Before the Senate Committee on Banking,

Housing and Urban Affairs

United States Senate

Testimony

United States General Accounting Office

GAO

For Release on Delivery

Expected at

10:00 a.m. EDT

on Wednesday

October 24, 2001

TERRORISM INSURANCE

Alternative Programs for

Protecting Insurance

Consumers

Statement of Thomas J. McCool

Managing Director, Financial Markets and

Community Investment

GAO-02-199T
Page 1 GAO-02-199T

Statement

Terrorism Insurance: Alternative Programs

for Protecting Insurance Consumers

Mr. Chairman and Members of the Committee:

The tragic events of September 11, 2001, bring to light numerous areas of

concern within the financial services sector, especially as threats of future

terrorist attacks continue. One area of concern voiced by various industry

groups and the Congress is how the insurance industry should respond to

risks posed by potential terrorist attacks and the extent to which the

government should play a role alongside the industry to address these

risks. We appreciate the opportunity to discuss this issue.

Prior to September 11th, insurance coverage for losses from terrorism was

included as a normal feature of insurance contracts. According to

industry analysts, this was because insurers’ experience suggested that

domestic exposure to terrorism, both in the number of occurrences and

the magnitude of losses, was limited. The September 11th attacks have

changed insurers’ perception of their potential risk exposure. Insurance

companies have indicated that they will pay their share of the losses from

these tragic events. However, both insurers and the reinsurers who share

the industry’s risks, have indicated that they don’t know how much to

charge for this coverage going forward because they cannot predict future

losses. As a result, it has been reported that industry leaders may exclude

insurance for terrorism from future insurance contracts unless the federal

government provides some form of assistance to the industry.

A financially strong insurance industry is essential to the smooth

functioning of the economy. Industry officials have indicated that

insurance coverage for catastrophic events such as a major terrorist act is

necessary for investors and other financial decision-makers to be willing

to provide capital to promote continued economic growth and stability. If

the federal government chooses to provide financial backing to this

industry, the primary driving force should be to safeguard the economy’s

access to necessary insurance protection. At the same time, care needs to

be taken to ensure that the interests of both the federal government and

American taxpayers are safeguarded, and that the industry is assuming its

fair share of risks.

Any mechanism established by the federal government to support the

ability of individuals and businesses to get insurance for terrorist acts

should address several significant concerns. Most importantly, the

program should not displace the private market. Rather, it should create

an environment in which the private market can displace the government

program. Second, it should be temporary, at least initially. Finally, any

program should be designed to ensure that private market incentives for
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 2 GAO-02-199T

prudent and efficient behavior are not replaced by an attitude that says,

“Don’t worry about it, the government is paying.”

In the aftermath of the September 11th terrorist attacks, the Congress is

considering whether and how to provide financial backing to the

insurance industry so that insurance is available for losses due to terrorist

acts. As requested, we will present (1) features of several existing

insurance programs, both domestic and international; (2) alternative

mechanisms for funding insured losses; and (3) some broad principles or

guidance that the Congress may wish to bear in mind as it considers

possible ways to support the insurance industry in case of future

catastrophic losses due to terrorist acts. My observations are based on

publicly available information on a variety of insurance programs within

the United States and other countries and from prior GAO work.

Today, a number of insurance programs exist in the United States and

other countries to help ensure that insurance will be available to cover

risks that the private sector has been unable or unwilling to cover by itself,

including losses from catastrophic events and terrorism. Certain

insurance programs are completely controlled and managed by the

government, while others have little or no explicit government

involvement. Likewise, in many programs the public and private sectors

share risks, though in several different ways.

For this testimony, we are highlighting features from selected insurance

programs, including some established by the federal government as well as

some from other countries, the states, and others. For example, the

federal government insures individuals and firms against natural disasters

under the flood and crop insurance programs and bank and employer

bankruptcies under the deposit and pension insurance programs. Some

federal programs cover political risk insurance for overseas investment

activities, third-party claims for nuclear accidents, and protection against

war-related risks. Other countries and organizations have also developed

insurance programs covering catastrophic or terrorist events. These

programs can provide useful insights in developing an appropriate

insurance mechanism to cover losses from terrorist acts.

For government insurance programs, the question of long-term cost and

program funding needs to be addressed before the program is established.

Some federal insurance programs have the statutory intent to provide

subsidized coverage, while others are intended to be self-funding. As

noted in some of GAO’s previous work, whatever merits the federal

Features of Selected

Insurance Programs

Covering Catastrophic

or Terrorist Events
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 3 GAO-02-199T

government has as an insurer, the same characteristics that inhibit private

insurance firms from covering certain events could also make a federallysponsored insurance program a costly undertaking.1

In some cases, the federal government subsidizes insurance programs in

order to achieve a public policy objective. For instance, catastrophic

coverage under the crop insurance program is subsidized in an attempt to

reduce reliance on ad hoc disaster assistance. In other cases, the federal

government may set up premium and fee structures intended to cover the

full cost of providing insurance. However, regardless of statutory intent, if

federal insurance is underpriced relative to its long-run costs and the

federal government pays the difference, a government subsidy results. For

example, under the Flood Insurance Program, program operating losses

have been financed through borrowings from the U.S. Treasury or covered

by appropriated funds.

The federal government’s size and sovereign power provide it with the

unique ability to offer insurance when the private market is unable or

unwilling to do so. Currently, the federal government has a variety of

mechanisms, including insurance programs, to cover risks that the private

sector has traditionally been unable or unwilling to cover. Appendix I,

table 1, highlights key features of several selected programs. We will

describe some of them further today.

A system that limits liability and provides indemnification for operators of

nuclear reactors was established through the passage of the PriceAnderson Act of 1957. Specifically, the act limits the total liability of

individual reactor operators for any accident. First, the operators must

obtain insurance up to the maximum amount of private insurance

available to the operator, which is currently about $200 million per reactor

per accident. In addition, in the event of an accident at any single reactor

that results in losses exceeding $200 million, all operators of the 106

commercial nuclear power reactors in the United States would be required

to provide additional protection by paying into a secondary insurance

fund. Depending on the amount of the claims, these contributions could

be as high as $88.1 million per reactor per accident. Following an incident,

the operators of commercial power reactors would be required to pay as

much as $10 million annually for 9 years to complete the secondary

 1

 Budget Issues: Budgeting for Federal Insurance Programs, (GAO/AIMD-97-16), September

1977.

Selected Insurance

Programs Established by

Federal Statute

Insurance for Catastrophic

Nuclear Accidents

Features:

- Mandatory participation

- Liability of the private sector

is limited

- Implicit government backing
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 4 GAO-02-199T

insurance fund. For the 106 reactors in the United States, the nuclear

industry’s current exposure to third-party liability claims would be

approximately $9.5 billion before the Congress intervenes.

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 the Congress to

investigate the accident and to take whatever action it deems necessary.

This action could include, among other things, appropriating funds or

requiring the nuclear industry to provide additional funding to satisfy

remaining claims. No nuclear accidents have occurred since PriceAnderson was enacted that cost more than was provided by the available

private insurance. As a result, the industry has never had to pay into the

secondary insurance fund, nor has the Congress been required to take

action on excessive losses.

The Overseas Private Investment Corporation (OPIC), which began

operations in 1971, was established to facilitate private investment by U.S.

investors in developing countries and countries with emerging markets.

OPIC insurance programs reduce the risk to U.S. investors in these

countries by offering protection against several political risks. In general,

the coverage offered by OPIC is more comprehensive both in scope and

duration than the coverage currently available from private sector

insurers. OPIC operates as a self-financing government agency. A

significant portion of its income is derived from premiums and fees, but

the program is also backed by $100 million in borrowing authority from

the U.S. Treasury. Premium rates are based on a standard pricing table for

different business sectors, with adjustments for project-specific risks. The

risk assessment methods OPIC uses to establish insurance reserves and

set premium rates rely heavily on expert judgment and are not highly

quantitative. According to OPIC officials, no standard actuarial model

exists for quantifying political risks. Over the life of OPIC, the

government has made money on the insurance provided.

Insurance Against Overseas

Political Risk

Features:

- Voluntary participation

- Federal government is the

insurer and risk bearer
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 5 GAO-02-199T

The National Insurance Development Program was established by the

Housing and Urban Development Act of 1968 (P.L. 90-448). The program

sought to ensure the availability and affordability of fire, crime, and other

property insurance to residential and commercial owners located in highrisk urban areas. The act created a Federal Insurance Administrator

within the Department of Housing and Urban Development to administer

the reinsurance program, but responsibility was later transferred to the

Federal Emergency Management Agency. The program was a response to

the urban riots and civil disorders of the 1960s, when many of America’s

cities suffered major property losses.

As a result of these losses, insurers became reluctant to underwrite

property insurance in communities considered to be at risk for such

events. The program had two purposes. First, the program encouraged

state insurance regulators and the industry to develop and carry out

programs to make property coverage more readily available. Second, it

provided a voluntary federal program of reinsurance for urban property

owner relief against abnormally high property insurance rates in private

markets. Under this program, federal reinsurance was made available to

property insurance companies operating in states that voluntarily adopted

Fair Access to Insurance Requirements Plans. Insurers were required to

retain a small portion of the liability,2

 which had to be paid first in the

event of a claim. Insurers could transfer most of the remaining risk by

making a premium payment to the federal government, which then

assumed the remaining liability. This liability ranged from 90 to 98 percent

of the remaining insured amount, and coverage increased as losses grew.

The program was backed by $250 million in borrowing authority from the

U.S. Treasury.

The program also included a requirement that states share in program

losses with the federal government.3

 According to a former program

official, state sharing of program losses was a feature designed in part to

keep states from setting property insurance premiums too low. At the

 2

 A “net retention amount” of not more than 2.5 percent of the premiums paid by owners,

calculated on a state-by-state basis, depending on the line of insurance offered. Insurers

purchasing reinsurance could also be assessed an amount in the event of losses in excess

of all reinsurance premiums paid nationwide.

3

 If federal reinsurance payments exceed premiums from the property-casualty companies

in a state, the state must pay an amount up to 5 per cent of the aggregate property

insurance premiums earned in that state during the preceding year of those lines of

insurance reinsured by the federal government.

Insurance Against Urban

Riots and Civil Disorder

Features:

- Voluntary participation

- Encouraged states and the

private sector to provide

insurance in urban areas

- Offered federal reinsurance

for insured property in urban

areas
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 6 GAO-02-199T

program’s inception, federal reinsurance was to last less than 5 years.

However, former officials reported that the program made money because

claims never reached the anticipated levels and, beginning in the early

1970s, the program premiums were used to subsidize a crime insurance

program. Reinsurance was discontinued in 1984 because of the small

number of insurers participating.

The National Flood Insurance Program, which was established by the

National Flood Insurance Act of 1968, makes federal flood insurance

available to property owners living in communities that join the program.

Some of the key factors that led to the program’s establishment were

private insurers’ reluctance to sell flood coverage, increasing losses from

floods because of floodplain encroachment, and high federal expenditures

for relief and flood control. This program, which is financed primarily

through premiums, fees, and interest income, aims to reduce federal

spending on disaster assistance. By design, this program is not actuarially

sound, because it does not collect sufficient income from premiums to

build reserves to meet long-term expenditures on flood losses. Though the

Federal Insurance Administrator is authorized to subsidize a significant

portion of the total policies in force, its annual appropriations do not cover

these subsidies. As a result, the Congress has appropriated funds for the

program from time to time. In addition, the Federal Insurance

Administration has periodically borrowed from the U.S. Treasury to

finance operating losses.4 The program is backed by $1 billion in

borrowing authority from the U.S. Treasury.

Many other countries have government-sponsored insurance programs

that cover catastrophes, terrorist events, or both. Some of these programs

are essentially run by the government, while others have little or no

government backing. Appendix I, table 2, highlights key features of such

programs in Israel, Japan, Switzerland, and the United Kingdom. We will

briefly discuss these programs.

 4

Flood Insurance: Information on Financial Aspects of the National Flood Insurance

Program, (GAOT-RCED-00-23), October 27, 1999.

Insurance Against Floods

Features:

- Voluntary participation

- Federal government is the

insurer for flood risk

- Subsidized rates offered to

encourage mitigation

Selected Insurance

Programs of Other

Countries
Statement

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Page 7 GAO-02-199T

Japan’s earthquake insurance program, originally conceived in 1966, arose

out of a major earthquake in that country in 1964. The insurance is

purchased as a supplement to residential fire insurance and covers homes

and household goods. Private insurers and the government share in any

losses that result from a disaster according to a three-tiered payment

system. Under the first tier of coverage, private insurers are responsible

for the first $625 million5

 of damages before government assistance is

triggered. This initial amount effectively acts as a deductible. Losses

above this amount trigger a second tier of coverage, for damages up to

$6.821 billion. The Japanese government pays 50 percent of the losses in

this second tier. The third tier of coverage involves losses of between

$6.821 billion and $34.166 billion, with the government paying 95 percent

of losses exceeding $6.821 billion. The Japanese government receives

reinsurance premiums from primary insurers, but its total liability is not

necessarily limited to the total amount of premiums received.

Japan’s program has several distinguishing features. First, the private

sector is responsible for the initial portion of losses. This feature helps to

ensure the development of a private market for earthquake insurance that

is unencumbered by a monopoly. Additionally, industry pool

arrangements are mandated under the program. The government takes on

an increasing share of losses as they rise, up to a maximum cap on the

total amount of exposure, but the private sector still bears some cost even

at higher levels. This feature helps to ensure that risk of disaster is spread

throughout the entire country and economy. Finally, the Japanese

program was not established to provide coverage for all potential losses,

but rather as a first step toward providing some level of coverage, with the

government and private sector working together.

 5

 Dollar figures presented are based on the conversion of yen to dollars from documents on

the program provided by Japan’s Board of Audit.

Japan’s Insurance Against

Earthquakes

Features:

- Mandated insurer

participation

- Private/public risk sharing

- Government share increases

as losses increase
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 8 GAO-02-199T

The United Kingdom’s Pool Reinsurance (Pool Re) program was

established in 1993 to provide insurance against losses and damages

caused by terrorists attacks on industrial, commercial, and residential

properties located within the British mainland. There are several distinct

layers of coverage. All policyholders who buy basic property coverage

from insurers have the option of buying additional coverage from the same

insurers to protect against terrorism. Insurers are responsible for the first

100,000 pounds of coverage per coverage type, with no reimbursement

from the government. Claims exceeding 100,000 pounds are paid from

premiums accumulated within a pool made up of insurance companies

and Lloyd's syndicates. (The British government and the insurance trade

group established a mutual company from these companies and syndicates

to provide terrorism reinsurance.) If the pool of funds is exhausted, all

participating insurers face a call of up to 10 percent of the premiums they

have collected during the year. Beyond the 10 percent call, the pool

investment income is tapped, and the government meets any claims in

excess of this. According to United Kingdom officials familiar with the

program, the government has not yet had to bail out the pool as the

reinsurer of last resort.

Israel has two programs for covering losses resulting from a terrorist

attack. The first is the Property Tax and Compensation Fund, which

covers property and casualty insurance. The second is the Law for the

Victims of Enemy Action, which covers life and health insurance. The

Israeli government funds and administers both programs. Under the

Property Tax and Compensation Fund, the Israeli Income and Property

Tax Commission levies a national property tax predominantly on Israeli

businesses. The commission pays claims on property damages that are the

direct result of a hostile terrorist attack (including losses of business

inventory), on the basis of the market value of a property immediately

before the attack. All indirect damages, including those for businessinterruptions, must be covered through private insurance. Private

supplemental coverage or additional state coverage can be purchased to

cover the difference between a property’s current market value and the

cost of rebuilding (known as the replacement value). State coverage is

capped by implementing regulations.

The second program, the Law for the Compensation of Victims of Enemy

Action, is a state-run program administered by the National Insurance

Institute (NII) and is also funded by the government. The NII is similar to

the U.S. Social Security Administration. Coverage is provided for medical

care, lost wages, extended payments to the families of attack victims, and

personal injury. Coverage also extends to visitors and tourists who are in

United Kingdom’s Insurance

Against Terrorist Events

Features:

- Voluntary participation

- Created because of

withdrawal of private

reinsurance

- Insurers pay 110 percent of

premium received before

government pays

Israel’s Insurance Against

Terrorist Attacks

Features:

- Mandatory participation

- Government bears all risk

- Funded by tax revenues
Statement

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Page 9 GAO-02-199T

Israel. Coverage amounts for this program are again determined by

implementing regulations.

Switzerland’s Catastrophe Insurance program was established to insure

against natural disasters, including storms, hail, floods, landslides, and

avalanches. Earthquakes are not covered under this program. This

program does not set up a separate catastrophic insurance fund, but

instead obliges insurers to include coverage for specified catastrophes in

fire insurance policies for buildings and their contents at a statutorily fixed

rate. These compulsory premiums are the sole means of financing the

catastrophe insurance program. Although this scheme does not set up a

separate catastrophe insurance fund, Swiss insurers have created a

reinsurance pool where these additional premiums are deposited.

Membership in this pool is optional for insurers, but currently 85 percent

of claims are ceded to it. Should claims exceed the funds in the pool, the

difference would be payable from the insurers’ capital and assets. There is

no government involvement or exposure associated with the operation of

the program, since the Swiss government does not provide any guarantee.

For this reason, the private sector has an incentive to reduce risks.

Insurers that participate in the pool are also subject to a cash-call in

proportion to their participation in the pool to cover claims that exceed

pool capacity.

Other insurance programs that may provide useful insights in developing

insurance coverage for terrorist acts include those established by state

governments and private sector entities. Appendix I, table 3, highlights the

features of several state and private sector insurance programs, and I will

describe these programs here.

Switzerland’s Insurance

Against Selected

Catastrophic Events

Features:

- Mandatory participation

- No government risk exposure

Insurance Programs

Sponsored by States or

Other Entities
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Page 10 GAO-02-199T

Every state has guaranty funds to protect policyholders when an insurance

company fails. These funds exist for property-casualty as well as lifehealth insurers. While there are differences between the funds for the two

insurance sectors, in general they operate similarly. Insurance guaranty

funds are not really funds. In nearly all states, the money used by guaranty

funds to pay policyholders of failed insurers is collected through postfailure assessments. After an insurance company is found to be insolvent

by a state regulator, the regulator and the guaranty funds in each state

where policies were sold determine by how much the failed company’s

policyholder claims exceed the value of the company’s assets. The

guaranty funds then provide sufficient funds to ensure that all claims are

paid (up to each state’s statutory limits). Guaranty funds are not operated

by state governments, nor are they funded by public money (i.e., there is

no explicit subsidy).

However, the funds were created by statute and operate as part of the

insurance regulatory system. Even though no appropriated funds are used

to fund the guaranty funds, insurers do not bear the entire cost of guaranty

fund assessments. While tax treatment varies among states, many states

allow the insurers to offset their premium taxes for assessments paid to

guaranty funds. Where this tax credit is permitted, insurers can usually

reduce their premium tax bill by 20 percent each year for 5 years. Other

states allow insurers to recoup assessments by increasing or adding a

surcharge to policyholder premiums.

The California Earthquake Authority was established to insure California

residents against losses caused by earthquakes. The Earthquake Authority

was set up by state statute. The state of California, however, does not

contribute any funding to the authority. After the Northridge, CA

earthquake in 1994, insurance companies determined that the premiums

they had been charging for earthquake coverage were inadequate.

Furthermore, the companies did not know how to set an actuarially sound

price. Insurance companies attempted to stop selling insurance against

earthquake damage, but were opposed by the state. After negotiations,

insurers were permitted to exclude earthquake coverage from their

property-casualty policies if insurance companies representing at least 70

percent of the market agreed to participate in the Earthquake Authority.

Participation meant agreeing to pay an initial assessment totaling $717

million plus two additional assessments of $2.15 billion and $1.434 billion

after certain levels of earthquake-related losses occurred. Thus, potential

Earthquake Authority losses are to be funded by a multilayered financing

arrangement involving insurer contributions, premiums, conventional

State Insurance/Guarantees

Against Insolvent Insurers

Features:

- Mandatory participation

- Funded by post event

assessments

- Operated by industry

- No explicit subsidy

California’s Insurance

Against Earthquakes

Features:

- Participation based on

statutory requirements

- Funded by assessments on

insurance companies

- No public funding
Statement

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Page 11 GAO-02-199T

reinsurance, and pre-established debt financing. In early 2000, these layers

totaled about $7 billion. In the event that all authority funds were

expended, claims payments would be prorated. The Earthquake Authority

currently provides virtually all of the earthquake insurance available in the

state of California.

The International Group of Protection and Indemnity Clubs (Group)

includes the 14 protection and indemnity associations or “clubs” that

insure about 90 percent of the world’s seagoing tonnage. The individual

clubs are nonprofit-making mutual insurance organizations that cover

third-party risks of shipowning members. The American Steamship

Owners Mutual Protection and Indemnity Association, Inc., known as the

American Club, was established in New York State in 1917 and is the only

U.S. domiciled member. 6 The American Club has no government subsidy.

The Group arranges collective insurance and reinsurance that covers risks

such as those arising from oil spills and other polluting substances. The

program uses primarily a prefunded approach to pool funds through

advance calls of premium. The advance premiums paid by shipowners are

80 percent of estimated claims for the policy year. Premiums are invested

by the Group. Should loss experience prove higher than anticipated, the

program also encompasses other reinsurance and a post assessment call

feature.

The pooling arrangement is a four-layered system. Claims of less than $5

million are essentially risk of loss retained by the club member

shipowners. The program then enables the pooling of claims from $5

million to $30 million between clubs based on a formula incorporating

tonnage size, premium income, and claims record. The next layer, called

“excess of loss reinsurance,” is reinsurance purchased by the Group for

third-party claims incurred in a single incident in excess of $30 million—

up to $1 billion in the case of oil pollution liabilities and up to $2 billion for

all other liabilities. Finally, the program encompasses an “over spill” layer

to cover claims in the $2 billion to $4 billion range. This layer is funded

through a post assessment of club members.

 6

The American Club became a signatory to the Pooling Agreement in February 1998. Prior

to that, the American Club was reinsured with the Group via the London Club. Protection

and Indemnity is the traditional name for insurance to cover ship owners and ship

chartering firms against their legal liabilities to third parties.

Ship Owner Insurance For

Ocean Pollution

Features:

- Voluntary participation

- Risks are pooled and funded

by pre and post assessments

- No government involvement
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Page 12 GAO-02-199T

In order to pay claims when an insured event occurs, a mechanism must

exist to ensure that the funds will be available when they are needed.

Currently, there are two possible models for such a mechanism. First,

insurers can prefund for expected losses by estimating potential liabilities

(establishing a reserve liability) and collecting assets (premiums) to pay

claims when an insured event occurs. Alternatively, under certain

circumstances, after an insured event when losses are known with

certainty, assessments can be levied to provide the necessary funds. Both

models, and in many cases a combination of the two, are widely used in

the insurance industry.

The deposit insurance provided by the Federal Deposit Insurance

Corporation (FDIC) is an example of a prefunded system. Banks pay

premiums into a fund. When a bank fails, the deposit insurance fund is

used to make up the difference between the bank’s remaining assets and

customer deposits, up to a legal limit. Of course, if the deposit insurance

fund falls below a certain level because of large payouts, banks must pay

additional amounts into the fund to ensure that sufficient funds are

available for future failures. In contrast, most of the state insurance

guaranty funds described earlier are examples of post assessment plans.

After an insurance insolvency, the remaining insurance companies in each

state where the company operated are assessed the difference between

the failed insurer’s legal obligations to its policyholders and its assets.

Some of the programs described earlier in this statement include a

combination of both prefunded and post assessment mechanisms,

including the British Pool Re and the California Earthquake Authority.

For ordinary, noncatastrophic events, insurance companies set up

reserves (liabilities) that measure their expected losses7 and set aside

assets to offset those liabilities. For catastrophic events, when both the

timing and magnitude of losses are difficult or impossible to predict,

insurance companies generally do not set up reserves.8 These losses are

 7

 For a reserve to be established by an insurance company, the losses must have already

occurred (either reported but unpaid, or incurred but not reported), or be “probable” and

“estimable.”

8

 Accounting standards and tax law discourage the establishment of “contingency

reserves.” That is, insurers must usually build such contingency reserves from after-tax

income (retained earnings). As a result, it is unusual for insurers to establish contingency

reserves for events like hurricanes, since it is impossible to measure either the probability

of such occurrences or the expected loss that is likely to occur during the current

accounting period, irrespective of the long-term predictability of the event.

Alternative

Mechanisms for

Funding Insured

Losses

Prefunding Versus Post

Assessment
Statement

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Page 13 GAO-02-199T

generally paid out of the company’s ongoing premium stream, the

company’s capital, or both. If income from premiums is too low or losses

are too high, an insurer’s capital can be depleted, and the insurer may

become insolvent. In the long run, if an insurer does not become

insolvent, it can recoup catastrophic losses by adjusting the premium rates

charged to policyholders. Thus, even insurance companies postfund some

of their insured losses. Both prefunding and post assessment are

reasonable ways to fund the exposure to losses from large catastrophic

events, including terrorism. Both mechanisms have advantages and

disadvantages. Used together, they could provide a multilayer mechanism

for funding levels of risk exposure that otherwise could limit the

availability of needed insurance.

Insurance companies that insure catastrophes can also reduce the

potential for insolvency by purchasing reinsurance. The insurer remains

liable for any claims when they are presented, but is later reimbursed by

the reinsurer for the portion of the liability that was reinsured. The

problem for the insurer then becomes one of liquidity rather than

solvency. Of course, over time both the insurer’s and the reinsurer’s

solvency depend on a reasonable correspondence between premium

income (plus investment income) and losses.

Reinsurers remain in business if the direct insurer can charge premiums

that provide sufficient income to pay claims and related expenses and to

record a profit. If a reinsurer does not believe an insurer is capable setting

a price commensurate with the risk, or of generating enough premium

income to pay those risks, it will not reinsure that business. According to

the insurance industry, it is now facing that situation in the aftermath of

the September attacks. One possible solution would be for a group of

insurers to establish a pool to take the place of the unwilling reinsurers. In

this case, losses from any terrorist event that affect only one or a few

members can be spread across the entire pool, reducing the likelihood that

individual members will become insolvent. However, while the pool may

take the place of the reinsurers, the pool faces the same difficulties in

establishing catastrophic (contingency) reserves as the individual insurers.

It would also be holding the same risks that the reinsurers were unwilling

to accept. Hence, the desire to add the government to the equation.

The federal government could help the insurers in a number of ways. It

could allow the pool to build tax-free, multiyear reserves for potential

losses that do not have a measurable probability or estimable value. Such

a pool arrangement has been used in Britain for the purposes of increasing

pool assets for catastrophic losses. This tax-free status would increase the

Reinsurance: A Further

Means of Protection

How the Federal

Government Can Support

Insurers Facing

Catastrophic Losses
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 14 GAO-02-199T

pool’s ability to pay for future terrorist events. However, if the insured

event occurs before the pool builds up substantial reserves, or if the prices

insurers are charging for coverage turn out to be too low, the pool’s

reserves would still be depleted. If so, the member insurers would still

risk insolvency, since they would be obligated to pay all legitimate claims

whether they could recover the funds from the pool or not. To alleviate

this possibility, the government could also stand behind the pool as a riskbearer. In this case, if the pool’s assets were depleted, the government

would assume the contingent liability, using its resources to pay additional

losses and reducing the risk of insolvency for the insurance companies.

The government could also fund its contingent liability to the pool in a

variety of ways. It could charge the pool a premium for the reinsurancelike protection it provides, accumulating a fund it could use to pay for

losses. Of course, any premiums charged to the pool would reduce the

pool’s assets and accelerate both the time when the government would

have to begin covering losses and its total exposure. Alternatively, the

government could fund its losses out of tax revenues, either with or

without repayment requirements.

Given that the problem currently facing the insurance industry is an

inability to correctly price the risk of a terrorist act, prefunding may not

generate sufficient funds to fully pay potential insured losses from major

terrorist events. A postfunding (post assessment) mechanism could be

used either to substitute for or to augment a prefunded reserving

mechanism. Post event assessments could be a feature of the pool, of the

government mechanism, or both. Pool Re, the British plan for

public/private sharing of terrorism risk, includes a call on each memberinsurer after the private pool is exhausted, in an additional amount equal

to 10 percent of the total premium that insurers collected for terrorism

coverage. Alternatively, the government could pay that portion of the

losses that exceed the pool’s resources and then assess the member

companies over time in order to recoup part or all of its expenditures. In

this variant, the government would be lending the insurance companies

part or all of the cash needed to meet liquidity demands resulting from the

terrorist event, but not bailing the industry out.
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 15 GAO-02-199T

At this point, we would like to discuss some broad principles that we have

drawn from lessons learned over several decades of supporting

congressional efforts to assist industries and firms in moments of crisis,

including the savings and loan industry and, most recently, the aviation

industry.9

 These principles may provide guidance as you consider whether

the government should take actions to ensure the continued availability of

insurance and reinsurance for terrorist-related acts. We believe that the

following three principles are key to such efforts:

• Clearly define the problem to be solved.

• Ensure that the program protects the government and taxpayers from

excessive and unnecessary losses.

• Avoid a self-perpetuating program, that is, the government’s involvement

should be temporary.

The industry and federal government need to work together to clearly

define the specific nature of the problems confronting the industry,

separating short-term needs from long-term challenges and wants from

genuine needs. It seems clear, given insurers increased recognition of

their exposures in the aftermath of the unprecedented events on

September 11, 2001, that coverage for terrorist acts is not now amenable to

normal insurance underwriting, risk management, and actuarial

techniques. As a result, insurers and reinsurers are concerned about their

ability to set an appropriate price for insurance coverage for terrorist acts.

Given this uncertainty if this kind of insurance were to be offered at all, it

is likely that either the prices insurers set would be prohibitively high or so

low as to invite insolvency. However, even if we conclude that insurers

cannot price and, therefore, cannot sell this kind of insurance, defining the

nature of the problem facing both the economy and the insurance industry

is a critical first step. Many important questions need to be addressed.

Among them are:

• What is the appropriate definition of a terrorist act?

• How would the lack of insurance coverage for terrorist events affect other

sectors of the economy?

• What are the public policy objectives to be achieved by an assistance

program?

 9

 Commercial Aviation: A Framework for Considering Federal Financial Assistance

(GAO-01-1163T, Sept. 20, 2001).

Principles to Consider

When Providing

Financial Assistance

Defining the Problem the

Industry Faces
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 16 GAO-02-199T

Whatever program or mechanism is put in place, protecting the

government—and, therefore, taxpayers—from inefficiency and excessive

costs needs to be a primary objective. When the government becomes

involved in providing insurance, it is usually because the private insurance

market is having difficulty underwriting and pricing certain risks. For

instance, some risks are difficult to predict and can be catastrophic in size.

Additionally, some risks may not be independent—that is, the losses may

strike a large number of insured individuals or entities at the same time.

Furthermore, spreading the risk to a large and diverse population may be

difficult. This difficulty sometimes results from adverse selection, which

occurs when those with the highest probability of loss tend to purchase

insurance, while those with the least risk opt out.

While these factors may provide a basis for government intervention in the

market, they also complicate efforts to measure the government’s

exposure to loss. Nevertheless, the government can take steps to control

and limit losses. For example, any program should have keep market

incentives where they belong—with private firms. As long as private firms

have their own money at risk, the private market is a better choice than

the government for handling traditional insurance functions such as

setting prices, underwriting policies, and handling and adjusting claims. If

the government is bearing all or most of the risk, private firms will not

have the same incentives to maximize efficiency.

Thus, any government program must be structured to ensure that private

insurers have the same incentives they would have if the government were

not involved. For example, firms should have an incentive to set the best

prices they can (even in an environment of insufficient information), to

require risk mitigation on the part of their customers in exchange for a

reduced premium, and to carefully investigate losses to ensure that claims

payments are appropriate. Creating a mechanism that places part of each

company’s capital at risk—as well as premium income—could serve to

maintain the correct incentive structure. If insurance companies believe

that their own exposure to losses is insignificant, they are not likely to

behave the same way they would if their own money was at stake.

Finally, in the current crisis environment any government solution should

be temporary and needs to be revisited periodically. Congress may decide

that ensuring the continued ability of the insurance industry to serve all its

customers is in the national interest. However, given the lack of

information about the scope and nature of the long-term problem, it does

not seem prudent to establish such assistance in a program that may

Protecting the Government

From Excessive Losses

Reevaluating Future

Government Involvement
Statement

Terrorism Insurance: Alternative Proposals for Protecting Insurance Consumers

Page 17 GAO-02-199T

become permanent. However, government programs that are not carefully

designed tend to become self-perpetuating. We can find examples of such

programs in our own government experience and in some of the foreign

programs we have described today. Fortunately, several strategies are

available to minimize the possibility that a program will perpetuate itself.

First, government bureaucracy should be kept to a minimum. An

established bureaucracy tends to find reasons for its own continued

existence. Second, any program should have an exit strategy from the

beginning. An exit plan will provide the insurance industry and program

administrators with congressional guidance on how the industry should

emerge from the assistance program. Finally, a primary goal of any federal

insurance program must be to create an environment in which the private

market can and will be reestablished.

The government may have an important role to play in helping the

insurance industry establish insurance coverage for losses from terrorist

acts. GAO believes that should any assistance program be established it

would be most successful if based on the principles we have described

today. Following these principles will help ensure that assistance

addresses market problems, protects taxpayers from excessive and

unnecessary losses, and does not displace the private market for providing

such insurance coverage.

Mr. Chairman, this concludes my statement. We would be pleased to

respond to any questions that you or other members of the Committee

may have.

For further information regarding this testimony, please contact Richard J.

Hillman, Director, or Lawrence D. Cluff, Assistant Director, Financial

Markets and Community Investment Issues, (202) 512-8678. Individuals

making key contributions to this testimony included James Black, Emily

Chalmers, Darryl Chang, Ryan Coles, Rachael Demarcus, Jeanette Franzel,

Thomas Givens III, Rosemary Healy, Ronald Ito, Stefanie Jonkman, Monty

Kincaid, Barry Kirby, Robert Pollard, and Angela Pun.

Conclusions

Contacts and

Acknowledgments
Page 18 GAO-02-199T

Appendix I: Summary of Alternative

Programs

Table 1: Summary of Insurance Programs Sponsored by the Federal Government1

Program Description Government subsidy Sources of financing

Castrophic Nuclear Accidents Insures operators of

commercial power nuclear

reactors from large liability

claims from a major nuclear

accident regardless of cause

such as terrorism, negligence,

and natural disasters.

Unclear Operators of commercial power

nuclear reactors obtain

maximum amount of private

insurance available. After an

accident occurs, they pay into a

secondary insurance fund.

Overseas Private Investment

Corporation (OPIC) Political

Risk Insurance

Insures the investments of U.S.

companies in developing

countries against several

political risks, including

expropriation, currency

inconvertibility, and political

violence.

No. Self-financing but

guaranteed by the full faith and

credit of the U.S. government.

Premiums, insurance claim

recoveries, and interest

earnings.

National Insurance

Development Program

(Riot Re)

Insures against property losses

due to riot and civil disorder.

Provides owners with affordable

insurance in high-risk urban

areas.

Provided federal reinsurance

mechanism.

Capped Treasury borrowing

authority at $250 million.

Deposited insurer premiums

into a Treasury account.

Required states to provide

funds for program losses.

National Flood Insurance Insures buildings and contents

against losses due to flooding in

communities nationwide that

enact and enforce appropriate

flood plain management

measures.

Yes Premiums, interest earnings,

and appropriated funds.

Bank Insurance Fund Insures deposits up to a

specified amount.

Deposits up to a specified

amount, backed by the full faith

and credit of the U.S.

government.

Premiums, recovery of assets

acquired in receivership,

deposit assumption

transactions, and interest

earnings.

Aviation War-Risk Insurance Insures against losses resulting

from war, terrorism, and other

hostile acts when commercial

insurance is unavailable on

reasonable terms and

conditions and continued air

service is in the interest of U.S.

policy.

No. Self-financing from

premiums for assumption of

anticipated risks.

Premiums, interest earnings,

and one-time registration fees

for nonpremium insurance.

Federal Crop Insurance Insures against crop damage

from unavoidable risks

associated with adverse

weather, plant diseases, and

insect infestations.

Yes Premiums and appropriations.2

 1

 Sources of information for these program summaries included (GAO/AIMD-97-16) and

various publicly available documents describing the programs.
Appendix I: Summary of Alternative Programs

Page 19 GAO-02-199T

Program Description Government subsidy Sources of financing

Maritime War-Risk Insurance Insures losses resulting from

war, terrorism, and other hostile

acts when commercial

insurance is unavailable on

reasonable terms and

conditions and continued

service is in the interest of U.S.

policy.

No. Self-financing from

premiums for assumption of

anticipated risks.

Premiums, interest earnings,

binder fees, and claim

reimbursements.

National Credit Union Share

Insurance

Insures member shares

(deposits) up to a specified

amount.

Deposits backed by the full faith

and credit of the U.S.

government up to a specified

amount.

Premiums, interest earnings,

and 1-percent deposit from

insured credit unions.

Pension Benefit Guaranty

Corporation Insurance

Insures retirement benefits of

workers and beneficiaries

covered by private sectordefined benefit pension plans.

No. Self-financing from

premiums paid by employers on

behalf of their employees.

Premiums, assets from

terminated plans, and

investment income.

Savings Association Insurance

Fund

Insures deposits up to a

specified amount.

Deposits backed by the full faith

and credit of the U.S.

government.

Premiums, recovery of assets

acquired in receivership,

deposit assumption

transactions, and interest

earnings.

Service-Disabled Veterans

Insurance

Provides life insurance to

veterans with serviceconnected disabilities.

Yes Premiums, interest on policy

loans, policy loan repayments,

and appropriations.

National Vaccine Injury

Compensation

Provides compensation for

vaccine-related injury and

death.

No Excise tax on manufacturers

and interest earnings.

 2

 The Federal Crop Insurance Corporation is authorized under the Federal Crop Insurance

Act, as amended, to use the funds from issuance of capital stock, which provides working

capital for the Corporation.
Appendix I: Summary of Alternative Programs

Page 20 GAO-02-199T

 Table 2: Summary of Insurance Programs Sponsored by Other Countries3

Program Description Government subsidy Sources of financing

Japan’s

Earthquake Insurance

Provides a public/private, threetiered payment system for

damages resulting from an

earthquake.

Not presently known Participating insurer and

reinsurer premiums; some

government tax revenue.

United Kingdom’s

Pool Re

Insures against losses resulting

from terrorism.

Self-financing from premiums,

pool members, and the

government as last source of

funds.

Premiums, collections from pool

members, investment income,

and government contributions.

Israel’s

Insurance for Victims of Enemy

Action

Provides government-funded

property/casualty and health/life

insurance for victims of a

terrorist attack.

Yes Government property taxation,

and premiums for additional

state coverage. Although not

explicitly stated, general tax

revenues stand behind the

primary funding sources.

Switzerland’s

Catastrophic Insurance

Insures against losses from

natural disasters (excluding

earthquakes).

No. Intent was that it would be

self-financing from premiums

for assumption of anticipated

risks. If claims exceed premium

payments, the difference would

be payable from the insurer’s

capital and reserves.

Premiums on buildings and

their contents.

 3

 Information on these program summaries was collected from a United Nations document

and various publicly available sources describing the programs.
Appendix I: Summary of Alternative Programs

Page 21 GAO-02-199T

Table 3: Summary of Insurance Programs Sponsored by States or Other Entities4

Program Description Government subsidy Sources of financing

State Insurance Guaranty

Funds

Protects policyholders when an

insurance company fails.

No. However, in some states

companies can deduct

assessments from state taxes

or recoup by increasing

insurance premiums.

In all states but New York,

insurers are only assessed after

a failure occurs. In New York,

insurers pay a premium into a

state guaranty fund, similar to

the way federal deposit

insurance is funded.

California Earthquake Authority Insures California residents and

businesses against losses

associated with earthquakes.

No subsidy. Funding is provided by a

multilevel mechanism, including

insurance premiums, insurance

company assessments, and

debt financing.

The International Group of

Protection and Indemnity Clubs

Insures shipowners against

third-party claims for oil spills

and other risks

No subsidy. Member contributions via preand post-funding mechanisms.

Workers Compensation

Residual Market Reinsurance

Pool

National Council on

Compensation Insurance

(NCCI) is operating mechanism

for paying claims from a pool

fund.

No subsidy. Premiums and additional

contributions from member

carriers in the state when pool

funds cannot pay claims.

 4

 Information on these program summaries was collected from various publicly available

documents describing the programs.

(250057)