Budget Issues: Budgeting for Federal Insurance Programs
Published: 1997-09-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pursuant to a congressional request, GAO reviewed the budget treatment of federal insurance programs to assess whether the current cash-based budget provides complete information on the government's cost and whether accrual concepts could be used to improve budgeting for these programs, focusing on: (1) potential approaches for using accrual concepts in the budget for insurance programs; (2) trade-offs among different approaches, including the current cash-based budget treatment; and (3) potential implementation issues such as cost estimation.
section_title: What GAO Found
paragraphs: GAO noted that: (1) the cash-based budget does not adequately reflect the government's cost or the economic impact of federal insurance programs because generally costs are recognized when claims are paid rather than when the commitment is made; (2) in any particular year, the cost of the government's insurance commitments may be understated or overstated because the time between the receipt of program collections, the occurrence of an insured event, and the final payment of a claim can extend over many budget periods; (3) decisionmaking is best informed if the government recognizes the costs of its commitments at the time it makes them; (4) for insurance programs, accrual-based budgeting which would recognize the expected long-term cost of the insurance commitment at the time the insurance is extended offers the potential to overcome a number of the deficiencies of cash-based budgeting by improving cost recognition; (5) in most cases, the risk-assumed approach to accrual would be analogous to a premium rate-setting process in that it looks at the long-term expected cost of an insurance commitment at the time the insurance commitment is extended; (6) in practical terms, however, attempts to improve cost recognition occur on a continuum since insurance programs and insurable events vary significantly; (7) the challenges involved in bringing accrual-based estimates into the budget are significant and dictate beginning with an informational and analytic step; (8) development of models to generate reasonably reliable risk-assumed estimates is made difficult by the nature of the risks insured by the government, frequent program modifications, and the sufficiency of data on potential losses; (9) the potential benefits of accrual-based budgeting for federal insurance programs warrant continued effort in the development of risk-assumed cost estimates; (10) supplemental reporting of risk-assumed estimates in the budget as they are developed over a number of years would help policymakers understand the extent and nature of the estimation uncertainty and evaluate whether a more comprehensive accrual-based budgeting approach should be adopted; (11) supplemental reporting of risk-assumed estimates in the budget would parallel the new accounting treatment required under accounting standards developed by the Federal Accounting Standards Advisory Board (FASAB); and (12) in requiring the disclosure of risk-assumed estimates as supplemental information to agency financial statements, FASAB recognized the usefulness of these estimates to better inform budget decisions.

section_title: Letter
paragraphs: This report responds to your request that we review the budget treatment of federal insurance programs to assess whether the current cash-based budget provides complete information on the government’s cost and whether accrual concepts could be used to improve budgeting for these programs. As requested, we (1) identified potential approaches for using accrual concepts in the budget for insurance programs, (2) highlighted trade-offs among different approaches, including the current cash-based budget treatment, and (3) discussed potential implementation issues such as cost estimation. We have included a matter for congressional consideration and are making a recommendation to the Director of the Office of Management and Budget to develop and evaluate risk-assumed cost estimation methods for federal insurance programs.
We are sending copies of this report to the Ranking Minority Member of your Committee, the Director of the Office of Management and Budget, and interested congressional committees. We will also make copies available to others upon request. Major contributors to this report are listed in appendix VI.
If you have any questions concerning this report, please call me on (202) 512-9142.
subsections: section_title: Introduction
paragraphs: During the last 50 years, many analysts and researchers have raised concerns that cash-based budgeting does not provide complete information on the cost of some federal programs. Concerns that the cash-based budget badly distorted information on credit programs led to the inclusion of accrual-based costs in the budget for credit programs as the result of the Federal Credit Reform Act of 1990. Similar concerns have been raised about other programs—most notably insurance and federal employee pensions. In 1992, the Bush administration proposed to change the budget treatment of insurance programs from a cash basis to an accrual basis. Although the proposal was not enacted, analysts continue to assess the merits of accrual-based budgeting for such programs.
Because of his concern that for some federal programs, the cash-based budget does not provide a complete picture of the consequences of the government’s actions, the Chairman of the House Committee on the Budget asked us to evaluate the use of accrual-based budgeting for federal insurance programs. He believes that making the government’s cost of these programs more visible will improve budget decision-making.
subsections: section_title: Background
paragraphs: The federal budget serves as the primary financial plan of the government. As such, difficult decisions concerning resource allocation and fiscal policy are framed by the information provided in the budget. Historically, government outlays and receipts have been reported on a cash or cash-equivalent basis. Receipts are recorded when received and expenditures are recorded when paid, without regard to the period in which taxes and fees were assessed or the costs incurred. For most federal programs, cash-based reporting provides adequate information on and control over the government’s spending commitments because the time between when a liability is incurred and when it is paid is short. Costs to the government are known at the time the decision is made to provide budget authority, and cash outlays generally capture the fiscal effects of the government’s spending. However, for certain programs, such as federal insurance in which the government’s commitment can involve cash flows to and from the government over many years, the actual cost to the government may not be fully recognized with cash-based reporting.
The failure of the cash-based budget to provide timely signals to policymakers on the rapidly deteriorating financial condition of the nation’s deposit insurance system and growing federal commitments for deposit insurance during the 1980s has been widely cited as a vivid illustration of the shortfalls of cash budgeting for federal insurance programs. Although GAO and some industry analysts raised concerns about the rapidly rising deposit insurance costs that were accruing to the government, corrective action was delayed and the government’s ultimate cost increased. If the budget had recognized the government’s expected cost of deposit insurance, the government’s ultimate cost might have been lower if such recognition had prompted earlier actions by policymakers to limit losses. Instead, the budget did not report these costs until institutions were closed and depositors paid. In addition, by not reflecting the government’s deposit insurance liabilities as they accrued, the cash-based budget proved to be a poor gauge of the program’s economic impact. Delay in recognizing these costs obscured the government’s underlying fiscal condition during and after the crisis. Furthermore, not only was the cash-based budget slow to recognize these costs, but it may have also created incentives to delay closing insolvent institutions (to avoid increasing the annual deficit), which increased the ultimate cost to the government. This experience with deposit insurance heightened concerns that the cash-based budget was not providing adequate information on the potential cost of other federal insurance commitments.
In a series of reports in the 1980s on managing the cost of government, GAO advocated the use of some accrual cost measures in the budget.Specifically, we reported that due to the budget’s exclusive focus on cash transactions, the costs of some programs, including retirement, insurance, and credit, may not be accurately reflected in the budget. However, given the limitations of governmentwide accounting systems, we suggested that budget reporting could be improved by recording annual accrued costs for selected programs. Since then, budget reporting has gradually been modified using accrual measures to recognize the government’s cost for certain programs. For example, in 1985, budgeting for military retirement costs was moved to an accrual basis reflecting—at the program level—the government’s expected costs for retirement benefits as they are earned. These program level accrued amounts are offset so that total budget outlays and the deficit are not affected by this change. Similarly, beginning in 1987, accruing retirement benefit costs not covered by employee contributions are now charged to employing agencies for civilian employees covered under the Federal Employees Retirement System.
More recently, the Federal Credit Reform Act of 1990 changed the method of controlling and accounting for credit programs to an accrual basis.
subsections: section_title: Credit Reform Marked a Significant Departure From Cash-Based Budgeting
paragraphs: On November 5, 1990, the Federal Credit Reform Act was signed into law, as Title 13B of the Omnibus Budget Reconciliation Act of 1990 (Public Law 101-508). The act, which legislated changes GAO and others advocated,addressed many of the concerns raised by various analysts by changing the budget reporting of the cost of credit programs from a cash basis to an accrual basis. Because the federal government uses loans and loan guarantees to achieve numerous policy objectives, the scope of this change was far-reaching. In fiscal year 1996, for example, the federal government entered into commitments to make or guarantee loans totaling approximately $200 billion.
Prior to credit reform, outlays for credit programs were reflected in the budget only when cash was disbursed. The full amount of a direct loan was reported as an outlay, ignoring the fact that many would be repaid. In the case of loan guarantees, initially no outlays were reported. This ignored the fact that some of the guaranteed loans would be defaulted upon and thus require future outlays. Consequently, the cash basis of reporting overstated the cost of direct loans in the year they were made because it ignored repayments and understated the cost of loan guarantees in the year they were issued by ignoring defaults. This deficient reporting skewed cost comparisons between programs with similar purposes but different funding approaches (i.e., direct loans, loan guarantees, or grants). Further, the relative cost of such programs in comparison to other federal spending was also misrepresented. By incorporating accrual cost measures in the budget for loan and loan guarantee programs, credit reform improved these cost comparisons.
Credit reform addressed the shortfalls of cash-based reporting for credit program costs by requiring the budget to include the estimated cost to the federal government over the entire life of the loan or loan guarantee, calculated on a net present value basis. For purposes of the Credit Reform Act, the estimated cost of a direct loan or loan guarantee is now the sum of all expected costs—including interest rate subsidies and estimated default losses—and all expected payments received by the government over the life of the commitment, discounted by the interest rate on Treasury securities of similar maturity to the loan or guarantee. Reestimation of the cost of loans disbursed or guaranteed in a given year is required over the life of the commitment. This more accurate reporting of credit program costs allows for more efficient allocation of budget resources and improved measurement of these programs’ economic impact.
section_title: Credit Reform Requires Recognition of Estimated Costs When the Government Enters Into a Commitment
paragraphs: Credit reform was significant not only because it changed the budget reporting for credit programs from a cash basis to an accrual basis but also because it prescribed a more prospective form of accrual measurement than required by generally accepted accounting standards used in financial statements prepared prior to credit reform. Traditional accounting standards required the recognition of all losses and expenses incurred during a reporting period, including those that have occurred but have not yet been reported. In other words, a cost would be accrued when it was more likely than not that a borrower had defaulted on his or her loan. In contrast, credit reform requires recognition of the expected costs of new loans and guarantees (on a net present value basis) at the time the credit is extended. This “risk-assumed” approach recognizes the expected cost to the government before the government commits itself to future losses inherent in the credit issued.
For example, prior to credit reform, if the government decided to provide $3 million in direct loans, the cash budget would have shown an outlay in the first year of $3 million. Repayments by borrowers would be recorded when received in future years, and, when some borrowers defaulted, net payments received by the government would simply be lower. Under traditional accrual accounting no cost would be shown in the first year since repayment is expected, but in subsequent years when some borrowers defaulted, the unpaid principle would be recognized as a cost. Thus, in neither case was the government’s cost recognized correctly at the time the decision was made to authorize the loans. In contrast, using the risk-assumed basis of credit reform, an estimate of the government’s cost would be recorded when the government made the commitment to provide the loans.
Adopting a full credit reform approach to deposit insurance has one major advantage and one major disadvantage . . . . The advantage is that only the accrual recognition of costs will provide an early warning of financial disaster in the budget. The disadvantage is that estimating the cost of deposit insurance—when cost is incurred—is very difficult.
OMB also reported that accrual-based budget reporting for deposit insurance could be an improvement over the current approach and outlined specific financial and econometric models that could be used to estimate deposit insurance costs as they arise. OMB recommended that these cost measures be further developed, tested, and validated before deciding whether or how to bring accrual-based estimates into the budget.
section_title: The Bush Administration Proposed Extending Credit Reform Principles to Insurance Programs
paragraphs: In the President’s fiscal year 1993 budget, less than a year after OMB and CBO reported on the budget treatment of deposit insurance, the Bush administration proposed applying credit reform principles to budgeting for deposit insurance and pension guarantees. Under the proposal, other insurance programs would be moved to an accrual basis the following year. The administration emphasized earlier concerns that cash-based budgeting for insurance programs did not provide clear and timely measurement of their cost to the government. It maintained that budget reporting for these programs on an accrual basis would provide policymakers with the information and incentives necessary to control their costs.
The similarities between loan guarantees and federal insurance were noted in the administration’s proposal. In both cases the government commits to paying some or all of future costs under specified conditions in exchange for a fee or premium. As with the new treatment of credit programs, the proposal called for the recognition of the government’s cost of new or expanded insurance coverage at the time the insurance is extended. The cost of the risk assumed by the government would be estimated on a net present value basis and would include all expected costs and collections related to the coverage extended. OMB showed estimates of the new accrual-based measures in the budget for deposit insurance and pension guarantees. These measures were based on complex, newly developed estimation methodologies using options pricing models. Legislation to effect the new budget reporting was introduced in the Congress.
Despite continued concern about the cash basis of reporting for insurance programs, both GAO and CBO objected to the administration’s proposal at the time. GAO affirmed its long-standing support of reporting accrual-based costs in the budget but concluded that the proposal made at that time was flawed. GAO and CBO questioned the sufficiency of available data and estimation methodologies necessary to make reasonably accurate accrual cost estimates. Both agencies expressed concern about the rush to implement a major conceptual and technically challenging change in budget reporting without thorough study. CBO also reported that by changing the way shortfalls in program funding would be financed, the proposal could have increased taxpayer liability for these programs.
Another major concern surrounding the initiative was the budget treatment of savings stemming from deposit and pension insurance program reforms that were also proposed. On a cash basis, these savings would not have been recognized for several years in the budget, but, by recording their effects on an accrual basis, the administration was able to show savings in fiscal years 1992 and 1993 to offset revenue lost from proposed tax reductions. CBO concluded that the savings achieved by the administration’s program reforms should not be available to pay for other policy initiatives. As a result, most observers viewed the accrual-based budgeting proposal as an accounting gimmick rather than a way to improve budget reporting for insurance programs. The merits of accrual-based reporting for these programs were overshadowed by these concerns. No action was taken by the Congress on the legislation.
Since the Bush administration’s proposal for changing the budget treatment of insurance programs, OMB has continued work on developing methodologies to estimate the risk-assumed cost of deposit insurance and pension guarantees. At the request of the Chairman of the House Committee on the Budget and because of continued interest in this area, we undertook this study to more thoroughly develop the issues involved in changing the budget treatment of insurance programs.
section_title: Objectives, Scope, and Methodology
paragraphs: The Chairman of the House Committee on the Budget asked us to review the budget treatment of federal insurance programs to assess whether the current cash-based budget provides complete information and whether accrual concepts could be used to improve budgeting for these programs. Specifically, we were asked to (1) identify approaches for using accrual concepts in budgeting for insurance programs, (2) highlight trade-offs among different approaches, including the current budget treatment, and (3) discuss potential implementation issues, such as cost estimation.
We limited the scope of our study to programs previously identified by OMB and FASAB as federal insurance programs. Programs included in our study are shown in table 2.1. OMB’s list forms the basis of its annual analysis of credit and insurance programs, which, in recent years, has been part of the Analytical Perspectives volume of the President’s budget. We added one program to the OMB list—the Federal Employees’ Group Life Insurance program. This program was included by FASAB as federal insurance in its recommended accounting standards for federal liabilities. Of the veterans life insurance programs underwritten by the federal government, we include only those which are still open to new participants.
In undertaking this study, we acknowledge that there is not universal agreement on which programs constitute federal insurance. The programs we included in our analysis share some, but not necessarily all, the characteristics of private insurance. Conversely, some programs not on our list have some of the characteristics of programs on our list. The diversity of the programs undertaken by the federal government could result in disagreement about what constitutes a federal insurance program. Valid arguments may be made for additions to or deletions from the list of insurance programs to consider for an accrual-based budgeting approach. This is but one of many issues policymakers face in incorporating accrual concepts in the budget.
To accomplish our objectives, we focused our analysis on the sufficiency of information provided for resource allocation and fiscal policy with the recognition that budget reporting must be understandable and facilitate budget control and accountability. This premise is grounded in the work of the 1967 President’s Commission on Budget Concepts, which stressed that resource allocation and fiscal policy outweigh all other uses of the budget, such as the cash and debt management activities of the Treasury and analyses of the impact of federal activity on the financial markets. To assess the sufficiency of information in the budget for these purposes, we reviewed the programs’ current budget treatment, consulted with budget experts, and analyzed historical data on budgeted and actual insurance outlays.
To develop approaches for using accrual concepts in the budget and to identify trade-offs among approaches, we began by reviewing the Bush administration’s 1992 proposal to adopt accrual accounting for federal insurance programs. We surveyed existing research on the budget treatment of insurance programs conducted by OMB, CBO, and other budget analysts. We examined various reports and documents pertaining to the accrual-based approach for loan and loan guarantee programs prescribed by the Federal Credit Reform Act of 1990. We studied the accounting standards for insurance activities promulgated by the Financial Accounting Standards Board (FASB) for private sector entities and FASAB for the federal government.
To identify potential implementation issues, we convened panels of federal insurance agency officials and staff to gather information on the operation of the programs and the agencies’ risk assessment capabilities. We also obtained their views on the potential benefits and drawbacks to the use of accrual-based budgeting. When we could not convene a panel or when key agency personnel were unavailable, we obtained written responses to our questions. We also discussed potential implementation issues with budget experts familiar with the implementation of accrual-based budgeting for credit programs.
To identify issues related to developing risk-assumed cost estimates, we interviewed agency actuaries, economists, and other staff responsible for risk assessment. We also analyzed documentation supplied by the agencies and prior GAO reports on individual programs. In addition, we retained the services of an independent contractor to assist us in reviewing OMB’s options pricing models for deposit insurance and pension guarantees. As part of the contractor’s review, it assessed the validity of using options pricing concepts and techniques to estimate insurance liabilities, the technical sophistication and data requirements of OMB’s models, and the reliability of OMB’s model estimates for budget and policy decision-making.
We did not test or validate (1) any of the other estimation methodologies currently used by the agencies for risk assessment or rate-setting or (2) any of the methodologies that could potentially be used for these purposes.
We performed our work in Washington, D.C., from September 1995 through November 1996 in accordance with generally accepted government auditing standards. We requested written comments on a draft of this report from the Director of OMB or his designee. The Deputy Assistant Director, Budget Analysis and Systems, provided comments, which are discussed in chapter 8 and are reprinted in appendix V.
section_title: Overview of Federal Insurance Programs
paragraphs: Federal insurance programs are a diverse set of programs covering a wide range of risks that the private sector has traditionally been unable or unwilling to cover. From a federal budgeting perspective, these programs present significant challenges because the insured events tend to be catastrophic or volatile in nature and may not occur for years after the government’s commitment is extended. Although several financial measures are available for insurance programs, estimates of the risk assumed by the federal government—the key information for budget decision-making—have been limited. Despite some common elements, these programs vary significantly in several respects, including size, length of the government’s commitment, frequency of activation, and financing. These differences warrant consideration in determining the appropriate budget treatment for these programs.
subsections: section_title: Federal Insurance Programs Cover a Wide Variety of Risks
paragraphs: The federal government insures individuals and firms against a wide variety of risks ranging from natural disasters under the flood and crop insurance programs to bank and employer bankruptcies under the deposit and pension insurance programs. Other federal insurance programs provide life insurance for veterans and federal employees and political risk insurance for overseas investment activities. The federal government also provides protection against war-related risks and adverse reactions to vaccinations. Further, in recent years, proposals have called for extending federal insurance activities to cover natural catastrophes, such as earthquakes and volcanic eruptions.
Some federal insurance programs have a statutory intent to provide subsidized coverage while others do not. In some cases, the government subsidizes insurance programs in order to achieve a public policy objective. For example, catastrophic coverage under the crop insurance program is fully subsidized in an attempt to reduce reliance on ad hoc disaster assistance. The Service-Disabled Veterans Insurance Program provides life insurance coverage to veterans with service-connected disabilities based on rates for healthy individuals or free to totally disabled veterans. In other cases, as noted later in this chapter, the federal government may intend to provide unsubsidized insurance. However, regardless of statutory intent, whenever federal insurance is underpriced relative to its long-run cost, those who are insured receive a subsidy because premiums will not cover program costs. Table 2.1 provides an overview of the programs included in our study. More detailed program summaries are provided in the appendixes to this report.
section_title: Characteristics of Federal Insurance Programs Complicate Budget Treatment
paragraphs: The budget treatment of federal insurance programs is complicated by the characteristics of the risks covered. In general, these programs assume risks that the private sector has historically been unable or unwilling to undertake. Ideally, individual risks should be independent and of sufficient number to reasonably project losses and adequately pool risk to be insurable. In addition, the occurrence of losses should be accidental or unintentional in nature and capable of being measured. Many of the risks undertaken by the federal government lack these key conditions for ideal insurability. Without these insurable conditions, establishing an actuarially sound rate structure is difficult and the likelihood of adverse selectionand moral hazard increases. From a federal budget perspective, the lack of these insurable conditions presents significant challenges.
The risks insured by the government are often hard to predict and catastrophic in size. In general, the lack of an actuarial base, an ever-changing environment, and low participation rates make it difficult to assess risk assumed and set premiums commensurate with the risk insured. For example, officials at the Overseas Private Investment Corporation (OPIC) cited the lack of an actuarial base as a factor in the limited availability of private sector political risk insurance. Further, some risks assumed by the federal government are not independent in that losses may strike a large number of insureds at the same time. For example, weather-related events may reduce crop yields over large areas of the nation in the same year. Similarly, changes in macroeconomic conditions may have widespread effects on banks and pension plans covered under the deposit and pension insurance programs.
Achieving adequate participation to spread risks may also be problematic. For example, our previous work found that the majority of federal crop insurance policies are in the contiguous areas of the Midwest and the Plains States. Similarly, those living in concentrated areas with the greatest risk of flooding are most likely to buy flood insurance while those with lower risk are not. Finally, according to agency officials, the war-risk and political risk insurance programs provide only a limited number of policies covering diverse events with strong individual and case-specific identities.
The catastrophic nature of these risks and the impediments to broad-based participation reduce the ability of an insurer to pool risk—an important way insurers reduce the costs of bearing risk. When insured events affect a large number of the insured population at the same time, the likelihood that the insurer would have to make large claim payments in a relatively short period of time increases. When there are only a few insured, the insurer is unable to pool risk and thus may be subject to virtually the same uncertainties of random experience as the insured.
OMB has cited the government’s size and sovereign power as providing it with the unique ability to offer insurance when the private market is unable or unwilling to do so. Some analysts contend that the size of the government makes it better able to absorb large losses if insurance reserves are not sufficient. Over time, by providing ongoing insurance, the government may be able to recoup some of these losses with future premium collections, thus in effect pooling risks over time. In addition, the government can attempt to spread the cost of these risks by providing insurance nationwide and/or mandating participation. Further, some analysts cited the government’s unique status as advantageous in monitoring and mitigating these types of risks. For example, for a community to participate in the flood insurance program, it must enact and enforce minimum flood plain management standards. Similarly, federally insured banks and thrift institutions must adhere to numerous regulations and periodic examinations.
Whatever the merits of the federal government as an insurer, the same characteristics that inhibit private insurance firms from covering these risks also complicate budgeting for them at the federal level. In some cases, the volatile and/or catastrophic nature of the insured risks make pooling risk and estimating claims on an annual basis difficult, if not impossible. For some programs, such as life and pension insurance, claims may not be expected to occur for years or even decades after the government’s commitment is made. Thus, a key budget consideration is how and when the government’s costs for these programs should be recognized in the budget.
section_title: Key Information for Budget Decision-making— the Risk Assumed by the Government—Is Not Readily Available
paragraphs: As a general principle, decision-making is best informed if the government recognizes the costs of its commitments at the time it makes them. However, despite numerous financial measures, in most cases, the expected cost of the government’s insurance commitments is not readily available. Table 2.2 provides several financial measures for the programs in our study including face value, net outlays, liability for claims, and net position. As discussed in the following sections, each of these measures provides useful information but, in most cases, does not adequately capture and isolate the cost of the risk assumed by the federal government at the time the insurance is extended. However, to the extent practicable, the government’s ultimate cost is key information that ought to be considered in making budget decisions.
Face value represents the total amount of insurance outstanding. For example, the face value of deposit insurance is the total insured deposits held by financial institutions. As such, it provides a measure of the maximum exposure undertaken by the federal government. As shown in figure 2.1 and table 2.3, the face value of federal insurance (in constant dollars) grew substantially between 1975 and 1990. The majority of this increase is attributable to the two largest insurance programs, pension and deposit insurance. For fiscal year 1995, the estimated face value of major federal insurance programs was approximately $5 trillion—more than half of which was deposit insurance. Figure 2.1 shows the trend in the face value of major federal insurance programs.
While face value provides one measure of program size, it overstates the potential cost to the government. The probable cost to the government is most likely some percentage of the total face value. However, a single fixed percentage cannot be used as a proxy for exposure since the government’s risk varies based on a variety of factors, such as the nature of insured risk and the extent to which premium collections offset costs. Thus, a self-supporting insurance program with a relatively high face value may have a lower potential cost to the government than a subsidized insurance program with lower face value.
Other financial measures may also be of limited help in assessing the cost of the risk assumed by the government at the time the insurance commitment is extended. For example, the outlays recorded in the President’s budget provide a measure of an insurance program’s estimated and actual annual cash flows but, in most cases, does not capture the government’s cost of insurance commitments at the time they are extended. In addition, cash outlays may be subject to significant volatility due to the irregular and catastrophic nature of some insured risks, such as natural disasters. Chapter 3 discusses in detail the shortcomings of the current cash-based budget reporting for federal insurance programs.
Further, while the claims liability and net position reported in the financial statements for federal insurance programs provide useful measures of the programs’ financial condition based on insured events that have occurred, these measures do not, in most cases, capture the expected cost of claims inherent in the government’s commitment. In general, the financial statement liability is an estimate of the amount needed to settle unpaid and expected claims related to insured events that have occurred on or before the reporting date. Net position is the difference between an entity’s assets and liabilities. The Federal Accounting Standards Advisory Board (FASAB) recently developed standards calling for the supplemental disclosure of estimates of the risk assumed by the federal government for its insurance programs. This action, which is discussed in greater detail in chapter 4, will help improve information on these costs.
section_title: Snapshot of Current Budget Treatment
paragraphs: All the federal insurance programs reviewed record collections and payments in net outlays on a cash basis and thus influence the deficit in the year cash flows occur, regardless of when the commitments are made. With one exception, the premiums and fees paid by participants are held in revolving funds—trust or public enterprise—and, in most cases, administrative expenses are also paid out of these funds. To the extent that the budget authority in these funds exceeds current cash outlay needs and remains available for future claims, most insurance programs have some level of reserves. Six of the 13 programs have permanent borrowing authority to cover the cost of claims, and 4 have received general fund appropriations within the last 10 years to pay claims in excess of available resources.
Budgetary characteristics, such as the classification of a program’s spending under the Budget Enforcement Act of 1990 (BEA), will affect the extent to which an accrual-based approach would change the information and incentives provided to policymakers. An examination of the programs included in our study shows that the majority are classified as mandatoryspending under BEA. Claim payments for only 3 of the 13 programs—Aviation War-Risk Insurance, Maritime War-Risk Insurance, and OPIC’s political risk insurance—are classified as discretionary spending. Table 2.4 summarizes key budget information for the insurance programs reviewed.
The programs also differ in the extent to which costs are currently recognized in budget authority and obligated based on accrual concepts.For example, two programs—the Federal Crop Insurance Program and OPIC’s political risk insurance program—currently obligate budget reserves based on accrual concepts. According to OMB, the crop insurance program obligates funds based on an estimate of claims incurred or expected to be incurred for outstanding policies at the end of the fiscal year. OPIC currently obligates budget reserves for its insurance program based on an estimate of the losses inherent in insurance outstanding.
section_title: A Budget Perspective on Federal Insurance
paragraphs: Budget reporting influences decision-making because it determines how critical choices are framed and how the deficit is measured. The method of budget reporting reflects choices about the uses and functions of the federal budget. Ideally, budget reporting should fully inform resource allocation and fiscal policy choices. Unfortunately, the current budget’s focus on annual cash flows provides potentially incomplete and misleading information on the cost of federal insurance programs. As a result, the information and incentives for sound resource allocation decisions and information on the timing and magnitude of the economic impact of these programs may be distorted. However, the impact of these shortcomings on budget decision-making varies significantly across the federal insurance programs we reviewed.
subsections: section_title: Budget Reporting Reflects Choices About the Uses and Functions of the Budget
paragraphs: In practice, the federal budget serves multiple functions. The budget is used to plan and control resources, assess and guide fiscal policy, measure the government’s borrowing needs, and communicate the government’s policies and priorities. The budget is both an internal management tool of the government and a public policy statement. The many uses of the budget lead to multiple and often conflicting objectives for budget reporting. For example, the budget should be understandable to policymakers and the public yet comprehensive enough to fully inform resource allocation decisions. Since no one method of budgetary reporting can fully satisfy all uses, the choice ultimately reflects a prioritization of the budget’s various uses.
The method of budget reporting influences decision-making because the way budget transactions are recorded determines how critical choices are framed and how the deficit is measured. For example, suppose the federal government extends insurance for which it collects $1 million in premiums and expects total losses of $3 million to be incurred in future years. If the primary objective of the budget is to track annual cash flows, then it is appropriate to record the $1 million cash inflow and to offset the aggregate deficit accordingly, as is currently the case. However, if the objective is to provide information on the government’s cost when program decisions are made then it is appropriate to recognize a net cost of the present value of $2 million in the year the insurance is extended. Clearly, the two methods of reporting provide policymakers with very different information and so may affect budget choices differently. While both methods provide useful information and can be tracked simultaneously, only one can be the primary basis upon which budget decisions are made.
subsections: section_title: Budget Reporting Should Fully Inform Resource Allocation and Fiscal Policy Decisions
paragraphs: Of the various purposes for which the President’s budget is prepared, two closely related purposes outweigh the rest. . . . In short, the budget must serve simultaneously as an aid in decisions about the efficient allocation of resources among competing claims and economic stabilization and growth.
Our assessment of the budget treatment of federal insurance programs focuses on the adequacy of budget information for resource allocation and fiscal policy. However, to support these purposes, budget reporting must be understandable and provide for budget control and accountability. As a result, implementation issues, such as estimation uncertainties and reporting complexities, may offset or even negate the potential benefits of some changes that would seem to support resource allocation and fiscal policy decisions. That is, decisions on budget treatment must balance the ideal of better information with the realities of implementation.
Information on the cost of the government’s commitments is vital for sound resource allocation decisions. In an environment of limited resources, decisions are based on the relative budgetary cost of each potential use. To permit fully informed choices and provide for budget control, the cost for each alternative use of federal resources must be clear and directly related to the commitments undertaken by the government. Full cost information in the budget not only allows policymakers to make relative cost comparisons but can also warn of estimated increases in costs when they are still controllable. To do this, budget reporting ideally would provide reliable information on the cost of commitments made in a given year. However, in practice, there is often no clear bright line at which this commitment point is made for any particular program.
For federal insurance programs, key information relevant to policymakers is the balance between collections and costs over time flowing from a commitment. Amounts not covered by program collections represent the government’s subsidy cost for the program. Because of the wide variety of risks covered by different federal insurance programs, the application of the risk-assumed concept is likely to differ depending on the nature of the program. For example, the extent to which a model can capture the full long-term expected cost of the government’s deposit insurance commitments, including rare catastrophic events such as the savings and loan crisis, is open to debate.
Fiscal policy decisions require information on the timing and magnitude of the economic impact of the government’s actions. Economic impact is generally considered to be the impact on aggregate demand and the allocation of resources between private and public markets. In general, the budget deficit (or surplus) is considered to be an appropriate measure of the macroeconomic impact of aggregate federal fiscal policy on the economy and for most programs cash-based reporting adequately captures the fiscal impact of budget decisions. However, for insurance programs cash-based reporting may misstate the economic impact of the government subsidy by recording cost when cash flows occur rather than when the insurance commitment is made. Although discerning the economic impact of insurance programs can be difficult, private economic behavior generally is affected when the government commits to providing insurance coverage and thus lowers the risk to the insureds. Therefore, to fully inform decision-making, the budget recognition of an activity’s expected costs ideally should coincide with the timing and magnitude of its economic effects. Similarly, financial transactions that have no impact on the cost to the government—such as temporary working capital needs—should not be recognized in the budget.
section_title: Cash-Based Budgeting Generally Provides Incomplete Information on Federal Insurance Programs
paragraphs: In general, the information provided by cash-based budgeting for federal insurance programs may be incomplete or misleading for both resource allocation and fiscal policy decisions. In most cases, the cash-based budget does not adequately reflect on a timely basis either the government’s cost or the economic impact of these programs because costs are recognized when claims are paid rather than when the commitment is made and when economic behavior is generally changed. Thus, the budget may provide neither complete cost information for budget decision-making nor the incentives necessary to control costs or ensure that adequate resources are available for future claims at the time the decision to extend the insurance is made.
In general, cash-based budgeting for insurance programs presents several problems. In most instances, it focuses on single period cash flows that may distort the program’s cost to the government and thus may distort the information and incentives for resource allocation decisions, not accurately reflect the program’s economic impact, and cause deficit fluctuations unrelated to long-term fiscal balance.
However, the magnitude of this problem and the implications for budget decision-making vary significantly across the insurance programs. This is due primarily to differences in the size and length of the government’s commitment, the nature of the insured risk, and the extent to which costs are currently recognized in the budget at the time decisions are made.
subsections: section_title: Single Period Cash Flows Distort the Government’s Cost for Federal Insurance Programs
paragraphs: With limited exceptions, current budget reporting focuses on annual cash flows. Collections for insurance programs are recorded in the budget when received and costs are recorded in outlays and the deficit when claims are paid. Yet the focus on annual cash flows may not adequately reflect the government’s cost for federal insurance programs because the time between the extension of the insurance, the receipt of program collections, the occurrence of an insured event, and the payment of claims may extend over several budget periods. As a result, the government’s cost may be understated in years that a program’s current collections exceed current payments and overstated in years that current claim payments exceed current collections. These distortions occur even if the collections and payments for an insurance commitment balance over time.
The timing differences between an insurance activity’s collections and payments on a cash basis are complicated by combining, in a single account, transactions that represent a cost to the government and transactions that merely represent cash flows that net out over time. A key feature of credit reform was the separation of the government’s cost, called the subsidy cost, from unsubsidized program costs. Similarly, federal insurance programs that do not set premiums high enough to cover expected future claims represent a cost to the government. Claim payments to the extent covered by collections and temporary transactions, such as the acquisition and sale of assets obtained in settlements, are examples of cash flows that over time, do not impose a cost to the government. However, since the current budget treatment focuses on annual cash flows rather than a program’s long-term financial balance, the cost to the government—the key information that should be used in budget decision-making—may be obscured. The cost of current decisions is further obscured because single period cash flows often reflect a mix of old and new insurance business.
As shown in table 3.1, the timing differences between cash flows for insurance programs occur for several reasons that vary across the programs. The length of the government’s commitment (policy duration) or the time between the occurrence of an insured event and the payment of claims (the claim settlement period) may extend over several years. In addition, erratic cash flows may result from temporary (working capital) transactions or from the nature and timing of insured events. The different reasons for the time lags between collections and payments among the various insurance programs are important because they influence both the extent to which cash-based budgeting is a deficient measure of program costs and the effectiveness of alternative accrual cost measures in overcoming these deficiencies.
A mismatch between collections and payments may occur when the government’s commitment extends over multiple years or budget periods. As table 3.1 shows, several federal insurance programs—those offering multiyear fixed term, renewable term, or noncancelable coverage—commit the government for extended periods. For example, OPIC provides multiyear political risk coverage for up to 20 years. In addition, some budget and financial experts view PBGC’s pension guarantee as a long-term, renewable, or noncancelable commitment. In all these cases, the extension of the insurance and the collection of premiums may occur years, even decades, before the insured event occurs and claim payments come due. As a result, there can be years in which an insurance program’s current cash collections are estimated to exceed current cash payments, and the program appears to be profitable regardless of its expected long-term cost to the government.
Time lags between the occurrence of an insured event and the payment of claims may also result in a mismatch between collections and payments. While some insurance programs pay claims within one or two budget cycles, several do not. For example, during the savings and loan crisis, a number of factors, such as inadequate regulatory oversight and the insurance fund’s lack of cash, delayed action to close failed institutions and pay depositors. A different set of factors create a delay in the pension guarantee program. Benefit payments of terminated plans assumed by the PBGC may not be made for years, even decades, because plan participants generally are not eligible to receive pension benefits until they reach age 65. Once eligible, these benefits are paid over a period of years or even decades. Payment of claim awards under the Vaccine Injury Compensation Program (VICP) may not be made for several years after the injury occurs or not at all. The total time lag is the sum of (1) the time between the occurrence of the adverse event and the filing of a petition for payment, (2) the time taken to reach a judicial decision with respect to the petition, and (3) the time between the decision to grant an award and payment. As of May 1994, the average time between vaccination and payment for VICP cases arising from 1989 vaccinations was 1,053 days.
In some cases, temporary transactions that occur over time may impede the proper matching of insurance collections and payments on a cash basis. During the savings and loan crisis, large temporary cash flows (working capital) resulting from the acquisition and sale of assets from failed institutions distorted the government’s cost for deposit insurance in the cash-based budget. In years that assets were acquired, the full amount of cash required was recorded as an outlay; later, when the assets were sold, the proceeds were recorded as income. As a result, the cash-based budget overstated the cost of the deposit insurance in some years and understated it others.
The catastrophic or uneven occurrence of some insured events also increases the difficulty in achieving the proper matching of insurance collections and payments on an annual cash flow basis. The focus on annual cash flows generally is not compatible with budgeting for these types of events because it is difficult to estimate the occurrence of the insured events and pool risk on an annual basis. This is true even when it is possible to estimate the long-term expected cost of the program. For example, while it is possible to estimate with a fair degree of accuracy the probability that floods will occur over a considerable number of years, predicting the timing and magnitude of any particular flood by more than a few days is considered impossible. Thus, even if long-term flood losses are correctly estimated, losses in a considerable number of years may deviate significantly from the long-term average. This means that in some years cash flows shown in the budget may neither adequately reflect the program’s cost to the government nor recognize the need to establish reserves over time to cover costs in high-loss years.
section_title: Failure to Reflect the Government’s Cost Distorts the Budget Information and Incentives Necessary for Sound Resource Allocation Decisions
paragraphs: When insurance costs measured on an annual net cash flow basis do not capture the cost of the government’s insurance commitments, policymakers may be basing decisions on incomplete or misleading information. The failure to isolate and recognize the government’s cost—the key information that should be used for resource allocation—at the time decisions are made can have significant implications. Generally speaking, cash-based budgeting for federal insurance programs may provide neither the information nor incentives necessary to signal emerging problems, make adequate cost comparisons, control costs, or ensure the availability of resources to pay future claims.
subsections: section_title: Cash-Based Budgeting Neither Provides Complete Cost Information When Decisions Are Made Nor Signals Emerging Problems
paragraphs: In most cases, the cash-based budget does not prompt decisionmakers to consider an insurance program’s actuarial soundness. When costs are not recognized and fully funded in the budget, policymakers may not receive adequate information on a program’s relative budgetary cost or incentives to address emerging problems. As a result, the government’s subsidy costs may be obscured until claim payments come due.
For example, the National Flood Insurance Program (NFIP) provides subsidized coverage without triggering recognition of potential subsidy costs to the government. Under current policy, the Congress has authorized the Federal Insurance Administration (FIA) to subsidize a significant portion (approximately 38 percent) of the total policies in force without providing annual appropriations to cover these subsidies. Although FIA has been self-supporting since the mid-1980s—either paying claims from premiums or borrowing and repaying funds to the Treasury—the program has not been able to establish sufficient reserves to cover catastrophic losses and, therefore, cannot be considered actuarially sound. Similarly, the two veteran’s life insurance programs included in our study—Service-Disabled Veterans Insurance (SDVI) and Veterans Mortgage Life Insurance (VMLI)—also provide subsidized coverage without accruing the annual cost of the subsidy in the budget in the year the coverage is extended.
The implications of the failure of cash-based budgeting to recognize potential costs and signal policymakers of emerging problems was most apparent during the 1980s and early 1990s as the condition of the two largest federal insurance programs—deposit insurance and pension insurance—deteriorated while the budget continued to present a favorable scenario. For decades, the deposit insurance program appeared to provide an efficient and self-financing form of protection. During this period, the program had positive cash flows and reduced the federal budget deficit. Yet, in the 1980s and early 1990s, over 1,600 banks and nearly 1,300 thrifts failed, resulting in direct costs to taxpayers of $125 billion. Although GAO and others raised concerns about these rapidly growing costs, corrective actions were delayed. The cash-based budget was slow to recognize the government’s mounting cost of resolving insolvent institutions because cash outlays were not required until actions were taken to close them and protect depositors. These costs had already been incurred by the time they were disclosed in the budget. Furthermore, the cash-based budget may have also created an incentive to delay closing insolvent institutions (to avoid increasing the annual deficit), which increased the government’s ultimate cost of resolving the crisis. Since the crisis, the condition of the deposit insurance funds has improved dramatically. Once again, the deposit insurance programs appear healthy and are generating budgetary cash income—approximately $8.4 billion for fiscal year 1996—that offset the aggregate deficit.
In a similar pattern, the cash-based budget did not signal the deteriorating financial condition of PBGC. As shown in figure 3.1, the cash-based budget consistently has reported collections exceeding payments (negative outlays), while the program’s financial statements, which take into account the present value of insured benefits the government has incurred, reported an accumulated deficit. For example, in 1981 when the account containing PBGC’s cash flows was put on-budget, the cash-based budget showed cash income of $29 million while the financial statements showed an accumulated deficit of about $190 million. Over a decade later, in fiscal year 1992, the cash-based budget continued to provide an optimistic picture, showing cash income of $654 million, while the financial statements reported a larger accumulated deficit of about $2.4 billion.
The cash-based budget has continued to be a poor gauge of PBGC’s financial condition in recent years. In fiscal year 1996, PBGC reported a surplus for the first time in its history of $993 million. This surplus contrasts sharply with the $2.6 billion accumulated deficit reported in fiscal year 1993. The cash-based budget, however, did not reflect this turnaround. In fact, cash income reported in the budget during this period was, on average, lower than in the previous 4 years when PBGC’s financial condition was deteriorating. Further, despite the improvement in PBGC’s financial condition, OMB’s more prospective estimate of the program’s future cost, included in the Analytical Perspectives of the President’s Fiscal Year 1997 Budget, ranges from $30 to $60 billion. Most important, if the program’s condition were to worsen in the future, the cash-based budget may not provide timely warning of the program’s deteriorating condition.
The Federal Employees’ Group Life Insurance program also demonstrates the disparity in the signals provided to policymakers from cash basis versus accrual basis data. For example, in fiscal year 1993, when the program’s financial condition shifted on an accrual basis from having a surplus to a deficit, the cash-based budget failed to signal this change in the program’s financial condition. While the program’s accrual-based net position shifted from a surplus of about $1.6 billion to a deficit of $5.8 billion, the cash-based budget showed cash income of just over $1 billion. More recently, the fiscal year 1998 budget year estimates show cash income of $1.2 billion, while the program’s balance sheet provided in the budget appendix reveals an increase in the actuarial liability of approximately $1 billion and a deficit of about $3.1 billion.
In addition, the Aviation War-Risk Program appears financially sound on a cash basis while exposing the government to potentially large unfunded claims when insurance is in force. Despite a current fund balance of approximately $67 million, the program’s resources may not be sufficient to cover potential insurance claims. One major loss—such as a Boeing 747-400, which can cost over $100 million—could liquidate all the available funds and leave a substantial portion of the claim unfunded. If a loss exceeded the available funds, the Federal Aviation Administration (FAA) would have to seek supplemental funding to cover the claim.
section_title: Cash-Based Budgeting Generally Provides Neither the Information Nor the Incentives to Control Costs
paragraphs: Because the cash-based budget delays recognition of emerging problems, it may provide little or no incentive to address potential funding shortfalls before claim payments come due. Policymakers may not be alerted to the need to address programmatic design issues because, in most cases, the budget does not encourage them to consider the future costs of federal insurance commitments. Thus, reforms aimed at reducing costs may be delayed. In most cases, by the time costs are recorded in the budget, policymakers do not have time to ensure that adequate resources are accumulated or to take actions to control costs. Delayed recognition of these costs can reduce the number of viable options available to policymakers, ultimately increasing the cost to the government.
Further, in some cases, the cash-based budget not only fails to provide incentives to control costs, it may also create a disincentive for cost control. Deposit insurance is a key example. Many analysts believe that the cash-based budget treatment of deposit insurance exacerbated the saving and loan crisis by creating a disincentive to close failed institutions. Since costs were not recognized in the budget until cash payments were made, leaving insolvent institutions open avoided recording outlays in the budget and raising the annual deficit but ultimately increased the total cost to the government.
In the past, the cash-based budget treatment and budget scoring rules also have been cited as creating disincentives for implementing pension insurance reforms. For example, CBO reported that the Bush administration’s 1992 program reform proposals would have reduced PBGC’s funding shortfall and enhanced the financial stability of the program. However, these reforms—specifically the one raising the minimum contributions required of sponsors of insured pension plans—would have reduced income tax revenues (because contributions are tax deductible) and added to the federal deficit in the near term. Thus, under the pay-as-you-go (PAYGO) provisions of BEA, these reforms would have required reductions in other spending or increases in other revenues.
section_title: Failure to Recognize Cost and Signal Emerging Problems May Distort Resource Allocation and Constrain Fiscal Policy
paragraphs: To the extent that the cash-based budget fails to capture the cost implicit in the government’s commitment and signal emerging problems, the relative budgetary costs of an insurance program will be distorted. In some cases, this may simply result in the delayed recognition of intended choices, but, in other cases, it may lead to unintended resource allocation and fiscal policy. For example, by the time claims come due the government may be faced with little choice but to increase the deficit, raise taxes, or cut other spending in order to honor these commitments. The lack of cost recognition may delay programmatic changes aimed at reducing costs at a point when they are manageable. In summary, the failure to recognize these costs when decisions are made may not only distort current budget choices among competing uses, but may also reduce options for cost control and future budget flexibility when bills come due.
section_title: Cash-Based Budgeting May Not Reflect the Economic Impact of Federal Insurance Programs
paragraphs: In addition to not providing sufficient information and incentives for resource allocation, the cash-based budget also may not be a very accurate gauge of the economic impact of federal insurance programs. Although discerning the economic impact of federal insurance programs can be difficult, private economic behavior generally is affected when the government commits to providing insurance coverage. It is at this point that insured individuals or organizations alter their behavior as a result of insurance. However, as noted above, the current cash-based budget records costs not at that point but rather when payments are made to claimants. Federal payments for insurance claims may have little or no macroeconomic effect because these payments generally do not increase the wealth or incomes of the insured. They are merely intended to restore the insured to the approximate financial position he or she would have been in absent the occurrence of the insured event.
For example, most analysts agree that the cash-based budget provided misleading information on the timing and magnitude of the economic effects of deposit insurance. A 1992 CBO study of the economic effects of the savings and loan crisis concluded that the economic impact of deposit insurance is more directly related to the accrual of new federal obligations for deposit insurance than to cash payments made under the program.While federal costs, on an accrual basis, mounted steadily during the 1980s as hundreds of thrift institutions became insolvent, the budget did not record any costs until institutions were closed and depositors paid. Although unrecognized in the budget, these accruing liabilities had economic effects at the time similar to conventional expansionary policy in that aggregate demand was maintained at a higher level than it would have been if the depositors had sustained losses. Conversely, the budget outlays made to restore saving and loan depositors’ accounts had little effect on overall demand because the wealth or income of depositors was not increased. Further, many analysts have concluded that unlike most spending on other federal programs, the federal borrowing to fund the payments for deposit insurance did not significantly increase interest rates because it did not lead to any increase in the demand for goods or services. Instead, interest rates tended to increase as the government’s deposit insurance liabilities accrued.
section_title: Cash-Based Budgeting for Insurance May Produce Fluctuations in the Federal Deficit Unrelated to Long-Term Fiscal Balance
paragraphs: Uneven cash flow patterns of some federal insurance programs can result in fluctuations in the federal deficit unrelated to the budget’s long-term fiscal balance. As noted earlier, uneven cash flows may result from both the erratic nature of some insured risks or temporary (working capital) transactions. For example, natural disasters, such as severe floods and droughts, may create spikes in spending patterns that are not indicative of long-term fiscal balance. In addition, the working capital used to resolve failed institutions under the deposit insurance program resulted in large temporary cash flows that distorted the aggregate deficit as a measure of the government’s long-term fiscal imbalance.
Insurance programs with long-term commitments, such as PBGC and life insurance programs, also may distort the budget’s long-term fiscal balance by looking like revenue generators and reducing the aggregate deficit in years that collections exceed payments without recognizing the programs’ expected costs. On a cash basis, premium income can divert attention from such programs’ financial condition. For example, although the PBGC reforms that were enacted in 1994 as part of the General Agreement on Tariffs and Trade (GATT) legislation will likely improve the financial condition of the program, they were adopted at least in part because on a cash basis they raised revenues. The increase in revenue, primarily resulting from the phase-out of the cap on premiums charged underfunded plans, was necessary under PAYGO budget rules to offset revenue lost from changes in various tariffs affected by the trade agreement. This budget accounting, however, does not recognize that these premiums will be needed to pay PBGC’s costs in the future.
section_title: The Implications of Cash-Based Budgeting for Decision-making Vary Across Programs
paragraphs: While annual cash flows for federal insurance programs generally do not provide complete information for resource allocation and fiscal policy, the magnitude of the problem and the implications for budget decision-making vary across the insurance programs reviewed. Specifically, the size and length of the government’s commitment, the nature of the insured risk, and the extent to which these costs are currently captured in cash-based budget estimates influence the degree to which cash-based budgeting is incomplete or misleading for a particular federal insurance program.
The size of a program relative to total federal spending and the potential magnitude of unrecognized costs are key factors in judging the severity of the shortcomings of cash-based budgeting. For example, the implications of the shortcomings of the current budget treatment appear greatest for the largest insurance programs, pension and deposit insurance. The large size of these programs means that incomplete or misleading information about their cost could distort resource allocation and fiscal policy significantly, making the limitations of cash-based budgeting more pronounced than for other federal insurance programs.
The limitations of cash-based budgeting are most apparent when the government’s commitment extends over a long period of time—e.g., life or pension insurance— and/or the insured events are infrequent or catastrophic in nature, such as severe flooding or depository losses. As discussed earlier, the cash-based budget may not provide timely recognition of the government’s costs for these commitments because of the time lags between the extension of the insurance and the payment of claims as well as the difficulty in estimating and pooling risk on an annual basis. As a result, the cash-based budget may provide misleading or incomplete cost information for extended periods, thus not signaling policymakers of emerging problems when costs are controllable. In these cases, both the direction—positive or negative—and the magnitude of the government’s costs may be distorted on an annual cash flow basis.
Conversely, the deficiencies of cash-based budgeting may not be as problematic when the length of the government’s commitment is short and claims occur relatively frequently, such as the occurrence of normal losses under crop and flood insurance programs. In these cases, because the length of time between the government’s commitment and the occurrence and payment of claims is relatively short, the accumulation of unrecognized losses over an extended period of time is less likely.
In addition, the implications for budget decision-making may be less severe if relatively frequent claim payments prompt policymakers to consider the financial condition and funding needs of the program. For example, some insurance programs, such as flood and crop insurance, use the average or normal annual loss to make annual budget estimates. Even so, this approach does not isolate and may not completely capture the programs’ full costs, including the need to establish reserves for catastrophic losses. While these estimates provide policymakers some signals about potential costs at the time decisions are made, the programs’ relative costs may still be understated. For example, in the case of flood insurance, premiums based on the historical average loss year may not be sufficient to establish reserves to cover catastrophic losses because the loss experience period used does not include a catastrophic loss year. As a result, the program’s cost is understated and the government’s cost may not be recognized until the bills come due.
section_title: Accrual-Based Budgeting Has the Potential to Improve Budget Information and Incentives for Most Federal Insurance Programs
paragraphs: Several characteristics of federal insurance programs support the use of accrual-based budgeting. Two general approaches for measuring accrual-based costs of insurance programs are (1) the risk-assumed concept, which recognizes the cost of claims inherent in the government’s commitment at the time of commitment, and (2) traditional financial reporting standards for claims liabilities, which generally recognize the cost of claims inherent in events that have already occurred. The risk-assumed basis would be more useful for budgeting because it looks further ahead at the time the commitment is made rather than waiting for claims-producing events. Thus, the information and incentives for resource allocation and fiscal policy could be improved—assuming it is possible to make reasonable cost estimates. While moving to accrual-based budgeting based on the risk-assumed concept would offer several benefits, the magnitude of the change in information and incentives provided to policymakers varies across insurance programs and depends on the design of the accrual-based budgeting approach used.
subsections: section_title: Characteristics of Federal Insurance Programs Support Use of Accrual Concepts
paragraphs: As discussed in the previous chapters, several characteristics of federal insurance programs complicate their budget reporting. In some respects, the difficulties in budgeting for insurance programs are similar to those for loan guarantees. Both insurance and guarantees commit the government to pay future losses inherent in the coverage provided. Both represent contingent liabilities that generally are not adequately reflected on a cash basis because the government’s full cost is not recognized when the commitment is made. While credit reform dealt with this problem for loan guarantees and improved the budget recognition of their cost, the cost of most federal insurance programs is not fully recognized in the budget at the time the insurance commitment is extended.
The analogy to credit programs suggests that some form of accrual-based budgeting could improve the budget treatment of federal insurance programs. Specifically, two features of federal insurance programs support the use of accrual-based budgeting for these programs: (1) the promise to cover future losses that may occur beyond the current budget period and (2) the difficulty in estimating and pooling some risks on an annual basis. Accrual-based budgeting would allow for the recognition of future costs at the time commitments are made. However, insurance is dissimilar to loan guarantees in some ways that present additional challenges for cost estimation and budget control. These issues need to be dealt with carefully before accrual-based budgeting can be applied to federal insurance programs. For example, the benefits of accrual-based budgeting depend heavily on whether reasonable cost estimates are currently available or can be developed. In some cases, estimating the risk assumed by insurance programs may be a greater challenge than for some credit programs.
Accrual-based reporting recognizes transactions or events when they occur regardless of when cash flows take place. An important feature of accrual-based reporting is the matching of expenses and revenues whenever it is reasonable and practicable to do so. In the case of insurance, accrual concepts would recognize the cost for future claim payments and the establishment of reserves to pay those costs. Thus, the use of accrual concepts in the budget has the potential to overcome the time lag between the extension of an insurance commitment and the payment of claims that currently distorts the government’s cost for these programs on an annual cash flow basis. To the extent practicable, the government’s ultimate cost is the key information for budget decision-making.
The Federal Accounting Standards Advisory Board (FASAB) has done significant work to develop financial reporting standards to meet the needs of the various users of federal financial statements. The accounting principles developed by FASAB provide a sound foundation for federal financial statements that are useful and relevant to needs of the federal environment. FASAB’s work also provides a useful framework for understanding the use of accrual cost measures for budgeting for federal insurance programs. As such, efforts to apply accrual-based budgeting for federal insurance should build on and further adapt this work for budget purposes.
section_title: The Risk-Assumed Concept Is Most Appropriate for Budgeting for Federal Insurance Programs
paragraphs: The focus and purpose of federal budget reporting argues for the use of forward-looking cost measures for federal insurance programs if reasonably reliable ones can be developed. In order to support current and future resource allocation decisions and formulate fiscal policy, the federal budget needs to be a prospective document that enables and encourages users to weigh the future consequences of current decisions. To do this, the budget should provide the information and incentives necessary to assess the future implications of various choices. For federal insurance programs, the information needed for budgeting is roughly analogous to the insurance rate-setting process because the relevant question in assessing the government’s ultimate cost is whether premiums over the long term will be sufficient to cover losses and, if not, what subsidy the government is agreeing to provide. That is, when the federal government decides to undertake the role of the insurer, policymakers need information on the cost of the risk inherent in the government’s commitment.
The risk-assumed cost measure would provide the prospective information necessary for budget decisions about insurance programs. For insurance programs, risk assumed generally refers to the portion of the full risk premium based on the expected cost of losses inherent in the government’s commitment that is not charged to the insured. As a result, the government’s subsidy cost—the difference between the full-risk premium and actual premiums charged—may be more visible in the budget process. Thus, the use of risk-assumed estimates in the budget would provide the information necessary for assessing the cost of establishing reserves and the ability of an insurance program to pay future losses. This approach is similar to that used under credit reform to measure the cost of direct loans and loan guarantees. However, because of the wide variety of risks covered by federal insurance programs, the risk-assumed concept may be interpreted differently depending on the nature of the program. For example, the time horizon used to estimate the risk assumed by the government under deposit insurance may be shorter than that used to estimate the risk assumed in providing life insurance coverage to federal employees.
The risk-assumed concept expands upon the standards used for financial statement reporting. Except in the case of life insurance, the risk-assumed concept takes a longer look forward than standards used to recognize insurance liabilities in financial statements. Under standards developed by FASAB, the financial statements for all federal insurance programs must recognize a financial statement liability based on insured events that have been identified by the end of the accounting period. The standard requires recognition of the expected unpaid net claims inherent in insured events that have already occurred, including (1) reported claims, (2) claims incurred but not yet reported, and (3) any changes in contingent liabilities that meet the criteria for recognition. Life insurance programs are required to recognize a liability for future policy benefits in addition to the liability for unpaid claims. This means that except for life insurance, no liability for an insurance cost is recognized in the financial statements until it is probable that a cost has actually been incurred and the amount of the cost can be reasonably estimated. These liability reporting requirements closely parallel the liability reporting requirements for private sector insurance companies and are based on the principles that are essential to support the purposes of financial statement reporting.
In developing these standards, FASAB also recognized the importance of the risk-assumed measure for federal insurance programs. Because the risk-assumed measure provides important information beyond that included in the financial statement liability, FASAB recommended and the final standards require that this information be disclosed as supplemental information beginning with financial statements for fiscal year 1997.However, concerns about the measurability and the exact nature of some risks assumed by the government dissuaded FASAB from recommending the use of risk-assumed estimates as the basis for liability recognition in the financial statements. Disclosure of risk-assumed estimates provides users with a broader and prospective cost measure that FASAB believes is relevant in assessing whether future budget resources will be sufficient to sustain public services and meet obligations.
The accrual-based cost measures appropriate for the budget differ from those appropriate for financial statements largely because of differences in the primary purposes of the information, the nature of the federal budget environment, and differences in the acceptable level of uncertainty for financial statements and budget projections. In the past, CBO and OMBhave expressed concerns about the limitations of traditional financial reporting standards for assessing future budgetary costs of insurance programs. Generally speaking, traditional financial statement reporting is of limited use for budget purposes because, in most cases, it does not recognize the potential costs of claims that have not yet been incurred or the present value of future premiums that offsets future budgetary costs. Federal accounting standards requiring supplemental disclosure of an estimate of the risk assumed should improve the recognition of these potential costs in federal financial statements.
The benefits achieved by budgeting using financial statement liability recognition standards would vary across the insurance programs. The benefits achieved depend primarily on the length of time between the occurrence of insured events and payment of claims. For some programs, the traditional liability recognition standards may yield information not very different from what is currently reported on a cash basis in the budget. However, for programs with long time lags between the occurrence of the insured event and the payment of claims, such as pension and deposit insurance, budgeting based on financial statement liability standards might provide earlier budget recognition of the costs incurred than does cash-based budgeting. In these cases, the earlier recognition could reduce the incentive to delay the payment of claims and would allow for some earlier action to reduce future costs. In most cases, however, this approach would not be as forward-looking as the risk-assumed concept and, therefore, would not provide recognition of the risks inherent in the government’s commitment at the time that the insurance is extended. It is at that time that decisions can be made to change the extent of the risk being assumed by the government. Since the financial statement liability standards generally report costs that have been incurred as the result of past decisions, using that standard for estimating the government’s cost in the upcoming budget year may not provide signals of the government’s risk exposure early enough so as to maximize options available for limiting program costs. This is true because the range of options for changing the program to reduce the government’s costs may be more limited after the cost has been incurred than it would have been when the insurance was extended. Nevertheless, until risk-assumed estimates are fully developed, insurance programs’ financial statements, which are included in the budget appendix, provide policymakers with valuable information on insured events (losses) that are probable and measurable as of a given date and should be considered in budget discussions.
Table 4.1 compares the potential benefits of accrual-based budgeting using these two cost recognition standards. The potential benefits of accrual-based budgeting based on the risk-assumed concept included in table 4.1 are discussed in the following section.
section_title: Accrual-Based Budgeting Has the Potential to Improve Resource Allocation and Fiscal Policy Decisions
paragraphs: Accrual-based budgeting for federal insurance programs based on the risk-assumed concept has the potential to improve the information and incentives for resource allocation and fiscal policy by overcoming many of the deficiencies of cash-based budgeting. Specifically, the potential benefits of accrual-based budgeting for federal insurance programs include providing more accurate and timely recognition of the government’s cost of insurance commitments, improving the information and incentives for managing insurance costs, making cost information for insurance programs more readily comparable to other federal programs, providing a mechanism to establish reserves for high or catastrophic loss reflecting more accurately the economic impact of insurance programs.
However, the extent to which a shift to accrual-based budgeting will change the information and incentives varies across insurance programs.
This is due primarily to differences in the size and length of the government’s commitment, the nature of the insured risk, and the extent to which costs are currently recognized in budget authority and obligations at the time the budget decisions are made. In addition, the approach used to incorporate risk-assumed estimates into the budget will affect the degree to which each achieves these benefits. Three general approaches to using accrual-based estimates in the budget will be discussed in chapter 6.
subsections: section_title: Accrual-Based Budgeting Would Provide More Timely Recognition of the Government’s Cost for Insurance Commitments
paragraphs: Accrual-based budgeting for federal insurance programs has the potential to reduce the cost distortions that occur in the cash-based budget by improving the match between estimated revenues and claims of insurance commitments. By doing so, accrual-based budgeting would recognize any imbalance or net cost to the government—the key information that should be considered in budget decision-making—in the year the insurance is extended.
The prospective recognition of insurance costs is the key advantage of accrual-based budgeting for federal insurance programs. Unlike the current cash-based budget, accrual-based budgeting would recognize and report the government’s costs for insurance commitments at the time decisions are made and costs are controllable. As a result, the adoption of accrual-based budgeting for federal insurance programs would shift the focus of the budget from retrospective reporting to prospective cost estimation.
section_title: Accrual-Based Budgeting May Improve the Information and Incentives for Managing Insurance Costs
paragraphs: The prospective focus of accrual-based budgeting has the potential to improve both the opportunities and incentives for controlling insurance costs by providing more timely warning of emerging problems. Under accrual budgeting, the subsidy costs—the difference between expected losses and expected income—would be included in the budget and serve as a gauge of the government’s risk exposure. Thus, policymakers would be encouraged to examine the underlying benefits and structure of insurance programs before large losses accumulate. Since policymakers are prompted to take action to reduce costs when costs are still controllable, the potential for unintended subsidies may be reduced. For example, according to OMB, the subsidy conveyed by deposit insurance rises with increased exposure, such as an increase in the number of weak institutions, and falls as policies are put in place that effectively limit risk-taking with insured funds. Thus, if properly recognized in the budget, the growing subsidy cost for deposit insurance would have signaled policymakers in the 1980s that thrifts and banks were undertaking greater risks and depending more heavily on deposit insurance guarantees.
In cases where the Congress intends to provide a subsidy in order to achieve some public policy objective—as is the case for some veterans life insurance programs and the flood insurance program—accrual-based budgeting would prompt recognition of the subsidy cost at the time the coverage is extended. Thus, the cost recognition in the budget would be more clearly linked to the decision to provide subsidized coverage rather than merely reflecting the unfunded bills when they come due.
The earlier reporting of costs on an accrual basis not only changes the information available to policymakers but also changes budget incentives if actually incorporated into outlays and/or budget authority. Unlike cash-based budgeting that delays cost recognition and does not encourage early action to control cost, the earlier cost recognition provided by an accrual basis shifts the budget incentives in favor of reforms aimed at controlling costs. For example, under some accrual-based budgeting approaches, policymakers would be faced with a choice of providing additional government funding to cover shortfalls, raising premiums, or otherwise reducing program benefits to reduce future costs. However, the extent to which budget incentives are changed depends on the nature of the particular insurance program, the accrual-based budgeting approach used, and the extent to which budget recognition leads to choices between additional funding and programmatic changes. These issues are discussed in more detail in chapters 6 and 7.
section_title: Accrual-Based Budgeting May Improve Relative Cost Information
paragraphs: The use of accrual-based budgeting for federal insurance programs also has the potential to improve the information available to make relative cost comparisons. As discussed in chapter 3, the cash-based budget may misstate the government’s cost for insurance commitments. On a cash basis, some insurance programs may appear profitable while subjecting the government to long-term costs. As a result, cost comparisons with programs whose costs are fully reflected on a cash basis will be distorted. Accrual-based budgeting allows for better relative cost comparisons by recognizing the government’s expected costs for insurance commitments at the time decisions are made. For example, for fiscal year 1993, an accrual-based budget would have shown that PBGC had a potential future cost to the government rather than being an income generator as reflected in the cash-based budget. As a result, pension insurance would have competed for budget resources with other federal programs based on the government’s expected cost rather than appearing to be a source of income in budget terms.
section_title: Accrual-Based Budgeting for Insurance Programs Would Provide a Mechanism for Establishing Program Reserves
paragraphs: In addition to improving cost recognition and resource allocation, accrual-based budgeting for insurance programs would provide policymakers with a mechanism for establishing program reserves for expected insurance losses. One outcome of budgeting based upon the full risk assumed by the government would be that in some years premiums collected and subsidies provided by the government would exceed cash payments for insured losses. This would occur because losses for some programs are highly variable from year to year and for other programs may not occur for many years. As a result, when premiums and the government subsidy exceed claim payments, funds could be held in reserve for expected future claims.
The establishment of reserves may be particularly important given that many of the risks insured by the federal government are catastrophic in size and/or erratic in occurrence. The uneven occurrence of these risks makes estimating funding needs on an annual basis difficult because actual losses in any particular year may vary, in some cases significantly, from the estimated annual cost based on the long-term expected risk. For example, a widespread drought can result in claim payments in a single year to a large proportion of farmers insured under the crop insurance program. Charging premiums sufficient to cover a catastrophic loss in any one year would be prohibitively expensive. As a result, in order for the program to be financially sound, amounts sufficient to cover high or catastrophic losses need to be accumulated over a number of years. Other federal insurance programs, such as life and pension insurance, commit the government to making payments many years in the future. As a result, premiums collected over the duration of the policy must be held in reserve to pay the promised benefits at some future date. If, over time, sufficient reserves are accumulated to pay expected costs, the program would be fully funded. However, a program could require additional funds—or borrowing authority—if significant losses occur before sufficient reserves are accumulated even if annual funding is based on the long-term expected cost.
While accrual-based budgeting for insurance programs would recognize any government subsidy at the time insurance is extended and hold such amounts in reserve, the government’s financing needs would not change. As is the current practice with insurance and many other funds, when a program’s collections exceed its cash needs for payments, reserves are held in Treasury securities (i.e., lent to the government), which, from a governmentwide perspective, satisfies some of the government’s borrowing needs. Under accrual-based budgeting, federal borrowing (or a reduction in other spending) would still be necessary when the insurance fund redeemed its Treasury securities to make cash payments if insurance claims exceeded premiums collected from the public in a given year. However, under accrual-based budgeting, the government’s cost for the program would have already been recognized in the budget when the commitment was extended.
section_title: Accrual-Based Budgeting May Improve the Information on the Fiscal Impact of Insurance Programs
paragraphs: In addition to improving the information and incentives for resource allocation, accrual-based budgeting would better reflect the fiscal impact of federal insurance programs. Although accrual-based reporting would lessen the extent to which the budget reflects the government’s borrowing needs, it would generally reflect the effects of an insurance program on the economy closer to the time when they occur by incorporating a prospective estimate of the program’s accruing cost. Discerning the economic impact of insurance programs can be difficult, but private economic behavior generally is affected when the government commits to providing insurance coverage and thus lowers the risk to the insureds. Therefore, accrual-based budgeting, which, by recognizing the government’s costs at the time the insurance is extended, would better reflect the timing and magnitude of the economic impact of these programs than the current cash-based reporting of outlays in the budget. Further, approaches to accrual-based budgeting that recognize accrued cost in net outlays would remove the uneven cash flow patterns of insurance programs from the budget deficit. By removing temporary working capital needs of deposit insurance programs and large sporadic payments for disaster insurance claims, accrued cost measures would provide a truer measure of the government’s underlying fiscal condition.
section_title: Benefits of Accrual-Based Budgeting for Individual Federal Insurance Programs Will Depend on Several Factors
paragraphs: Although the use of accrual-based budgeting for federal insurance programs has the potential to overcome a number of the shortcomings of cash-based budgeting for these programs, a number of factors influence the extent to which the information and incentives for a particular insurance program would be changed. These factors include individual program characteristics, a program’s BEA spending classification, the extent to which costs are already recognized in cash-based estimates, and the approach used to incorporate accrual measures in the budget. Further, the effective implementation of an accrual-based budgeting approach depends on the ability to generate reliable risk-assumed estimates.
The characteristics of individual insurance programs will influence the potential benefits achieved under accrual-based budgeting. As noted in chapter 3, the larger the government’s commitment relative to total federal spending, the greater the potential for budget and fiscal policy distortions and the greater the need to capture the government’s cost at the time the commitment is made. Thus, the larger size of the deposit and pension insurance programs make the benefits of accrual-based budgeting more pronounced than for other smaller programs.
In general, the effects of shifting to an accrual-based approach would be beneficial for long-duration insurance programs with large subsidies. In these cases, the shift to accrual-based budgeting may affect the magnitude of the reported program cost in the budget, or whether the program is reported as having a cost rather than cash income. However, it does not appear that the benefits of accrual-based budgeting would be as great for programs that offer short-duration insurance coverage and experience relatively frequent claims, such as crop or flood insurance. For these programs, the benefits of accrual-based budgeting primarily would be in recognizing the cost of less frequent catastrophic losses and eliminating the effect of programs’ uneven cash flows on the budget deficit.
As discussed later in the report, whether the program is classified as mandatory or discretionary under BEA will also influence the degree to which increased cost recognition is likely to influence budget incentives.For mandatory programs, accrual-based budgeting’s effect on decisions would be most apparent when legislated program changes—such as an increase in benefits—are considered. For discretionary programs, accrual-based budgeting may have a more significant influence on budget incentives, as their full cost becomes apparent and must be provided for each year.
The extent to which costs are currently recognized in budget authority and obligations also influences the degree to which budget information will change due to a shift to accrual-based budgeting. For example, according to OMB, the crop insurance program currently estimates annual funding needs based on the normal loss year at the time decisions are made. In addition, OPIC currently receives budget authority for and obligates loss provisions in the year the provisions are recognized. In both cases, program officials and analysts believe that the current budget treatment adequately reflects the program’s expected costs at the time budget decisions are made.
If accrual-based budgeting were to be undertaken, the approach used to incorporate accruals into the budget will also have an impact on the extent to which budget information and incentives are changed by a shift from cash-based budgeting to accrual-based budgeting. As will be discussed in chapter 6, different approaches to accrual-based budgeting incorporate these costs into the primary budget data—budget authority, net outlays, and the deficit—to varying degrees. Finally, the feasibility of accrual-based budgeting will depend on whether reasonable unbiased estimates of the risk assumed by the government for the various programs are available or can be developed. Estimation challenges and other implementation issues that will have to be addressed in order to achieve the potential benefits of accrual-based budgeting will be discussed in the chapters that follow.
section_title: Estimation Limitations at Center of Accrual Budgeting Debate
paragraphs: A crucial component in the effective implementation of accrual-based budgeting for federal insurance programs is the ability to generate reasonable, unbiased estimates of the risk assumed by the federal government. Although in most cases the risk-assumed concept is relatively straightforward, generating estimates of these costs is considerably more complex. The development and acceptance of methodologies to estimate the risk assumed by the government varies significantly across the federal insurance programs we reviewed. The following sections discuss some limitations of existing risk assessment approaches that might be used to generate risk-assumed cost estimates under an accrual-based budgeting approach.
subsections: section_title: Calculation of Risk Assumed by the Government Is Complex
paragraphs: The risk assumed by the government is most easily thought of as the difference between the actual premiums paid by the insured and the premiums necessary to fully cover losses inherent in the coverage provided. This difference between the full risk premium and the actual premium charged—the “missing premium”— represents the government’s subsidy cost for the insurance program. In general, decision-making is best informed if this subsidy cost is known at the time a commitment is made. This would suggest that to the extent practicable, the budget ought to reflect this subsidy cost. Under an accrual-based budgeting approach, it would be recognized at the time the government extends insurance coverage. The ability to assess the risk covered by the various insurance programs is central to being able to determine the subsidy cost to the government. This task is made difficult by the nature of the risks insured by the government and the methodological and data limitations discussed below.
For insurance, the accuracy of estimated future claims is determined by the extent to which the probability of all potential outcomes can be determined. Unfortunately, these probabilities are not known with certainty for most activities more complex than the toss of a fair coin. However, for activities in which data on actual outcomes exist, the underlying probabilities can be estimated based on the law of large numbers. When these conditions are understood and the probabilities of future events can be inferred, estimates are said to be made under the condition of risk. In other words, since the possibility of each outcome can be estimated, the risk undertaken by the insurer can be measured. However, when underlying conditions are not fully understood estimates are made under uncertainty. For most federal insurance programs, this latter case holds due to the nature of the risks insured, program modifications, and other changes in conditions that affect potential losses. Thus, estimating the government’s subsidy cost, including the time period considered, may vary by program out of necessity.
Complete data on the occurrence of insured events over a sufficiently long period and under similar conditions are generally not available for many federal insurance programs. Frequent program modifications as well as fundamental changes in the activities insured reduce the predictive value of historical data and further complicate risk estimation. For example, the crop insurance program has been modified a number of times by the Congress in the last 15 years affecting key conditions, such as participation rates. Similarly, advances in technology and new competitive pressures have significantly transformed the banking and thrift industries.
These factors, which limit the ability to predict losses and the potential for catastrophic losses, have been cited as preventing the development of commercial insurance markets for the risks covered by federal insurance programs. As a result, private sector comparisons are generally unavailable to aid in the risk estimation process for these programs. For example, although several private sector companies offer aviation war-risk insurance, the coverage is generally limited to random acts of terrorism and often excludes areas of military conflict. Federal war-risk insurance is only made available when commercial insurance cannot be obtained or is available only on unreasonable terms and conditions and it is in the national interest to provide air service to a particularly risky area. The risk inherent in these two situations is not comparable.
Some have suggested the use of simple historical loss averages as an alternative to the complex estimation methodologies. However, the same conditions discussed above that make risk estimation difficult may reduce the usefulness of this alternative. Losses incurred under most of the federal insurance programs over a 10- or 20-year period may not adequately capture the risk inherent in the insurance because such relatively short experience periods do not encompass the full range of possible outcomes, including infrequent catastrophic events. Historical averages also may not be reflective of future losses if there have been program changes or changes in underlying conditions that may affect outcomes.
section_title: Ability to Estimate the Risk Assumed by the Government Varies Across Programs
paragraphs: The extent to which risk assessment methodologies are currently developed and accepted varies significantly across federal insurance programs. Some federal insurance programs, such as the life insurance programs, cover risks that are commonly insured by the private sector and are based on widely accepted actuarial science. However, as discussed in earlier chapters, most federal insurance programs cover catastrophic or case-specific risks that the private sector has been unwilling or unable to cover. Risk assessment for these programs is considerably more challenging. For some insurance programs, such as deposit insurance, several quantitative risk assessment techniques have been developed but there is no strong consensus supporting any particular technique. For other federal insurance programs, such as the war-risk insurance programs and OPIC’s political risk insurance, risk assessment currently relies heavily on expert judgment rather than highly quantitative or standardized risk assessment methods.
Given these estimation challenges and the shortcomings of cash-based budgeting, consideration of the adequacy of risk-assumed estimates for budget purposes is likely to be most beneficial when the focus of the discussion is on whether these estimates would provide policymakers with more timely information and signals about the underlying insurance programs. For these purposes, what is important is that the estimates are based on the best information available at the time the insurance commitment is extended. In this sense, it may be most important that the budget information and incentives provided to policymakers be “more approximately right rather than precisely wrong.”
The remainder of this chapter discusses risk assessment for the various types of federal insurance programs we reviewed: disaster insurance (flood and crop insurance); deposit insurance; pension insurance; and other insurance (war-risk, political risk, and vaccine injury insurance).
The sections that follow are ordered approximately according to the current level of the development and acceptance of methodologies that could be used to estimate the risk assumed by the government. The first programs discussed—life insurance—have a methodology that is well established in actuarial science. Next, we discuss disaster insurance programs for which methodologies have been developed and used to set risk-related premiums. These methodologies may provide a useful foundation for estimating the risk-assumed costs for these programs. For the large programs—deposit and pension insurance—competing methodologies exist or are under development that potentially could be used to estimate risk-assumed costs; however, little consensus exists on any one model. The remaining programs—overseas private investment, vaccine injury, and war-risk insurance—present significant estimation challenges and rely heavily on expert judgment.
section_title: Risk Assessment for Life Insurance Has Its Foundation in Actuarial Science
paragraphs: The methodology for measuring the risk assumed by the government under life insurance programs for government employees and service-disabled veterans is well established in actuarial science. The certainty of death and the compilation of extensive data on mortality have made it possible to estimate future life insurance claims with a high level of accuracy. The Department of Veterans Affairs (VA) and the Office of Personnel Management (OPM) currently use actuarial approaches that are the standard practice of the life insurance industry. Although modifications are made to reflect the unique characteristics of the insured groups, the basic assumptions used are comparable to those used by commercial life insurance companies.
By applying the laws of probability to mortality statistics, actuarial science provides a methodology to estimate future rates of death. A basic principle of actuarial science states that by studying the rate of death within any large group of people and gathering information on all factors that may affect that rate, it is valid to anticipate that any future group of persons with approximately the same factors will experience the same rate of death. Mortality tables are constructed to reflect probabilities of death at each age. The accuracy with which the estimated future claims approximate actual experience depends upon two key factors: (1) the accuracy and appropriateness of the underlying mortality statistics and (2) the number of observations the estimate is based on and the number of individuals insured.
Most mortality tables in use today are based upon the experience of commercially insured individuals. Because the mortality experience of federal employees appears to be different from the experience used to construct these tables, OPM constructs its own mortality tables based on program experience to more accurately capture the insurance risk. VA also conducts periodic studies of mortality and disability to ensure that its assumptions are sufficiently conservative. The information on mortality, together with data on policy benefits and interest rate assumptions, makes it possible to calculate the present value of future insurance claims. The extent to which this amount differs from premium and investment income would constitute the risk assumed by the government or the government subsidy. However, as is the case with most long-term forecasts, estimates of a life insurance program’s income are sensitive to interest rates. For example, interest earnings on funds collected from policyholders are a significant source of revenue in the Federal Employees’ Group Life Insurance program. OPM officials cited the difficulty in forecasting fluctuations in interest rates over the long term as a weak point in the estimation process.
section_title: Disaster Insurance Programs Have Established Rate-Setting Methodologies
paragraphs: The two disaster insurance programs we reviewed—the National Flood Insurance program and the Federal Crop Insurance program—currently have established methodologies for setting risk-related premium rates. These methodologies and the corresponding agency risk assessment experience should provide a useful foundation for estimating the cost of the risk assumed by these programs if an accrual-based budgeting approach is adopted. However, some modifications and refinements to the methodologies and other implementation challenges should be expected. Further, as is the case with all modeling efforts, professional judgment and underlying assumptions are necessary components of these methodologies.
subsections: section_title: Flood Insurance Losses Are Erratic but Measurable Over the Long Term With a Fair Degree of Accuracy
paragraphs: The Federal Insurance Administration (FIA) has an established rate-setting model, which, according to FIA, could be used to assess the risk assumed for policies issued by the National Flood Insurance Program (NFIP). FIA officials told us that this model is based on generally accepted actuarial principles and has been used by the agency for years to set premium rates for unsubsidized insurance policies. They told us that the model and its output, however, do not undergo regular external reviews. In addition to the rate-setting methodology, the FIA has worked on developing catastrophic loss estimates that may prove useful in assessing the appropriateness of reserve levels under an accrual-based budgeting approach. As an alternative to the detailed rate-setting model, some budget experts suggested that historical averages—which do not include catastrophic losses unless they have occurred during the chosen experience period—may provide a sufficient basis for measuring the program’s accrual-based costs.
Flood hazards have several characteristics that are important in considering risk assessment and budgeting for the NFIP. Although the timing and magnitude of floods is considered unpredictable by more than a few days or hours, the probability that they will occur is measurable with a fair degree of accuracy. Flood losses are very predictable in that they occur in well-defined areas and are inevitable in these areas over the long run. However, as noted in chapter 3, the erratic nature of floods can have serious implications for risk assessment and budgeting. A Department of Housing and Urban Development (HUD) study points out that while most property and casualty insurance is based on realized losses over a period of time, this approach is not applicable to flood insurance because of the highly skewed nature of flooding losses. Rather than following the normal bell-shaped statistical curve, there are many small to moderate floods, some larger floods, and a few extremely large ones. As a result, an average of even a considerable number of years may differ significantly from the true long-term average.
The NFIP illustrates this point. The NFIP is not actuarially sound even though it has achieved a goal of collecting premium income sufficient to at least cover expenses and expected losses for an average historical loss year. This is because the historical experience period, beginning in 1978, does not include any loss years that can be considered to be of a catastrophic level for the program. As a result, the average historical loss year involves fewer claim losses than the expected per annum claim losses in future years. Thus, the premium income currently collected by the program may not be sufficient to build reserves for potential catastrophic losses.
Despite this limitation, some budget experts indicated that they thought it acceptable to use historical averages as the basis for measuring the program’s accrual cost in the budget while providing some additional funding mechanism, such as the program’s borrowing authority, to cover catastrophic losses. Funding this amount would allow for the accumulation of reserves during years where losses are less than the historical average. According to the FIA, this level of funding in conjunction with the program’s borrowing authority of $1 billion should be sufficient to cover costs approximately 85 percent to 90 percent of the time. Further, the average historical loss year is not a static measure and could be expected to move toward the long-term average as the experience period increases over time. Nevertheless, if the objective of adopting accrual-based budgeting is to recognize the currently unrecognized government subsidy and/or to accumulate reserves to cover future losses, including catastrophic losses, then the program’s long-term expected cost is the most appropriate measure to use as the basis for measuring the government’s cost in the budget.
FIA officials told us that they were reasonably confident that the actuarial rate-setting method currently used to establish premium rates for unsubsidized polices could be used to generate reasonable estimates of the expected long-term risk for all policies. The difference between the program’s expected long-term risk and the actual premium rates would then provide an estimate of the risk assumed by the government. The FIA estimated this difference or “missing premium” at approximately $520 million per year.
FIA’s method for establishing rates for unsubsidized policies follows a hydrological method based on studies performed by the U.S. Army Corps of Engineers and private engineering companies. These rates are based on available hydrological data, flood insurance claims and simulations, as well as engineering and actuarial judgment. According to FIA officials, the key components of the method are (1) probability estimates of the frequency with which floods of different severity will occur and (2) estimates of associated structural property damage incurred due to different types of floods. Program expense items, such as administrative costs, are also accounted for in the actuarial rates. These rates are based on actual risk exposures and generally vary according to risk-related features, such as the flood zone, the elevation of the structure, and the amount of insurance purchased.
As is often the case in modeling, professional judgments and assumptions are necessary to overcome data limitations. For example, the flood histories used to develop the original estimates of the probability of floods of different severity were generally not very long. Consequently, modifications had to be made to prevent statistical bias. In our discussions, FIA officials described the measurement of flood frequency as “good as the state of the art” but noted that not every area has been studied in depth due to resource constraints. Agency officials said that in these cases, the frequency estimates are based on various histories and statistical analysis which ad hoc studies have shown to yield reliable results. In addition, the original estimates of the structural damage caused by floods of various depths were based on engineering studies and available flood claims. According to agency officials, these estimates are regularly updated with claims data, and credibility analysis is used to check validity. Appendix IV provides a more detailed description of the model and its key data elements.
According to FIA, additional assumptions and judgments would be necessary if the model were to be used for the entire program because there is currently a lack of information on pre-flood insurance rate map (FIRM) properties. FIA said that a current study on the impact of charging actuarial rates for pre-FIRM properties will be gathering additional information on these properties. Agency officials also noted that a trade-off exists between the benefits of more precise estimates and the cost of making these improvements. While factors such as the frequency of remapping and rezoning may affect the quality of the model’s estimates, the costs of these studies should also be considered. For example, agency officials stated that even if sampling were done to get more precise estimates of the evaluations for pre-FIRM properties, the cost of this type of refinement could outweigh the potential benefits of improved estimates.
FIA has also done some work on developing catastrophic loss estimates that may be useful in assessing the program’s appropriate reserve levels under an accrual-based budgeting approach. According to FIA, the method used to estimate catastrophic funding levels uses additional statistical analysis and simulations in conjunction with the hydrologic method and is more complex than the actuarial rate-setting method alone. An FIA official estimated that catastrophic reserve levels of $4.5 billion to $5 billion should be sufficient 99.9 percent of the time. In recent years, FIA has been unable to establish reserves and has had to borrow funds from and repay funds to the Treasury to cover excess losses. These estimates of catastrophic reserve requirements were described as orders of magnitude, suitable for program planning purposes, rather than precise estimates. The FIA official explained that the closer the actual reserve funding level gets to the estimated amount, the more important data limitations and underlying assumptions become.
In summary, FIA has an established method for setting risk-related premiums for its unsubsidized policies. According to FIA, this methodology could be extended to generate risk-assumed estimates for the entire program. In addition, FIA’s work on catastrophic reserve requirements may prove useful in assessing the appropriateness of reserve levels under an accrual-based budgeting approach. However, while this work should provide a useful foundation for developing risk-assumed estimates, FIA indicated that some modifications and refinements would be desirable before these estimates are used for accrual-based budgeting purposes and fully funding a reserve level target. One FIA official noted that this may involve considerable effort.
section_title: Crop Insurance Program Has an Established Rate-Setting Methodology
paragraphs: The Federal Crop Insurance Corporation (FCIC) has an established premium rate-setting methodology and considerable experience assessing crop risk. According to FCIC, the basic rate-setting methodology used by the agency—the loss cost ratio method—is commonly used in the insurance industry. Within agriculture, it is used by the rating bureaus that support the crop-hail insurance industry. Although this methodology could be used as the basis for measuring the program’s cost in an accrual-based budget, several implementation issues stemming largely from the diversity of crop risks and timing differences between the budget cycle, the rate-setting process, and the exposure period would have to be overcome. In addition, some limitations in the methodology’s underlying data and assumptions have been identified. According to the FCIC, internal reviews of the model and its key assumptions are ongoing and an external review of the model by an actuarial firm is underway. This external review should provide additional insights to help evaluate the model’s ability to generate risk-assumed estimates for accrual-based budgeting and identify areas for continued improvement. The last comprehensive review of the methodology was completed in 1983 by the same firm.
The nature of crop losses makes risk assessment challenging. In prior reports, we have identified inherent problems in the ability to pool and assess the risk of crop losses. Crop losses are not normally independent—some perils are likely to strike a large number of insured farmers in the same crop year. Further, it is difficult to align premium rates directly with risk because the risk associated with growing a particular crop varies by county, farm, and farmer. For example, the risk associated with a particular farmer is influenced by a variety of factors, including farm management practices, soil type, and the productivity of individual tracts of land. Monitoring these individual risks may be neither feasible nor cost-effective. In addition, crop risks are volatile. The performance of any specific crop or any area of the country is subject to wide variations depending on the state of nature. In general, the performance of any particular crop in a county is characterized by relatively infrequent catastrophes of moderate to extreme severity and a number of annual spot losses resulting from noncatastrophic events, such as hail.
As a result, the program’s rate-setting methodology is complex. To align crop insurance premium rates with the associated risk, FCIC establishes rates that vary by crop, location (county), farm, and farmer. Because of all the combinations involved, literally hundreds of thousands of premium rates are in place. These rates are adjusted annually using a multistep process involving considerable computer analysis and professional judgment. FCIC begins the process each year by looking at crop insurance experience over the past 20 years (if available) for each county and state. On the basis of county and state historical experience, FCIC sets basic rates for each crop in each county at the 65-percent coverage level for average production. These basic rates are adjusted for specific risk classifications including each farming type (such as whether the insured acreage is irrigated or dry land) and for each crop type (such as winter wheat or spring wheat). Using these basic rates, FCIC makes several adjustments to establish rates for other coverage levels and for farmers whose production levels differ from the county’s average. FCIC’s rate-setting methodology is described in more detail in appendix IV.
FCIC agreed that this methodology could be used to estimate the program’s expected risk but noted that data for detailed rate-setting are not available at the time the budget year submission is prepared. Because the risk of crop damage is closely aligned with specific characteristics of the crop, county, and individual farming practices, detailed information on the composition of coverage extended is necessary to provide projections of the full risk assumed for policies issued in any given year. However, detailed information on the composition and volume of policies and updated premium rates are not available at the time the budget year submissions are made. FCIC said that reasonable projections of insurance coverage can be made on a national scale at a higher level of aggregation, such as by crop type, but considerable uncertainty surrounds more detailed projections of specific policy coverage, such as crop-county combinations. Since estimates based on the actual composition of policies provide a more appropriate measure of the risk assumed, adjustments based on more detailed information may have to be made when the information becomes available.
According to FCIC’s senior actuary, FCIC currently bases its budget estimate on current year sales data adjusted for several factors, such as projections of commodity prices, planted acres, and anticipated changes in premium rates. He agreed that this more aggregated approach would provide a sufficient basis for an accrual-based budget year estimate, even though the data for detailed rate-setting, including crop/county level data, are not available when the budget submission is prepared. He said that the more detailed rate-setting methodology could subsequently be used to re-estimate the government’s risk for actual policies issued during the year by “repricing” these polices using the full risk premium rates when sufficient information becomes available. The difference between the full risk premium for policies issued and actual premium collections would constitute the government’s subsidy costs for policies issued in a given year. He agreed that the full risk premiums, which take into account specific risk and generally include amounts for catastrophic losses, are probably the appropriate basis for establishing reserves under an accrual-based budgeting approach. Even with this, there are decisions to be made about the confidence placed in these estimates, which—like other risk assessment models—depends on the acceptance of the methodology’s underlying assumptions and data limitations.
A key assumption of the FCIC’s rate-setting methodology is that the 20-year base period is sufficient to assess the program’s future costs. The FCIC’s senior actuary acknowledged that the appropriate period to use is debatable and that any finite number of years is inadequate to observe all possible states of nature or to assess the probability of each state of nature. He explained that the 20-year rolling average has been used primarily due to concerns about the availability, quality, and applicability of data from the early years of the program.
Our previous work found that premium rates depend heavily on the number of years included in the experience period and the weight assigned to each year. For example, in 1983 USDA’s consultant suggested changing from the current methodology of giving equal weight to each of the 20 years’ experience to giving greater weight to more recent years’ experience. We found that the consultant’s approach had a significant impact on the premium rates for three crops of the six major crops we reviewed. The USDA consultant is evaluating whether the trend in losses in recent years requires a change in the methodology.
Another key assumption is that the sample of previous buyers of crop insurance is adequately representative of future buyers. Recent changes in the program have resulted in changes in the characteristics of the buyer population. As such, there is considerable uncertainty surrounding the future composition of the insurance portfolio. The model is also based on a number of secondary assumptions. These include the choice of parameters used to (1) allocate basic rates to the various components of risk, such as crop type and planting practice, and (2) adjust the basic rates for different coverage and production levels.
Our previous work raised concerns about the adjustments made to the basic rate level to arrive at rates for coverage and production levels that differ from those of the basic rate. These adjustments are important because the majority of all crop insurance is purchased at rates for coverage and production levels that differ from those covered under the basic rates. However, our previous work found that these adjustments did not result in rates that are aligned with risk. For example, to set the rates for the 75-percent and 50-percent coverage levels, FCIC applies preestablished mathematical factors to the basic rate. According to our analysis of six major crops, the rates for this insurance were too high at the 75-percent coverage level and too low at the 50-percent coverage level in relationship to the basic rates. FCIC, using a mathematical model that sets rates according to preestablished relationships between production levels, also adjusts the basic rates for production for farmers whose historical production levels are above or below the county’s average. However, as with the varying rates for coverage levels, we found that these adjustments did not result in rates that accurately reflect the risk involved at each production level. In the past, agency officials cited a lack of time and resources as a barrier to revising the formulas applied to the basic rates to calculate these other rates. Currently, however, FCIC and its consultant are reviewing these factors and FCIC anticipates making adjustments in the future. Further, the FCIC noted that these differences may be offsetting in the aggregate and thus may not be as important for budget purposes as for setting individual farmers’ premium rates.
Additional modeling techniques to aid in assessing the risk of crop losses may become available in the future. For example, FCIC said it is doing some work with multistage econometric models and OMB suggested that options pricing could potentially be used to estimate the risk assumed by the government. However, these methods are only in the conceptual or early stages of development. The FCIC’s senior actuary told us that the alternative models the FCIC is working on may provide useful supplemental information but are not reliable or useful enough for budget purposes. In addition, the use of these methods would require a significant upgrade in staff skills.
In summary, the FCIC has an established rate-setting method that could serve as the basis for estimating the risk assumed by the government. However, risk assessment for crop insurance is complicated by the variation of risk associated with different combinations of crops, counties, and farming conditions and practices. Detailed information to estimate the risk assumed based on specific characteristics of the insureds is not known at the time of the budget year submission. Therefore, a higher level of aggregation—perhaps similar to what is used for current budget estimates—could be used for the budget year estimates. Reestimates for the risk assumed based on actual polices issued in a particular year could then be achieved by repricing the polices based on the full risk premium when necessary information becomes available. Many of the methodology’s assumptions and underlying data limitations are currently under review. This review should provide additional insights into the reasonableness of the methodology and its use for accrual-based budgeting.
section_title: Lack of Consensus on Risk Assessment Methodology for Deposit Insurance
paragraphs: The historic number of thrift and bank failures in the late 1980s and early 1990s and the costs associated with resolving these institutions motivated the development of methodologies to estimate future failures and their expected costs to the government’s deposit insurance funds. In a prior report, we reviewed methodologies used by various federal agencies and private forecasters. We found that different estimation approaches produced widely disparate results due in part to heavy reliance on professional judgment in specifying critical assumptions, such as estimates of market value, and the historical period used to project expected future losses. An analysis by staff of the Office of the Comptroller of the Currency (OCC) concluded that different estimation methodologies have strengths and weaknesses but no one approach appears to be superior. Appendix II contains a description of six loss estimation methodologies.
The health of the bank, thrift, and credit union industries is subject to many variables that are extremely difficult to predict. These include variables related to local and national economic conditions, behavior of regulators and management, and structural changes in the industries. Thus, attempting to predict the future prospects of financial institutions and estimate future losses to the insurance funds is an intrinsically uncertain proposition. In preparing loss estimates, there is no empirical formula for forecasters to follow that would enable them to know with certainty what approach or assumptions can most accurately reflect both present and future conditions and events that can play a significant role in the solvency of a financial institution. Only by making many assumptions can the available methodologies generate estimates of the impact of changes in the economy, industries, or regulatory behavior on the government’s cost of providing deposit insurance. In addition, small changes in these key assumptions can produce large changes in cost estimates.
Determining the value of an institution’s assets is one of the most challenging steps in estimating the government’s cost of deposit insurance losses from failed institutions. Economic insolvency of a financial institution occurs and costs accrue to the insurance funds when the value of the institution’s liabilities exceeds the market value of its assets. While the value of an institution’s liabilities—primarily deposits—is generally known, the value of its assets—primarily loans—is much more uncertain. Most loss estimation methodologies rely on unaudited financial data that financial institutions are required to report—in call reports—to regulatory agencies. Experience has shown that these data do not always provide an accurate picture of the value of an institution’s assets. For example, in 1991 we reported that asset valuations prepared by FDIC for 39 failed banks revealed $7.3 billion in additional deterioration in asset values (losses) compared to the last quarterly call reports filed by the institutions. As a result, most estimation approaches adjust call report data in an attempt to approximate the market value of an institution’s assets.
Estimating the market value of an institution’s assets allows for earlier recognition of the government’s deposit insurance losses than does reliance on historical book value measures reported in call reports. However, the use of market-value accounting is still controversial. Market values are not readily available for all categories of bank and thrift assets and liabilities. Analysts are divided over whether market-value accounting is precise enough for financial statements or whether it provides better estimates than book-value accounting. In addition, some models, such as OMB’s, include a closure rule as a policy variable defined in terms of the asset-to-liability ratio of an institution. This variable can (1) be set based on observed behavior of regulators in a given period or (2) reflect prompt closure as mandated by the Federal Deposit Insurance Corporation Improvement Act of 1991. Delay in closing an institution after it has become insolvent has been shown to increase resolution costs.
Because of the nature of deposit insurance and the significant challenges associated with estimating the program’s full long-term risk described previously, some departure from the pure risk-assumed cost concept may be appropriate in calculating risk-assumed estimates. For example, experts we consulted with held differing views on the degree to which OMB’s model accounts for the full range of possible future outcomes, such as the catastrophic losses associated with the savings and loan crisis. However, the model’s market-value-based accrual cost estimates would have provided policymakers with earlier recognition of deposit insurance costs than cash-based reporting.
The following sections discuss some of the limitations of the various types of models that are currently used by different forecasters to project losses to the deposit insurance funds. An assessment of the applicability and accuracy of any model for estimating the government’s cost for deposit insurance can only be made in the context of alternative models so that the benefits and limitations of different approaches can be compared. The first section highlights some of the limitations of OMB’s options pricing model, which the Bush administration proposed using for accrual-based budget reporting. The second section discusses some of the weaknesses of other loss estimation methodologies. A description of each of the methodologies is included in appendix II.
subsections: section_title: OMB’s Options Pricing Model
paragraphs: Although any of the methodologies described in appendix II could be adapted to estimate the government’s annual costs of deposit insurance, the focus has been on OMB’s options pricing model because it provides a direct computation of accruing deposit insurance costs. Under OMB’s estimation approach, deposit insurance is treated as giving the owners of a bank or thrift institution the option to transfer its liabilities to the government if the value of its assets falls below that of its liabilities. A brief overview of options pricing theory is provided in figure 5.1. OMB’s deposit insurance model has two distinct components. The first part attempts to estimate the financial condition, or market value, of every institution with liabilities over $100 million and then simulate their financial condition for future years. The second part uses options pricing techniques to calculate the expected costs of deposit insurance.
OMB’s model is conceptually sound and OMB’s efforts have made a significant contribution in extending the use of options pricing theory to estimate government insurance costs. However, a number of modifications to the model should be considered in order to improve its ability to estimate the government’s deposit insurance cost. These refinements are geared toward addressing some of the concerns raised by experts about the model, including (1) the approach used to value financial institutions’ assets, (2) the treatment of interest rate risk, and (3) the sensitivity of estimates to the specification of model assumptions and parameter values.
A key assumption of options pricing theory is that asset values are observable, measurable, and vary randomly over time. For assets for which there are efficient, well-developed markets, such as stocks, bonds, agricultural commodities, and foreign currencies, this assumption is not problematic. However, the value of a financial institution’s assets is not readily observable or measurable. Although stocks of the very largest banks are traded actively, adequate market value data are not available for the many smaller and non-publicly-traded institutions. As such, the unavailability of market value data on bank and thrift assets is a limitation of OMB’s options-based approach to estimating deposit insurance costs. In order to calculate the government’s cost for insuring all institutions, OMB uses call report data to estimate the market value and volatility in the rate of return of bank and thrift assets.
OMB’s use of estimated asset values and its method for calculating these estimates have been criticized. Some financial economists we spoke with questioned the practical application of options theory in the absence of observable and measurable market data that are generally available in more common uses of options theory. The use of an estimate of asset values is problematic because it may introduce measurement errors if the input data are not unbiased and efficient estimates of market value. The lack of an explicitly stated and observable exercise price of the option makes it difficult to determine when the option would be exercised. In the OMB model, the exercise price—economic insolvency—is expressed as a ratio of an institution’s estimated assets and liabilities. The valuation of assets and liabilities is often difficult and depends on the measurement basis used, thus identifying the timing of when a firm’s liabilities exceed its assets can be problematic.
Other financial economists argue that the lack of observable and measurable market value data for many financial institutions makes the use of call report data to infer market values a reasonable approach. OMB bases its estimate of market value on an institution’s current cash flowfrom call report data and a set of econometrically determined variables. This approach, however, has been criticized because cash flows are very sensitive to business cycles, which may result in overestimating or underestimating the market value of an institution. Furthermore, in estimating the cash flows for individual banks, OMB divides all banks into four groups and estimates parameters, such as cash flow volatility and loan chargeoffs, for each group. These group parameters are applied to individual bank earnings in order to project future cash flows. This introduces correlation among banks in each of the groups when none in fact may exist. The limitations of OMB’s asset valuation process were evident from its initial estimates of the parameters, which implied a negative net worth for all banks. This occurred because the estimation period included a banking recession. To correct for this, OMB adjusted its estimates of market values using stock market data on the largest publicly traded bank holding companies.
The OMB deposit insurance model has also been criticized because it does not explicitly take into account interest rate risk. The profitability of banks, thrifts, and credit unions is heavily dependent on both short- and long-term interest rates. The OMB model implicitly incorporates interest rate risk and other risks that affect an institution’s profitability through assumptions made about asset value and volatility of asset earnings. However, the financial economists we consulted with suggested that because of the importance of interest rates to the financial health of a depository institution, explicit modeling of interest rates would be desirable. Some recent research in the options pricing area incorporates interest rate risk in an options pricing framework to estimate the government’s deposit insurance liability.
Another concern raised by experts is the sensitivity of the deposit insurance cost estimates generated by OMB’s model to changes in key assumptions and parameters. Although the sensitivity of a model’s output to changes in parameter values is not necessarily a negative attribute of a model, it heightens the need for unbiased assumptions and parameter estimates. For example, insurance cost estimates generated by OMB’s model are particularly sensitive to assumptions about the future value of financial institutions’ assets. Two key assumptions affecting estimates of future asset values are asset volatility and mean-reversion of earnings.Analysis of OMB’s model using alternative values for these assumptions produced significant changes in the estimated cost of deposit insurance. Using an Office of Thrift Supervision (OTS) estimate of mean-reversion reduced the government’s estimated 5-year accrued costs by 49 percent compared to the estimated cost using OMB’s assumptions. Using OTS estimated standard deviation of thrift assets increased the estimated 5-year cost by 56 percent. The differences in assumptions made by various financial institution experts and the resulting impact on the cost estimates demonstrates that additional research on the appropriate assumptions and parameter values is desirable.
Cost estimates generated by OMB’s deposit insurance model are also highly sensitive to initial period financial data on depository institutions. OMB’s model uses only the most recent four quarters of data on an institution’s earnings to estimate its market value. The model projects the existing financial condition of institutions into the future and does not account for wide swings in the general financial health of the industry. As a result, input data from relatively good economic times will tend to underestimate future costs, while input data from an economic downturn will overestimate future costs. For example, using financial data from 1992, a recessionary year, the OMB model estimated that in 1994 the government would assume liabilities of $51 billion from failed banks with the cost to the government being a percentage of this amount. Actual liabilities from failed banks in 1994 were approximately $1 billion. Forecasting turning points in the economy is difficult for all forecasters—not only OMB’s options model—but is one of the major hurdles to generating risk-assumed estimates for deposit insurance.
Financial economists at bank regulatory agencies were divided in their views on the use of OMB’s model for accrual-based budgeting. An official at one agency stated that he did not believe that the model estimates are valid and reliable enough for budget and policy decisions. Some banking agency officials expressed concern that the complexity of OMB’s model made it difficult to replicate and analyze the reliability of the cost estimates. On the other hand, an official at another banking agency stated that the concept of accrual-based budgeting makes sense given that once the government extends the insurance it has already accrued a cost. He stated further that some estimation uncertainty may be acceptable in the reported accrual-based cost for deposit insurance in the budget as long as there is a general understanding of the limitations involved. In contrast, he suggested that the same level of uncertainty would not be appropriate for setting insurance premium rates for individual banks.
section_title: Other Loss Estimation Methodologies for Deposit Insurance
paragraphs: Although the OMB options pricing model is the only methodology that directly provides an estimate of the government’s accrued cost of deposit insurance, alternative models exist that provide forecasts of future bank insolvencies. These forecasts could be used to estimate the government’s accruing costs. Appendix II provides a brief summary of the actuarial, transition matrix, asset markdown, proportional hazards, and pro forma projection models currently being used by various researchers to estimate bank and thrift institution losses.
All of the estimation models are limited by their high degree of reliance on professional judgment in setting assumptions and in their use of unaudited call report data. For example, actuarial models generate loss estimates based solely on historical incidence of resolution. Accordingly, the model estimates are highly sensitive to the choice of the historical period used to set these probabilities. For example, at the same time that the financial condition of the bank and thrift industries was improving in recent years, expected future loss estimates based on resolutions during the 1987 through 1992 period tended to be very high because they reflected the dismal performance of the industry during this period.
Actuarial approaches are also limited in that the effects of only two or three variables can easily be incorporated into the model. Estimates are thus highly sensitive to analysts’ choice of the variables used and the grouping of institutions by these variables. Transition matrix models, a variation of actuarial models, implicitly incorporate more information into loss estimates by using regulatory ratings of financial institutions to estimate the probability of resolution for different categories of institutions. Regulators assign financial institutions a rating to reflect their financial and operating condition, determined through on-site examinations and examiners’ assessment of risk. However, in addition to the limitations described above for all actuarial-based approaches, transition matrix models assume that regulatory ratings are the sole determinant of an institution’s failure.
Asset mark-down approaches to estimating the cost of bank and thrift insolvencies are based on the premise that the market value of an institution’s assets and equity can be used to identify potentially insolvent institutions. These types of approaches are limited in that they are very data intensive, relying heavily on call report data and other data not readily available for all institutions. For example, some asset mark-down approaches attempt to discount the cash flows of several categories of an institution’s assets and liabilities over their expected lives. In addition to detailed call report data, this process requires information, such as the maturity or duration of different types of loans, differences between loan contract and market interest rates, and expected prepayments. Other less rigorous approaches simply use analysts’ judgments to adjust reported asset values and earnings growth. Even if these assumptions appear reasonable, it is difficult to reproduce or verify the adjustments.
Proportional hazard models, another type of econometric approach, attempt to predict the failure of an institution based on financial characteristics, regulatory ratings, and economic indicators. As with other methodologies, the analyst’s ability to identify and measure the variables is fundamental. Central to proportional hazard models are historical data on failed institutions and the timing of regulatory action to close the institutions. Measuring time to failure can be problematic due to the history of delay in closing many insolvent institutions in the late 1980s. Use of this type of an approach has generally been limited to short-term forecasts although some recent research has attempted to forecast failures over a 5-year period.
Forecasts based on simple projections of current income and capital levels—pro forma projections—are also highly sensitive to assumptions and limitations of call report data. Such approaches assume that an institution’s earnings are its only source of funds and therefore are highly sensitive to reported income and capital.
The existence and diversity of alternative loss estimation methodologies for deposit insurance provide a rich body of experience to draw upon in estimating costs under an accrual-based budgeting approach. However, such significantly different designs and the widely disparate cost estimates highlight the difficulty and uncertainty inherent in estimating deposit insurance costs. The current use of different approaches by federal agencies will also complicate efforts to reach consensus on the appropriate method to use to accrue costs in the budget. The uncertainties and limitations of the various estimation methodologies also underscore the need to have well-capitalized insurance funds to absorb losses from failed institutions that are intrinsically difficult to estimate over a long-term period.
section_title: Risk-Assumed Estimation Methodologies for Pension Insurance Not Fully Developed and Tested
paragraphs: Methodologies that could be used to estimate the full risk assumed by the government in insuring private pension plans are not fully developed and validated. However, considerable research and development has been invested in two potential approaches—an options pricing approach and a simulation approach. OMB has built upon the work of several academic researchers and applied options pricing theory to estimate the government’s liability for pension insurance. The Pension Benefit Guaranty Corporation has extended the research of Federal Reserve Bank of New York economists to simulate funding necessary for future plan terminations. Appendix III provides a brief overview of these two estimation approaches.
Estimating the cost to the government for the risk assumed in the pension insurance programs is a difficult exercise primarily because it entails forecasting the failure of firms with underfunded pension plans. Firm failure is dependent on a number of economic, industry-specific, and behavioral factors, which are highly uncertain and interrelated. In addition to forecasting firm bankruptcy, estimating the cost of pension insurance is complicated by the need to forecast the financial condition of pension plans. The health of a pension plan is greatly affected by the value of its assets, which depend upon uncertain market conditions and interest rates. In addition, the financial condition of the firm also affects the liabilities of the plan through factors such as employment and benefit levels as well as statutorily defined minimum funding requirements. Under current law, PBGC is allowed to charge plan sponsors a variable premium based only on its level of unfunded vested benefits.
subsections: section_title: OMB’s Options Pricing Approach
paragraphs: In recent years, OMB has invested significant effort in using options pricing theory to estimate the government’s cost of federal pension guarantees. The Bush administration’s 1992 accrual budgeting initiative proposed using options pricing methodologies for estimating the accrual costs for both deposit insurance and pension guarantees. In OMB’s pension model, the government’s guarantee is treated as giving the owners of a firm the option to transfer the pension plan liabilities to PBGC when the firm becomes insolvent. This is similar to the concept used by OMB for estimating the cost of deposit insurance. However, since the cost to the government for the pension guarantee is contingent on the financial conditions of both the pension plan and the plan’s sponsoring firm, OMB’s pension model specifies a probabilistic process for deriving the future value of both the pension plan’s and the sponsoring firm’s assets and liabilities.
OMB’s options pricing model for estimating the government’s cost of pension guarantees requires certain modifications and assumptions that go beyond common applications of options theory. In most applications of options pricing, the time to expiration of the option is typically short. As such, assuming that the value of assets, liabilities, or interest rates will change at a constant rate over time is not problematic. However, for pension insurance, the duration of the option is long, making such standard assumptions unrealistic. For example, the OMB model assumes that the value of a firm’s assets will vary in the future but always at the same rate. This assumption is important in determining the future value of firm and pension assets and, ultimately, the value of the option and the government’s cost. Experts with whom we consulted pointed out that common applications of options pricing for long-lived options typically use probabilistic functions, which allow for large changes in asset values. Thus, the OMB model potentially could be improved by specifying a probabilistic process that would allow greater volatility in future asset values. PBGC officials also noted that OMB’s model does not take into account Internal Revenue Code rules that specify minimum and maximum pension plan funding that may dampen actual volatility in the growth of pension plan assets.
Modifications to the OMB model with regard to its treatment of interest rates could strengthen its estimation capability. The values of pension liability are dependent on prevailing and future interest rates because these liabilities are due in the future. The assumption that future interest rates are determined today, as assumed in OMB’s model, will cause inaccuracies—especially in a long-term estimate. The experts that we consulted also recommended that since interest rate risk has significant implications for pension liabilities, a separate recognition of interest rate risk within the OMB model should be considered. Modeling variations in future interest rates using an appropriate probabilistic process would introduce variation in a firm’s future pension fund liabilities and potentially improve estimates of the government’s liability.
Sensitivity analysis performed on the OMB model demonstrated that assumptions about how much the value of firm and pension plan assets will vary over time have significant impact on the model estimates. For example, PBGC’s net liability decreased 80 percent when the volatility of a firm’s assets assumed by OMB was cut in half. When volatility estimates derived by other researchers were plugged into the model, the government’s estimated net liability dropped by 92 percent. Such significant differences in the model estimates indicate that additional research on key model parameters and assumptions should be undertaken. Other parameter assumptions, such as the level of net worth at bankruptcy, have also been questioned and should be grounded in empirical research.
In addition to the modifications described previously, additional research and development would be necessary before estimates from OMB’s model could be used for accrual-based budgeting. In its current form, the OMB model only generates an estimate of the government’s cost of pension insurance over an indefinite period. In order to use this cost estimate in an annual budget context, a methodology to amortize the cost on a yearly basis is necessary.
In discussing OMB’s model with PBGC officials, concerns about the complexity of the model were raised. Even though OMB’s research has been published, and officials have been open in providing researchers access to the model, PBGC’s chief economist characterized the OMB model as a black box. He noted that the model is too complex for most analysts and economists to fully understand and does not provide an intuitive understanding of the factors influencing the government’s cost. In part, these concerns led PBGC to pursue a simulation-based approach to model the financial condition of its insurance program under a range of economic scenarios. PBGC officials asserted that less restrictive computer simulation models are increasingly taking the place of options pricing approaches in financial markets as financial instruments have become more complex and computing power less expensive.
section_title: PBGC’s Simulation Approach
paragraphs: Over the last several years, PBGC has been developing a computer simulation model, called the Pension Insurance Modeling System (PIMS), to improve its capacity to estimate future claims and evaluate the impact of proposed legislative or regulatory changes on its financial condition. PIMS allows PBGC to model a large number of firm and pension plan attributes, including interest rates, asset returns, and bankruptcy rates, over a wide set of possible economic scenarios. PBGC believes that its simulation approach is a better tool for policy analysis than OMB’s options pricing model, but agency officials we spoke to were divided over its use for accrual budgeting. OMB has indicated that it would like insurance program agencies to have responsibility for developing accrual-based budget estimates and views PBGC’s PIMS research efforts as a step in that direction.
Opinions about the usefulness of PIMS for accrual-based budgeting purposes differ. PBGC’s chief economist expressed concern about using PIMS or any model for accrual-based budgeting purposes. He said that the future expected cost of PBGC’s pension insurance is very sensitive to changes in key assumptions. For example, he said using interest rate experience from the period 1926 to 1991 produces a considerable change in the expected cost compared with using the experience of the 1970 to 1991 period. Although the information provided by different simulations is very useful for policy analysis, he does not think it is stable enough for budgeting or accounting. The chief economist suggested that some of his concern could be alleviated if assumptions were set by a neutral body to minimize the potential for manipulation of the cost estimates.
PBGC’s chief actuary stated that actuaries look for the best estimate and not the “right” number. He pointed out that all budget estimates are imperfect and PIMS has real value as an estimating tool. Estimating the exposure undertaken by the government is self-correcting—gains and losses over time offset each other. However, if over a number of years gains or losses start adding up and exceed a certain level, then the methodology would have to be reassessed. He stated that this approach has been used by insurance companies to estimate risk-based reserves.
section_title: Other Insurance Programs Also Present Estimation Challenges
paragraphs: The other insurance programs we reviewed—the war-risk insurance programs, the Overseas Private Investment Corporation’s (OPIC) political risk insurance, and the Vaccine Injury Compensation Program (VICP)—will likely present significant estimation challenges under an accrual-based budgeting approach. The unique role of these programs, the subjective or volatile nature of the insured risks, or a lack of relevant historical data complicate risk assessment. According to agency officials, none of these programs currently rely on heavily quantitative or systematic risk assessment tools.
subsections: section_title: OPIC’s Risk Assessment Process Relies Heavily on Expert Judgment
paragraphs: OPIC relies heavily on expert judgment to assess the risk it undertakes in insuring investments of U.S. companies abroad against expropriation, currency inconvertibility, and political violence. Although the use of more quantitative methods, such as econometric modeling or options pricing, has been suggested by some budget experts, no specific comprehensive models have been developed. Further, OPIC officials and some analysts expressed skepticism about the usefulness of this type of modeling for OPIC’s insurance activities.
The complexity and subjectivity of political risks along with a lack of relevant data make risk assessment difficult. Political risks tend to be country-, industry-, company-, and project-specific. Political risks are subject to many variables that are inherently difficult to predict, such as the political stability of governments, long-term macroeconomic conditions, changes in future foreign relations, or the acceptability of a given project or industry to the host country. Thus, a risk for one industry may not be relevant for another industry in the same country. Further, because there is a lack of empirical evidence, assessment of the potential implications of various events and conditions is based on primarily subjective evaluation. An OPIC official stressed that there can be considerable uncertainty surrounding the business environment and other factors that influence the risk associated with a particular project. For example, agency officials stressed that many of the countries covered by OPIC do not have an extensive history of private sector development and economic reform programs that would be necessary to develop a useful model. One official noted that in some areas, such as Eastern Europe and Russia, there is no historical experience to draw on. Agency officials said that for these reasons, there are no effective quantitative models or actuarial tables for OPIC’s political risk insurance.
Currently, the risk assessment methods used by OPIC to set premium rates and establish insurance reserve levels rely heavily on expert judgment. However, according to OPIC officials, while the risk assessment process is not highly quantitative, efforts are made to establish premium rates based on the risk assumed for a particular project. In determining the risk associated with a given project, OPIC considers the project-specific risk, such as the structure of the project and the experience of the project’s sponsors, and country-based risk, such as projections of the country’s general economic condition, including balance of payments and foreign exchange reserve levels. According to OPIC officials, each investment is negotiated and underwritten individually. They stressed that this process is important in controlling OPIC’s risk exposure precisely because predicting political risk over long periods is so difficult.
OPIC establishes general reserves based on losses inherent in its entire portfolio. For budget purposes, budget authority is obligated for these reserves when identified. Reserve levels are developed by OPIC’s management in consultation with the agency’s independent auditors and are based on historical experience and an assessment of other factors, including changes in the composition and volume of the insurance outstanding and worldwide economic and political conditions. However, according to agency officials, there is little historical data or 20-year trend information that can be used to develop actuarial tables to accurately predict risk. They noted that the program’s entire historical experience is considered because claims have been sporadic over the life of the program and no discernable patterns exist. Further, they emphasized that although historical data provides a starting point, adjustments are made to account for OPIC’s new business and other factors that affect the level of risk undertaken. As a result, OPIC officials stressed that management’s judgment is a key factor in determining the appropriate reserve levels.
OPIC officials expressed serious concerns about the feasibility and usefulness of generating risk-assumed estimates for budget outlays on either a project-specific or annual cohort basis. They pointed out that since only a few (about 150) policies for an even fewer number of projects are issued each year, adequately pooling risk in any year is extremely difficult. According to agency officials, a primary concern in minimizing overall risk is maintaining an appropriate balance across clients, business sectors, and countries. They stressed that in their opinion, the focus of management’s efforts and decision-making should be on “good portfolio management,” such as using contract provisions and client diversification to mitigate the aggregate risk undertaken by the program. Agency officials did not believe that a focus on annual cohorts—rather than on OPIC’s entire portfolio—was conducive to this broad management focus.
Agency officials also noted that a number of factors make determining the net cost to the government at the time insurance is extended difficult. For example, they explained that the amount of recoveries associated with specific projects is very uncertain but not including these amounts would overstate the government’s potential cost. They also said that it would be very difficult to determine how to account for and allocate the benefits of contract provisions that limit total covered losses for multiple projects by the same company. Overall, OPIC officials said that they strongly opposed the use of cohort-based budget estimates and were skeptical of whether a comprehensive risk assessment model for their insurance activities could be developed. They maintain that their current practice of obligating reserves based on losses inherent in their portfolio when identified is a reasonable approach.
section_title: Unique Role of the War-Risk Programs Complicates Risk Assessment
paragraphs: The unique role of the maritime and aviation war-risk insurance programs complicates risk assessment. The war-risk insurance programs provide insurance to commercial airlines and ship owners during extraordinary circumstances, such as war and other hostilities, in order to support the foreign policy interests of the United States. Both programs provide coverage only when commercial insurance is not available or is available only on unreasonable terms and conditions. This unique role complicates risk assessment because by design (1) the insured risks tend to be case-specific and highly variable, (2) historical program data are limited, and (3) commercial sector war-risk insurance data are unlikely to be directly applicable to the risk assumed by these federal programs. Currently, risk assessment for both programs relies heavily on expert judgment. Neither program uses quantitative modeling or standard risk assessment procedures.
Officials from both agencies told us that because of the programs’ infrequent activation and extremely rare losses, there is a lack of historical program data for risk assessment. For example, according to Federal Aviation Administration (FAA) officials, aviation war-risk insurance has only been issued during a few brief periods since 1975. Maritime Administration (MARAD) officials also stated that their war-risk insurance is activated very infrequently and remains active for short durations, usually less than a year. Claims under the programs are also extremely rare. In addition, agency officials told us that historical information from commercial war-risk insurance may not be useful in assessing the risk undertaken by their war-risk insurance programs because commercial information often is not readily available or applicable. For example, officials at both agencies told us that premium information is generally not released by commercial sector war-risk insurers.
Because of the above limitations, risk assessment for the federal war-risk programs currently relies heavily on expert judgment. Premiums for both programs are set in consideration of the risk involved and U.S. policy interests and to encourage the participation of commercial insurers. In general, risk assessment involves the subjective evaluation of the numerous factors associated with a particular flight or voyage. For example, according to FAA officials, they consider factors such as (1) the hull value, (2) the potential liability for passengers, crew, cargo, and losses on the ground, and (3) the apparent danger associated with flights into the area(s) excluded by commercial insurers. They told us that in assessing the risks associated with a particular area, they consider available information on potential dangers, such as intelligence information on terrorist groups and the types of weapons involved in the conflict. MARAD officials also described their risk assessment process as ad hoc and subjective. They said that a number of factors are considered in assessing risk, such as (1) the destination of the vessels, (2) the extent of the military threat, (3) the current commercial rates, and (4) the value of the vessels. According to agency officials, an outside consultant, the American War-Risk Agency, has provided advice on risk assessment.
Overall, officials from both war-risk programs expressed concerns that accrual-based budgeting may not be feasible for their programs. Officials at both agencies described the infrequent and limited issuance of insurance and the resulting lack of historical experience as key obstacles to developing risk-assumed estimates and using accrual-based budgeting for these programs. The emergency—or stand-by—nature of the programs makes it difficult to know in advance when they will be activated and limits the time available for risk assessment. FAA officials stated that in their opinion it was not feasible to generate reliable risk-assumed estimates for the budget. MARAD officials provided a similar assessment for their war-risk program, stating that given the nature of the program, reliable estimates of the risk assumed could not be developed.
section_title: Vaccine Injury Compensation Program’s Limited Historical Experience May Impede Risk Assessment
paragraphs: According to Health Resources and Services Administration (HRSA) officials within the Department of Health and Human Services (HHS), systematic risk assessment is not currently undertaken for VICP. The program’s limited historical experience was cited as a key factor in the uncertainty surrounding its future costs. HRSA officials stressed that in their opinion, there is not sufficient historical evidence on the cost of claims to produce meaningful estimates of the program’s future costs because the program has only been in operation since 1989. A 1994 Treasury report also concluded that VICP had not been in existence long enough to project future outlays with confidence.
The lack of scientific evidence linking adverse events to vaccines and the dynamic or subjective nature of some variables, such as the amount of settlement awards, have also been cited as factors complicating risk assessment. According to the Treasury study, “the scientific literature indicates that most injuries and deaths of the type compensable under VICP cannot be said with certainty to be caused by vaccinations.” In addition, HRSA officials expressed concern that the dynamic or subjective nature of some variables make it difficult, if not impossible, to generate reasonable projections of the program’s future claims. For example, the introduction of new vaccines and the increasing use of combined antigens in a single vaccination make it more difficult to determine risk. Also, HRSA officials described settlement amounts awarded by the courts as case-specific and subjective.
Overall, HRSA officials expressed serious reservations about the feasibility of producing reasonable projections of the program’s future costs and the use of accrual-based budgeting for VICP. The Treasury report concurred that until the program matures, program outlays cannot be estimated with confidence, but noted that “as the program matures sufficient program data will become available to permit more sophisticated methods of estimating future outlays to be used.” For example, a Treasury analyst noted that it may not be necessary to establish causation between the vaccine and the adverse event in order to establish an estimate of the program’s future outlays. As more cases are settled, it may be possible to establish a pattern between adverse events and award amounts based on historical data. However, changes in variables over time, such as injury coverage and the introduction of new vaccines, will have an impact on the usefulness of cost estimates based on historical data.
section_title: Estimation Challenges Are the Critical Factor in Use of Risk-Assumed Estimates
paragraphs: The ability to generate reasonable, unbiased estimates of the risk assumed by the federal government is of primary importance in the effective implementation of accrual-based budgeting for federal insurance programs. However, as the discussion in the preceding sections shows, the current development and acceptance of risk assessment methodologies varies significantly across these programs. This variation reflects the diversity and nature of the risks insured by the federal government. For some programs, such as the Service Disabled Veterans Life Insurance program, estimates are sufficiently established so that the government’s cost—“the missing premium”—can be reasonably estimated. For other programs, such as deposit insurance, alternative models with different theoretical and practical approaches result in an array of estimates of the government’s costs. Other insurance programs, such as the war-risk insurance and vaccine compensation programs, have no or limited systematic risk assessment experience. To date, no formal or quantitative risk assessment methodologies have been established for these programs. All risk assessment approaches, regardless of their technical sophistication, are based upon many judgments and the quality and quantity of available data. As such, assumptions and the process used to arrive at estimates need to be well documented. In this regard, the use of econometrics or other quantitative methods can facilitate the replication of estimates by other analysts and auditors.
The estimation challenges highlighted in this chapter are at the center of the accrual-based budgeting debate. Within the budget community, there are a variety of views on the acceptable level of uncertainty and complexity to introduce into the federal budget. As discussed in chapter 7, consideration of these issues is likely to be most beneficial when the focus of the discussion is on whether or not the inclusion of risk-assumed estimates would provide policymakers with more accurate information and signals about the underlying insurance programs, rather than on whether an estimate is the “right” number. It may be most important that the budget information and incentives provided to policymakers be “approximately right rather than precisely wrong.”
section_title: Approaches for Incorporating Accrual-Based Estimates Into the Budget for Insurance Programs
paragraphs: The way in which accrual-based cost information for federal insurance programs is incorporated into the budget will influence the extent to which budget information and incentives are changed and the limitations of cash-based budgeting are overcome. A key issue surrounding the use of accruals in the budget is the extent to which earlier cost recognition is linked to increased cost control. It is clear that risk-assumed estimates are not yet sufficiently developed to be incorporated directly into the primary budget data—budget authority, outlays, and the deficit. Supplemental reporting of these estimates as they develop would provide policymakers additional information and serve as the basis for future evaluation of whether to incorporate the estimates into the primary budget data. If, over time, reasonable unbiased estimates are developed and a decision is made to use them in the primary budget data, approaches to doing so need to be considered. In this chapter, we examine three general ways of using accrual-based estimates in the budget and their respective advantages and disadvantages. In chapter 7, we discuss other issues related to the implementation of accrual-based budgeting for insurance programs.
subsections: section_title: Three General Approaches Offer Progressive Integration of Accrual-Based Information Into the Budget
paragraphs: Three general approaches to using accrual-based estimates in the budget demonstrate how these measures might be progressively integrated into the primary budget data—budget authority, net outlays, and the budget deficit. Each approach would have a different effect on the aggregate budget totals.
Supplemental Approach:  Under this approach, accrual-based cost measures would be included as supplemental information in the budget documents. The current basis of reporting budget authority, net outlays, and the budget deficit would not be changed.
Aggregate Budget Authority Approach:  Under this approach, accrual-based cost measures would be included in budget authority for the insurance program account and in the aggregate budget totals. Net outlays—and hence the budget deficit—would continue to be reported on a cash basis.
Aggregate Outlay Approach:  Under this approach, accrual-based cost measures would be incorporated into both budget authority and net outlays for the insurance program account and therefore in the aggregate budget totals. Thus, unlike the other approaches, the budget deficit would include the accrual-based cost for federal insurance programs. This approach is the most comprehensive and would be similar to the approach used for credit programs under credit reform.
section_title: Supplemental Approach Would Retain Current Basis of Budget Reporting for Federal Insurance Programs
paragraphs: Under the supplemental approach, estimates of the risk assumed by the government would be included in the budget documents as additional information. Given the existing state of the art in making accrual-based estimates, this approach is the most feasible at this time. The current basis of reporting budget authority, net outlays, and the deficit would not be changed. Including accrual-based information in the budget to supplement the traditional cash-based budget reporting for federal insurance programs would increase the information available to decisionmakers by helping to highlight the potential costs of these programs. This approach would also allow time to test and improve estimation methodologies and increase the comfort level of users before considering whether to move to a more comprehensive approach. In a similar fashion, information on federal credit programs and estimates of the government’s subsidy costs were reported for years in the Special Analyses volume of the President’s budget prior to the enactment of credit reform.
However, this approach might not have a significant impact on the budget decision-making process because the accrual-based cost information would not directly affect the budget totals and the budget allocations to congressional committees. Furthermore, there may be little incentive to improve cost estimates and/or risk assessment methodologies for the various insurance programs since this information would not be the basis for budget decisions. Figure 6.1 provides a summary of the key advantages and disadvantages of the supplemental information approach.
Accrual-based costs for federal insurance programs could be presented as supplemental information in the budget in a number of ways. In recent years, OMB has provided some risk-assumed cost information on insurance programs in the Analytical Perspectives volume of the President’s Budget.This presentation could be continued and enhanced by developing a consistent format for reporting the risk assumed by each program.
Useful information for this type of presentation, some of which has been presented in previous budgets, includes (1) the annual risk-assumed cost for each program, (2) summaries of the methodologies used to generate cost estimates, and (3) explanations of any changes in estimates from year to year. Two key advantages of this type of presentation are (1) a more detailed narrative discussion is possible than in the account-level presentation of the budget appendix and (2) all federal insurance programs are discussed in one place.
Such a discussion could be further supplemented if accrual-based cost information was also displayed at the insurance program account level in the budget appendix even though it would not be included in the budget totals. For example, the cost of insurance programs could be shown on an accrual basis in one table for display purposes and on a cash basis in another table for the same account. Although only the cash-based amount would be included in the budget totals, this presentation may increase attention paid to risk-assumed cost estimates at the time budget decisions are made. Such a display would highlight the differences in the type of information provided on a cash basis versus an accrual basis for the various insurance programs without changing the reporting basis of total budget authority, net outlays, or the budget deficit.
section_title: Aggregate Budget Authority Approach Would Introduce Some Accrual Amounts Into the Budget
paragraphs: The aggregate budget authority approach moves further along the continuum from cash-based budgeting to full accrual-based budgeting. This would incorporate accrual-based cost measures into budget authority but would stop short of adopting the full credit reform approach. The full cost of the risk assumed by the government would be recognized in the budget authority for the insurance program and the aggregate budget authority totals. Net outlays and the budget deficit would continue to be reported on a cash basis. Budget authority would be obligated at the time an insurance commitment was made and would be held as a reserve in the program account earning interest. Future claims would be paid from the authority in these reserves.
A key advantage of the aggregate budget authority approach is that it provides earlier recognition of insurance costs directly in the budget (in budget authority) while preserving cash-based reporting for net outlays and the deficit. Recognizing accrual cost estimates in budget authority may increase attention to these costs without potentially subjecting outlays and the deficit to estimation uncertainty. This increased attention may also focus efforts on improving cost estimates. However, since the accrual-based cost would not be reflected in the budget deficit, it is unclear how much more this approach would affect the budget decision-making process than the supplemental information approach.
Figure 6.2 presents a summary of the key advantages and disadvantages of the aggregate budget authority approach.
The influence of this approach is likely to be further limited by the fact that most federal insurance programs are classified as “mandatory” under BEA. This means that only increases in budget authority caused by changes in legislation must be addressed by the Congress. Although this is also true for automatic increases in outlays, the fact that changes in outlays increase the deficit could prompt action. The budget authority only approach does not offer this incentive. The potential impact of this approach on the decision-making process would likely be greater for insurance programs that are classified as discretionary spending because accrued costs would be included under the discretionary budget authority spending caps. As discretionary budget authority totals near the discretionary spending limits, this approach may prompt the Congress to specifically address the costs of these programs.
subsections: section_title: A Discretionary Feature Combined With Aggregate Budget Authority Approach Could Prompt Action to Address Costs
paragraphs: Actions to control costs under the aggregate budget authority approach could be prompted by requiring a discretionary appropriation for the government’s subsidy cost. For insurance programs classified as mandatory, a separate discretionary account would be created to record the government’s subsidy costs. A general fund appropriation to the discretionary account would be required to cover any subsidy costs in the year the insurance is extended, unless alternative actions were taken to reduce the government’s cost, such as increasing program collections or reducing future program costs. Amounts appropriated to the discretionary account would then be paid to a mandatory program account. The mandatory program account would handle all other cash flows including premium collections and claim payments. This account would also hold the program’s reserves for future claims. As a result, the government’s accrual-based costs would be reported in the budget authority and net outlays for the program’s discretionary account and in the budget authority totals for the government. Total net outlays and the budget deficit would continue to be recorded on a cash basis.
Figure 6.3 demonstrates how the cost of a hypothetical insurance program would be recorded under this approach, assuming that a funding deficiency exists on an accrual basis. The insurance program is assumed to have the following activity:(1) premium collections of $5 billion; (2) claim payments of $3 billion; and (3) an accrual-based subsidy cost to the government of $4 billion, i.e., an estimated funding shortfall between the risk assumed and estimated collections.
As shown in Figure 6.3, the mandatory program account would record cash flows, including $5 billion in premium collections and cash outlays of $3 billion for claim payments. The accrual-based subsidy cost of $4 billion would be appropriated to the discretionary account and then transferred to the mandatory account. As a result, the subsidy cost of $4 billion would be scored against the discretionary spending caps and, negative outlays of $2 billion would be recorded in the mandatory program account and included in the deficit. Reserves of $6 billion would be held in the program account as obligated budget authority invested in Treasury securities.
A key advantage of this approach is that it prompts budget decisionmakers to address explicitly the government’s cost while preserving the more straightforward cash-based reporting for net outlays and the budget deficit. Since the appropriation would be discretionary, and thus subject to BEA caps (assuming their extension), decisionmakers would have an incentive to reduce the government’s costs. Despite this advantage, however, there are broader policy considerations involved with creating a discretionary aspect for programs originally funded as mandatory spending. In most cases, such a step would go beyond simply changing the reporting of program costs in the budget by shifting the locus of decisions to the annual appropriation process thereby possibly changing program operations. Figure 6.4 summarizes the key advantages and disadvantages of this feature.
section_title: Aggregate Outlay Approach Incorporates Accruals Into the Primary Budget Data
paragraphs: The aggregate outlay approach is the most far-reaching of the three general approaches outlined. This approach is similar to both the treatment of credit programs under credit reform and the approach proposed by OMB for federal insurance programs in the fiscal year 1993 budget. Under this approach, accrual-based costs would be recorded in both budget authority and outlays for the program and in the aggregate budget totals, including the budget deficit.
Like credit reform, two key features of this approach include (1) the use of a program account and a financing account and (2) the separation of insurance program activities into transactions that represent a cost to the government and transactions that are merely cash flows with no cost to the government, such as working capital transactions. The government’s accrual-based subsidy cost for an insurance activity would be recorded in the program account while all other cash flows would be handled in a separate financing account. Similar to credit reform, the program account would be budgetary and thus included in the calculation of the budget deficit. The financing account, on the other hand, would be a nonbudgetary account and thus not included in the deficit calculation. Table 6.1 illustrates the relationship between these accounts, the budget deficit, and the government’s borrowing needs.
Under this approach, the accrued cost to the government would first be recognized in the program account and then outlayed to the nonbudgetary financing account. This transaction will cause the government’s accrual-based subsidy cost to be included in the deficit at the time the insurance is extended. Therefore, the measurement basis of outlays for the program account and deficit would be changed from the current cash basis to an accrual-based estimate of the government’s subsidy cost for an insurance activity. An appropriation would cover the government’s cost unless other actions were taken to eliminate the funding shortfall, such as increasing collections or reducing program costs. Since most insurance programs are mandatory, this appropriation would occur automatically unless additional control mechanisms, as discussed previously, were adopted. Even without this additional feature, the fact that increases in outlays would be reflected in the deficit could prompt action to address the causes of such increases. Key factors involved in implementing this general approach, including reestimation, funding sources, and reserve levels, are discussed in chapter 7.
Figures 6.5 and 6.6 compare how the cost for the hypothetical insurance program outlined above would be recorded under the current cash-based approach versus the aggregate outlay approach.
As shown in figure 6.5, the current cash-based budget would record cash inflows of $5 billion and cash payments of $3 billion, resulting in negative net outlays (income) of $2 billion. Total net outlays and the budget deficit would be reduced by this amount in the current budget period. Conversely, as shown in figure 6.6, under the aggregate outlay approach, the insurance program would receive an appropriation to reflect the subsidy on a risk-assumed basis, unless some alternative actions are taken to eliminate the funding shortfall. An appropriation of $4 billion would be received by the program account and outlayed to the financing account.This amount would be included in total net outlays and the budget deficit. The financing account would also record nonbudgetary cash flows, including premium income of $5 billion and claim payments of $3 billion. As a result, under this approach, the insurance program would increase the budget deficit by $4 billion rather than reducing it by $2 billion, as was the case on a cash basis.
Without fundamentally changing the nature of most federal insurance spending, the aggregate outlay approach is the most comprehensive of the three approaches outlined and has the greatest potential to achieve many of the conceptual benefits of accrual-based budgeting. The isolation and recognition of the government’s full cost when budget decisions are being made would permit more fully informed resource allocation decisions. By recognizing the government’s cost in the budget deficit at the time decisions are made, the incentives for managing insurance costs may be improved. Furthermore, recognizing costs in net outlays and the deficit at the time insurance commitments are made would better reflect their fiscal effects. In some cases, such as for the deposit insurance programs, accrual-based budgeting using the aggregate outlay approach may smooth spending patterns and reduce cost distortions created by temporary or sporadic cash flows.
Despite these potential advantages, the aggregate outlay approach has several disadvantages. A primary concern is the uncertainty surrounding the estimates of the risk assumed by the federal government for federal insurance programs. To the extent that estimates are unreliable, resource allocation may be distorted and the potential for manipulation increased. As discussed in chapter 5, risk-assumed cost estimates for most insurance programs are either currently unavailable or not fully accepted and thus the uncertainty surrounding these estimates presents a key obstacle to the successful implementation of this approach. In addition, the aggregate outlay approach adds a layer of complexity to an already complex budget process. As was the case with credit reform, the use of accrual-based budgeting for federal insurance programs will result in new complexities and implementation challenges.
Further, unlike the majority of programs covered under credit reform, most federal insurance spending is classified as mandatory under BEA. As discussed above, under BEA for mandatory programs, only legislated changes that increase the level of the government’s commitment would have to be offset by spending reductions or revenue increases. Increases in existing spending for mandatory federal insurance programs would not require action to address these costs, but the inclusion of accrued costs in the deficit calculation may provide more incentive to address them than the aggregate budget authority approach. Figure 6.7 summarizes the key advantages and disadvantages of the aggregate outlay approach. If additional budget control is desirable, a discretionary appropriation could be required to fund the government’s accrued subsidy cost unless other corrective action is taken. But doing so would go beyond merely changing the reporting of program costs in the budget by shifting the locus of decisions to the annual appropriation process, thereby possibly changing program operations.
section_title: Different Approaches to Accrual-Based Budgeting Have Different Impact on Information for Budget Decisions
paragraphs: The various approaches to incorporating accrual-based information into the budget have different effects on the information and incentives provided to decisionmakers. As noted previously, earlier cost recognition under any of the three general approaches would not necessarily mean that action would be taken to address costs. In fact, the supplemental approach may have little, if any, effect on budget decision-making. The extent to which earlier cost recognition under the other two general approaches prompts action to address accruing cost depends primarily on whether the program has permanent budget authority and is classified as mandatory spending. Since most insurance programs have permanent budget authority and are classified as mandatory, even the most comprehensive general approach—the aggregate outlay approach—would not necessarily require any action to be taken without the adoption of additional budget control mechanisms. It would, however, make more visible any increase in costs.
While earlier reporting of accrual-based costs in net outlays and the budget deficit might prompt deficit reduction efforts, nothing in the current budget process would require that the cost of insurance programs specifically be addressed as long as permanent authority was available to cover these costs. The earlier recognition would, however, increase control over legislated changes that increase future costs because, under PAYGO, legislation enacted during a session of the Congress affecting mandatory programs must be at least deficit neutral in the aggregate. Under both the budget authority and outlay approach, mechanisms could be developed to increase the link between earlier cost recognition and budget control. For example, requiring the accrued cost to be funded by discretionary appropriation would increase budget control because these costs would be forced to compete for limited resources under the discretionary spending caps. Alternatively, mechanisms that link funding shortfalls to premium increases or program coverage reductions could also be adopted.
Whether it is desirable for cost recognition automatically to trigger congressional action is a policy question. Consideration of the varied purposes and characteristics of these programs should inform the discussion on whether to adopt a trigger mechanism, and if so, how to design it. For example, requiring a discretionary appropriation would result in a fundamental change in the nature and operation of the majority of federal insurance programs that were originally classified as mandatory spending. The various approaches reflect trade-offs between changing budget incentives and other policy considerations. Table 6.2 provides an assessment of the relative potential of each approach to influence budget decision-making.
In summary, the supplemental approach would improve and provide more consistent disclosure of estimates of risk-assumed costs in the budget documents than is currently the case and might cause discussion, but it would not directly influence the budget incentives for these programs. The aggregate budget authority approach goes a step further and begins to incorporate accrual-based costs into the budget process by requiring the provision of budget authority at the time decisions are made. However, because accrual-based costs do not affect the “bottom line” or the budget deficit, the impact of this approach on budget decision-making is unclear. The aggregate outlay approach goes even further by incorporating costs directly into the deficit calculation and therefore is more likely to influence budget decisions than the aggregate budget authority approach. But direct budget control is not achieved for the majority of federal insurance programs, which are classified as mandatory spending. Under either the aggregate budget authority or the aggregate outlay approach, requiring a discretionary appropriation for the government’s subsidy costs would provide direct budget control.
As shown in table 6.2, the aggregate outlay approach and the two approaches using a discretionary control option are most likely to prompt action to address accruing program costs. However, under current budget rules, the incentives provided by each differ. Requiring a discretionary appropriation under the aggregate outlay approach would have the most influence on budget decision-making by affecting both the deficit and the discretionary spending caps. Under the aggregate budget authority approach with a discretionary control option, cost would have to be included under the discretionary spending caps but would not affect the deficit. As discussed earlier, if changing the locus of budget decision-making for these programs and thereby possibly affecting program operations is undesirable, then the aggregate outlay approach, through its impact on the deficit, has the greatest potential to influence budget decision-making.
section_title: Approaches Reflect Differing Views on the Use of Accrual-Based Information in Budgeting for Federal Insurance Programs
paragraphs: Within the budget community there exists a range of views about the appropriate balance between the need to change budget information and incentives for federal insurance programs and the increased uncertainty and complexity introduced by the use of accrual-based estimates directly in the budget. The various approaches to incorporating accrual-based information in the budget discussed above represent a spectrum of views about the uses of the federal budget and the trade-offs faced in using accrual-based information in budgeting for federal insurance programs.
The aggregate outlay approach reflects the opinion of some budget experts that the only way to influence budget decision-making significantly is to have a direct impact on the “bottom line” or the budget deficit. The key argument is that since the primary focus of the budget debate is the deficit, accrual-based reporting will not significantly influence budget decisions unless these costs are part of the deficit calculation. The use of a financing account to separate costly transactions and noncostly cash flows focuses reporting on the government’s subsidy cost. And, in the opinion of some budget experts, this increases the difficulty of diverting to other uses the funding accumulated as reserves.
The aggregate budget authority approach reflects both general concerns about the use of the nonbudgetary financing mechanisms and specific concerns that the aggregate outlay approach may not be necessary for some federal insurance programs. Despite the potential benefits of accrual-based information, a key reservation surrounding the adoption of the aggregate outlay approach is its use of nonbudgetary financing accounts. As a general point, some experts believe that all cash transactions should be included in the budget totals and that cash is a superior measure for the deficit because it is understandable and relatively transparent. Specifically, concerns have been expressed that the use of nonbudgetary financing accounts introduces new risks and may increase the incentive for cost manipulation. For example, estimates could be manipulated to obscure the potential program costs or the deficit if estimation methodologies are not widely accepted and documented. The uncertainty surrounding the risk-assumed cost estimates for some insurance programs increases these concerns. Thus, until estimation techniques are developed sufficiently to allay most of these concerns, the aggregate budget authority approach may be the most appropriate way to implement accrual-based budgeting for federal insurance programs.
In addition, some agency officials, budget experts, and analysts expressed concerns that the use of the aggregate outlay approach would increase the complexity of the budget reporting. According to some budget experts, budget authority and obligations are more appropriate than outlays for recognizing potential costs that have not yet materialized and that for some programs the costs of implementing the aggregate outlay approach would outweigh the potential benefits. Budget experts also differ on the use of discretionary spending mechanisms to increase budget control. One budget expert emphasized that requiring a discretionary appropriation for subsidy costs under the budget authority approach would increase budget control while preserving cash-based reporting of outlays and the deficit. However, other budget experts cautioned against changing the fundamental nature of mandatory federal insurance spending by requiring a discretionary appropriation under either the budget authority or outlay approach. For example, OMB has stressed that the goal of its previous proposal was not to change the nature of the spending but rather to improve the budget reporting for these programs.
Finally, the supplemental approach reflects the view that cash is the superior measure for budget decision-making or that the shift to accrual-based budgeting for federal insurance programs is premature or unnecessary. A key argument is that supplemental information can be used to improve budget decisions without subjecting the budget to any additional uncertainty or complexity. However, with this approach, there is no guarantee that the information will be used since it is not a part of the formal budget process.
Any choice among these approaches or variants of them is further complicated by the fact that the relative implementation difficulties—and the benefits achieved—vary across federal insurance programs. The trade-offs and implementation challenges associated with adopting accrual measures in the budget are discussed in the next chapter.
section_title: Implementing Accrual Budgeting for Federal Insurance Programs
paragraphs: Although accrual-based budgeting for federal insurance programs has the potential to improve the information available for resource allocation and fiscal policy decisions, implementing an accrual-based approach will present policymakers, budget professionals, and agency managers with many challenges. As discussed in chapter 5, the key implementation issue is whether reasonable, unbiased risk-assumed cost estimates can be developed for the insurance programs. However, generating cost estimates is only the first step in implementing accrual-based budgeting. Other significant challenges exist that would need to be addressed in implementing an accrual-based budgeting approach. These challenges fall into three broad categories: (1) issues inherent in the use of risk-assumed estimates in the budget, (2) short-term implementation issues that may be reduced or eliminated over time, and (3) issues related to the design and structure of an accrual-based budgeting system.
subsections: section_title: Issues Inherent in the Use of Accrual Estimates in the Budget
paragraphs: One of the major benefits of accrual-based budgeting is the recognition—when programmatic and funding decisions are being made—of the cost of future insurance claims related to the government’s insurance commitment. This earlier recognition of costs improves the information available to policymakers about their decisions and may improve the ability and incentives to manage these costs. However, as discussed, this earlier recognition of program cost is dependent upon reasonable, unbiased estimates of the risk assumed by the government in undertaking the insurance commitment. Because insurance program costs are dependent upon many economic, behavioral, and environmental variables, which cannot be known with certainty in advance of the insured loss, there will always be uncertainty in the reported accrual-based estimates. In addition, the use of risk-assumed cost estimation methodologies that attempt to capture the effects of these variables and new budget mechanisms to report estimates and reestimates will add complexity to budget reporting for these programs.
subsections: section_title: Earlier Cost Recognition Increases Estimation Uncertainty
paragraphs: While budgeting based on estimates of the full cost of the risk assumed by the government for federal insurance programs has the potential to improve the information available to policymakers at the time budget decisions are being made, actual claims paid in any one year will differ from the estimated cost of the commitments reported in the budget. This is an expected condition of using risk-assumed accrual cost estimates in the budget for insurance programs. Although estimates may get more accurate over time due to improvements in estimation methodologies, available data, and assumption specification, some error will always remain. Policymakers need to understand the nature and extent of the uncertainty in risk-assumed cost estimates and have assurances that the estimates are unbiased and based on the best available information and estimation methodologies.
The uncertainty embedded in estimates of the risk assumed by federal insurance programs is unavoidable. As discussed in earlier chapters, the nature of the risks covered by some federal insurance programs require that the risks be pooled over time. As a result, the expected long-term cost of the program reflected in the risk-assumed cost estimates will differ from the cash paid out in any given year. Reestimates will probably also be required over time if the program’s claim experience differs significantly from the previously calculated expected long-term cost. Improved program data could also lead to reestimates.
The uncertain nature of risk-assumed cost estimates must be weighed against potential improvements in budget reporting and cost control. A similar trade-off was made in budgeting for credit programs under the Federal Credit Reform Act of 1990. Although the accrual-based cost estimates of some loan and loan guarantee programs have significantly changed and their actual cost may not be known for 20 or more years, most budget experts believe that the budgeting for these programs has been improved. Specifically, by improving information and the recognition of program costs, accrual-based budgeting for credit programs has increased control over credit program costs, improved comparisons of the costs of credit program with that of other programs, and subjected credit programs to the competitive allocation of resources in the budget process. An accrual-based budgeting approach for insurance programs also has the potential to provide an opportunity to consider the appropriate or desired amount of government funding—or subsidy—provided to a particular program. Risk-assumed cost estimates would also allow policymakers, oversight agencies, and program managers to monitor the government’s risk exposure and to take timely steps to control program costs.
Uncertainty in the estimation of insurance program costs must be evaluated in terms of the direction and magnitude of the estimation errors. For budgeting purposes, decisionmakers would be better served by information that is more approximately correct on an accrual basis, than they are by cash-based numbers that are exactly correct but misleading. For example, industry analysts estimated that the accruing liabilities of insolvent thrift institutions exceeded the resources of the insurance fund in the early 1980s, years before the full magnitude of losses began to be recognized on a cash basis in the budget. Although estimates of the growing cost of the savings and loan crisis were not exact, the magnitude of the estimated losses proved to be correct. At the same time, the President’s budget request for the insurance fund prior to its collapse in 1989 estimated that cash collections would exceed cash losses in all but one year in the 1980s. Despite the uncertainty in the estimates of the government’s accruing cost—the exact cost of the savings and loan crisis is still not known with complete certainty—policymakers would have had better budgetary information and incentives for decision-making if the budget had reported such accrual-based estimates.
A key implementation challenge in adopting accrual-based budgeting for insurance programs is the difficulty in producing risk-assumed cost estimates. Although analogous to the implementation of credit reform, the estimation challenges for some insurance programs may be greater than those faced for most credit programs. For example, the cost of the government’s deposit and pension insurance commitments is dependent upon the ability to model complex interrelationships among highly uncertain variables such as interest rates, market risks, and the solvency of private companies. Estimation uncertainty will dictate continual evaluation of the risk estimation methodologies used to generate risk-assumed cost estimates for federal insurance programs.
For two programs in our study—Aviation War-Risk and Maritime War-Risk insurance—the uncertainty in the risk-assumed cost estimates and other implementation complexities probably outweigh the potential benefit from an accrual-based budget treatment. Given the emergency or stand-by nature of these programs, it is difficult to even know when they will be activated. As a practical matter, the infrequent and sporadic issuance of insurance, the resulting lack of historical experience, and the extraordinary circumstances surrounding activation of the programs may make the development of reliable risk-assumed estimates and the use of accrual-based budgeting for these programs infeasible.
section_title: Accrual Budgeting Will Increase the Complexity of Budget Treatment
paragraphs: Earlier recognition of insurance program costs under an accrual-based budgeting approach will add to the complexity of the budget treatment of these programs compared with the current cash-based reporting. Complexity is increased through the use of (1) sophisticated estimation models, (2) multiple budget accounts and/or presentations, and (3) procedures for reestimating costs reported as budget authority and/or outlays. Although recognition of insurance program costs may be improved under an accrual-based budgeting approach, general understanding of budget data and the budget process may decline. All of this must be assessed in relation to the adequacy and often misleading nature of cash budgeting for insurance programs.
As discussed in chapter 3, cash-based budgeting for insurance programs generally does not provide adequate information for resource allocation and fiscal policy decision-making. Although cash-based budgeting is readily understandable to policymakers and the public, it generally does not provide full information on insurance program costs at the time the government’s commitment is extended and thus may impair resource allocation and fiscal policy decision-making. Under credit reform, many budget experts agree that despite the complexity of credit reporting, decisions regarding a program’s structure—direct loans versus loan guarantees versus grants—and funding have been improved. A similar increase in complexity may be a necessary element to improving the budget information on the cost of insurance programs. Discomfort with and skepticism of these new measures could be alleviated by complete documentation of the estimation and reestimation procedures.
The complexity of the budget treatment of credit programs was significantly increased under the Federal Credit Reform Act of 1990. Very few people really understand the details of budgeting and accounting for credit programs. Although policymakers generally understand the concept behind budgeting for credit programs—setting aside funds for future losses—many still consider estimates of such costs as coming from a “black box.” Such lack of understanding of the estimation and reporting processes risks a loss of confidence in budget data. An accrual-based approach to budgeting for federal insurance would entail many of the same complexities, such as prospective cost estimation, multiple budget accounts, and periodic reestimation of reported costs. To provide confidence in the budget data, documentation and clear reporting are crucial.
section_title: Approaches for Incorporating Accrual Concepts Into the Budget Reflect Trade-Off
paragraphs: The three general approaches for incorporating accrual concepts into the budget for insurance programs discussed in the previous chapter illustrate the fundamental trade-off between earlier cost recognition on the one hand and increased uncertainty and complexity of budget reporting on the other. The degree of integration of accrual estimates in the budget—whether in budget authority alone or also in outlays—will determine the impact of this information on decision-making. While supplemental reporting of accrual-based costs would improve the information available for resource allocation and fiscal policy decisions, the actual impact on budget decisions is uncertain since the primary budget data would be unaffected. However, integration of accrual estimates into the budget beyond the supplemental approach also increases the complexity of the budget treatment and the uncertainty in the budget numbers.
The inherent uncertainty and complexity of accrual-based budgeting approaches for insurance programs heightens the need for careful consideration in the design and implementation of accrual-based budgeting for these programs. Policymakers face a trade-off between the need to improve information and incentives for decision-making and the acceptable level of uncertainty and complexity in budget reporting. Some budget experts believe that to have the most influence on budget decisions, accrued costs should be recognized in budget authority and outlays so that costs are reflected in the deficit. Others expressed concern about increased complexity and the use of nonbudgetary financing mechanisms such an approach would entail. This concern was heightened by the uncertainty surrounding risk-assumed estimates for some insurance programs. Further, some budget users stated that accrual-based information is already available to policymakers—in supplemental budget schedules and financial statements—and could be used in budget decision-making without the added complexity of putting accrual estimates into the budget numbers. The design and implementation of accrual-based budgeting needs to address these concerns if the potential benefits of accrual-based budgeting are to be achieved.
section_title: Short-Term Implementation Issues
paragraphs: In implementing any of the three general approaches for accrual-based budgeting for insurance programs, several short-term transitional issues would need to be addressed. First, as discussed in detail in chapter 5, the current capacity to generate reliable risk-assumed estimates varies considerably across insurance agencies. Difficulty in developing risk-assumed cost estimates should be anticipated. Second, many agencies expressed concern about the skills and resources necessary to implement accrual-based budgeting and comply with new reporting requirements. Experience gained in implementing an accrual-based budgeting approach for credit programs could help guide the transition to accrual-based budgeting for insurance programs. Supplemental reporting of risk-assumed estimates would provide additional information for policymakers while providing time to evaluate a more comprehensive approach.
subsections: section_title: Difficulty in Developing Risk-Assumed Cost Estimates Should Be Anticipated
paragraphs: Agency capacity to generate reasonably reliable risk-assumed cost estimates for budget purposes varies considerably across programs. Indeed, the ability to generate reasonable cost estimates of the risk assumed by the government was a primary concern expressed by the insurance program agency officials and budget experts we spoke with. At present, risk-assumed estimates of insurance losses related to coverage extended in a budget year do not exist for all programs and are not reported on a regular basis. Time and experience in developing these estimates will be required. Credit agencies have had difficulties in calculating reasonably accurate accrual cost estimates; similar and in some cases greater difficulties can be anticipated for insurance programs. However, experience also indicates that the focus placed on these estimates in the budget has led to their improvement.
Agency capacity to generate risk-assumed cost estimates for insurance programs will take time to develop. To implement accrual-based budgeting for insurance programs would require refining and adapting the models discussed in chapter 5. For example, an amortization process must still be developed and tested to take the total estimated cost to the government of pension insurance commitments generated by OMB’s model and convert it to an annual basis for budgeting. Modifications that are likely to be necessary to adapt the flood and crop insurance premium rate-setting models for use in generating risk-assumed cost estimates for the budget will also require time and resources. Agencies will require specialized professional staff such as actuaries, economists, and statisticians to develop and refine estimation models and produce the accrual cost estimates on a regular basis. Some agency officials we spoke with expressed concern about their ability to generate such estimates given current staff resources.
In implementing credit reform, we found that agencies experienced difficulty accurately estimating accrual-based cost estimates for three principle reasons: (1) future economic conditions are uncertain, (2) the government often is the lender of last resort, making it difficult to judge the risk, and (3) agencies’ historical data were nonexistent or unreliable.These same factors will complicate estimating risk-assumed cost estimates for insurance programs. In addition, differences between insurance commitments and loan guarantees will add to the complexity of generating accrual cost estimates for insurance programs. Unlike most credit programs which are limited by discretionary appropriations, the majority of insurance programs are mandatory and thus are not limited to a specific amount of insurance. Estimation is therefore complicated by the need to forecast demand for insurance—for example, the number of farmers opting for crop insurance coverage or the amount of deposits flowing into banks as opposed to other investment opportunities.
Improvements in the estimation of the government’s cost of insurance extended can be expected if accrual-based budgeting is adopted for these programs. Advocates of accrual-based budgeting point to the credit reform experience and argue that requiring estimates of the full cost of insurance programs in the budget would provide the incentive necessary to improve the quality of the estimates. For example, in response to credit reform reporting requirements, the Small Business Administration (SBA), in conjunction with OMB, recently completed an extensive analysis of its loan records dating back to fiscal year 1983. Prior to this study, SBA had been unable to validate its subsidy estimates or provide reestimates as required by credit reform. As a part of this analysis, SBA developed a model which allows it to take into account various loan and borrower characteristics in its subsidy estimates. Refined estimates of historical default and recovery rates were used to generate fiscal year 1997 budget estimates and reestimate prior year subsidy estimates.
The accuracy and reliability of estimates will also improve as a result of refinements in methodologies and the collection of additional data on program experience. For example, OMB has made several refinements to its deposit insurance model since it first applied options pricing theory to estimate the accruing costs of the program in 1990. The availability of data necessary for estimating accrual costs for some programs should improve over time, which in turn should improve the reliability of the risk-assumed cost estimates. For example, in its model for estimating costs of thrift deposit insurance, OMB has used data from small commercial banks to estimate various parameters. Although significant differences exist between bank and thrift institutions, the data OMB needed for its model do not exist for thrifts before 1990. Data available since 1990 are biased due to the recovery of the thrift industry during this period after the savings and loan crisis. As thrift data encompassing periods of both economic growth and contraction become available, OMB will be able to incorporate them into its thrift deposit insurance model. Similarly, risk assessment for the National Vaccine Injury Compensation program has been hampered by the relatively short existence of the program. Claims from 1989, the program’s first year of operation, have not all been settled. The reliability of estimates of the program’s potential costs will be difficult to judge until data from at least several years of program operation are available.
section_title: Agencies Raised Concerns About Their Ability to Implement Accrual-Based Budgeting
paragraphs: Agencies expressed concern about the staff and system resources necessary to implement an accrual-based budgeting approach similar to the outlay approach described in the previous chapter. They stated that additional resources would likely be necessary to generate cost estimates, collect the necessary data, and comply with new reporting requirements. Some agencies question whether the benefits of this type of an approach would be worth the resources required. Smaller agencies expressed concern that new requirements under an accrual system could divert resources from program operations and management. For example, the National Vaccine Injury Compensation program is administered by a staff of 25, 12 of whom are medical examiners. According to the agency, an increase in resources would be necessary to develop risk-assumed estimates for the budget.
As with credit reform, agencies would be faced with significant implementation challenges. While the characteristics of insurance programs may add additional complexity, experience gained from implementing credit reform could mitigate some of the agencies’ concerns. Some agencies that administer insurance programs also administer credit programs. Officials and staff at these agencies expressed strong concerns about the expanded reporting and data requirements of accrual-based budgeting, which were required under credit reform. For example, officials at the Veterans Benefits Administration (VBA), which oversees veterans’ life insurance programs as well as several loan guaranty programs, were generally supportive of an accrual-based budgeting approach for insurance. However, they stated that they would not be supportive of an accrual-based approach modeled after the treatment of loan guarantees under credit reform. They said that they did not believe that the outcome would be worth the cost needed to achieve it. In particular, they cited greatly expanded reporting requirements for VBA’s loan guaranty programs that required a large increase in resources needed to prepare the budget and track all the necessary data. Officials and staff of the Overseas Private Investment Corporation expressed similarly strong concerns. These concerns were based on their experience implementing credit reform for OPIC’s loan and loan guarantee programs.
Some agency officials suggested that accrual-based information is already available in the budget. Officials at OPIC expressed the opinion that the agency uses accrual-based estimates in the budget to the extent appropriate. OPIC currently obligates funds as a general reserve for the risk inherent in its insurance activities in the period it is estimated. OPIC officials stressed that the tools necessary to recognize insurance program costs already exist within the current budget process. Improved recognition of insurance program costs could be achieved by requiring agencies to obligate budget authority as a reserve when costs are estimated. This is essentially the aggregate budget authority approach outlined in the previous chapter. OPIC officials said that such an approach would improve cost recognition for federal insurance programs without adding to the complexity and burden of a system similar to credit reform. Officials of the Office of Personnel Management Retirement and Insurance Service also stated that currently, information on the assets and accrued liabilities of the Federal Employees’ Group Life Insurance fund is provided as part of the budget presentation. They said that they would be uncomfortable using accrual concepts more extensively in the budget due to the many factors involved in estimation and the uncertainty of such estimates.
Lessons learned from the implementation of credit reform could help address agency concerns about accrual-based budgeting for federal insurance programs. In the 5 years since credit budgeting and accounting reforms were implemented, OMB and the Department of the Treasury have been working with credit agencies to simplify requirements. Several interagency working groups have been formed to identify ways to comply with credit reform at the lowest possible cost, improve and standardize audit requirements, and utilize credit reform data and concepts for internal management purposes. Recommendations to streamline a number of data reporting and reestimation requirements have been partially implemented. The experience and recommendations of these work groups could aid in the development of rational procedures and reporting requirements for an accrual-based budgeting approach for insurance programs.
section_title: Supplemental Reporting of Risk-Assumed Estimates Would Allow Time to Evaluate a More Comprehensive Accrual-Based Budgeting Approach
paragraphs: The potential for accrual-based budgeting based on estimates of the risk assumed by the government to improve budget information and incentives for federal insurance programs argues for its implementation. However, the need to build capacity to generate risk-assumed cost estimates and the complexity of the implementation issues involved indicate that it is not feasible at this time to integrate risk-assumed cost estimates directly into the budget. Since risk-assumed estimates have not been produced and reported on a regular basis for most insurance programs, supplemental reporting of these estimates over a number of years could help policymakers understand the extent and nature of the estimation uncertainty and allow time to evaluate the feasibility of adopting a more comprehensive accrual-based budgeting approach.
If evaluation of the risk-assumed estimates demonstrates that estimation has developed sufficiently so that use of risk-assumed data in the budget will not introduce an unacceptable level of uncertainty, policymakers could consider a second phase of implementation—incorporating risk-assumed estimates into budget authority. The final phase would be the use of risk-assumed estimates in budget authority, outlays, and the deficit.
Supplemental reporting of risk-assumed cost estimates in the budget would allow time to: develop and refine estimation methodologies, assess the reliability of risk-assumed estimates, gain experience and confidence in cost measures for budget purposes, evaluate the feasibility of a more comprehensive accrual-based budgeting approach, and formulate cost-effective reporting procedures and requirements.
During this period, policymakers should continue to draw on information provided in audited financial statements. As noted in the report, financial statements can provide earlier recognition of accruing liabilities than does the cash-based budget for insurance commitments.
The Government Performance and Results Act (GPRA) of 1993, which laid out a series of steps to better integrate performance measures into the budget, could be used as a model for incorporating accrual cost measures in the budget. Statutorily-required evaluation of risk-assumed estimates would focus attention on improving cost estimation and provide an opportunity to assess the practicality of incorporating such estimates directly into budget authority, outlays, and the deficit. In the case of credit programs, estimates of interest rate subsidies were reported in the budget for 20 years prior to the implementation of accrual-based budgeting for those programs. The current capacity to generate risk-assumed estimates for insurance programs suggests that the additional focus and time allowed under a phased-in approach is warranted. Experience gained from this period would also be helpful in evaluating whether additional control mechanisms, such as discretionary funding of subsidies, are needed or desirable.
An alternate strategy would be to implement accrual-based budgeting on a program-by-program basis with consistent treatment of all insurance programs as the ultimate goal. Programs which have well-developed or established estimation methodologies would immediately be switched to an aggregate outlay accrual approach. Programs for which estimation methodologies do not exist or are not widely accepted would be required to develop or refine models. This would allow for the benefits of accrual-based budgeting to be realized immediately for some programs while other programs develop the necessary estimation methodologies and expertise.
Such a program-by-program approach has several drawbacks. First, it would introduce a lack of comparability among insurance programs in the budget—perhaps even skewing their apparent relative costs—and increase confusion about the information provided on insurance program costs. Second, a program-by-program approach fails to establish a standard for new insurance programs. Without such a standard, the long-term expected cost of any new insurance program may not be fully considered when the decision is made to establish it since only the program’s initial years’ cash flows would be reported in the budget. Finally, programs for which accrual-based budgeting holds the greatest benefits, such as deposit insurance and pension guarantees, are the ones for which implementation will be most difficult. Focusing time and resources on implementing accrual-based budgeting where the potential benefits are greatest offers the greatest potential for improved information. Implementing accrual-based budgeting for those programs where the benefits are low but not for other programs may lead to a situation in which efforts exceed the benefits and this could make it more difficult to sustain the effort necessary to proceed where potential benefits are greatest.
section_title: Technical Design Issues
paragraphs: The design and structure of an accrual-based budgeting approach for insurance programs will be a critical factor in its acceptance and effectiveness. Although accrual-based budgeting for these programs has the potential to improve budget information and incentives, individual program characteristics, differences in the government’s commitment, and the ability to generate reasonably reliable accrual cost estimates will require considerable effort in the design of processes and reporting requirements. The increased uncertainty and complexity involved in incorporating accrual measures into the budget heightens the need for careful consideration of technical design issues before moving to a more comprehensive accrual-based budgeting approach. These issues include the treatment of loss reserves, reestimation and funding shortfalls, previously accumulated program deficits, and administrative costs.
subsections: section_title: Establishing and Maintaining Insurance Reserves
paragraphs: Under a risk-assumed accrual-based budgeting approach for insurance programs, premium income in some years will exceed claim payments, while in other years income will be lower than claims. Because the insured risks cannot be diversified or pooled over a large enough number of participants with different potential for losses, reserves cannot be tied to commitments made in a given year. Instead, a general reserve would be established based on the risk inherent in the type of insurance provided. This would be a major difference between reserves for insurance programs and credit programs. In general, for credit programs, the large volume of loans or guarantees issued in any single year allows for sufficient diversification of risk and permits reserves to be set aside for each annual “book of business.” These reserves are reestimated annually over the life of each book of business.
Establishment of program reserves sufficient to cover the long-term cost of the insurance extended will take time and involve significant program funds. If premium rates were set to cover the long-term expected cost of the insurance extended, sufficient reserves could be established over time. However, until such reserve levels are reached, appropriations or borrowing authority may be necessary to cover claims in high loss years. Assuming that the program’s risk is adequately estimated, premium income would be sufficient in the long-term to repay any borrowing or appropriation and build reserves.
Maintaining funds set aside for insurance program reserves was a concern raised by several budget professionals. Because insurance reserves must be accumulated over several years and since the reserves are not tied to any specific year’s insurance commitments, funds could potentially be diverted to fund other program priorities, particularly given current budget constraints. This may be more of an issue under the budget authority approach than the outlay approach described in the previous chapter. Reserves held in nonbudgetary financing accounts under credit reform have thus far been maintained for their intended purpose. On the other hand, officials at the Federal Emergency Management Agency (FEMA) stated that when the flood insurance program began to accumulate reserves in the late 1980s, the Congress used the surplus to fund flood studies, flood plain management, and program salaries.
section_title: Reestimation and Funding Shortfalls
paragraphs: Periodic reestimation of the expected cost of the government’s insurance commitments will be necessary. Upward reestimates of the cost of the risk insured should be reflected in premium rates for new insurance commitments and/or the government’s subsidy. More complicated will be the funding of increases in the estimated costs of outstanding insurance commitments. Under credit reform, agencies are given permanent, indefinite authority to cover upward reestimates of the government’s costs related to credit commitments made in prior years. The architects of credit reform contend that this authority is necessary to encourage unbiased cost estimates and because some factors that affect costs—such as the economy—are beyond an agency’s control. Agencies are required to incorporate the factors that prompted a reestimation into the estimates of future subsidy costs. Conversely, some budget experts contend that the provision of permanent authority has created the potential for bias in original estimates since funding for any additional cost is provided automatically outside the appropriation process.
The nature of the government’s insurance commitment and the sensitivity of the largest insurance programs—deposit and pension insurance—to fluctuations in interest rates and general business conditions may make limiting the costs of reestimates and funding shortfalls difficult. Most federal insurance programs are open-ended, providing as much insurance as demanded. Unlike most federal credit programs in which the number of loans or loan guarantees can be specified and funding provided, it is neither practical nor desirable to directly limit insurance coverage—for example, by limiting the number of children vaccinated or the vesting of pension benefits. Thus, in changing the budget treatment of these programs, consideration must be given to the impact changes may have on the programs’ operations.
The Bush administration’s 1992 accrual budgeting proposal would have required the Congress to provide a mandatory appropriation when an insurance program’s costs exceeded its available resources on an accrual basis. The administration argued that, given the nature of the insurance commitments and their current budget treatment, this would have only explicitly authorized what was implicit under existing law. Other methods of handling shortfalls in a program’s funding could be considered. For example, a funding shortfall could trigger a premium increase unless the Congress acted to implement program reforms aimed at reducing program costs. Alternatively, premium increases or program coverage reductions could be implemented if reserves fell below certain specified levels. The impact on program participants could be mitigated by spreading the premium increase over several years.
Additional control mechanisms must be carefully designed or they could risk increasing overall costs to the government due to program interactions. For example, if a funding shortfall were to develop in the flood insurance program leading to a premium increase, this could cause participation in the program to fall. Ultimately, diminished participation could potentially lead to increased future costs to the government in the form of disaster relief.
section_title: Previously Accumulated Program Deficits
paragraphs: Some federal insurance programs that provide coverage for an extended or indefinite period of time, such as the Federal Employees’ Group Life Insurance program, currently report program deficits as measured under traditional accounting standards. The deficit for FEGLI at the end of 1996 was $3.4 billion. How costs incurred prior to conversion to accrual-based budgeting should be treated would have to be determined.
Several options exist for the reporting and funding of these costs. If estimates of the accrued costs at conversion can be made, under an accrual outlay approach these costs could be reported as a separate line in the program account. If the information necessary to estimate the future cash flows resulting from the previously accrued costs is unavailable or if the population insured changes significantly from year to year, a separate liquidating account could be used. If a liquidating account is used, funding of accrued costs could remain on a cash basis and simply be paid as claims come due. Alternatively, accumulated deficits could be amortized over a reasonable period of time and funded through appropriations or premium increases. These funds would be outlayed to the financing account and paid out for claims as necessary.
section_title: Administrative Costs
paragraphs: The treatment of insurance programs’ administrative costs will need to take into account the intended financing of such expenses. Currently, most programs fund administrative costs out of premium income, although some receive appropriated funds to cover these expenses. If a program is intended to be self-supporting, then an amount to cover administrative costs should be included in the risk-based premiums charged to participants. Under an accrual outlay approach, premium income would flow into the financing account and an amount would be transferred to the program account to cover administrative costs. The reported cost to the government would be zero. If a program is not self-supporting, an appropriation to the program account to cover administrative costs would be required. Administrative costs would be charged to the program account along with any premium subsidy. Outlays from this account would equal the total cost to the government for the insurance extended.
section_title: Conclusions, Recommendation, and Agency Comments
paragraphs: To support current and future resource allocation decisions and be useful in the formulation of fiscal policy, the federal budget needs to be a forward-looking document that enables and encourages users to consider the future consequences of current decisions. As such, the budget should clearly reflect the financial consequences of decisions made and provide the information and incentives necessary to assess the future implications of these choices. The current cash-based budget, however, generally provides incomplete and misleading information on the cost and fiscal impact of federal insurance programs. The use of accrual concepts in the budget for these programs has the potential to better inform budget choices. However, technical and practical challenges exist which will require careful and deliberate consideration in the design and implementation of an accrual-based budgeting approach for insurance programs.
Cash-based budgeting for federal insurance programs is limited for resource allocation and fiscal policy decisions because its focus on single-period cash flows does not usually reflect the government’s cost at the time the decisions are made to provide insurance coverage. The cash-based budget may misstate the cost of the government’s insurance commitments in any particular year because the time between receipt of program collections, the occurrence of an insured event, and the final payment of a claim can extend over several budget periods. As a result, current and future resource allocations may be distorted. Cash budgeting also is generally not an accurate gauge of the economic impact of federal insurance. While these shortcomings of cash-based budgeting exist for all insurance programs, the degree to which cash-based information is misleading varies significantly across programs.
The use of accrual-based budgeting for federal insurance programs has the potential to overcome a number of the deficiencies of cash-based budgeting. Accrual-based reporting would recognize the cost of the insurance commitment when the decision is made to provide the insurance, regardless of when cash flows occur. This earlier recognition of the cost of the government’s commitment would (1) allow for more accurate cost comparisons with other programs, (2) provide an opportunity to control costs before the government is committed to making payments, (3) build budget reserves for future claims, and (4) better capture the timing and magnitude of the impact of the government’s actions on private economic behavior. The degree to which accrual-based measures would improve cost recognition in the budget for insurance programs will vary based on the size and length of the government’s commitment, the nature of the insured risks, and the extent to which costs are currently captured in the budget. Further, whatever the conceptual benefits of risk-assumed cost measurement, the effective implementation of accrual-based budgeting on this basis is dependent on the ability to generate reasonable unbiased estimates of these costs.
In the past, concerns over the limitations of cash-based budgeting and the benefits of a shift to accrual-based budgeting have been driven by the financial condition of the two largest programs—deposit and pension insurance. These two programs remain central to the argument for accrual-based budgeting for insurance programs. The size of these programs in relation to total federal spending, and therefore their potential to distort resource allocation and fiscal policy, make the limitations of cash-based budgeting and the benefits of accrual-based budgeting more pronounced. The case for using accrual-based budgeting for other federal insurance programs varies in strength. Their smaller size and the degree to which cost information is currently considered by policymakers reduce to a varying degree the extent to which information and incentives would be improved under an accrual-based budgeting approach.
The ability to generate reasonable, unbiased estimates of the risk assumed by the government is critical to the successful implementation of accrual-based budgeting for insurance programs. As described in this report, the development and acceptance of estimation methodologies varies considerably across programs. The characteristics of the risks insured by the federal government, frequent program modifications, and the absence of sufficient data on possible losses have hampered the development of risk-assumed estimates. The use of risk-assumed estimates in the budget will require the refinement and adaptation of existing models and, in some cases, the development of new methodologies. Because risk-assumed estimates for the various insurance programs have not been produced and reported on a regular basis, it should be expected that agencies will need time to develop the capacity to generate these estimates for the budget. During this time period, the information on insurance losses contained in the programs’ financial statements, which are included in the budget appendix, provide policymakers with a valuable resource in monitoring these programs.
Improvements in estimation methodologies, available data, and assumption specifications may, over time, lead to more accurate cost estimates, but because insurance program costs are dependent upon many variables, some uncertainty in the reported accrual estimates is unavoidable. The use of sophisticated estimation models, new budget presentations, and the need for periodic reestimates will add complexity to the budget process. As a result, understanding of budget data and the budget process may decline. However, this increased complexity should be assessed in relation to the adequacy of cash-based budgeting for insurance programs. Although cash-based budgeting is readily understandable to policymakers and the public, it generally provides incomplete or misleading information on insurance program costs and thus may impair resource allocation and fiscal policy decision-making.
We believe that the potential benefits of an accrual-based budgeting approach for federal insurance programs warrant continued effort in the development of risk-assumed cost estimates. The complexity of the issues involved and the need to build agency capacity to generate risk-assumed cost estimates suggest that it is not feasible to integrate accrual-based costs directly into the budget at this time. Supplemental reporting of these estimates in the budget over a number of years could help policymakers understand the extent and nature of the estimation uncertainty and permit an evaluation of the desirability and feasibility of adopting a more comprehensive accrual-based approach. The value of reporting risk-assumed estimates was also endorsed by FASAB in accounting standards it developed, which require disclosure of risk-assumed cost estimates as supplemental information for insurance programs beginning with financial statements for fiscal year 1997. However, the Board also recognized the difficulty of preparing reliable risk-assumed estimates and, therefore, did not require their recognition on the financial statements as a liability.
Supplemental reporting of risk-assumed cost estimates in the budget has several attractive features. It would allow time to (1) develop and refine estimation methodologies, (2) assess the reliability of risk-assumed estimates, (3) formulate cost-effective reporting procedures and requirements, (4) evaluate the feasibility of a more comprehensive accrual-based budgeting approach, and (5) gain experience and confidence in risk-assumed estimates. At the same time, the Congress and the executive branch will have had several years of experience with credit reform, which can help inform their efforts to apply accrual-based budgeting to insurance. During this period, policymakers should continue to draw on information provided in audited financial statements.
If risk-assumed estimates develop sufficiently so that their use in the budget will not introduce an unacceptable level of uncertainty, policymakers could consider incorporating risk-assumed estimates directly into the budget. While supplemental reporting of risk-assumed estimates would improve the information on the cost of insurance commitments, the actual impact on budget decisions is uncertain since the primary budget data—budget authority and outlays—would be unaffected. Directly incorporating accrual-based cost estimates in both budget authority and outlays would have the greatest impact on the incentives provided to decisionmakers but would also significantly increase reporting complexity and introduce new uncertainty in reported budget data. Between these two approaches is one of incorporating accrual-based costs in budget authority alone, which has fewer of the disadvantages of the full accrual approach but also less impact on decision-making incentives. If an action-causing budget mechanism is desired, requiring a discretionary appropriation for the accrual-based cost of the government’s subsidy could provide additional incentive to control the government’s cost but—by changing the locus of decisions to the annual appropriation process—would go beyond merely changing the reporting of program costs and change the nature of federal insurance.
subsections: section_title: Matter for Congressional Consideration
paragraphs: The Congress may wish to consider encouraging the development and subsequent reporting of annual risk-assumed cost estimates in conjunction with the cash-based estimates for all federal insurance programs in the President’s budget. The Congress may also wish to consider periodically overseeing and assessing the reliability and usefulness of these estimates, making adjustments, and determining whether to move toward a more comprehensive accrual-based budgeting approach for insurance programs.
section_title: Recommendation
paragraphs: We recommend that the Director of the Office of Management and Budget develop risk-assumed cost estimation methods for federal insurance programs and encourage similar efforts at agencies with insurance programs. As they become available, the risk-assumed estimates should be reported annually in a standardized format for all insurance programs as supplemental information along with the cash-based estimates. A description of the estimation methodologies used and significant assumptions made should be provided. To promote confidence in risk-assumed cost measures, the estimation models and data should be available to all parties involved in making budget estimates and should be subject to periodic external review. As data become available, OMB should undertake and report on evaluations of the validity and reliability of the reported estimates.
section_title: Agency Comments and Our Evaluation
paragraphs: Officials from OMB agreed with this report’s conclusion that budgeting for insurance programs should be based on the government’s long-term expected cost of the insurance extended—the risk assumed by the government. Furthermore, OMB agreed that the challenges involved in bringing risk-assumed estimates into the budget are significant and that additional effort to improve estimation methods is required. OMB officials noted that they would like to pursue such improvements but are not doing so because they do not currently have the expertise that would be required.
OMB officials expressed concern about GAO’s use of the terms “cash” and “accrual” in this report to describe different approaches to budgeting for insurance programs. GAO chose to use the term “cash-based” because cash is the measurement basis for the amounts shown in the budget for budget authority, obligations, outlays, and receipts. The estimates for these amounts generally are made in terms of cash payments to be made or received. Under current budget concepts, these amounts reflect the cash flows associated with the insurance program activities—paying claims for events that have already occurred and collecting premiums for new commitments. GAO uses the term “accrual-based” to describe the use of risk-assumed cost estimates as the basis for reporting an insurance program’s budget authority, obligations, and outlays. Although, as OMB noted and discussed in chapter 4 of this report, the term “accrual” can be applied to a range of concepts and measures, GAO uses the term in the report because it is generally understood as a basis of measuring cost rather than cash flows.
OMB officials also suggested that the current federal budget system can be thought of as commitment-based or obligation-based budgeting and that the use of risk-assumed cost estimates is consistent with this concept. GAO agrees that this is a useful way of thinking about the potential changes in budgeting for insurance programs described in this report. As discussed in the report, using accrual-based cost information rather than cash-based information for reporting budget authority, obligations, and outlays could improve the recognition of the cost of the government’s commitments at the time it makes them. OMB officials made this same point saying that “cash does not carry out the principle of recognizing the cost of commitments at the time they are made.”
GAO modified relevant sections of the report to clarify its explanation of OMB’s views on the budget treatment of deposit insurance under an accrual-based approach. According to OMB officials, it was not OMB’s intent to treat deposit insurance differently from other insurance programs under the Bush administration’s 1992 insurance budgeting proposal. OMB agrees with GAO that for all programs what should be measured is the long-term expected cost of loss-generating events less premiums collected. However, given the nature and complexity of deposit insurance, the extent to which the OMB model—or any model—would be able to capture the full long-term expected cost of the government’s commitments is open to debate. This is due, in part, as OMB acknowledges, to the very difficult conceptual and measurement problems associated with accounting for rare catastrophic events, such as the savings and loan crisis, in a risk-assessment model.
Based on OMB officials’ suggestions, GAO dropped from chapter 1 a brief discussion of early budget commissions’ recommendations regarding accrual accounting in the federal government which was not necessary to convey our message that the current system of budgeting for insurance programs is deficient and may be improved with the use of risk-assumed measures.
OMB officials also provided a number of technical comments, which were incorporated into the report as appropriate.