the concept received near unanimous support from the industry, the Administration expressed concern over the creation of a monopolistic fund that, because of the federal backing, would deter the development of a private market for insurance for acts of terrorism. The Administration was supportive of a federal role and proposed a program whereby insurers and the government would co-insure losses for acts of terrorism on a quota share with the government picking up the vast majority of the exposure. This proposal was criticized by many in Congress who believed the industry must rst bear some signi cant loss before any federal role would apply and that insurers must pay a premium for the government share. As the concept evolved in the legislative process, a combination of a retained industry loss prorated among insurers on a market share basis above which a government quota share program applied gained support. The U.S. House of Representatives passed legislation that included these concepts together with a payback feature that included an industry assessment and a surcharge on policyholders. The U.S. Senate, which did not eventually act, incorporated the industry retention allocated on a market share basis but dropped the payback provision. The legislation was not adopted, in large part, over issues relating to the resolution of tort claims arising out of any future terrorist losses. 4. Conclusion Several conclusions can be drawn from the experience over the last few years in the debate over the role of government in nancing catastrophe losses. The rst is that at the state and federal level solutions tailored to the issue are better received than broad, unfocused proposals. A program for addressing natural catastrophes or terrorism losses has more credence than proposals for catastrophe reserves and tax bene ts for future unspeci ed events. Tax exemptions or tax offsets have limited appeal. Any proposal that gives corporate insurers tax breaks has a higher standard to achieve in light of the government's own scal issues. A risk-bearing role for insurers in any government program or before any government role seems essential. The government is willing to step in, but for a limited time, for limited purposes and capped funds. The federal government strongly prefers a program that stimulates or facilitates a private market in the near future. The government prefers a backstop role rather than any role directly related to consumers. The relationship between any federal (re)insurance program and state regulation of rates, forms and solvency is a critical issue that requires a balancing of interests. No obvious approach has emerged although the proposed federal terrorism legislation pre-empted state regulation to some degree with state acquiescence. The federal government has little appetite to regulate insurers for solvency or forms and rates. The industry opposes government loans and prefers an insurance or reinsurance program that maintains the nancial integrity of balance sheets. De ning a government role for nancing catastrophes involves a natural tension between consumer issues, such as the cost and availability of insurance, industry concerns over solvency-threatening exposures, and the government reluctance to expose taxpayers to unknown costs. Clearly, balancing these interests is risk-speci c.

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