FROM THE OFFICE OF PUBLIC AFFAIRS
July 30, 1999LS-35
Chairman Leach, Representative LaFalce, Representative Lazio, Representative Frank, Members of the Committee. Thank you for providing me the opportunity to discuss with you the important issue of disaster insurance.
Let me begin by complimenting Representatives Lazio, McCollum, LaFalce, Frank, and other members of the Committee for the bipartisan leadership they have shown in facilitating the deliberations on this proposed legislation. Your skill, insight, and perseverance will lead to a better legislative outcome than would otherwise have been achievable.
I. Review of Principles
That we are again here with you on the issue of disaster insurance demonstrates the grave importance that we all attach to it. Although no piece of legislation can ameliorate the human costs of such disasters, the Administration remains convinced that a well-designed reinsurance program for homeowners= losses could help provide the foundation for communities, individuals, and the private markets on which they depend to make a sound recovery in financial terms. Our approach to this issue reflects the conviction that a policy we adopt prior to a catastrophic event will not only serve the public interest better than one adopted in the immediate aftermath, but also enhance the ability of private insurance markets to cope with the threat of loss from such an event.
The characteristics of natural disasters make their risk especially difficult for insurers to handle: they happen only infrequently, but when they do occur, they can be exceedingly expensive. Reflecting this difficulty, prices for disaster reinsurance for homeowner losses can be very high measured in terms of expected losses, and prices can spike -- and markets shrink -- for a considerable period of time following a disaster.
Because of their tremendous capacity for absorbing losses, we view the capital markets, in which disaster risk increasingly can be bought and sold like many other risks, as a crucial complement to the traditional reinsurance industry. We have closely monitored the development of capital markets. Recent progress encourages us in our belief that insurance securitizations in capital markets will be a significant part of well-functioning markets for disaster risk in the long run. But we are persuaded that a problem still remains in the interim -- while the volume of these securitizations builds. A carefully designed Federal involvement may be able to alleviate this problem.
Three considerations argue for prudent, interim participation of the Federal government in the market for disaster reinsurance. First, the Federal government is uniquely capable of spreading risk across the population and over time. The capacity of the Federal government to gather resources from a wide base for the purpose of meeting short-term contingencies dwarfs that of any single private sector entity. Second, the Federal government would likely bear part of the cost associated with stabilizing distressed insurance markets in a truly cataclysmic event regardless of whether legislation of the type now before the Committee is enacted. Finally, prudent participation at this stage of development may enhance the ability of private markets to deal with these risks.
It is essential that any Federal involvement be guided by a set of common-sense principles. Secretary Summers has defined them in previous testimony to you. Let me enumerate them again.
- Federal involvement must support, not supplant, private insurance markets.
-- it must be partial, applying only to true catastrophes that the private market is not capable of handling; and
-- it must be strictly transitional, phasing out as private markets develop.
- Federal involvement must share, not subsidize risk
-- Federal involvement should create new capacity to absorb risk, but that involvement must be at no net cost to the taxpayer
II. Where We Are Today
We see the legislation now before the Committee as a generally positive step forward. In our view, the proposed legislation constructively and creatively responds to the difficulty faced by both state funds and private entities in purchasing reinsurance against their large, but low-probability losses on homeowners= insurance. The bill has improved as it has moved through the legislative process. That said, we remain concerned about some aspects of the bill. We have attempted to articulate clearly our concerns with the bill at every stage of the process and to work with staff to explore means of resolving those concerns. We look forward to continuing that approach, working with Members of the Committee on both sides of the aisle.
Let me now turn to the specifics of the proposed legislation before you. In brief, H.R. 21 would have the Federal government sell excess-of-loss reinsurance to qualifying state funds, and auction industry excess-of-loss contracts to eligible private or state purchasers for losses above certain threshold amounts incurred on residential policies. The bill would establish a Disaster Reinsurance Fund that would receive all premium income and the proceeds of any borrowing done on the program=s behalf, and would disburse payments in the event of qualifying disasters. It would establish a Commission for the purpose of advising the Secretary of the Treasury as to the appropriate price for the reinsurance sold to the states as well as the minimum price at which insurance would be provided through the regional auctions.
III. Outstanding Concerns
We continue to be concerned about several aspects of the proposed legislation. Our concerns are derived from our desire for legislation that addresses the market problem and fulfills our public stewardship responsibility. We know you share that desire.
Let me enumerate the most important of these concerns:
Cap
The proposed legislation would cap annual payouts under the program at $25 billion. The bill provides that, if claims in any one year were to exceed that amount, each claimant would receive a prorated portion of the $25 billion.
As you know from Secretary Summers= previous testimony, we share your objective of developing a fiscally prudent piece of legislation. Moreover, we believe that a hard limit on the potential draw on the Treasury is an essential component of fiscal prudence. However, as Secretary Summers testified in 1998 and as we explained in communications to Subcommittee staff, after careful study, we have concluded that the cap on annual insurance payouts may not be the best mechanism for limiting the Federal liability. To see why, consider what would happen if a covered event were to occur. In the aftermath of such an event, people and communities in the affected area might be financially devastated, and the insurance industry might be under great financial stress. It would be difficult for the Federal government to withhold payout on claims under this program on the argument that such payout might later need to be pro-rated against claims from another event.
If a second event were to occur within the same insurance year, it is entirely plausible that future Congresses and Administrations would make full payment on all claims stemming from the second event, notwithstanding the requirement to pro-rate. The only alternatives would be either to recall monies that were paid out pursuant to the first event, or impose the full burden of the annual cap on the victims of the second event. Neither alternative seems realistic.
Thus, a real possibility is that the insurance would be priced under the false assumption that the annual cap on payouts would hold, while in practice it would not. In essence, the premium would be set too low. The Federal government and the American taxpayer should not be placed in this position.
We strongly share the motivation that brought this provision into the current draft legislation, but we believe that it is possible to design a more effective mechanism for limiting the Federal liability and ensuring fiscal prudence. One possible approach would involve limiting the amount of insurance to be sold rather than the amount of payout to be made. Briefly, a mechanism along these lines would work as follows: Contracts sold under the legislation would cover 50 percent of any losses above the threshold level that triggers the Federal payout, up to an upper limit corresponding to the dollar amount that would be lost in an event of some more remote probability. For the sake of illustration, one could consider setting the upper limit at the dollar amount corresponding to a one-in-500-year event.
For example, if the 1-in-100 loss in a region were $12 billion and the 1-in-500 loss were $48 billion, the Federal liability in the region would be capped at half the difference between $48 billion and $12 billion, or $18 billion, and this loss would occur only if the industry actually purchased all the contracts they were offered.
The aggregate maximum Federal payout could then be computed as the sum of the maximum obligations in each state and region. The preliminary data we have indicates that if the upper limit were set at the dollar amount associated with a one-in-500-year event in each state and region, the maximum Federal liability in any given year would be on the order of $50 billion. Under this approach, the maximum Federal liability is easily dialed up or down by adjusting the probability associated with the upper limit. The probability of hitting this cap would be extraordinarily small.
Three aspects of this approach are worth emphasizing. First, and most importantly, it would provide a realistic guarantee of fiscal control over the losses that might be sustained under this program. Second, it would have the virtue of providing a natural means of allocating coverage between the two fundamental branches of the program, and -- within each branch -- among the various states and regions. In the draft legislation as it stands, the mechanism for allocating coverage across states and regions is not spelled out. Third, the dollar figure giving the maximum possible loss under this approach is conceptually different from the dollar amount of the cap embodied in the current draft of the legislation. Put simply, the conceptual difference is this: Under the draft legislation, an undefined amount of insurance would be sold, but the Federal government in some circumstances ostensibly would make good on only a part of what was sold. Under the approach we are proposing, the government would sell only a limited amount of insurance, but, having sold it, would make good on all of it.
In sum, our objective is to propose an even more effective tool for fiscal control than is contained in the current draft of the legislation. We have held extensive discussions with committee staff to lay this proposal out for them. The appendix explains our proposal in more detail.
Appropriated Payouts
The proposed legislation would require that all payouts from the Fund and borrowing by the Fund be subject to Congressional appropriations.
We believe that all involved in this process intend that, if the program is established, the government should meet its financial obligations under the program, in full. However, the requirement that payouts be subject to appropriation would cast a shadow over the certainty of full payout, and could therefore limit the number of bidders and possibly dampen their aggressiveness in bidding. The net result could be that the Federal government receives less than the value of the risk that it assumes..
The concern can be addressed by striking the requirements for appropriations of payouts and borrowing. This would create the greatest clarity and certainty among all the parties to the contracts, and thereby ensure that the government obtains the most favorable price for the reinsurance provided. And it would bring the provisions of this bill into line with the approach taken under a number of other Federal insurance programs, including deposit insurance, pension guarantees, flood insurance, and crop insurance. Payments for eligible claims under these programs are made from program reserves and receipts and, when necessary, borrowing from the Treasury under authority granted in authorization law, and do not depend on appropriations.
Continued Purchase Requirement
The proposed legislation would require a state program participating in the Federal program to continue purchasing reinsurance from the Federal program in the event that the state program were to receive a payout from the Fund that caused the Fund to borrow from the Treasury. Such borrowing would happen if the payout to the state program either caused the balance in the Fund to go below zero or took an already negative balance down further. The state program must continue to purchase the reinsurance until the borrowed funds are repaid.
This provision raises some difficult issues. For one, it could further burden an already stressed state program in the aftermath of an event. Further, there would be the possibility of a scenario, not unlike the one that causes us concern over the annual cap, in which the requirement would be waived. If a state has experienced a huge disaster, and needs to devote scarce resources to promoting recovery, the additional burden of continuing to make premium payments may be viewed as untenable by future Congresses and Administrations, and might therefore be waived. In this case we would have been inadequately compensated for the reinsurance we would have, in fact, provided.
This provision should be eliminated because, like the pro-rating provision, it could place the Federal government in an extremely difficult position. We could, however, suggest an alternative that could both adhere to our principles and be consistent with the intent of this provision -- to give Treasury the option of offering multiple-year, as well as one-year, contracts, if market conditions indicate that such contracts would be appropriate and desirable.
IV. Triggers
The threshold Atrigger@ levels for a Federal payout are an extremely important parameter of the proposed legislation. They must be designed to strike an appropriate balance between two very important considerations. On the one hand, the triggers should not be set so high that the program is irrelevant for either state programs or private participants. On the other hand, as I mentioned at the outset, a key principle for us has been that Federal involvement in this market should not crowd out private sector activity. This program should insure only losses of true catastrophes that the private market is not capable of handling.
Operationally, it would be difficult to strike the right balance between these two considerations. In part, this difficulty reflects the fact that the appropriate trigger level will be a moving target, changing across time and by risk, according to the state of reserves in the traditional reinsurance industry and the state of development of capital markets, among other factors.
We observe in this connection that Congress has wisely chosen to delegate to the Secretary the determination of annual adjustments to the trigger levels, but did not explicitly give the Commission a role in advising the Secretary on this issue. This strikes us as an issue where advice from the Commission would be welcome and constructive. A modified approach that allowed for such a role on the part of the Commission would further make sense because it would more nearly parallel the process outlined for dealing with the annual adjustments to the estimates of expected loss.
Overall, there is no easy answer on the issue of setting the triggers, but it must reflect a sensible balancing of competing considerations. Accordingly, we strongly encourage this Committee and the rest of the Congress to continue in your process of consultation with all interested parties.
V. Technical considerations
We want to flag for the Committee=s attention one issue of a more operational nature. In particular, you should be aware that, given the complexity of the undertaking, a considerable length of time will be required to bring the full program, and the required dedicated resources, on line. There will accordingly be an issue with respect to paying start-up costs. There will be a period while the Treasury prepares to offer the program, including developing the appropriate organization, hiring staff, and seeking qualified contractors to define the exposure to loss; and yet no insurance will have been sold. We must be assured of a clear mechanism for funding these costs. As a practical matter, we could use the proposed borrowing authority to cover these costs, to be repaid from eventual receipts from the sale of disaster reinsurance,.
VI. Conclusion
The Clinton Administration has long recognized the importance of improving the nation=s ability to deal with natural disasters. While our list of concerns may seem long, all of our suggestions derive from our two core concerns: that relief for insured homeowners not come at the expense of taxpayers, and that any Federal program share risk and support private markets. We believe that we all share a clear recognition of the importance of moving forward. The current proposed legislation provides a sound foundation for progress in this area, and we look forward to working with Members of this Committee, its staff, representatives of industry and of affected communities, and with other stakeholders, to resolve these issues.
Appendix
Capping Federal Payouts
The proposed legislation would cap annual payouts at $25 billion. The bill provides that, if claims in any one year exceed that amount, each claimant is to receive a prorated portion of the $25 billion. After careful study, we have concluded that this provision is an imperfect mechanism for limiting the potential draw on the Treasury. As the body of the testimony describes, the proposed cap would place the Federal government in a difficult situation. If claims of more than $25 billion were to be lodged against the government, future Congresses and Administrations would face enormous pressures to make good on the full amount of those claims, notwithstanding the requirement to prorate.
We believe that an effective mechanism for limiting the Federal liability and ensuring fiscal prudence is an essential feature of fiscally prudent legislation, and we are confident that such a mechanism can be devised. One approach we have been exploring would involve capping the amount of insurance to be sold rather than the amount of payout to be made. Under this approach, the total amount of insurance offered to each state would equal 50 percent of the difference between (a) a threshold trigger level(essentially, a Adeductible@), and (b) an upper limit loss. The bill sets the threshold trigger level at the greater of (a) the amount that would be lost in a 1-in-100-year event, (b) $2 billion, and, for existing state programs, the claims paying capacity of the program; the bill also provides for certain transition trigger levels. The upper limit loss could be set similarly at the amount that would be lost in some less probable event, such as a 1-in-500-year event.
- For example, if the 1-in-100-year loss on insured residential property in Missouri were $4 billion, and the 1-in-500-year loss were $8 billion, then the total amount of coverage offered to Missouri would be half of the difference between $8 billion and $4 billion, or $2 billion.
Coverage would be allocated between the state programs and the regional auctions in proportion to the share of the industry risk in each state that the state program (if any) covers.
- State with 100 percent state program: If a state elects to create a state program that, as a matter of policy, reinsures every insurance entity with exposure to residential property losses in the state for all its losses above the deductible, we propose to offer the full state allocation to the state program. Because the full amount of coverage for the state had been offered to the state program, nothing attributable to this state would be offered in a regional auction.
- No state program: If a state elects not to create a state program, we would attribute the full amount of that state=s allocation to the applicable regional auction. If Missouri chose not to establish a state program, we would add $2 billion in total insurance to the auction of contracts for the region covering Missouri.
- State with partial state program: A state could create a state program that, as a matter of policy, does not reinsure all residential exposure in the state. For example, the state could allow private insurers operating in the state the option (but not the obligation) of purchasing reinsurance with the state program. If, as a result, the state program bore two-thirds of the aggregate exposure to losses in the state from catastrophes above the threshold trigger, we would offer two-thirds of the state=s total allocation to the state program, and would attribute the remaining one-third to the regional auction pertinent to the state in question. If the state in question were either California or Florida, for which we are directed to hold state auctions, the amount available in the auction would simply be the one-third not offered to the state program. If the state in question was covered by a multi-state region, the total amount offered in the regional auction would be incremented by the one-third not offered to the state program. The total amount of insurance offered in a multi-state regional auction would simply be the sum of the obligations that would have been sold to the states, had they been treated as individual entities.
Under this approach, the total Federal exposure would be capped at the sum of the obligations sold to each state and region. If we set the upper limit at the 1-in-500 loss, the rough calculations we have performed suggest that this total could be on the order of $50 billion. Reducing the upper limit, to, say, the 1-in-400-year loss, would lower the cap on the annual Federal payout. Raising it, to, say, the 1-in-1000-year loss, increases the cap. Of course, the total maximum Federal exposure could be set at any level the political process felt was best. The problem for modelers would be simply to deduce the probability associated with that cap, and hence the allocation of coverage across states and regions.
The probability of hitting this cap would be extraordinarily small; the cap would be hit only if every state and region bought its full allotment of contract protection, and huge events happen to every state in one year that cause the maximum payouts to be made.
An ancillary benefit of the approach sketched here is that it provides a natural method of allocating coverage across states and regions. The legislation as currently drafted does not address that issue.