FROM THE OFFICE OF PUBLIC AFFAIRS

Chairman Leach, Representative LaFalce, Representative Lazio, Representative Kennedy, members of the Committee. Thank you for affording me the opportunity to speak with you this morning on the important issue of disaster insurance.

Let me begin by complimenting Representatives Lazio, McCollum, Fazio, and other members of the Committee for the bipartisan leadership they have shown in bringing together concerned interest groups, members of the insurance and reinsurance industries, capital market interests, and state and federal government representatives to discuss this issue. Given the complexity of the issue, and the range of interested parties, the fact that we are here today is a testament not only to the skill, insight, and perseverance of this group, but that of their staffs as well.

Disasters are a matter of grave concern for all: They make no distinctions as to where or whom they strike; they make no pretense of waiting until all who would be affected are fully prepared. Their cost can be astronomical, not only for homeowners, but also for businesses large and small alike, as well as state and local governments. While insurance cannot undo all the costs in human terms, it can provide the foundation for a sound recovery in financial terms. We need to ensure that the insurance foundation is as sound as possible.

My overriding purpose today is to convey to you on behalf of the Administration that we see much promise in the current legislation as a means of addressing many of the problems relating to the availability and price of insurance and reinsurance for disaster risk. We have some concerns with specific provisions of the bill, as I shall outline shortly, but we would hope that continued efforts of the kind that this Committee has sponsored would generate appropriate solutions to these concerns. Moreover, we commit to working with you for the purpose of crafting provisions that would address our concerns. While the resulting legislation would not solve every problem related to Federal policy toward natural disasters, it would, in our view, represent a very constructive step.

1. Diagnosis of the problem

To frame our thinking, let me indicate to you the outlines of the problem as we see it:

• The characteristics of natural disasters make the risk associated with them especially challenging for insurers to handle: they happen only very infrequently, but when they do occur, they can be exceedingly expensive.

• In addition, estimating the losses associated with such an event is extremely difficult. Our models are good, and getting better, but with events this infrequent, it is virtually impossible to gauge their predictive accuracy. This substantially increases the uncertainty faced by both homeowners and insurers.

• As a consequence, prices for disaster reinsurance can be very high, especially if judged in terms of the losses incurred in a typical year. These prices are often quoted in multiples of expected loss; for reinsurance against very low-probability events, these multiples can run in the neighborhood of 4 to 7 times expected losses.

• Not only are prices high, but when a disaster occurs, prices can spike, and availability can be curtailed.

• These are the problems that insurers are currently wrestling with. Because of their tremendous capacity for absorbing losses, we view the capital markets, in which disaster risk increasingly can be bought and sold like any other security, as a crucial complement to the traditional reinsurance industry. We have closely monitored the rapid development of capital markets and believe that they should provide for well-functioning markets in the long run. But they remain today in a relatively early stage of development. Clearly, a serious problem remains in the interim.

• Indeed, while in the last several years our nation has not experienced what is called a "major occurrence" in the insurance industry, the ravages of Hurricanes Iniki and Andrew, and the Northridge Earthquake are all too recent reminders of the potential scale and scope of possible destruction. These events form the backdrop for our efforts today. We are working today in the knowledge that calamities of almost unimaginable scale do occur; we are also working in the knowledge that a policy we adopt out of the current deliberative process will likely better serve the public interest than a policy that we adopt in the immediate aftermath of another such event.

2. Rationale for Federal involvement

In this context, the rationale for Federal involvement in this market rests on three key considerations:

• First, the Federal government is uniquely capable of spreading risk across the population. When a private sector insurance company absorbs risks, it can only pass them on to its stockholders and reinsurers. By contrast, when the Federal government absorbs risks, it can pass them on to the entire population of taxpayers -- clearly a much broader base than is available to any private sector entity.

• Second, the Federal government is uniquely capable of spreading risk over time. Private insurers can absorb part of a loss by issuing debt, but there is a limit. In the jargon of economics, a private insurer is said to suffer from "timing risk," which is to say that it can only lose so much money in any given period without being declared bankrupt. By contrast, the capacity of the Federal government to borrow for the purpose of meeting short-term contingencies dwarfs that of any private sector entity.

• Third, the Federal government would likely be saddled with part of the cost associated with a truly cataclysmic event, regardless of the outcome of this deliberative process. Therefore, to some extent, the decision here can be viewed as determining whether the Federal liability will be explicit and deliberate, or implicit and indirect.

• Taken together, these considerations constitute a strong case for prudent participation of the Federal government in the market for disaster reinsurance. Lest I be misunderstood, we see this as a case for limited participation for a limited time: It is a case for making hardheaded investments on behalf of taxpayers, absorbing risks at a price that provides fair compensation to taxpayers. And it is a case for making those investments for a limited time only, until the private market can mature. Finally, it is a case that argues for exploiting the fiscal capacity of the Federal government in a way that does not jeopardize that capacity.

  3. Where we are today

  • In framing our current thinking on this topic, we have found it useful to enumerate a set of common-sense principles. Specifically, we believe that:

  • the government should provide disaster insurance when its ability to spread risk across the population and over time would allow it to do so temporarily on substantially more favorable terms than the private market;

  • the government should provide disaster insurance in a manner that avoids imposing a net cost on the taxpayer;

  • the government should provide disaster insurance in a way that harnesses existing market forces to the maximum extent, and encourages their further development in the future; and

  • the government should be prepared to put itself out of the business of providing disaster insurance, making way for a strengthened private market to take over.

  Adhering to these principles will limit the risk that a program of this type could impose on taxpayers. Because the potential liability in this market is so enormous, we must design the Federal role with the same kind of hardheaded fiscal prudence that has been so important in achieving a balanced budget. Adhering to these principles will also ensure that government participation in this market supports private structures rather than supplanting them. Ultimately, private capital markets should be able to diversify this risk as well as or even better than the Federal government. But clearly, the capability of those markets to perform that task will never emerge if government participation is not carefully delimited. We believe that a middle way exists: one that meets the interim need, while preserving adequate incentives for market development for the longer term.

  Let me be clear: we believe that HR 219 provides a foundation that could, with suitable modifications, be made consistent with these principles. In the remainder of my remarks, I will be focussing on HR 219 because that is the legislation before the Committee. However, I should like to make clear that I do not want to preclude other approaches to addressing the problem of disaster insurance. In particular, we still view an industry excess-of-loss contract as a potentially valuable way of providing disaster reinsurance to a broader class of counterparties than state funds. Indeed, we should certainly avoid sending the message with this legislation that, in order to reap the benefits of Federal reinsurance, a state must establish a centralized fund or auction program. An approach that seems promising to us is one that would, in effect, marry the best ideas of HR 219 and HR 230, by offering not only reinsurance to state funds, but also excess-of-loss contracts on similar terms to an unlimited class of buyers, possibly by means of an auction. We think it would be a substantial improvement to the current legislation to ensure that the playing field is kept level, as between state programs and other potential customers of disaster reinsurance.

  4. The legislation at hand

  Let me now turn to the specifics of the legislation before you. In essence, HR 219 would have the Federal government provide reinsurance to qualifying state funds and auctions for losses incurred on residential policies within the state. It would establish a trust fund that would receive all premium income and the proceeds of any borrowing done on the program's behalf, and would dispense payments in the event of qualifying disasters. In the event that some borrowing is required, the legislation would require every state program participating at the time to continue purchasing reinsurance at no less than the prior level until the borrowing is repaid. The legislation would also establish a Commission for the purpose of advising the Secretary of the Treasury as to the appropriate price for the insurance.

  In our view, this legislation represents a constructive and creative response to a serious situation, namely, the difficulty faced by state funds (notably the California Earthquake Authority and the Florida Hurricane Catastrophe Fund) in purchasing extensive reinsurance against low-probability risks, either because the reinsurance is simply unavailable or because premiums are high. We welcome this response, and applaud the efforts of all those who have worked so hard to bring it to this stage.

  That said, we do have some concerns about this legislation. But let me be clear: while we view these concerns as important, we would hope that continued efforts of the kind that this Committee has sponsored would generate appropriate solutions.

  Chief among these concerns is that the pricing decision be sufficiently insulated from political pressures as to remain objective. In order to buttress the integrity of the pricing process, we suggest that the Secretary of the Treasury be allowed to adjust the Commission's estimate of expected loss upward, but not downward. We also suggest that the language of the legislation be clarified as to the factors that the Secretary should take into account in setting the "risk load" in the price of the reinsurance contracts.

  In addition, as I indicated before, we believe the legislation should be modified to provide for the sale of excess-of-loss contracts to all entities on an unrestricted basis. Our objective is to improve the availability of disaster reinsurance, not to favor state programs over other possible vehicles for delivery of insurance to homeowners. Indeed, it might be possible to devise an auction mechanism for the distribution of these contracts; this would have the virtue of ensuring that competition plays a role in setting the price of the contracts, and channeling them to those who see the greatest value in them.

  We believe that the scope of the Federal program should be limited, in order to preserve adequate incentive for the further development of the private market. Specifically, we suggest that the Federal program be sunsetted after some fixed number of years; that the Federal program be authorized to underwrite no more than some specified fraction of the risk faced by any given state fund; and that provision be made for periodic review of the trigger points in light of the ongoing development of private markets. In all these respects, the goal should be to ensure that the Federal program supports rather than supplants the private market.

  We also suggest that you consider reengineering several aspects of the design of the contracts in ways that might make them more useful to the state funds. Specifically, we suggest that you consider covering multiple perils rather than a single peril. We suggest that you carefully consider how best to limit the Federal liability under this program. The current legislation proposes a cap on aggregate payout; it strikes us as possible that some other mechanism might be preferable. For example, a simple limitation on the amount of insurance that any particular state fund could purchase might serve the same objective, without causing the value of the insurance to each state to depend on the actions of all other states. We also suggest that the state funds not be compelled to continue as purchasers of reinsurance in the event that borrowing is required to make good on some other state's contracts. And we suggest that eligibility for the Federal program not be contingent on the state program's using a specified fraction of its investment earnings for mitigation.

  I have attached as an Appendix a staff document that lists a number of technical questions regarding the legislation in greater detail.

  The budgetary treatment of this legislation is a complex and highly technical topic, and my purpose today is not to explore those issues with you, not least because, as many of you know, these are not settled issues. Nonetheless, it would be our hope, first, that the legislation could be reworked along the lines we have suggested, and second, that we could accomplish our goals without burden to the taxpayers, or adverse impact on the deficit. I look forward to working with you to preserve the integrity of the pricing that is envisioned in the current language.

  While the list may seem long, all of our suggestions derive from our two core concerns, that relief for affected homeowners not come at the expense of taxpayers, and that any federal program support, rather than supplant, private markets. We look forward to working with Members of this Committee, its staff, representatives of industry, of affected communities and with other stakeholders to resolve these issues.

  5. Conclusion

  From the beginning, the Clinton Administration has recognized the urgency of improving the nation's ability to deal with natural disasters. Indeed, our initial efforts on this issue culminated in a February 1995 Administration Policy paper, "Natural Disaster Insurance and Related Issues." In that paper, as you know, we supported the idea that the Federal government should issue excess-of-loss contracts as a means of fostering liquidity in the market for disaster insurance. We also strongly supported a comprehensive approach, including among other elements, measures to ensure that cost-effective mitigation is undertaken. We still believe in the wisdom of a comprehensive solution, and reaffirm the importance we attach to prudent and appropriate mitigation. However, further study has made clear to us the impracticality of achieving all of our objectives in one Federal program.

  Progress on this issue has been too long in coming. We believe that we all share a clear recognition of the urgent need for moving forward on a timely basis. In particular, we will certainly be well served if we have a sensible and constructive structure in place before the next major disaster strikes. Surely, the time to build a better roof is when the sun is shining. The current legislation provides a sound foundation for progress in this area, and I look forward to working with you to improve the legislation.

  Appendix
  Technical Questions about HR 219

  This appendix lists a number of concerns about the current legislation, and advances some ideas for addressing them.

  • In the letter of invitation, you asked for comments on whether it would be useful, in terms of insulating the pricing decision from political pressures, to limit the Secretary's discretion in deviating from the recommendation of the Commission regarding expected cost. We believe that such a limitation would be helpful; we recommend that the Secretary be given one-sided discretion, to move the estimate of expected cost up from the Commission's estimate, but not down.

  • An additional salutary feature of the current language in the bill is that the Secretary is given discretion to increase the "risk load" component of the price upward from 1 times expected cost. It would be helpful if the legislation specified that, in making this determination, the Secretary's objective should be to provide taxpayers with fair compensation for the risk they are bearing, and that the factors he takes into account should include the stage of development of empirical models of natural disasters, and the state of private markets, among other factors.

  • The budgetary impact of this program is critical. It is extremely important that the proceeds from the sale of Federal disaster insurance not be spent or otherwise dissipated. If these proceeds were spent, and then a covered event were to occur with an associated payout from the Federal government, the pressure on the fisc would be greater with this program than without. How best to prevent this from happening is a difficult question. The present language in the legislation proposes the creation of a Disaster Reinsurance Fund, for the purpose of accumulating premium payments and disbursing payouts in the event a covered disaster occurs. A Fund of this type has the virtue of suggesting that the revenues from the program should not be diverted to other purposes, and that the program should be viewed as operating on a self-financing basis. However, it has the potential shortcoming that the balance in the Fund at any given time could easily provide a misleading signal as to the adequacy of pricing. If a calamity were to occur in the early years of the program, the Fund would run a negative balance for a very long time (financed by Treasury borrowing), and the temptation would be to conclude that premium rates had been set too low. On the other hand, if -- as is hoped -- no covered event occurs for a period of some years, the balance in the Fund will accumulate to a substantial sum, and some will question the need for continuing to levy additional premiums "simply" for the sake of building up the balance in the Fund further. The desirability of a Disaster Reinsurance Fund is an open question, and the relative pluses and minuses must be weighed from the perspective of maximally ensuring the integrity of pricing.

  • As for the form of the insurance, one option would be to authorize the Federal government to provide aggregate coverage for more than one event occurring within a 12-month period, rather than just a single event. Discussions with various market participants suggest that a great deal of concern revolves around the availability of coverage for a second event.

  • Careful consideration should be given to the question of whether Federal liability should be capped at $25 billion per year across all insured programs. A disadvantage of this approach is that it would cause the value of the reinsurance to any given State to depend on the decisions of other States. An alternative approach would be to limit the amount of reinsurance that any given State program can purchase.

  • On a related point, the legislation as currently written specifies that all State programs with reinsurance in force at the time that any borrowing is undertaken on behalf of the Federal program would be required to continue purchasing reinsurance at no less a level until the debt is fully paid off. It may be preferable to omit this requirement. Imposition of this requirement would substantially complicate the decision of any given State program as to whether it should participate in the Federal program, and could lead to divisive controversies regarding transfers of resources across States.

  • With regard to the Commission, it may be advisable to augment its membership to include experts from the world of finance and economics, since knowledge of those fields will certainly be germane to the pricing decision.

  • With regard to the eligibility requirements for state programs, it may be desirable not to require these programs to commit a specified percentage of their investment earnings toward mitigation. States should engage in all cost-effective mitigation and no more, and it is not clear that linking the mitigation decision to an arbitrarily specified fraction of net investment earnings would advance this objective. Similarly, the pricing decision by State programs should be tied to actuarial risk, and it is not clear that creating a requirement to fund mitigation advances that objective.

  • The Committee should consider augmenting the legislation with a number of measures designed to preserve incentives for the development of a parallel market for disaster risk in the private sector. Specifically, the program could be hardwired to sunset after some fixed period of time, perhaps 10 years; in light of the rapid pace of development of private capital markets, this should provide ample time for alternative mechanisms to develop that will allow State programs to lay off their risks efficiently.

  • The Federal program should be authorized to underwrite no more than some specified fraction of the risk in excess of the trigger faced by each participating State fund, perhaps 50 percent. Even with a limitation of this type, the Federal commitment would be very substantial relative to the volumes currently being transacted in private markets, and the resulting program would still leave an incentive for private market development even while the Federal program is in operation. Provision should also be made for periodic review of the trigger points in light of the ongoing development of private markets.
  
  

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