Storm clouds over Capitol Hill. House Banking Committee members are teetering on the brink of triggering a mega-disaster this week that is pointed straight at the pockets of federal taxpayers and the future growth of competitive private-sector insurance markets. The Homeowners’ Insurance Availability Act of 1999 (H.R. 21), sponsored by Rep. Rick Lazio (R-NY) and Rep. Bill McCollum (R-FL) and scheduled for mark up on November 9, remains a flawed legislative proposal that fails to present the best answers to the challenge of dealing with natural disaster risks.
The proposed bill would undermine private insurance markets and crowd out the development of better alternatives. It inevitably will produce cross subsidies from low-risk insurance policyholders to high-risk ones (indeed, that is one of its primary political rationales), distort incentives for loss control and loss mitigation, further subsidize development in catastrophe-prone areas, increase unnecessary federal intervention in state regulation of insurance, and impose significant financial risk on taxpayers throughout the country.
Treasury enters the reinsurance business. HR 21 would authorize the Secretary of the Treasury to sell excess-of-loss1 reinsurance contracts for losses from natural catastrophes. Contracts could be sold directly to state-operated insurance and reinsurance programs, covering losses sustained by eligible programs above a threshold determined by the Secretary. The Secretary would establish both the minimum level of retained losses and the prices for those reinsurance contracts in consultation with a commission on catastrophe risk and loss costs.
Other reinsurance contracts covering insurance industry losses on a regional basis also could be sold to private insurers, private reinsurers, and state programs. Those contracts would be auctioned, after the Secretary first established minimum "reserve" prices and the minimum level of retained losses for them, in a method similar to that used for determining the prices and loss thresholds for direct sales of reinsurance contracts to state programs.
The federal reinsurance contracts would pay 50 percent of eligible losses that were in excess of (1) $ 2 billion, (2) the estimated magnitude of a one-in-100-year event in the relevant state or region, and (3) in the case of state programs, the program's current claims paying capacity. The Secretary would be authorized to sell a total amount of reinsurance contract coverage such that the aggregate annual federal liability for payment of claims is "unlikely" to exceed $ 25 billion, and the total amount of coverage in a particular state or region is no greater than the difference between the eligible losses likely to occur from a one-in-500-year event and those likely to occur from a one-in-100-year event.
Limbo level triggers, how low can you go? The triggers set as thresholds for federal reinsurance coverage under HR 21 are still terribly too low. These "attachment levels" that are provided for the beginning of federal coverage would impede the development of private market insurance coverage. Private industry has already handled much more costly events, and -- since Hurricane Andrew and the Northridge earthquake -- the capacity of the entire private insurance industry has grown significantly. Reinsurance availability in particular has increased remarkably, and overall industry capacity and efficiency to handle catastrophic risks continues to improve. Although gaps in industry capacity provide a necessary role for further development of innovative financial instruments and contracts to handle catastrophic losses, those shortfalls in private sector financing do not justify this type of federal reinsurance program.
Low contract prices = high taxpayers costs. The pricing provisions of the Homeowners' Insurance Availability Assistance Act threaten to distort private insurance markets. Although the full effects of those provisions remain uncertain, in part because the Secretary of the Treasury would retain a considerable amount of discretion in setting those prices and implementing the reinsurance program, it remains highly doubtful that the federal government would perform better than the insurance industry in overcoming the problems of estimating catastrophic losses and properly pricing insurance contracts. Given likely political pressure by particular states and other interests to keep the reinsurance contract prices low so that insurance coverage would be affordable in high-risk areas, it remains much more likely that the federal reinsurance contracts would be priced too low rather than too high.
Because the bill’s combination of regulatory discretion and mounting political pressures in future years to expand subsidized insurance coverage will make adherence to actuarial principles and market-based pricing extremely unlikely, it promises to increase potential unfunded liabilities that will be transferred to federal taxpayers. Once enacted, this new federal reinsurance program would live on indefinitely like most federal programs. It would develop all of the flaws of similar ventures by the federal government into politically managed insurance operations (e.g., flood insurance, crop insurance, Medicare Part B, government-sponsored enterprises).
Feds Crowding out private sector. Moreover, as the Shadow Insurance Regulation Committee noted on October 25, HR 21 favors state programs and would encourage their expansion, further crowding out private sector coverage. States would be allowed the option to buy coverage at the lower of the price set by the Treasury for direct sales and the price determined in regional auctions. The Committee also warned, "By crowding out private sector reinsurance coverage at relatively low levels of loss, the federal government will have a strong incentive to intervene in the primary insurance market since it will ultimately bear a portion of the losses generated on these individual policies." 2
Fix the real problems. Before it launches an "artificial disaster" in public policy, Congress should consider more promising and prudent alternatives. Instead of creating a new federal program that directly crowds out existing private sector insurance supply and encourages the creation and expansion of state programs that further displace private coverage, we should fix current public policies that impede the ability of private insurance and financial markets to promote better management of catastrophic risks.
Regulatory restrictions on rates, underwriting, and product design undermine the supply of catastrophe insurance, discourage entry of new insurers into the market, and cut the incentive to mitigate hazards. State reinsurance funds and residual market pools tend to fix prices below market levels and crowd out viable private-sector coverage. Federal post-disaster assistance discourages the purchase of private insurance and investments in hazard mitigation. Current accounting rules and federal tax law discourage insurers from setting money aside as reserves for catastrophe losses that have not yet occurred.
Market alternative: tax-deferred reserves. A different legislative proposal, the Policyholder Disaster Protection Act (HR 2749), sponsored by Rep. Mark Foley (R-FL), Rep. Rick Hill (R-MT), Rep. Robert Matsui (D-CA), and Rep. Ed Royce (R-CA), would begin to reform tax policy and provide correct incentives for growth of private insurers' catastrophe reserves. Current federal tax rules make insurance against relatively rare but very large catastrophe losses much more expensive, because insurers are not allowed to establish tax-sheltered reserves for catastrophe losses; they can only deduct catastrophe losses that have occurred. The combined effects of taxes on premiums and investment income produce very large premiums in relation to expected indemnity for small probability events. A well-designed system of tax-deferred reserves for catastrophe coverage would materially improve the affordability and availability of catastrophe insurance in the private sector. 3
Encouraging growth of substantial pre-funded insurer reserves would establish a necessary "buffer" against insurer insolvencies, keep natural disaster claims handling in efficient private markets, and help maintain the link between risk taking and personal responsibility through risk-based insurance pricing. Reducing current impediments under federal tax law and state regulation to using innovative capital market instruments also would have beneficial effects on catastrophe insurance markets.
Freeing up the private market will, in the long run, prove to be more productive than creating yet another partly disguised federal subsidy program through enactment of the Homeowners' Insurance Availability Act.
1 These contracts would cover contingent claims against the upper (and capped) layers of catastrophic disaster losses on a per occurrence basis. Before any reinsurance payout can begin, eligible disaster losses first must exceed some pre-determined trigger level. If the losses exceed the cap, the contract pays out according to the difference between the cap and the trigger. See J. David Cummins, Christopher M. Lewis, and Richard D. Phillips, "Pricing Excess-of-loss Reinsurance Contracts Against Catastrophic Loss," Working Paper No. 98-09, Financial Institutions Center, The Wharton School, University of Pennsylvania, January 8, 1997.
2 Shadow Insurance Regulation Committee. "Proposed Federal Catastrophic Reinsurance," Statement No. 5, October 25, 1999, http://rmi.lsu.edu/shadow/
3 See Scott E. Harrington, "Taxes and the High Cost of Catastrophe Insurance," Competitive Enterprise Institute, October 1999.