What should the role of government be in the effective management of natural and manmade catastrophes? ask Franklin Nutter and Cynthia J Lamar
The role of Government in financing catastrophe losses is a subject of some importance, given the prominence of high-impact, low-probability events since the start of the millennium. Since then, a number of initiatives have been undertaken, some successful and some less so.
In particular, with the 31 December 2005 expiration of the Terrorism Risk Insurance Act of 2002 (TRIA) looming, important decisions lie ahead.
Whether TRIA is extended for a short period of time or whether a long-term solution is sought, determination of the appropriate role of government with regard to the risk of terrorism loss is of utmost importance (see page 22).
One argument runs that, since terrorism risk is analogous to war, government funding of the risk is entirely appropriate. Further, insurance and reinsurance industry capital is limited, and there is very little appetite for the voluntary assumption of terrorism risk. Without the ability to limit exposure to loss, the industry views terrorism risk as uninsurable. There is therefore complete agreement among industry experts that the federal government must bear some responsibility for the risk of terrorism loss. There is less agreement on the specifics of what the government role should be and how it should be carried out.
Many see a need for the federal government to act on several fronts, in order to address the full range of potential losses from terrorism.
Government participation is called for in varying degrees at the catastrophic layer, the intermediate layer, and the lower layer of risk of loss. Proposed government participation may take the form of providing funding directly, or through changes to tax policy, pre-empting or repealing certain existing laws that mandate insurance coverage or restrict premium rates, or establishing quasi- public/private entities for risk transfer.
At the catastrophic layer, there is widespread agreement that the federal government is the only entity with the means to indemnify the upper limits of potential losses. At the intermediate and lower layers of risk of loss, several proposals for government action to assist in the development of the private market for terrorism insurance are emerging. Many of these proposals have been employed in the past, as policymakers called on government to assist in funding other types of catastrophe losses. A review of these previous government programmes and proposals may be instructive as policymakers consider how to address terrorism risk upon the expiration of TRIA.
The National Flood Insurance Program
In 1968, the National Flood Insurance Program was adopted to provide government insurance coverage to residential and small commercial risks. The program operates much like an insurance company, with some limited subsidisation of risk premium but a stated goal of reducing disaster assistance. It does this by requiring those at risk of flooding to bear the cost of insurance and by requiring participating communities to adopt building codes with flood hazard reduction features. The financial backing of the Federal government permits the program access to below-market federal funds in the event that it cannot meet liquidity needs.
Catastrophic nuclear accidents
The Price-Anderson Act of 1957 is a public/private approach to commercial nuclear risk. It 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. In the event of an accident at any single reactor that results in losses exceeding its insurance coverage, 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 $10m annually for 9 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 Congress to investigate the accident and take whatever action it deems necessary, which could include appropriating funds or requiring the nuclear industry to provide additional funding to satisfy remaining claims.
A number of conclusions can be drawn from these initiatives and debates over the role of government in financing catastrophe losses:
- Solutions tailored to a specific issue or event (eg, terrorism, hurricanes, earthquakes) are better received than broad financing proposals. A legislated program for addressing natural catastrophes or terrorism losses will be more favourably considered than proposals for catastrophe reserves and tax benefits for future unspecified events.
- Tax exemptions or offsets to finance catastrophe exposure have limited appeal. Any proposal that gives corporate insurers tax breaks may be difficult to achieve in light of the government's own fiscal issues.
- If insurers have previously provided coverage for the types of risk at issue, a risk-bearing role for insurers in any government sponsored, backed or funded program seems politically essential.
- Government is willing to step in if a government nexus clearly exists (eg terrorism), but only for a limited time, for limited purposes, and with capped funding obligations. The federal government strongly prefers a program that stimulates or facilitates a private market.
- Government prefers to be a backstop rather than to have any role directly related to consumers.
- The relationship between any federal re/insurance program and state regulation of insurers is a critical issue. Although TRIA pre-empted state insurance regulation to some degree, the federal government has little appetite to regulate insurers.
- Industry generally opposes government loans and prefers an insurance or reinsurance program that maintains the financial integrity of balance sheets.
- Any program must balance the competing perspectives of the private sector (unlimited risk but limited capital) and the public sector (unlimited capital but a limited risk appetite).
- Franklin W Nutter, president, and Cynthia J Lamar, vice president & assistant general counsel, Reinsurance Association of America.
Catastrophes Recent initiatives involving public/private risk sharing
Government Sponsored Enterprise: Early industry 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 through federal loans and favourable tax treatment. The corporation would have been authorised to provide reinsurance to insurers. The principal resistance to the concept was that insurers bore no direct risk to their own insurance portfolio and therefore had little incentive to underwrite appropriately. Even suggestions to require insurers to share losses were met with opposition from those viewing GSE's as a subsidy to corporate America that could not be justified by the promise of more affordable or available insurance for catastrophe exposure.
Reinsurer of State Funds: Another idea for a public/private partnership was a proposal for a federally-backed reinsurer of state catastrophe funds.
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 insurance rates and coverage, with no Federal regulatory authority over such action.
Federal Auction of "Cat" Bonds: This approach provided for the federal government to auction reinsurance catastrophe contracts to qualified bidders. Government could control and limit its exposure, industry would have additional reinsurance protection, and taxpayers would not subsidise the risk. 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 ($2bn of insured loss) to improve capacity and pricing at the consumer level.
Catastrophe Reserves and Tax Shelters: Some have advocated allowing insurers to establish catastrophe reserves that would accumulate funds tax-free, or tax deferred, for future catastrophes. Current accounting and tax policy do not permit such reserves. While proponents argue that offshore insurers have the benefit 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 special purpose reinsurance vehicles (SPRV's) to be tax exempt. Proponents argue that offshore tax havens have used SPRV's to create additional catastrophe capacity. Congress has not yet addressed these proposals, largely because of concerns relating to tax shelters for corporate insurers and buyers.
Catastrophes Effectiveness of TRIA
Since the time of writing, the US Treasury has released the findings of a study into the effectiveness of TRIA, which stated that in its current format continuation of TRIA would likely hinder the further development of the insurance market. In an accompanying letter, Treasury Secretary John Snow wrote, "The Administration would accept an extension only if it includes a significant increase to $500m of the event size that triggers coverage, increases the dollar deductibles and percentage co-payments, and eliminates from the program certain lines of insurance, such as Commercial Auto, General Liability, and other smaller lines, that are far less subject to aggregation risks and should be left to the private market."