It’s time to rewrite the script for that long-running disaster movie – "When Dangerous Public Policies Attack Insurance Policyholders and Taxpayers!!!"
Over the last decade, the human and economic losses from natural disasters such as earthquakes, hurricanes, and floods have grown tremendously. Using inflation-adjusted dollars, the Insurance Services Office (ISO) estimates that catastrophe losses from 1989 through 1997 were nearly 68 percent higher than the total of such losses from 1959 to 1988. Hurricane Andrew ($15.5 billion in insured losses in 1992) and the 1994 Northridge Earthquake ($15 billion) top the recent list of major disasters, but estimates of the maximum possible loss from the next mega-catastrophe that could strike early in the next century range from $50 billion to more than $100 billion, depending on its nature and location. A disaster of that magnitude could bankrupt as many as one out of three insurers, according to the ISO, and it would leave many consumers holding empty promises of private insurance protection.
The full burden of catastrophic risk, however, is not just "an Act of God." The ability of private insurance and financial markets to promote better management of catastrophic risk "has been impeded by regulation and government policies," according to the Shadow Insurance Regulation Committee. A number of current public policies distort private incentives and drive total losses higher than they need to be.
Shortsighted state government regulations restrict private insurers’ rate setting, underwriting, and insurance product design.
State-managed insurance funds and residual market mechanisms unfairly compete with private insurers and crowd out the voluntary supply of market-priced insurance.
Federal post-disaster assistance is distributed haphazardly and discourages both purchases of insurance and investments in hazard mitigation.
Federal tax laws, outdated accounting rules, and regulatory uncertainty impede the full potential of additional capital market financing of catastrophic risk exposures.
The starting point for policy reform this year involves bolstering the capacity of private insurers to handle increased levels of catastrophic risk. The Policyholder Disaster Protection Act, likely to be introduced before Congress later this month, will fix current tax law to encourage insurers to set aside and accumulate special reserve funds devoted exclusively to covering future catastrophic losses.
Present tax laws and accounting rules in the United States provide perverse incentives to insurers that underwrite catastrophic risks. Insurance companies only are allowed to set aside funds as reserves for losses that already have occurred. Any premium income collected that exceeds current year losses and expenses is treated as profit and subjected to federal corporate income taxes. Even when insurers try to base part of the annual premiums they charge on the expected cost of future catastrophes, federal taxes reduce such long-term "reserves" by 35 percent. Reserve funds are taxed away instead of giving them a chance to accumulate while the uncertain risks of major catastrophes play out.
Thus, private insurers are discouraged from accumulating after-tax retained earnings to protect their policyholders against low-probability, high-cost catastrophes at some future date. Mutual insurers face strong pressure to use more of their capital "surplus" to pay tax-deductible dividends to policyholders each year. Publicly traded insurers also may prefer to pay higher dividends to their stockholders than risk takeover bids attracted by "spare cash" that cannot be held in a separate reserve account.
The Policyholder Disaster Protection Act would provide incentives, not penalties, for insurers to increase their capability to manage catastrophic loss exposures. The legislation allows insurance companies to establish tax-deferred catastrophic reserves for various lines of coverage.
In an ideal world without competing political claims for federal budget resources and tax relief, such reserves could build up rapidly and remain free of taxes unless converted into dividend payments. However, the proposed legislation acknowledges the political limits of the tax-bill-writing process.
Reserves are phased in gradually over a 20-year period, restricted to a cap based on each insurer’s particular lines of business and levels of written premiums, and then subject to federal taxes only in the year the funds are withdrawn to pay catastrophic claims.
Withdrawals from the segregated fund reserves may only be made after a "qualifying" catastrophic event has been designated, and eligible losses first must exceed a threshold level.
Despite those cautious layers of regulatory "protection," the Policyholder Disaster Protection Act would enhance the capacity of private insurers to write policies in catastrophe-prone areas.
Within the first 10 years after enactment, the bill could produce an estimated $19 billion pre-funded reserve financed by private insurance premiums, at a tax-deferral cost to the federal budget of about $500 million per year.
Building such a pre-funded foundation of solvency protection would reduce the potential of insurer insolvencies, unpaid policyholder claims, and after-the-fact taxpayer bailouts. By helping to stabilize private insurance markets, the legislation promises to make coverage more available and reliable.
Most other major industrialized countries already allow, or require, insurers to reserve for future catastrophe losses on a tax-deductible basis. Even several state government-run catastrophe funds in the United States have received similar favorable federal tax treatment.
Correcting the current flaw in the U.S. tax code for private insurers’ catastrophe reserves will help 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.
Although federal taxpayers may never be eliminated completely as an emergency resource for truly unprecedented disasters, the mirage of "free"money and easy credit in Washington should not be allowed to crowd out the full potential of private markets to handle diverse risks more efficiently.
The rental rate for that "last resort" is much higher than advertised. Let’s first stop the myopic tax termites from eating away at the foundation of protection for private insurance policyholders.
Tom Miller ([email protected]) is director of economic policy at CEI.