[Senate Hearing 107-1032]
[From the U.S. Government Publishing Office]
S. Hrg. 107-1032
FUTURE OF INSURING TERRORISM RISKS
=======================================================================
HEARING
before the
COMMITTEE ON COMMERCE,
SCIENCE, AND TRANSPORTATION
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
__________
OCTOBER 30, 2001
__________
Printed for the use of the Committee on Commerce, Science, and
Transportation
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SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
ERNEST F. HOLLINGS, South Carolina, Chairman
DANIEL K. INOUYE, Hawaii JOHN McCAIN, Arizona
JOHN D. ROCKEFELLER IV, West TED STEVENS, Alaska
Virginia CONRAD BURNS, Montana
JOHN F. KERRY, Massachusetts TRENT LOTT, Mississippi
JOHN B. BREAUX, Louisiana KAY BAILEY HUTCHISON, Texas
BYRON L. DORGAN, North Dakota OLYMPIA J. SNOWE, Maine
RON WYDEN, Oregon SAM BROWNBACK, Kansas
MAX CLELAND, Georgia GORDON SMITH, Oregon
BARBARA BOXER, California PETER G. FITZGERALD, Illinois
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
Kevin D. Kayes, Democratic Staff Director
Moses Boyd, Democratic Chief Counsel
Mark Buse, Republican Staff Director
Jeanne Bumpus, Republican General Counsel
C O N T E N T S
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Page
Hearing held on October 30, 2001................................. 1
Statement of Senator Boxer....................................... 4
Statement of Senator Hollings.................................... 1
Prepared statement........................................... 1
Statement of Senator Kerry....................................... 2
Prepared statement........................................... 3
Statement of Senator Nelson...................................... 5
Statement of Senator Wyden....................................... 3
Witnesses
Hawkins, Phillip L., Chief Operating Officer, CarrAmerica Realty
Corporation.................................................... 44
Prepared statement........................................... 46
Keating, David, Senior Counselor, National Taxpayers Union....... 28
Prepared statement........................................... 30
Koken, Diane, Commissioner of Insurance for the Commonwealth of
Pennsylvania, National Association of Insurance Commissioners.. 36
Prepared statement........................................... 38
Moss, David, Associate Professor, Harvard Business School........ 48
Prepared statement........................................... 50
Nutter, Franklin, President, Reinsurance Association of America.. 65
Prepared statement........................................... 66
O'Neill, Hon. Paul, Secretary, Department of the Treasury........ 6
Prepared statement........................................... 9
Plunkett, Travis, Legislative Director, Consumer Federation of
America........................................................ 54
Prepared statement........................................... 56
Vagley, Robert, President, American Insurance Association........ 61
Prepared statement........................................... 62
Appendix
Prepared Statement On Behalf of the Following Associations and
Their Members: American Council for Capital Formation;
Associated General Contractors of America; American Resort
Development Association; Building Owners and Managers
Association International; International Council of Shopping
Centers; Mortgage Bankers Association of America; National
Apartment Association; National Association of Industrial and
Office Properties; National Association of Real Estate
Investment Trusts; National Association of Realtors; National
Multi Housing Council; Pension Real Estate Association; The
Real Estate Board of New York; The Real Estate Roundtable...... 81
FUTURE OF INSURING TERRORISM RISKS
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TUESDAY, OCTOBER 30, 2001
U.S. Senate,
Committee on Commerce, Science, and Transportation,
Washington, DC.
The committee met, pursuant to notice, at 2:30 p.m. in Room
SR-253, Russell Senate Office Building, Hon. Ernest F.
Hollings, Chairman of the Committee, presiding.
OPENING STATEMENT OF HON. ERNEST F. HOLLINGS,
U.S. SENATOR FROM SOUTH CAROLINA
The Chairman. The committee will come to order. We are very
honored this afternoon to have our distinguished Secretary of
Treasury. In that light, I am going to file my opening
statement.
[The prepared statement of Senator Hollings follows:]
Prepared Statement of Hon. Ernest F. Hollings,
U.S. Senator from South Carolina
I would like to welcome everyone today's hearing. I would like to
extend a special welcome to Treasury Secretary O'Neill for his
appearance before the Committee today.
This afternoon, the Commerce Committee will address the need for a
national policy and terrorism and other forms of insurance in light of
the changes the Sept. 11th terrorist attacks have wrought in the
private insurance market.
The problem exists because of insurance companies' threat that they
will either cease writing coverages for acts of terrorism unless they
receive some relief from the federal government. Given the many key
industries that now need terrorism insurance to carry out their vital
functions, with the major transportation industries being most
significant--airlines, airports, maritime, local port authorities,
rail, busing, pipelines--the Congress is compelled to act on this
matter.
The question now is not whether the Congress must act, but how?
What are the best policy and approach? In acting upon these questions,
the principle that we must follow, and the mission that we must stick
to--is protecting the American taxpayers from unreasonable risk of
exposure. The only way to do this is to ensure that the private market
assumes as much responsibility as its capacity will allow it.
The American people already appalled with the level of big business
bailouts that are occurring as they on the other hand continue to lose
their jobs. The Wall Street Journal--clearly no advocate of
liberalism--has raised questions about the economic policies Congress
is putting forth. The last thing we must do is push forward a bill that
leaves insurance companies on the windfall end and the American
taxpayers on the--stuck-with-the-bill-end!
We now know that the Administration has attempted to work out a
compromise with the Banking Committee. The agreement purportedly would
have the American taxpayers indemnifying 80% of all terrorism damages
for the first year, and assuming all damages beyond $10 billion the
second and third years, with the hopes the industry will come up with
the plan afterwards.
A number of groups, however, have raised doubts about the fairness
and prudence of this plan. They claim that it hardly forces the
industry to shoulder the financial responsibility of terrorism
commensurate with the industry's capacity. The groups that are
expressing these concerns range from conservative groups, such as the
American Taxpayers Union, to public interest groups, such as the
Consumer Federation of America. Some are asking the question as to
whether the proposal is too generous for an industry that today has
over $300 billion in surplus alone, over $100 billion in reinsurance,
in addition to over a trillion in asset worth. We now hear that new
entities already are preparing to enter the reinsurance market--thus
likely significantly increasing the market's capacity.
This gets to the point of this hearing and the action the Committee
plans to take on this issue.
The purpose of this hearing is to hear from the policy experts on
how the Congress ought to proceed on addressing the concerns about the
private insurance market in the wake of the terrorist attacks. The
Administration proposal will be examined, but we also will gather
comments on other approaches.
I know an issue of jurisdiction has arisen over this issue. Let the
record show, however, that for the past three decades, the Commerce
Committee has acted as the Committee of jurisdiction over the business
of insurance. It was this Committee that received the legislation
introduced in 1980 to amend the McCarran-Ferguson Act. Both in the
102nd and 103rd Congresses, the Commerce Committee was referred
legislation to establish broad federal regulation of the insurance
industry.
Additionally, through the hard work of Senators Stevens and Inouye,
over the past ten years, this Committee has been intensely engaged in
efforts to construct a national policy on natural disasters, with the
goal of making disaster insurance more available in the marketplace.
The Committee's work on that legislation has entailed continuous
discussions with state insurance commissioners and the insurance
industry. The issues and models that have been put forth to address the
issue of disaster insurance are, in essence, similar to the proposals
that are being discussed regarding terrorism insurance.
Before closing, I would like to again thank Secretary O'Neill for
agreeing to appear to present the Administration's proposal and look
forward to working with his Department on this issue.
Senator Kerry.
STATEMENT OF HON. JOHN F. KERRY,
U.S. SENATOR FROM MASSACHUSETTS
Senator Kerry. Mr. Chairman, I would like to ask unanimous
consent that my full statement be put in the record.
The Chairman. It will be included.
Senator Kerry. Unfortunately, I cannot stay through the
hearing, but I wanted to. Clearly we have to do something, Mr.
Chairman. The question is what, is how to structure this.
Obviously, if we are going to eliminate any risk-taking by--I
mean, the definition of where you have your cut line on what
risk you assume within industry and what we risk is the tricky
thing here, where you write it.
I suppose one could ask the question in some ways whether
the Government is in effect taking over all of that risk or
limiting it in some way, that we are in the business, we are
going to go on the downside but we are not going to be there on
the upside. It is that whole question, and so I am for
guaranteeing that people can be insured. Obviously the American
economy is going to need the reinsurance capacity, but the
question is, Mr. Secretary, where we draw the line and how we
do it in a sensible way. Insurance is supposed to reflect risk,
and now that risk is much greater, obviously, for something
like the World Trade Center or other kinds of things, or
perhaps even aircraft in the current mood. You cannot get the
insurance, so we need to guarantee that you can, even as we do
not assume something that takes away the marketplace itself, I
guess is what I am saying.
So Mr. Chairman, I hope we can answer those questions
today, and I thank you for having this hearing.
[The prepared statement of Senator Kerry follows:]
Prepared Statement of Hon. John F. Kerry,
U.S. Senator from Massachusetts
Mr. Chairman, thank you for holding this hearing to help our
insurance industry maintain our economic stability in the wake of the
events of September 11 attacks.
Without access to insurance, future economic activity in the United
States is imperiled. I believe we must do everything possible to
stabilize the private insurance market and ensure that coverage for
terrorism risk is available to businesses and individuals who need it.
It is one more action the Congress can take to ensure that terrorists
do not win.
The attacks of September 11 have taken important reserves away from
the insurance and reinsurance industry and have made it more difficult
for the insurance industry to develop prices on terrorism risk
insurance. With terrorists attacking our freedom, we must help our
insurance and reinsurance companies so they can hold firm and continue
offering coverage to their clients. I am disappointed to hear that some
reinsurance companies are considering dropping terrorism risk insurance
at the end of this year.
Without access to reinsurance, many insurance companies will be
unable to offer terrorism risk insurance to its clients next year. This
could affect the future economic growth of our nation because access to
terrorism risk insurance is vital so that financial institutions can
provide financing for businesses, real estate and construction
projects. Without access to capital from financial institutions,
businesses will have difficulty expanding or even meeting payrolls.
That is why I believe it is important for the federal government to
take appropriate action to assist our insurance industry in providing
terrorism risk insurance during this crisis. However, I am concerned
about a provision of the Bush Administration proposal that would
provide new legal procedures to manage and structure litigation arising
out of mass tort terrorism incidents. This legislation is likely to be
considered on an expedited basis in the Congress. I believe it will be
very difficult if not impossible to craft a provision that will ensure
that any liability arising from terrorist attacks results from culpable
behavior without imposing inappropriate limits on the legal rights of
those affected by a terrorist act. Therefore, I do not believe any
provision to limit legal action should be included in any insurance aid
package.
I look forward to working with the Bush Administration in
developing a terrorism insurance proposal that would have the federal
government assist insurance companies in paying any significant future
terrorism claims. However, as we develop this proposal into
legislation, I believe it is important that the federal government
provides taxpayer funds as a last resort and only for a limited period
of time. It is crucial that the insurance industry continues to be
responsible for the risks borne by property/casualty insurance
policies. Further, while it will be difficult for insurance companies
to develop appropriate prices for terrorism risk insurance, I will
strongly object to any company taking this opportunity to gouge their
customers or force them to pay rates above what is necessary.
I look forward to hearing the testimony of the witnesses.
The Chairman. Thank you. Senator Wyden.
STATEMENT OF HON. RON WYDEN,
U.S. SENATOR FROM OREGON
Senator Wyden. Thank you, Mr. Chairman. I will be brief. I
think this is an important hearing that you are holding, and I
will tell you I have been troubled about the fact that
insurance premiums have risen sharply since September 11, even
in a number of areas of this country that seem unlikely to be
terrorist targets, and what I am particularly hopeful is that
the Secretary can spell out today how his approach specifically
will help to keep insurance rates down for consumers.
I think it is important that anything Congress does in this
area actually translates into more affordable insurance for
consumers, rather than just funds that the companies would
keep, and so I would just pass this on, Mr. Secretary, by way
of saying that this is really in my view central to doing this
in the right way.
In addition to that, I think it is important that there be
more openness and more accountability with respect to this area
than there was in the airline bailout legislation. It is very
clear that we are going to be faced with one industry after
another coming to the United States Senate asking for
assistance, so I come today to listen, and I am certainly
anxious to work with the administration in a bipartisan way,
but first and foremost I think it is important that this effort
spell out how it will help to moderate rates, and the New York
Times and others are reporting rates are going up all over the
country, even in areas where terrorist acts are unlikely, and
then the additional concerns of having openness and
accountability are important, Mr. Chairman.
I thank you.
The Chairman. Senator Boxer.
STATEMENT OF HON. BARBARA BOXER,
U.S. SENATOR FROM CALIFORNIA
Senator Boxer. Thank you, Mr. Chairman, and welcome. I also
am interested in listening. I want to make a couple of
observations that I hope maybe could be answered, Mr. Chairman.
I share what Senator Wyden said about the long-term impact
on rates. I also know how effective you have been, Mr. O'Neill,
in bringing this issue to our attention. I would like to see
the administration be just as strong in terms of helping the
people who lost their jobs, because now this would be the
second industry, quote-unquote, bail-out, or assistance, but we
have not seen, at least I have not seen the same excitement and
commitment to do something for the working people who are
really struggling with this.
A couple of inconsistencies that I want, or I hope that Mr.
O'Neill could discuss is these different signals coming from
them that, let us get back to normal, business as usual, go to
the World Series, live our life, and yet let us get ready to
bail out the insurance companies when the next terrorist attack
comes, so if you know something that we do not know in terms of
that, I would like to know it.
And then secondly, what I thought was interesting is the
National Association of Insurance Commissioners' press release
after the recent attacks, that read as follows: Policyholders
can rest assured, knowing that the insurance industry in the
United States is a $1 trillion industry, with assets of more
than $3 trillion. Therefore, and this is their words,
preliminary loss estimates of $20 billion represent only 2
percent of the premiums written in 2000, end quote.
Now, having said all of that, I do think the issue of
reinsurance is crucial. I mean, if it is not there, it is a
problem, but if we are to become a reinsurance company, that
is, Uncle Sam, the taxpayers, I would like to see us in essence
get some payment from the insurance companies, just like they
pay reinsurance companies, and so I think if we are going to
take on this role as being a reinsurance company, that means
taxpayers, U.S. taxpayers, it should not be a bail-out. It
should be a pay-as-you-go situation.
I might close in saying in California we do that with
earthquake insurance. The state has stepped in and in fact
functions in that fashion, and there are funds that are paid
in, and the Government acts as a reinsurance company.
So those are my thoughts, Mr. Chairman. I thank you.
The Chairman. Thank you. Senator Nelson.
STATEMENT OF HON. BILL NELSON,
U.S. SENATOR FROM FLORIDA
Senator Nelson. Mr. Secretary, good to see you again. Mr.
Chairman, I just simply want to make one statement, what should
be our goal, our challenge here, and it is that we ought to be
protecting America's insurance consumers, both corporate and
individual, by making sure that the insurance, this terrorism
insurance is both available and affordable to protect against
these kinds of despicable acts in the future, and so I had an
opportunity to testify last week at length on this subject. I
am just going to not make any more statements, and get into it
as we get into the discussion and the questions.
The Chairman. One thing, Mr. Secretary, that disturbed the
committee, we have been handling insurance matters for my 35
years as a member of this committee, but the administration has
never contacted anybody on this committee or myself or the
Ranking Member relative to any kind of plan to assist with this
terrorism insurance. It looked like an end run by the
companies, not by the administration, and in that light I
thought it certainly was our responsibility to look into it.
Looking into it, as has been noted, as Senator Boxer said,
not a free ride. I just looked at my current issue of Business
Week entitled, Giving Insurers a Break But Not a Free Ride, and
the administration is not asking underwriters to pay anything
for this new terrorism coverage, but the Government should
charge insurers premiums for it so that over time insurers will
reimburse the U.S. Treasury for any cost, otherwise, in the
London Economist, with respect to--and that is, again, October
26, insurance looking up on page 71, after calamity, investors
and insurers panic. It happened after Hurricane Andrew struck
Florida in 1992, after the Northridge Earthquake wreaked havoc
in Los Angeles in 1994, and again after the attacks of
September 11, when investors dumped their shares in insurance
companies around the world, then all of a sudden the investment
mood changed.
The sector has recovered to a level higher than immediately
before the attack, and then going on, talking about the hardest
hit by the cost of claims were Berkshire Hathaway, Munich Re,
Swiss Re, Zurich Financial Services, and AIG, quote, if they
can pay their claims, they say, and the share prices of almost
all of them have recovered.
So we need to meet not within a panic situation, but within
a judicious temperament here to try to make sure, as Senator
Nelson has pointed out, that there is affordable, and in making
it affordable, the United States government, which does not
have jurisdiction over insurance, it is the States has had that
for years. Let us be fair about the thing and try to spread the
cost amongst the carriers themselves.
With that, let me yield first to Senator Breaux and then
Senator Smith.
Senator Breaux. I will wait.
The Chairman. Senator Smith.
Senator Smith. Mr. Chairman, I do not have an opening
statement. I am anxious to hear the witnesses.
The Chairman. Very good. Mr. Secretary, we welcome you.
STATEMENT OF HON. PAUL O'NEILL, SECRETARY,
DEPARTMENT OF TREASURY, ACCOMPANIED BY SHEILA BAIR, ASSISTANT
SECRETARY FOR FINANCIAL INSTITUTIONS
Secretary O'Neill. Thank you, Mr. Chairman. It is a
pleasure to be here and meet with you and members of the
committee. We have, in fact, testified before your colleagues
on the Senate Banking Committee and have been meeting with
them. In fact, we had a meeting with Chairman Sarbanes and
Senator Dodd and Senator Gramm this afternoon that we have been
developing the subject, and have also testified in the House,
and I welcome this opportunity to appear.
If you do not mind, I would like to introduce Sheila Bair
who is sitting here with me. She is an Assistant Secretary at
the Treasury Department, and when I was congratulated the other
day on how acute my testimony was I had to quickly say, Sheila
did it, and so I thought rather than leave the impression that
I wrote this myself I wanted you to know Sheila Bair wrote this
testimony, which I am very proud to deliver, because I agree
with everything that is in it, and I have spent a lot of time
thinking about it.
The Chairman. We are delighted to have her.
Secretary O'Neill. I have a statement that I would like to
submit for the record.
The Chairman. It will be included.
Secretary O'Neill. If you do not mind, Mr. Chairman, I have
a statement that will take about 10 minutes to work through
that I think is worth working through because it addresses some
of the issues that have been raised in the first round by the
committee, and then go directly to questions.
Mr. Chairman, members of the committee, I appreciate the
opportunity to comment on terrorism risk insurance. We believe
there is a real and pressing need for congress to act on this
issue now. Market mechanisms to provide terrorism risk
insurance coverage have broken down in the wake of September
11. Such coverage is now being dropped from casualty and
property reinsurance contracts as they come up for renewal.
With most policies renewing at year end, if congress fails to
act, reinsurers have signaled their intention to exclude such
coverage, meaning that primary insurers may have to drop this
coverage or institute dramatic price increases.
As a result, after January 1, the vast majority of
businesses in this country are at risk for either losing their
terrorism risk insurance coverage or paying steep premiums for
dramatically curtailed coverage. If businesses cannot obtain
terrorism risk insurance, they may be unable to obtain
financing or financing may be available only at much higher
costs. This would have widespread effects as businesses of all
types may, for instance, be unable to expand their facilities
or build new facilities.
First, to state the problem as clearly as I know how, and
of course you all know this, insurance companies do not take
risks. They knowingly accept and mutualize risk. Because
insurance companies do not know the upper bound of terrorism
risk exposure, they will protect themselves by charging
enormous premiums, dramatically curtailing coverage or, as we
have already seen with terrorism risk exclusion, simply refuse
to offer the coverage.
Whatever avenue they choose, the result is the same,
increased premiums and/or increased risk exposure for
businesses that will be passed on to consumers in the form of
higher product prices, transportation costs, energy cost, and
reduced production.
Put another way, any of these choices have the potential to
cause severe economic dislocations in the near term, either
through higher insurance costs or higher financing costs, and
let me say parenthetically that no insurance company would
receive a single penny from the federal government if the
administration's proposal were to be enacted by the congress.
This is not a bail-out bill for the insurance industry that we
have proposed. It is, we believe, on the other hand a way to
provide for the continuation of insurance coverage for the
private sector, by the private sector.
Since September 11, the uncertainty surrounding terrorism
risks have disrupted the ability of the insurance companies to
estimate, price, and insure the risk. In grappling with this
problem, we have had several objectives. First and foremost, we
want to dampen the shock to the economy of dramatic cost
increases for insurance or curtailed coverage. We also want to
limit Federal intrusion into private economic activity as much
as possible while still achieving the first objective, and we
want to rely on the existing State regulatory infrastructure as
much as practicable.
After reviewing an array of options, we developed a plan
that we think best accomplishes this objective. This reflects
the current evolution of our thinking on this issue and, as I
have said to the other committees of congress, we want to work
with the congress to achieve the best possible solution, and
the way to know when we have achieved the best possible
solution will be that the market works. If what we do as a
result of our consultations results in legislation that does
not permit the existence of a terrorist risk insurance, then we
have failed. No one yet knows what those terms will be that
will work in the marketplace.
When terrorists target symbols of our nation's economic,
political, and military power, they are attacking the Nation as
a whole, not a symbol. This argues for spreading the cost
across all taxpayers, yet there are also reasons to limit the
Federal role. If property owners do not face any liability from
potential attacks, they may underinvest in security measures
and backup facilities. In addition, the insurance industry has
sufficient experience and capacity to price some portion of the
risk associated with terrorism and has the infrastructure
necessary to assess and process claims.
Under the approach we are suggesting, individuals,
businesses, and other entities would continue to obtain
property and casualty insurance from insurance providers as
they did before September 11. The terms of the terrorism risk
coverage would be unchanged and would be the same as that for
other risks. Any loss claims resulting from a future terrorist
act would be submitted by the policyholder to the insurance
company. The insurance company would process the claims and
then submit an invoice to the Government for the payment of the
uncovered share by the insurance company.
The Treasury would establish a general process by which
insurance companies submit claims. The Treasury would also
institute a process for reviewing and auditing claims and for
ensuring that the private-public loss-sharing arrangement was
apportioned among all insurance companies in a consistent
manner.
State insurance regulators would also play an important
role in monitoring the claims process, and ensuring the overall
integrity of the insurance system.
Through the end of 2002, the Government would absorb 80
percent of the first $20 billion of losses resulting from
terrorism and 90 percent of insured losses above $20 billion.
Thus, the private sector would pay 20 percent of the first $20
billion in losses and 10 percent of losses above that amount.
Under this approach, the federal government is observing a
portion, but only a portion of the first dollar of losses,
which we believe is important to do in the first year of the
program.
The key problem faced by insurance companies now is pricing
for terrorism risk. We favor a first dollar loss-sharing
approach in the first year, because we are concerned about
premium increases over the next 12 months. We see this as the
best way to mitigate against premium increases, but it may not
be the only approach. Again, we are prepared to work with you
to find an approach that works in the marketplace.
The role of the federal government would recede over time,
with the expectation that the private sector would further
develop its capacity each year. In 2003, we would have the
private sector be responsible for 100 percent of the first $10
billion, 50 percent of the losses between 10 billion and 20,
and 10 percent of the losses above $20 billion. The Government
would be responsible for the remainder.
In 2004, the private sector would be responsible for 100
percent of the first $20 billion, 50 percent of losses between
$20 and $40 billion, and 10 percent of losses above 40, and the
Government would be responsible for the remainder. To preserve
flexibility in an extraordinary attack, combined private-public
liability for losses under the program would be capped at $100
billion in any year that is left to the congress to determine
what to do if payments needed to be or were required to be by
experience above $100 billion.
The federal government's involvement would sunset after 3
years. That is to say that we would be out of it.
This approach would also provide certain legal procedures
to manage and structure litigation arising out of mass tort
terrorism incidents. This includes consolidation of claims into
a single form, a prohibition against punitive damages, and
provisions to ensure that defendants pay only for noneconomic
damages for which they were responsible.
It is important to ensure that any liability arising from
terrorist attacks results in culpable behavior rather than
overzealous litigation. These procedures are important in
mitigating losses arising from any future terrorist attack on
our Nation, and are an absolutely essential component of the
program that we propose.
Mr. Chairman, for the reasons I have set forth, the
administration believes the economy is facing a temporary but
nevertheless critical market problem in the provision of
terrorism risk insurance. Leaving this problem unresolved we
believe threatens our economic stability. The approach that I
have outlined limits the Government's direct involvement,
retains those elements of our private insurance system that
continue to operate well, and provides a transition period to
allow the private sector to establish market mechanisms to deal
with this insidious new risk that confronts our Nation.
Now I would be pleased to respond to any questions you or
the committee may have, Mr. Chairman.
[The prepared statement of Secretary O'Neill follows:]
Prepared Statement of the Honorable Paul H. O'Neill,
Secretary of the Treasury
Mr. Chairman, Senator McCain, and Members of the Committee, I
appreciate the opportunity to comment on terrorism risk insurance.
These hearings are extremely important. We believe that there is a real
and pressing need for Congress to act on this issue now. As I will
discuss in more detail, market mechanisms to provide terrorism risk
insurance coverage have broken down in the wake of September 11. Such
coverage is now being dropped from property and casualty reinsurance
contracts as they come up for renewal, with most policies renewing at
year-end. If Congress fails to act, reinsurers have signaled their
intention to exclude such coverage meaning that primary insurers may
have to drop this coverage or institute dramatic price increases. As a
result, after January 1 the vast majority of businesses in this country
are at risk for either losing their terrorism risk insurance coverage
or paying steep premiums for dramatically curtailed coverage. This
dynamic can in turn be expected to cause dislocations throughout our
economy, particularly in the real estate, transportation, and energy
sectors.
1. The Problem
The terrorist attacks of September 11 created widespread
uncertainty about the risk and potential costs of future terrorist
acts. Since September 11, we have endured this uncertainty every day as
a country. It has permeated every sector of our economy.
A key part of the government's response to the events of September
11 is to ensure that our economic stability is not undermined by
terrorist acts. Continued economic activity is dependent on well
functioning financial markets--where the lifeblood of capital is
provided to business enterprises. Financial markets allocate capital
based on the potential success of a business. In doing so, financial
markets rely on the insurance sector to mitigate certain types of risk
that are not directly related to the plans or operations of a business.
Insurance companies manage risk in economic activity and facilitate
the efficient deployment of capital in our economy by estimating
probabilities of possible adverse outcomes, and pooling risk across a
large group. Since September 11 the uncertainty surrounding terrorism
risk has disrupted the ability of insurance companies to estimate,
price, and insure the risk.
We learned on September 11 that, while perhaps highly improbable,
terrorists are capable of enormous destruction. Could such an event be
repeated? As a country and a government, we are doing everything in our
power to prevent a repetition of anything like the events of September
11. But how does an insurance company assess this uncertainty? How does
an insurance company price for it? At the moment, there are no models,
no meaningful experience, no reasonable upper bound on what an
individual company's risk exposure may be.
Insurance companies do not ``take'' risks. They knowingly accept
and mutualize risks. They are private, for-profit enterprises. If they
do not believe they can make money by underwriting a particular risk,
they will not cover it. Because insurance companies do not know the
upper bound of terrorism risk exposure, they will protect themselves by
charging enormous premiums, dramatically curtailing coverage, or--as we
have already seen with terrorism risk exclusions--simply refusing to
offer the coverage. Whatever avenue they choose, the result is the
same: increased premiums and/or increased risk exposure for businesses
that will be passed on to consumers in the form of higher product
prices, transportation costs, energy costs and reduced production.
The consequences of uncertainties surrounding terrorism risk are
already evident in the airline sector. The Department of
Transportation's initial projection is that, as a result of the
September 11 attacks, airlines will pay nearly $1 billion in premium
increases for terrorism risk insurance in the next year despite a
congressionally imposed cap on third-party liability. Within the next
few months, similar increases can be expected for other forms of
economic activity deemed ``high risk''--if coverage is available at
all. Higher premiums will divert capital away from other forms of
business investment.
The need for action is urgent. From our conversations with
insurance company representatives, state insurance regulators,
policyholders, banks and other entities which provide financing for
property transactions, the next two months are critical. The insurance
industry relies on a complicated structure of risk sharing. Risk is
shared among primary insurers, reinsurers, and retrocessionairs (i.e.,
providing reinsurance to the reinsurers). This structure has worked
well in the past and greatly contributed to widely spreading losses
associated with the events of September 11 across the insurance
industry.
However, in light of the uncertainty created by September 11,
reinsurers have told us that they will no longer cover acts of
terrorism in their reinsurance contracts with primary insurers. And as
I have said, most property and casualty insurance contracts are up for
renewal at year-end. This will create the following choices for
insurers: assume all of the risk of terrorism coverage and raise prices
to cover all of the associated, unshared costs; reduce coverage levels;
or cancel coverage. Any of these choices has the potential to cause
severe economic dislocations in the near-term either through higher
insurance costs or higher financing costs.
2. Objectives
In grappling with this problem, we have had several objectives.
First and foremost, we want to dampen the shock to the economy of
dramatic cost increases for insurance or curtailed coverage. We also
want to limit federal intrusion into private economic activity as much
as possible while still achieving the first objective. And we want to
rely on the existing state regulatory infrastructure as much as
practicable.
Note that none of these objectives are directed at providing
government assistance to the insurance industry. The industry is
absorbing the financial losses it contracted for as a result of the
September 11 attacks, and is fully capable of making good on those
losses. The industry is also capable of continuing to provide insurance
for non-terrorist hazards. The problem, as I have said, is one of
uncertainty about future terrorist risk. At the moment, there is no
basis upon which to price terrorism risk and no sense of the upper
bound on the risk exposure.
3. Options
Over the past few weeks, a variety of proposals have emerged to
deal with the problem I have outlined. Before turning to the approach
we have developed, I will briefly discuss a few of the alternatives we
considered and some of the shortcomings we identified with each.
A case could be made to treat terrorism risk insurance like war
risk insurance. During World War II, the federal government provided
property owners with insurance protection against loss from enemy
attack. Similarly, the Israeli government provides insurance for
terrorism risk. This approach would recognize the terrorist threat as
one made against all Americans and would establish the broadest
possible risk pool for insuring against this risk. At the same time,
such an approach implies a permanent federal intrusion in the market so
long as any terrorism risk remains.
A second approach, one suggested in various forms by insurance
industry representatives, involves the creation of a reinsurance
company to pool terrorism risk. This model follows an approach
developed in the United Kingdom in response to IRA terrorist
activities. This approach has some appeal, especially in providing a
vehicle for pooling the industry's risk while providing an upper bound
on industry losses through a government backstop. With more time, or in
different circumstances, this approach may have been desirable.
In our judgment, however, it has several significant shortcomings.
First, the approach ultimately leads to the federal government setting
premium rates by establishing the rate charged to the pool for the
government's backstop. If the basic problem is that the insurance
industry--whose business it is to measure and price risk--cannot
currently price terrorism risk without distorting markets, why would we
think the government can do a better job?
Establishing a pool would also take time, and time is very limited
since most policies expire at year-end. It is unclear how long it would
take industry to capitalize the pool. In the interim, the government's
exposure could be substantial, insofar as it would be liable for 100
percent of losses that exceeded the pool's capitalization. In addition,
we question whether the government could move quickly enough on its end
to establish the contracts, the pricing structure, and the regulatory
structure needed to make the proposal work.
Finally, the pool approach creates a federal insurance regulatory
apparatus with some presumption of permanence, and a potentially
enormous pool of captive capital that we may never need to use. We
believe that there will be less uncertainty about terrorism risk a few
years from now and that uncertainty will be more manageable by the
private sector than is the case today. Given that, why undertake the
effort to create a monopoly reinsurer and give a new federal regulator
the power to both set prices and regulate insurance companies and their
activities?
A third option would be to simply set a large industry deductible
and let the federal government cover all losses from acts of terrorism
past that point. For instance, the federal government could require the
insurance industry to cover all losses up to, say, $40 billion in a
given year and the federal government would pay all losses above that
amount.
This approach has two substantial drawbacks. First, it does not
address the fundamental problem: the industry has no basis for
knowing--and hence pricing--terrorism risk. A large deductible would
require them to assess premiums large enough to cover a large potential
loss. In the absence of better information, we might well expect
companies to price insurance as if they fully expected losses up to the
deductible amount. Second, this approach makes it difficult to control
losses above the deductible as insurance companies would have no
incentive to limit costs once their deductible has been paid.
4. A Shared Loss Compensation Program
After reviewing these and other options, and discussing these
issues with congressional and industry leadership and the state
insurance regulatory community, we developed an approach that we
believe best accomplishes the objectives I set forth. Let me say at the
outset that this approach reflects the current evolution of our
thinking on this issue. We want to work with Congress to achieve the
best possible solution. As I have said, the insurance industry can
easily protect itself by eliminating coverage or charging very high
premiums. What we are trying to do is craft a plan that will prevent
the economic dislocations that will otherwise take place if private
insurers follow the course they are now on. It is imperative that we
find a solution that works in the marketplace. We must get it right,
and we must get it right now.
When terrorists target symbols of our nation's economic, political
and military power, they are attacking the nation as a whole, not the
symbol. This argues for spreading the cost across all taxpayers. Yet
there are also reasons to limit the federal role. If property owners do
not face any liability from potential attacks, they may under-invest in
security measures and backup facilities. In addition, the insurance
industry has sufficient experience and capacity to price some portion
of the risk associated with terrorism and has the infrastructure
necessary to assess and process claims.
Under the approach we are suggesting, individuals, businesses, and
other entities would continue to obtain property and casualty insurance
from insurance providers as they did before September 11. The terms of
the terrorism risk coverage would be unchanged and would be the same as
that for other risks.
Any loss claims resulting from a future terrorist act would be
submitted by the policyholder to the insurance company. The insurance
company would process the claims, and then submit an invoice to the
government for payment of its share.
The Treasury would establish a general process by which insurance
companies submit claims. The Treasury would also institute a process
for reviewing and auditing claims and for ensuring that the private/
public loss sharing arrangement is apportioned among all insurance
companies in a consistent manner. State insurance regulators would also
play an important role in monitoring the claims process and ensuring
the overall integrity of the insurance system.
Through the end of 2002, the government would absorb 80 percent of
the first $20 billion of insured losses resulting from terrorism and 90
percent of insured losses above $20 billion. Thus, the private sector
would pay 20 percent of the first $20 billion in losses and 10 percent
of losses above that amount.
Under this approach the federal government is absorbing a portion--
but only a portion--of the first dollar of losses, which we believe is
important to do in the first year of the program. The key problem faced
by insurance companies right now is pricing for terrorism risk. While
this type of loss sharing approach does not completely alleviate that
problem, it does provide insurance companies with the ability to
evaluate potential losses on a policy by policy basis, with clearly
defined maximum exposures. For example, on a $100 million commercial
policy the insurance company's maximum exposure would be $20 million.
If industry losses were greater than $20 billion that exposure would be
reduced even further.
More importantly, price increases to policyholders should be lower
under this approach than under an approach that requires companies to
absorb 100 percent of losses up to a large, aggregate industry loss
deductible. Under this approach, if an insurance company's maximum
exposure was defined at $20 million on a $100 million policy, the
insurance company could then price that $20 million exposure on the
probability of a complete loss event occurring.
Suppose instead that the insurance industry had to absorb $20
billion in losses before any government loss sharing began. Then, in
our example, the insurance company's maximum loss exposure would be
$100 million on that policy, not $20 million. Pricing to this maximum
loss would create the economic dislocation we are trying to avoid.
The role of the federal government would recede over time, with the
expectation that the private sector would further develop its capacity
each year. As private sector capacity increases, the nature of the
government's loss sharing agreement would also change. Given more time
and experience, we believe that the insurance industry could
reestablish robust risk-sharing arrangements such as reinsurance that
would enable the private sector to insure losses from terrorism before
the government loss sharing commenced.
Thus, in 2003, we would have the private sector be responsible for
100 percent of the first $10 billion of insured losses, 50 percent of
the insured losses between $10 and $20 billion, and 10 percent of the
insured losses above $20 billion. The government would be responsible
for the remainder.
In 2004, the private sector would be responsible for 100 percent of
the first $20 billion of insured losses, 50 percent of the insured
losses between $20 and $40 billion, and 10 percent of the insured
losses above $40 billion. The government would be responsible for the
remainder.
To preserve flexibility in an extraordinary attack, combined
private/public liability for losses under the program would be capped
at $100 billion in any year. It would be left to Congress to determine
payments above $100 billion.
The federal government's involvement would sunset after three
years. It is our hope, indeed our expectation, that the market problem
we face today will have been corrected by then so that the private
sector will be able to effectively price and manage terrorism risk
insurance going forward. Of course, should that prove not to be the
case, Congress and the President can reevaluate the program in place
and decide at that time on an extension of the program or establishment
of some other approach.
This approach would also provide certain legal procedures to manage
and structure litigation arising out of mass tort terrorism incidents.
This includes consolidation of claims into a single forum, a
prohibition on punitive damages, and provisions to ensure that
defendants pay only for non-economic damages for which they are
responsible. It is important to ensure that any liability arising from
terrorist attacks results from culpable behavior rather than
overzealous litigation. These procedures are important to mitigating
losses arising from any future terrorist attack on our nation, and are
an absolutely essential component of the program I have outlined.
Finally, this approach requires a clear definition of an ``act of
terrorism.'' We suggest that the Secretary of the Treasury, with the
concurrence of the Attorney General, and in consultation with other
members of the Cabinet, be given authority to certify that a terrorist
act had taken place for purposes of activating the shared loss
compensation arrangement.
We believe that this approach dampens any adverse economic impact
from a sudden increase in the cost from terrorism risk insurance over
the next 12 months. The imposition of a deductible in the second year,
and an increase in the deductible in the third year, permits the
federal government to gradually withdraw from the market as the private
sector adapts to measuring and pricing terrorism risk.
5. Conclusion
Mr. Chairman, for the reasons I have set forth, the Administration
believes that the economy is facing a temporary, but critical, market
problem in the provision of terrorism risk insurance. Keeping our
economy moving must be our overriding concern. Leaving this problem
unresolved threatens our economic stability. The approach I have
outlined limits the government's direct involvement, retains all those
elements of our private insurance system that continue to operate well,
and provides a transition period to allow the private sector to
establish market mechanisms to deal with this insidious new risk that
confronts our nation.
There are no perfect solutions to this problem. We have developed
what we believe is a sound approach. As I explained earlier, we do not
believe that creation of a reinsurance pool can be accomplished under
the time constraints we face, but we would be glad to explore
modifications to our approach with the Committee.
I would be pleased to answer any questions the Committee may have.
The Chairman. Well, Mr. Secretary, you say it is not a
bail-out, but what will the government be paid, or how will the
government be paid for this particular approach?
Secretary O'Neill. Well, they would not be paid at all, and
we would not have given the industry anything at all, except,
in effect, a clear declaration to the industry and to people
who buy insurance that in the event they are struck by a
terrorist act, that they will not be forced to suffer a 100
percent loss, and we have proposed, in order to keep the
insurance industry in this process that their exposure to
liability be limited, and if I may, with the structure we have
proposed, with industry exposure for 20 percent of the first
$20 billion, the aggregate exposure for the insurance industry
up to $20 billion would be $4 billion.
Now, none of us know, no one knows how to put a risk
premium on a terrorist act, because the way insurance prices
are set now is by experience and by the collection of
statistical data that reflects an anticipated rate of
experience of something happening. We can do this for age for
life insurance, and we can do it from automobile insurance from
knowing crashes that occur. We can even do it for hurricane.
The chairman knows this very well from his own State's exposure
to hurricanes and others of you have had tornadoes and
earthquakes and the rest.
We have enough experience that the insurance industry knows
how to put a premium price on all kinds of events. Thank God,
we do not have enough experience to put a price on terrorist
events, and so one of the options that we looked at was to say,
since this is effectively for the moment, and hopefully
forever, an unpriceable event, we could consider saying that if
an event is determined to be in a terrorist event, it should
accrue to the cost structure of the American people, which is
to say, we the people of the United States.
Rather than do that when we show the President all of the
options, he decided we should put forward this 80/20 proposal,
which we know does something very important. It keeps the
insurance industry in the business of assessing risk and
working with individual companies to tend to the questions of
whether individual companies are making the proper level of
investment to reduce the risk that is associated with the way
that they conduct their business.
Second, in the event there is a terrorist act and a claims
process, having the insurance companies involved gives us that
front line of engagement of people who are trained in assessing
the cost that should be paid out as a consequence of the loss,
and with our 80/20 proposal up to 20 billion, we believe the
insurance industry can figure out how to collect premiums to
cover their risk exposure up to $20 billion.
It is not the usual way one would price insurance premiums,
but it has the virtue of keeping the companies in. It costs the
government nothing to do and so we think that this is a way to
proceed, and the reason we are concerned is, frankly, it is not
because we have a burning heart for the insurance industry, but
because in many, many business situations, if a business cannot
get coverage for all kinds of risk, including the risk of
terrorist acts, their financial backers are either not going to
give them the money they need for expansion or continuation, or
the financing cost is going to affect insurance premium, which
the lender will in effect put into his own price to the
borrower.
And we think the danger of being in a position when 70
percent of today's property and casualty coverage comes up for
renewal on January 1 with no provision at the moment, or
appearance on the horizon of property and casualty insurance
with a terrorist risk provision, we think we run a great danger
of causing chaos in the financing arrangements between those
who are investing and those who wish to invest, because there
is no assurance of coverage against this kind of catastrophic
loss.
The Chairman. But you say at no cost to the government?
Secretary O'Neill. Right.
The Chairman. How do you figure that? That is wonderful.
That is the first I have ever heard of up here that does not
cost us. Where are we going to get the money? I mean, you say
you are not charging the companies, not even a premium so that
they can over the years subsist, as you say, and survive and
continue in business, and then pay it back, but you do not have
a charge.
Secretary O'Neill. Senator, under our plan the companies
will go out and they will sell insurance at premiums that cover
their potential loss.
The Chairman. How about our loss?
Secretary O'Neill. Let us think about the terrorist risk
insurance. All the risk belongs to the American people. Now,
you could say, well, it does not really belong to the American
people, because we are going to turn a blind eye to those who
do not have terrorist insurance, and it is just too bad if you
have a billion-dollar building in Chicago and it is lost, and
we have not done anything to create a mechanism for some
terrorist risk insurance.
We could say it belongs to the property owners of America.
We think that will raise the cost of doing business in the
United States, because the financial community in effect will
impose more than a traditional insurance cost to assure that
they do not lose all of their money because the property buyer
or the group that is on its way to earning an equity position
in the property, if they cannot assure the lender that they are
going to be able to pay the money back in the face of a
terrorist loss, they are not going to provide the money at the
same cost, and so the cost of financing our society is going to
go up to reflect this loss of capacity.
The Chairman. I have an order of appearance as Senator
Nelson, Wyden, Boxer, Breaux, Smith, Inouye, and Dorgan, who is
really the chairman of this subcommittee. Let me yield, then,
to Senator Nelson.
Senator Nelson. Thank you, Mr. Chairman.
Mr. Secretary, you have outlined the position of the
administration that you had presented last week. Are you
presently under discussions with members of the Senate about a
compromise that would basically eliminate year 1 of your
proposal and instead insert a $10-billion retention level up to
which the companies would have to absorb that as part of their
terrorism risk insurance?
Secretary O'Neill. I said earlier, indeed, I just this
afternoon have spent another hour with members of the Banking
Committee to talk about how we can do something quickly. I
frankly feel the most important thing is that the congress act
quickly.
I said earlier no one knows what will work yet in the
marketplace. I am frankly skeptical that starting off the first
year with $10 billion will work, but I do not have any evidence
to present to you except my own 25 years worth of experience in
private sector being a buyer of insurance and knowing what
insurance cost does to the total cost of products, and knowing
what risks are associated with not being able to get coverage
against terrorists unless you are a very big company with very
deep pockets, and so I have said yes, we are working with the
committee, and yes they are talking about a 10 billion dollar
deductible, and yes I have doubts whether the market will take
it. We will find out. If the market will not take it we are
going to have to do something else or accept responsibility for
adding a very big cost of doing business in the United States,
which is another penalty for the United States economy.
Senator Nelson. It has been my experience in dealing with
with insurance companies that the best way to have the private
sector is for the insurance companies to stay in the game, and
in the proposal that you have outlined, the maximum exposure
that the company would have in the first year is $4 billion. We
are talking about a P and C industry that has a surplus in the
range of $300 to $350 billion, and so we are talking about not
anywhere close to tapping what this industry's surplus is.
Tell me, what is your philosophy of why you would not want
the insurance companies to stay in the game? The only way,
having to accept that risk responsibility, and then for the
gargantuan type of terrorism loss, that the federal government
would step in in some form or fashion there.
Secretary O'Neill. Senator, I am a businessman temporarily
on leave to be a public servant, and so let me tell you my
answer as a businessman. Insurance companies are like all other
kinds of companies. They have a requirement to earn the cost of
capital. Those who do not earn the cost of capital over time go
out of business, and they are not businessmen or businesswomen
any more, they are failures, and so at least for me, it helps
me to be really clear about what business is all about.
Now, it is true that the insurance companies have reserves.
Why do they have reserves? Because under State laws--and you
know this as a former insurance commissioner--insurance
companies that write insurance are required to have reserves so
that if and when, as often is the case, they are called on to
pay the claims that are associated with coverage they agree
contractually to provide, so that when we show up with a broken
car or someone dies they pay off. That is why the reserves are
there, and for no other reason.
Now, one could say the reserves have been permitted to get
too big and they are earning too much money on the reserves.
That is a separate conversation. It may be a worthy
conversation, but it has nothing whatsoever to do with the
question of whether we should have this kind of mechanism or
not, and if we should have this kind of mechanism, they are
going to have to have reserves to pay off these claims.
The reason I am worried about the $10 billion deductible
that we are talking about with the Senate Banking Committee is
this. If you think about what this means from an insurance
company or an insurance industry point of view, when we say
they should be responsible for 20 percent of the first $20
billion, and then we say, and then they should be responsible
for $10 billion on top of that, we are really saying we want
the insurance industry to go out there and collect premiums in
the amount of $14 billion, because in order for them to protect
themselves against loss--and let me say again, insurance
companies do not take risk, they mutualize the risk, and so if
they are on the hook for the potential of $14 billion, only an
idiot would not go out and collect enough premiums to pay the
exposure that is associated with the terrorist risk, and so
they will go out and collect the premium.
Now, as I said before, we do not know how to put an
actuarial value on these premiums, because we only have one
experience of this kind, and it could very well be--hopefully
it will be we never have another terrorist example like this
one, and so if we put a $14 billion premium charge out there
that has got to be collected by the insurance industry and
there is never another terrorist event, through our legislative
action we have created a $14-billion gift for those who wrote
the insurance, who then did the logical thing and went out and
collected the premiums, so the more you want to penalize the
industry, the bigger the premiums, the less likely that it is
actually going to work. In the event that we do not have a
terrorist event, the more money you have, in fact, created for
the insurance industry.
Senator Nelson. Mr. Chairman, by the logic of the
Secretary--and I respect your opinion, but I just respectfully
disagree. By your logic, your governmental proposal is to let
them go out and charge a premium for the $14 billion that you
say they may be liable for while at the same time letting that
be on a shared basis with the U.S. Government doing 80/20 on
the first $20 billion, when in fact the last time I checked,
insurance companies were supposed to be in the business of
assuming the risk.
Now, we have never anticipated these kinds of catastrophic
risks until we had to face what we did in Florida with
Hurricane Andrew and a $16 billion insurance loss, and now we
have a new kind of catastrophic risk, and what I would
respectfully recommend to the committee is that as we grapple
through something very, very difficult, that you have got to
keep the insurance companies in the game, functioning as
insurance companies with States insurance regulators looking
over their shoulder checking their premiums, and then for the
real catastrophic rise above a certain figure, that the federal
government would participate in some way, either direct grants,
or loans, or whatever the committee devises, but that is just
my 2 cents, and I look forward, Mr. Chairman, to following this
discussion.
The Chairman. Senator Wyden.
Senator Wyden. Thank you, Mr. Chairman. What really
generated my opening remarks, Mr. Secretary, was that survey
that was done by the New York Times and others saying that
since 11 September insurance premiums have soared in places
that are extremely remote.
In fact, the New York Times said with respect to the
increases, quote, far from being limited to cities and
companies that seem most vulnerable, the rising rates are
reaching into the quietest, most remote areas of the country,
so clearly mom and pop companies in rural America are being hit
in a way that has no relation to terrorism.
What would your plan do to if not completely reverse that,
at least stabilize it so that people would see that this was
truly related to terrorism?
Secretary O'Neill. Senator, I am sure you know that
traditionally and historically the insurance industry has been
regulated at the state level, and our proposal would in no
significant way change that regulatory process. We would leave
it at the State level.
Again, as one who has bought a lot of insurance from a
company point of view, the best friend of a consumer is
competition, and it may very well be that there are some rate
increases in the wake of what we saw on September 11, and the
way that those rates will come down is with competition.
Most of what we are seeing so far is increases in property
and casualty insurance that will be taken out by competition,
but it will take some time. If you go in and look at other
catastrophic events that we have had like this, the insurance
industry is one where, if they do not collect enough premiums
to pay for all of their losses, they will raise the premiums in
the next round in anticipation of another event, and the
survivors will collect enough premiums to pay the cost.
Insurance companies--believe me, insurance companies do not
lose money and stay in business.
Senator Wyden. I am all for competition. It is just in
these rural areas there really is not much competition, and you
see particularly with these mom and pop firms that their
increases do not seem related to risk, which leads me to my
second question.
In your view, what is the fundamental problem you want to
see the United States Senate deal with? Is it that the current
risk of terrorist events is too large for the industry to have,
or is it that the risk of terrorism is too difficult to price?
Secretary O'Neill. I think we need to think about multiple
objectives. I think it makes a lot of sense to keep the
insurance industry in place and working with companies of all
sizes to help companies take the investment actions and develop
practices that will reduce risk as much as possible related to
terrorist events, and I think when a company has an insurable
relationship, has an insurance relationship, it works with
companies to reduce risk, and I think that is very valuable,
and as I said earlier, I think in the event there is another
catastrophe, having the insurance company out there assessing
claims and helping to pay claims is a really valuable thing to
do, and getting the right valuation up front on the value of
property that might be total losses is a very useful thing. We
have no capacity to do that in the Federal Government. It would
take an unbelievable amount of time to develop a parallel
capacity to what exists in the private sector.
Senator Wyden. That leads me to my last question. You are
saying this really relates to valuations, it relates to prices,
it relates to financial terms. Insurance companies tell
political risk insurance, for example, which covers
multinational companies against the risk of political turmoil
in foreign countries. I mean, they seem to sell insurance in a
variety of instances where it is fairly hard to make
calculations.
Is it your sense that this is largely a temporary problem,
and that if the United States Senate was back here in a year or
two that the industry would have figured out terrorism pricing?
Secretary O'Neill. I hope so. If you had had a hearing on
this subject 2 months ago, or 3 months ago, the industry would
have told you that they are providing terrorist risk coverage,
and they were. I mean, the policies, many policies did not have
any exclusion, but they realized after the event that they had
not really believed that anything like the World Trade Center
could happen, and so an industry person would tell you it is a
completely new set of facts that they have got to deal with.
They can deal with hurricanes, they can deal with tornadoes,
they can deal with earthquakes, because there is some level of
predictability, but willful acts of evil people is not
something the insurance industry has traditionally had a
probability series that it could apply to casualty losses and
give you a premium number.
Senator Wyden. Mr. Chairman, I would wrap up simply by
saying that I think, Mr. Secretary, what you have done is made
the case for what Senator Nelson and I and others are calling
for, and that is the federal government should not be picking
up 80 percent of the losses from the first dollar of those
losses incurred, because you have just said the industry is
really going to sort this out, and I would hope that as we go
through this, and we are going to work with you, then instead
of picking up such a big chunk of the cost from the very first
dollar out, that in effect the Government is regarded as a
backstop. We are essentially a backstop out there for
extraordinary losses when the private sector in effect is not
working, and I hope we can work with you towards that end.
Thank you, Mr. Chairman.
The Chairman. Senator Boxer.
Senator Boxer. Mr. Chairman, thank you. I want to be
helpful here and I want to be sensible and I want to do the
right thing, but I am extremely troubled by something you said,
and help me get through it. If I misinterpreted, let me know.
You said only an idiot would not go out and collect
premiums to cover the risk, but yet you are asking the Federal
Government to in a sense be idiots, because we are at risk for
untold billions of dollars, and there is nothing in your plan
that we collect premiums to cover our losses, and so in that
statement that you made, I think you are putting taxpayers in a
position of being idiots, and I am not going to let it happen,
to be honest with you.
I want to be helpful, I am willing to be helpful, but just
to say we are going to pick up a portion of the first dollar
losses--and you said two other things. You said twice--you said
it in different ways. You said, this plan of the
administration's costs the government nothing, and then you
said, insurance companies will get nothing. Well, I hope you
are right. Under your plan, if nothing happens, that is right,
but yet your plan says that government will pick up untold
billions, no cap on that. Am I correct, if something happens
next week or next year, or the next couple of years, wouldn't
the government have to pay in that case if there were tens of
billions of dollars of losses?
Secretary O'Neill. Maybe it would be helpful to work
through a specific example, and maybe to do it, let us take the
World Trade Center, and just use some rough numbers, and let us
roll the clock back and say, now, the experience of these awful
acts, I have a $4 billion building, and let me be the owner of
the building first, and I have financing lines and insurance
companies and other people have invested in backing me, and I
borrowed the money because I am going to be able to make enough
money with the occupancy that I am going to make a 15-percent
rate of return on my money, all right, and before this event I
was able to get coverage, property and casualty coverage for--
let us say for $100 million a year.
After this event, and I have still got a $4 billion
building, let us say, and there is now knowledge in the world
of this experience, and I go to the insurance company and they
say, I am not going to write you terrorist coverage any more,
and my bankers say, and I am not going to loan you money so you
can have this building. Maybe we go through bankruptcy until we
find, maybe there is an individual in the world with $4 billion
that does not need to have banking relationships or insurance
relationships, and the building ends up with that person, but
short of that there is no owner for this building, because it
cannot be financed. It cannot be financed because I cannot get
insurance.
Senator Boxer. I totally understand the problem. That is
why we are here, and you are right, we have a problem. The
question is the solution to the problem, and that is where you
lose me when you say, again, only an idiot would not go out and
collect premiums to cover the risk, and I think that is where
we have taxpayers in a position, if we follow your leadership,
and the administration's leadership on this, I look at it as
taxpayers are on the line for untold billions, and there is no
source of revenue coming in to help us. How is that fiscally
responsible for us?
I mean, if we are going to be the insurer of last resort,
and we just say, we are there for you, without having some kind
of a businesslike plan, that is the issue.
I totally get what you are saying, and that is why I want
to be helpful, but I am just identifying myself with my
colleagues who say at this point, the plan that we see before
us is very troubling as far as the taxpayers of this country
are concerned, and I think that your comments that you made
here today even underscore it, absolutely.
How many times have Republicans said, and Democrats, we
need to run the government more like a business? We need to run
the government more like a business and be smart and not put
ourselves out on the line like this, and that is what is
concerning me. I hope we can work together toward a bill that I
think gives taxpayers some more protection than the current
plan.
Secretary O'Neill. May I finish my example, Mr. Chairman?
If I am sitting there with a $4 billion building and you are an
insurance company now, and I insist that I want you to provide
terrorist coverage for me, your premium to me, if you believe
that this is an unknowable event, is $4 billion a year, and
that is not payable for me.
Senator Boxer. I understand the problem.
Secretary O'Neill. So I am fundamentally out of business,
and so if you would like for me to pay my $4 billion to the
insurance company and to the federal government, it does not
really help me with my investment.
Senator Boxer. No, I was not suggesting that. I was just
suggesting that if we are going to be in the business of
backing all this up, we should not be idiots, and we should
follow your leadership on that point just as insurance
companies are going to go out and say, well, we will pick up
everything. I understand the problem, but we can have an
insurance pool just as we have in California, and it is
functioning very well so far, because the risk is spread and
you do not have to pay $4 billion in reinsurance, even though
you may get hit really hard.
So I just want to work with you, because I think what you
have got on the table is unfair to taxpayers, exceedingly fair
to insurance companies. I want to help them, but I just do not
think it is a checks-and-balances type of situation.
The Chairman. Senator Breaux.
Senator Breaux. Thank you very much, Mr. Chairman, for
having the hearing, and thank you, Mr. Secretary. The fact is,
I think the American taxpayer is going to be picking up the
cost of these terrorist acts several times over. I mean,
through charitable contributions and fundraisers, through the
money that this Congress is appropriating to cover the losses
in New York, the tax incentives, we are going to be adopting in
order to encourage businesses to stay in New York, or to locate
in New York, to make sure that the economy survives, I mean,
the taxpayer in fact is going to be putting out a great deal of
money because of the acts of the terrorists. It is a question
of how we do it.
I think history is going to be an important lesson as we
all, I think, would agree, and I was interested in your
comments about World War II and what this country did under
President Roosevelt in World War II. I do not remember. Our
distinguished chairman probably remembers that time.
It seems that what you are saying is that the Congress at
that time passed legislation which basically insured and picked
up 100 percent of the loss for terrorist attacks against our
merchant ships, even before the war. Is that what we did then?
Secretary O'Neill. Senator, that is my understanding. In
fact, I do not think we provided insurance. We agreed that the
American people would cover the cost through our agreed system
of taxes.
Senator Breaux. I take it at that time, companies that had
merchant ships had commercial insurance, but I guess we made a
decision that that insurance was either not able to cover
terrorist attacks or just was not the right thing, so the
Government just picked up the whole cost.
Secretary O'Neill. Exactly.
Senator Breaux. Is there any distinction in the suggestion
from the administration as to any differences between foreign
terrorists and domestic terrorist attacks?
Secretary O'Neill. What we are proposing would have effect
only inside the geographic boundaries of the United States, but
the origin of the act would not distinguish among those who
might have committed the act
Senator Breaux. And there would have to be a certification?
Secretary O'Neill. There would have to be a certification
of a terrorist event having taken place.
Senator Breaux. How can we price the cost of this insurance
you are talking about, the fact that if the insurance companies
have 100 percent of the risk against terrorist attacks, that is
something that you really cannot price because of the
uncertainty of it? Well, if that is true for 100 percent of the
cost, why is it not just as true for 20 percent of the cost?
Isn't the basic problem the same, that you cannot put a cost on
100 percent? How can you put a cost on the first 20 percent?
Secretary O'Neill. Senator, you are absolutely right, and
that is why we have tried to limit in what we have done the
upper level of exposure to those who are going to write these
policies, because as I said earlier, they are going to go out
and they are going to price their premiums at a level that
covers their full exposure, and so the more we think we are
putting their skin in the game, or causing them to be part of
this, the more we are insisting in effect on the buyers of
these policies pre-budgeting the unknown cost of the terrorist
act.
Senator Breaux. Well, I do not want anybody to be
unjustifiably be compensated, or reimbursed, or unjustifiably
make money out of these terrorist activities. I do not think
anyone in the congress or the administration is aimed at doing
that.
The fact is, the taxpayer and this congress is going to be
spending a great deal of money for the cost of terrorism. We
are going to be funding a lot of things. We are going to be
reimbursing a lot of losses to cities, and we are going to do
that basically on a 100-percent reimbursement rate, and I think
everybody agrees that is the right thing to do, because we are
a country, regardless of where we are from and what State we
are from.
I just think that we ought to be very careful that in doing
that, in guaranteeing that the insurance would be there, that
we are not somehow creating a situation where some industry or
business unjustifiably is compensated or benefits from that,
and I would hope that we would make sure that whatever you
propose does not allow that to happen.
Thank you, Mr. Chairman.
The Chairman. Thank you. Senator Smith.
Senator Smith. Thank you, Mr. Chairman. Mr. Secretary,
thank you for being here.
Why should we pay the first dollars, 20 percent of $80
billion. Why can we not pay the last portion of that, to be the
backstop, as some of my colleagues have talked about?
Secretary O'Neill. All right, let us conceptualize a
different approach. Let us say that the federal government
should be there only after we have experienced $50 billion
worth of losses.
From a point of view of an individual buyer of insurance,
and from the point of view of insurance companies, as they come
together to write insurance coverage for the terrorist loss
they are going to end up with prices we think are going to be
staggering increases in prices for the privilege of having
insurance, because to the degree that we put our contribution
in, or our participation at higher and higher levels, we are
leaving all the ground between zero and whatever magic number
you want for the private sector to mutualize through premiums.
So, for example, if I were still where I was, and I had
lots of billion dollar plants, and one of those plants might be
the subject of a kamikaze attack, then my risk is really the
whole billion-dollar plant to a terrorist act, and from an
insurance company point of view, if you think there is a high
probability that it is officially visible and damaging to the
American economy that you are really at risk for the billion
dollars, you are either going to not sell me insurance, or you
are going to charge me a premium that is staggering to my total
cost.
Senator Smith. But are we not just speculating now?
Secretary O'Neill. We are, absolutely.
Senator Smith. Are you hearing from banks that they are not
going to make operating loans to businesses unless they have
terrorist insurance?
Secretary O'Neill. In fact, what I am hearing from the
insurance industry in this country and around the world is
basically saying, count us out, and last week I had lots of
business people in town for a variety of meetings, and so I
made a practice of asking some of those I saw, tell me about
what is happening with your insurance.
One person from Chicago has a $600 million office building,
and he told me his policy, like most insurance policies, are
subject to renegotiation at the call of either the insured or
the insurer, certainly within a relatively short period of
time, usually a year. His policy had been called. His rates had
been tripled for property and casualty, and his terrorist risk
insurance had been taken out of his policy.
Senator Smith. Won't he just go bare?
Secretary O'Neill. He is big enough to do it. He is big
enough to do it. You know, the people who--except for one
thing, which I quickly said to him, the fact that he goes bare
will be noted by S&P and Moody's. These are the rating
agencies, and they will say, we, the shareholders, or proxies
for shareholders, now have a new $600 million hole in our
protection against a catastrophic loss and we are going to
lower your bond rating so that your financing cost goes up to
reflect, in effect, the insurance premium that you are not
paying, so do not think you can escape this evil thing that is
going to happen to you. It will be reflected. The finance
system grinds very finely. It will find all the tricks. There
are no ways to avoid this problem.
Senator Smith. And do you think if we do not act on this,
that we are contributing to this recession in some way? Do you
think this is important to be part of a stimulus package?
Secretary O'Neill. I think we run an untold and uncertain
risk, but I do not think there is any doubt that we could do
substantial damage to the thrust of the economy if we turn off
investment on 1 January because so many businesses are unable
to get financing because they cannot get terrorist insurance.
Senator Smith. Since we are speculating here, do you have
in your proposal any kind of a sunset, and what is that?
Secretary O'Neill. We propose, Senator, that this go on for
3 years, that as time goes, that over the second and third year
we would lower the federal participation. I have to tell you
frankly we do not know whether that is workable. It is a set of
ideas about how we think to proceed. The critical thing is what
is available on January 1 and for 12 months, because that is
the basis on which insurance policies are conventionally
written, for 1 year, and the terms will be established or not
established as a reference from whatever legislation you all
enact.
Senator Smith. Mr. Chairman, I assume the point of that
phaseout is that we will have some pricing history then that
allows the marketplace to get in there.
Thank you, Mr. Chairman.
The Chairman. Let the record show, insurance shares looking
up, surprising beneficiaries of terrorism, and I am reading the
overall cost for insurers are now put at $35 to $41 billion.
According to estimates by Morgan Stanley, those hit by costly
claims are likely to include Berkshire Hathaway, Munich Re,
Smith re, Zurich Financial Services, and AIG. They can pay
their claims, they say, and the share prices of almost all of
them have recovered, rather than everybody out, that you just
attested to.
Senator Inouye.
Senator Inouye. I believe all of us agree that since we
have not had any experience with so-called acts of terrorism
that insurance industry provided casualty and property but no
terrorism coverage.
Having said that, even without the experience under your
proposal you will have to certify that this was an act of
terrorism and this was not, and I think there is a lot of
confusion, not among the experts, but among people in general,
because we do not refer to this as terrorism. We say, this is
war here, war there, war everywhere. What is your definition of
an act of terrorism? Would the letter that Senator Daschle
received be an act of terrorism or an act of war?
Secretary O'Neill. This is dangerous territory, especially
to deal with specific examples. What we have done in the past--
and let me go back to what Senator Breaux was saying. In the
past, we have had a declaration of war, and we were able then
to say this is an act of war or this is not an act of war. We
are in wholly new territory here, and one of the big challenges
is writing a testable and hopefully lasting definition of
terrorism, which is something we need to do with you all.
Would I say in a general sense that the letter to Senator
Daschle is an act of terrorism? Yes, but I am not sure that I
would want that to be the centerpiece of how we write terrorism
insurance, because I want to write it for property and casualty
as the main line of what we are trying to do, because I think
that is where the biggest risk is, is that we are going to have
the absence of coverage for property and casualty insurance.
Some of these other areas are much more difficult to deal
with. For example, one could ask why should life insurance not
be subject to some sort of special provision related to
terrorism? I do not have an answer for you. Again, this is
wholly new territory that we are moving into here.
Senator Inouye. Would Oklahoma be considered an act of
terrorism?
Secretary O'Neill. I am sorry.
Senator Inouye. The Oklahoma federal building.
Secretary O'Neill. I would say yes. In that case, it was
self-insured, because it was a governmental building.
Senator Inouye. How far would your coverage be in the case
of New York?
Secretary O'Neill. Well, what we have said in our
recommendation for the congress to consider is a cap of $100
billion to proceed under this scheme. In the conversations we
have been having with the Banking Committee and with the
committee in the House there have been arguments on both sides
of either reducing the $100 billion or taking the limit off
completely, and there are arguments for doing a host of
different things. The scale of New York is--I do not really
think we know yet, $40 or $50 or $60 billion, perhaps, and so
again I do not think you can make our conceptual arguments at
$100 billion, that that is enough, without some sort of a cap.
Again, if you agree to keep the private sector in it means
that however small their share of the risk, it is the risk to
infinity if you do not have a cap, and so that is a
consideration, because again it will affect the premiums that
they feel they have to charge in order to insure their sliver
of infinity.
Senator Inouye. I realize that, for an economy to continue
in a viable fashion, these losses would have to be covered one
way or the other, whether it is by the industry or by the
Government, or combined, but my colleagues will cover the
technical aspects. I am just curious, when the time comes, you
will have to decide, will you not, as to what is terrorism?
Secretary O'Neill. Unfortunately, that is right.
Senator Inouye. And you will have to decide whether the
Daschle letter was an act of terrorism, but at this moment you
are not prepared to do so?
Secretary O'Neill. No. I would like to have the benefit of
working with all the members of the congress who need to be
involved in this process, and with your staff experts, and with
the people, the experts outside so that we approximate as best
we can a solution that will work in the marketplace.
Senator Inouye. Thank you very much.
The Chairman. Senator Dorgan.
Senator Dorgan. Mr. Chairman, thank you very much.
Mr. Secretary, thank you for being here. I think the
question is not whether something needs to be done, but the
question is how do we do it, and my guess is from your
testimony and from other things that I have reviewed that the
new and previously unanticipated risk that now exists in the
marketplace renders the marketplace incapable of dealing with
it otherwise. All of us believe the marketplace is a pretty
good allocator of goods and services, but the marketplace at
this point cannot work under these circumstances, is that your
point?
Secretary O'Neill. It is our view that if we do not do
something like what we have proposed, that there is not going
to be a reinsurance pool after January 1 for terrorist risk
insurance, and therefore there will not be any terrorist risk
insurance, and as a consequence we will do substantial, if not
great damage to the momentum of our economy, because people who
want to make investments or continue with the ones we have will
not be able to secure financing at all, or for sure at the same
rates that they have enjoyed in the past.
Senator Dorgan. Well, I share the view that if we do
nothing, all of those plans that are on the drawing boards at
this point for new buildings and buildings partially under
construction, I assume there are consequences for all of that
activity, and the result would be a real depressing effect on
the economy, an economy that is already struggling mightily, in
my judgment one that requires a stimulus package now. This
would be exactly the opposite influence on the economy at
exactly the worst possible moment.
But I was getting to a different point. Will there be at
some point a market evaluation of the pricing of this so that
there comes a time when we do something that intervenes and
then it is handed off to the market system that prices what is
the risk, and how do we price the risk with respect to these
activities?
Secretary O'Neill. We are anticipating that as we go
through next year we will begin to gather some experience, and
as we go through the next 3 years we will gather a considerable
amount of experience, and the insurance industry and the
private sector will figure out how to deal with this problem,
and honestly, if we did not think we were headed towards this
cliff effect we would not be here at all, because many of us
are from the private sector, and believe that the private
sector can work out most problems. We do not think the private
sector is going to come to a conclusion that works very well
for our economy because of the uncertainty of dealing with
terrorist risks.
Senator Dorgan. Well, Mr. Secretary, I think your testimony
is helpful to us, and I do think we have to take action. I
would agree with many of my colleagues saying that I do not
think we ought to be participating in the first dollar of loss.
I think that ideas that have been developed around an approach
that would create a safe haven beyond which we would
participate makes the most sense.
Having taught some economics in college, I really believe
the market system works well, but it occasionally does not work
at all, and I am always amused that, depending upon the hearing
you are involved with and whose interests are affected, you
hear people say the market system ought to be relied upon, and
it is always the bigger interest in which when the market
system fails, people say, we have got to get involved, but
somehow the little folks do not get so much help.
I do think your testimony is helpful to our committee and
to our congress, and I think we have to move. I do not think we
can possibly go to the end of this year and do nothing, because
I worry that this economy is in much more trouble than most
people understand. I think September 11 put a hole in the belly
of this economy that was already struggling in a way that most
of us do not quite fathom, and so we must not only try to give
it lift, we must avoid doing things that provide a depressing
impact on the economy, and doing nothing with respect to this
issue in my judgment would be almost irresponsible, so the
question is not whether, it is how, and I am anxious to work
with you, as are my colleagues, to find a way to solve this
problem.
Mr. Secretary, thank you.
The Chairman. Thank you. Senator Fitzgerald, and this is
the last one. I know the Secretary has been trying to get away,
and you have been very gracious with your time. Thank you.
Senator Fitzgerald. Mr. Secretary, I want to congratulate
you. I have been following closely your activities in the
administration since September 11, and I think you have been a
real strong voice for the taxpayers. I know you were advocating
restraint in the airline bailout, and I think more so than many
on Capitol Hill, and even elsewhere in the administration, and
so I want to thank you.
I actually think that you may be right in your proposal
providing the first dollars as opposed to the Banking
Committee's approach, and I will tell you why I think that. In
the private sector, I was General Counsel for a bank holding
company, and I understand fully what happens if a borrower
cannot have insurance. That is immediate grounds for
foreclosure by the bank. It is malpractice for a banking
attorney at a loan closing not to get evidence of paid-up real
estate taxes and a paid-up insurance binder showing the lender
as the mortgage loss payee.
If the owner of the World Trade Center had some insurance,
those insurance proceeds are not going to be paid to him, they
are going to be paid to whoever is his lender; and, in fact,
his lender may be an insurance company in this case, as most
tall buildings are financed by life insurance companies, and I
wonder--I understand the concern everybody has with the
government providing the first dollars, but let us consider the
example of the Sears Tower in Chicago, the world's tallest
building, actually taller than the Petronis Towers, if you do
not count antennas, and it is taller than the World Trade
Center was by a little bit.
If there is a deductible for the insurance companies, who
is going to provide a policy for that building? Am I right in
that assessment?
Secretary O'Neill. You are absolutely right.
Senator Fitzgerald. One of your objectives must be to allow
people who own commercial buildings--who want to build new
commercial buildings--to be able to get insurance. The
deductible approach will not solve that problem as far as I can
tell, at least not on tall buildings.
Secretary O'Neill. Well, again, we can rely on some
experience, and you all I am sure have had your own automobile
insurance, and you know how automobile insurance works. If you
are over 25 years old and you are married and you have three
children and you do not drink and smoke, you can get what is
called a preferred premium because you are a low risk.
If, on the other hand, you are 16 years old and you do all
those other things, then you are an assigned risk, and your
policy premium may be three or four or ten times bigger than it
is for your parents, and the same goes for--let us use your
example, high rise buildings. There is going to be, there has
always been, and there will be, we think, an assigned risk pool
for the obvious targets of terrorist acts, and the essential
question is, how much of a deductible can the industry deal
with in going to people that are going to be in the assigned
risk pool and charge them a premium that discharges the cost
exposure that an insurance company is accepting and still is
affordable from the point of view of an owner or a borrower?
That is the essential issue, and it is why we have taken
this 80/20 approach, because we think the reinsurance process
of mutualizing risk can deal with $4 billion. As the numbers
mount, it becomes more problematic whether the people in the
assigned risk pool and even the people in the non-assigned risk
pool are going to be able to pay the premiums that give them
access to financial markets. That is the unknown.
Senator Fitzgerald. My question would be, why not adopt
something like the riot risk concerns pool that we started in
the sixties? I know you want to have the government involvement
here be very temporary, but I question our ability to exit in 3
years for the very reason that most commercial real estate is
financed on a very long-term basis. It will not be enough for
somebody to line up a construction loan to build a building if
no one is willing to give him a 30-year mortgage at the end of
the construction period. If we do not have the insurance
problem solved on a long-term basis, I do not know that we are
going to solve the inhibitions that the current climate is
creating in the construction industry and in the commercial
office building industry.
Secretary O'Neill. Again, a couple of things from
experience. It is the general practice to have a 1-year
cancellation provision in property and casualty insurance, and
so I think having a 1-year duration is not a problem, and it is
not unusual to have construction-only insurance provisions, so
I think with what we are proposing we can gain some experience
and hopefully not have to do something that becomes a more
permanent engagement of the federal government in regulating
and directing the U.S. insurance industry, but I think none of
us know the longer-term answers to these issues which you very
appropriately raise, and it really cries out for a year's worth
of experience, and as best we can, a couple of years worth of
design parameters, which is what we have suggested for year 2
and year 3, and if I were writing this legislation--and I have
said this to the other committee--I would put in a provision
that says in 15 months we want you to come back. We want to
know how much premiums were collected, how much insurance face
value was written, what are the problems that have developed
under this process, and how can we improve this so that it is
beneficial to the American economy.
Senator Dorgan. (presiding) Mr. Secretary, thank you very
much for your appearance today. We appreciate it.
Secretary O'Neill. Thank you all very much.
Senator Dorgan. While the Secretary departs, we would like
to announce we will have both panel II and III come to the dais
together. We have three witnesses in the second panel and four
witnesses in the third, and I would like to ask if we could get
a couple of additional chairs at the table so we could have all
seven witnesses come up.
We will ask Mr. David Keating, senior counsel, National
Taxpayers Union to come forward, Ms. Diane Koken, Commissioner
of Insurance for the Commonwealth of Pennsylvania, Mr. David
Moss, associate professor, Harvard Building School, Mr. Phillip
Hawkins, chief operating officer, CarrAmerica Realty, Mr.
Franklin Nutter, president, Reinsurance Association of America,
Mr. Travis Plunkett, legislative director for the Consumer
Federation of America, and Mr. Robert Vagley, president of the
American Insurance Association.
Senator Dorgan. We thank all of you for being here with us
today, and because of the hour, late in the afternoon, we are
going to combine the panels. We would take them in the order
that I have announced them. I believe first will be Mr. David
Keating, senior counsel, National Taxpayers Union.
STATEMENT OF MR. DAVID KEATING, SENIOR COUNSELOR, NATIONAL
TAXPAYERS UNION
Mr. Keating. Thank you, Mr. Chairman, members of the
committee for holding this hearing and for your interest in
offering some protection not only to people operating
businesses and homes across the country, but the American
taxpayer. We have some very serious concerns in opposition to
the administration's proposal as it was presented, as well as
the industry proposal, although that seems to be on the back
burner at this time.
We believe that insurance companies do have to pay if there
is going to be a federal reinsurance program. They need to pay,
otherwise they will compete by giving the coverage away to
their clients, and we think this creates problems, not only
moral hazards for the insurance concepts, but security hazards.
We also believe that insurers will have little or no
incentive to underwrite individual risks with any caution to
avoid concentration risks or to help clients reduce their own
risks. They will assume more risk for the government than they
ever would have if their own money were at risk. We think it is
very important that if the congress moves forward on a program
here to limit the government's total liabilities, set firm
limits per policy, clearly define terrorism, and limit the
government's exposure to certain types of losses such as
business interruption.
My testimony outlines a number of principles that I hope
Congress will abide by if it decides to move forward with a
program. One is that any federal capacity offered should offer
the maximum amount of economic benefit to the Nation, as well
as to injured parties at the lowest possible cost to the
taxpayer.
Another important principle is that legislation must not
erode strong incentives for wise underwriting and insurance
company management of risk. In other words, we do not want to
take away incentives for insurance companies to work with their
clients to minimize losses, and that means proper security and
proper escape contingency plans. This is not only important to
safeguard against the risk of loss of property, but the loss of
human life.
As I said earlier, we also think that it is crucial that if
federal reinsurance capacity is offered, then there should be a
payment for the use of this capital of the federal government
and the assumption of risk.
We also believe that federal coverage should not insure
against all industry terror losses, 1) because of the
incentives that would be taken away to increased security, but
we also think it is important that insurance companies properly
monitor claims administration. It is very easy to make people
happy when you have no money at stake, or very little. If you
are paying out a claim of a dollar, and you only pay 10 cents,
there is not an incentive to watch to make sure those claims
are being properly administered.
We also support the concept of making the capacity
temporary. We believe market mechanisms should be used to the
extent possible, and we should encourage the reentry of private
reinsurance at high levels at the earliest possible date.
I was quite disturbed to hear Secretary O'Neill say earlier
that some consideration was being given to removing the cap. We
think it is very important that the Federal Government's total
exposure be capped. Whether it is $100 billion, or $60 billion,
or some cap, there needs to be a cap. We cannot write a federal
entitlement program to insure against unlimited losses. If we
are going to be fighting a war, we need to make sure the
federal government has the fiscal flexibility to win that war,
and you cannot do that if you take unlimited risk for
everything, so it is very important to keep a cap on the total
amount covered.
We also believe that there needs to be some mediation panel
or some efficient way of solving disputes about claims. We do
not want the federal government and the taxpayer's money
wrapped up in paying a lot of unnecessary litigation costs and
dragging out claims over many years.
We also believe there needs to be a clear definition of
what is a terror loss and what losses are covered.
Now, to turn my attention to the administration's proposal,
it does have some sensible provisions of capping federal
liability--that is important--providing for cost-sharing,
although the cost shares are too high for the government, and
it does have a sunset provision. That is good.
I do want to point out that many things are sunsetted in
Washington, and the sun always seems to rise once again, and we
believe that if you give away federal reinsurance, which the
administration is proposing to do, people are going to say, I
love getting free things, let's have more of it, so even though
there is a sunset after 3 years, the sun may well rise again.
As far as the administration's plan goes, there are six
points we would like to make about how it can be improved.
We think each individual company should have a retention
amount, or deductible.
We think there should be a payment for the federal
reinsurance. We suggest 1 percent of each company's insured
volume less the retention amount.
We think reinsurance should not pay more than 80 percent of
all claims over the retention amount, and diminishing amount in
the outyears.
We also think it is important that the tax penalty against
reserving for terror risks should be repealed for all insurance
companies. This would help increase private sector capacity.
I see my time is up, so I will just end right here. Our
testimony, our written statement also has a suggestion for an
alternative facility that would allow the private sector to
take as much of the risk as possible as quickly as possible,
and give not only the federal government but the individual
insurance companies real incentives to manage these claims
properly, to manage security risk properly, and to get out of
the business as quickly as possible.
Thank you very much.
[The statement of Mr. Keating follows:]
Prepared Statement of David L. Keating, Senior Counselor, National
Taxpayers Union
Mr. Chairman, and members of the Committee, thank you for the
opportunity to present our views on proposals for terror reinsurance.
The 335,000-member National Taxpayers Union strongly opposes the
proposals offered by the insurance industry and the Administration,
both of which would violate key principles of sound insurance
policymaking. These flaws would put lives and property in danger and
expose taxpayers to unnecessary losses.
Congress should move cautiously as precedents may be created for
Congressional responses to other large losses and major insurance
industry difficulties.
Unless insurance companies have to pay--and pay a lot--for Federal
reinsurance, they will compete by giving the coverage away to clients.
This creates moral and security hazards. Second--and this is very
important--they will have no incentive to underwrite individual risks
with any caution, to avoid concentration risks or to help their clients
reduce their risks. They will assume more risk for the government than
they ever would have if their own money were at risk.
It is essential to limit the government's total liabilities, set
firm limits per policy, clearly define terrorism and limit the
government's exposure to certain types of loss (e.g., business
interruption). Otherwise, we could be paying companies not to be going
back to work for years. Of course, the insurers should have to pay
enough of the claims, a minimum of 20 percent in the first year, to
carefully monitor claims administration.
Too often legislation is passed as a quick response to a problem
without addressing fundamental flaws in public policy. During our work
over the last six years studying proposed legislation and public policy
regarding natural disasters, we have found that a number of Federal and
state laws and regulations greatly hamper the ability of the private
sector to provide insurance for catastrophes.
Perhaps the most important impediment to affordable insurance
against man-made or natural catastrophes is the Federal tax law, which
contains a huge implicit tax penalty on businesses and homeowners who
attempt to purchase such insurance. These same laws prevent insurance
companies from deducting an amount equal to the risk of catastrophic
natural disasters or terror attacks; amounts that we consider
legitimate business expenses. We hope this problem will be corrected
and urge the Committee to use the Policyholder Disaster Protection Act
(HR 785), by Representatives Foley and Matsui, as a starting point.
It is not clear to us whether a Federal terror reinsurance program
is needed at this time. Certainly it is completely unacceptable to
enact a program that would increase risks to lives, property and
federal finances.
Insurers are not claiming they are in trouble, only that the market
may fail to respond to higher pricing with more capacity. That's
dubious at best and there's a good case to be made that we ought to
wait and see what happens in the market. Even if terrorism is excluded
from some policies, life and business will certainly go on.
Since the Sept. 11 attacks, property and casualty insurers' stocks
have significantly outperformed the S&P 500, and the stocks are up, not
down. Insurance stocks' performance shows a great deal about market
experts' view of the industry's future claims-paying ability, future
risk, and the opportunities associated with expected higher pricing. It
also shows--along with the new company announcements--that the capital
markets have in no way restricted the industry's ability to raise
capital and take on additional risk.
If Congress enacts such a reinsurance program, we strongly urge you
to be guided by the following principles.
1. Any Federal capacity should offer the maximum amount of
economic benefit to the nation as well as injured parties at
the lowest possible cost to the taxpayer.
2. Legislation must not erode strong incentives for wise
underwriting and insurance company management of risks (e.g.,
proper security and escape contingency plans). If no
reinsurance is available, then the insurance industry will
continue to cover claims until their current policies expire or
a time the current policy allows for modification of the
coverage. Until then, the insurance companies have an extremely
high incentive to help their clients take sensible steps to
reduce their risk of terrorism loss. Likewise, if a business
finds it cannot insure for terror risks when its policy
expires, it too will take much more vigilant steps to secure
its property, customers and employees. A blank federal
reinsurance check would eliminate a very important incentive to
increase security.
3. If Federal reinsurance capacity is offered, then there
should be payment for the use of that capital and assumption of
risk. Any plan that fails to collect premiums is a giveaway
that will increase losses from any future attacks since it
would undermine insurer incentives to boost security and create
effective disaster control and reaction plans. It would be
irresponsible to discourage effective safeguards that can
reduce the number of lives and amount of property that could be
lost from a terror attack. While no one knows how to price this
risk since the market is not offering it now, the government
should attempt to price it at a level that would likely be
charged by the private sector after it emerges from this market
disruption. The Treasury should use very conservative
assumptions in pricing for that risk so that the private sector
can retake this market as soon as possible.
4. Federal coverage should certainly not insure against all
industry terror losses. Coverage of the first dollar of losses
is both unnecessary and unwise because this too will erode
incentives to increase security. Lower levels of financial risk
should remain in the private sector, which will attempt to
price the insurance for the limited risk. Those price signals
will provide important pricing information to the government
for the use of its capacity. If the government provides
coverage, we strongly recommend restricting coverage to
property loss and workers' compensation only. If insureds also
want business interruption coverage, they can go to the private
sector for supplemental coverage.
5. Federal reinsurance capacity should be temporary, maximize
the use of market mechanisms and encourage the reentry of
private reinsurance at higher levels at the earliest possible
date. We must rigorously avoid any establishment of a permanent
entity. Insurance is available for many other large and highly
uncertain risks and terror insurance will be more efficiently
administered and priced by the private sector in the long run.
It is too easy to make a mistake in haste, which could prove
impossible politically to fix later.
6. Legislation must contain strong incentives to pay only
valid claims. The Federal government's co-payment of claims
should never exceed 80 percent, and 70 percent or less would be
preferable. It is easy for insurance companies to keep
customers happy if they have little or no financial incentive
to monitor claims for fraud and overpayments.
7. The federal government's exposure must be capped to
preserve America's national security options. The Federal
government must not insure against unlimited terror or war
risks. In the event of a war or a terror attack with weapons of
mass destruction, the losses would be far more serious than
those experienced in the September 11th attacks. The government
needs to limit its liability so that it can preserve the fiscal
flexibility needed to fight a war.
8. Incentives should be created to get the federal government
out of this business and reduce its role to covering a higher
layer of loss as early as possible.
9. A mediation panel is needed to quickly pay and settle
claims for terror losses in a fair and inexpensive way. However
undesirable it may be to spend taxpayer monies on terrorism
losses of property, it will be completely unacceptable to pay
large amounts to the trial bar in the aftermath of an event,
and further slow the process of getting funds into the hands of
rightful recipients. Any non-productive activity such as
litigation, which slows the process of pricing the event, will
lead to more uncertainty in repricing insurance for future
events and will add to the ultimate cost of such events. Such a
variation was included in the airline industry bailout. If
people do not wish to waive their rights to sue, then they
should purchase their own terrorism coverage, unsubsidized by
the government.
10. Legislation should contain a clear definition of what is
a terror loss, and all other losses should be excluded from
coverage. The formulation of coverage will need to be quite
specific or there will be lots of opportunities for financial
mischief at taxpayers' expense. This definition would then need
to be met on any private industry claim payment, prior to
allowing either the customer or the insurance company to
present the balance of the claim to the government. If this
definition is not clear or not rigorously applied, there will
be endless disputes. We strongly believe that any program
should be limited to property coverage, where losses are easier
to verify.
11. Federal law should override any state terror insurance
regulations until the Federal capacity has disappeared.
The Administration Proposal
The proposal is a public-private sector program. In 2002, the
government would absorb 80 percent of the first $20 billion of insured
losses resulting from terrorism, and 90 percent of insured losses above
$20 billion.
In 2003, the private sector would handle the first $10 billion of
loss. Losses between $10 billion and $20 billion would be shared, with
the government paying 50 percent and the private sector paying 50
percent. After losses exceed $20 billion, the government would cover 90
percent of losses, and the private sector would cover 10 percent.
In 2004, the private sector would cover the first $20 billion in
losses. Between $20 billion and $40 billion of losses, the government
and private sector would each cover 50 percent of the losses. At above
$40 billion in losses, the government would pay 90 percent of losses.
Overall liability would be capped at $100 billion.
The Administration plan has some sensible provisions. We support
the provisions that cap Federal liability, provide for cost sharing
(though the shares are too high for the government) and eliminate the
program after three years.
Still there are many serious problems with the Administration
proposal.
1. If Federal reinsurance capacity is offered, then there
should be payment for the use of that capital and assumption of
risk. Any plan that fails to collect premiums is a giveaway
that will increase losses from any future attacks since it
would undermine insurer incentives to boost security and create
effective disaster control and reaction plans.
2. Federal coverage should certainly not insure against all
industry terror losses. Coverage of the first dollar of losses
is both unnecessary and unwise because this too will erode
incentives to increase security and monitor claims for fraud
and overpayments. Coverage of the first dollar of losses for
all insurance companies would also lead to an unnecessary
increase in Federal bureaucracy, costs, and insurance waste. It
is hard to find any consumer or business insurance policies
that do not have some form of a deductible, and Federal terror
reinsurance shouldn't eliminate this sound principle of
insurance.
3. Legislation must contain strong incentives to pay only
valid claims. The Federal government's co-payment of claims
should never exceed 80 percent. The co-payment by the insurance
companies must be substantial in order to guard against
excessive claims payments.
4. The plan should clearly define coverage, and should not
cover risks that are harder to verify such as business
interruption and liability insurance.
We should note that the ``industry'' doesn't insure anything;
individual companies do, and these companies vary considerably in their
capabilities and capacity. It isn't apparent how the Administration's
plan would distribute the losses around the industry. Individual
companies write individual risks that will incur discreet losses (some
of which might be covered, some not under normal policy conditions),
then claim payments are made as negotiated with each individual client.
Risks and losses are not distributed proportionately around the market,
as will be seen when the cost of September 11 is tallied.
The New York Times reported Oct. 22 that Berkshire Hathaway chief
executive Warren Buffett said, ``I think there is nothing wrong with
having the industry lose a lot of money if something like [a terror
attack] happens. We just have to keep it within the ability of the
industry to pay. The industry can pay for a $10 billion loss. It can't
price for a $500 billion loss.''
Lower levels of exposure should remain in the private sector, which
will price the insurance for the limited exposures. Those price signals
will provide important pricing information to the government for its
reinsurance capacity.
Improving the Administration Proposal
The Administration proposal can be greatly improved with some key
modifications. Clearly, the Federal government must charge for its
reinsurance capacity and the coverage should kick in at higher levels.
In addition to the provisions contained in the Administration plan,
these key provisions are needed:
1. Each individual company should have a retention amount (or
deductible) for terror claims.
2. We recommend making the payment for the Federal
reinsurance equal to one percent of each company's insured
volume less the retention amount.
3. The reinsurance would pay 80 percent of all claims over
the retention amount in the first year, and diminishing amounts
in the second and third years.
4. To help build capacity in the private sector, the tax
penalty against reserving for terror risks would be repealed
for all insurance companies. This provision could be drafted by
using the Policyholder Disaster Protection Act (HR 785), by
Representatives Foley and Matsui, as a starting point. The
phase-in provisions in this bill should be deleted.
5. The coverage should be clearly defined to cover only
actual commercial property losses and workers' compensation.
6. A mediation panel is needed to quickly pay and settle
claims for terror losses in a fair and inexpensive way.
While it may seem like a good idea for the Federal government to
stay out of pricing, we must not lose sight of the fact that the
Federal government is offering $88 billion in reserves against terror
losses. It should certainly charge some reasonable amount for that
risk.
If the insurance companies are covering only 12 percent of losses,
then they should be receiving, on average, 12 percent of the associated
premium. Since there is no traditional way to estimate or annualize
losses, there probably should be a nominal ``load'' established to be
added to every dollar of non-terrorism premium.
We strongly recommend that the first year of the program also
require that the private sector cover at least the first $10 billion of
losses. After that amount the government should cover no more than 80
percent of additional losses.
In 2003, the private sector should cover the first $15 billion of
losses. Between $15 billion and $25 billion, the private sector should
cover 50 percent of losses, and between $25 billion and $100 billion,
the government would cover 70 percent of additional losses.
In 2004, the private sector should cover the first $25 billion of
losses. Between $25 billion and $100 billion, the private sector should
cover 50 percent of losses.
A Plan for a Public and Private Terrorism Facility, with Increasing
Share Being Owned by The Private Sector at Higher Levels of
Capacity
All of the proposed Federal terrorism reinsurance plans offered to
date violate key principles of sound insurance policymaking. These
flaws would put lives and property in danger and expose taxpayers to
unnecessary losses.
If Congress concludes it must do something to provide capacity and
maintain insurance for terror risks, there is a better way to set up a
terrorism facility. Our suggestion is an approach that would involve
the industry financially and operationally while creating incentives to
properly price and manage risks. The strength of this proposal is that
it creates extremely powerful incentives for the facility to operate
efficiently, minimize risks to lives and property and carefully pay
claims.
Equally important, the industry and government have immensely
powerful financial incentives to disband the facility after three
years. A wonderful bonus of the dissolution would be a huge improvement
in the capacity of the industry to pay for man-made or natural mega-
catastrophes.
This facility allows the Federal backstop to constantly move up,
farther from the risk as time goes on, with the Federal backstop
eventually being eliminated entirely as a result of accumulating funds
in the facility.
This facility was designed to last for three years, but could
easily work for just one year or two years.
We welcome comments and suggested improvements to this proposal.
1. Each company would invest capital to prime the facility,
with an initial investment of 2 percent of the previous year's
annualized premium charges. This would give the facility about
$6 billion of capital at its launch, and would serve to start
the operation with no outlay of Federal funds.
2. The total capacity and liability of the facility would
equal $100 billion, with the Federal Government providing the
difference between the facility's capital and total liability.
For example, after one year (if no losses occurred and ignoring
investment income) the facility would have $36 billion, with
Federal backstop loan availability of $64 billion.
3. If a Federal backstop loan is triggered, the Government
would be repaid over a 20-year period at the then-prevailing
interest rate for 20-year borrowings by an S&P rated AA
financial institution.
4. The facility would be permitted to build reserves for
terror risks on a tax-deferred basis.
5. The facility would cover only real and personal property
loss and workers' compensation arising from a formally declared
event and only for those losses defined in the facility's
charter.
6. Each company would have a retention equal to 20 percent of
its written premium as a self-insured loss, to be funded by it
from its general revenue and investments. Individual companies
would be free to reinsure this amount commercially if possible.
7. After the individual company retention, the facility would
pay 80 percent of remaining losses, which would be pro-rated if
total losses exceed $100 billion per year.
8. Terror losses eligible to be paid by the facility and the
Federal government would be specifically declared and certified
by the Secretary of the Treasury, and claims would be paid to/
through individual companies after they had presented evidence
of payment of their 20 percent share of any declared loss.
9. Quarterly, each company would collect from its customers
and remit an amount equal to 10 percent of their gross written
premium collections to the facility. These additional premiums
would carry no agent or broker commissions and the insurers
would make no administrative charge for collecting and
remitting these funds. The premiums so collected would be
specifically designated as funding the national terrorism
facility, and insurers would be expressly and legally
prohibited from charging customers any other premiums related
to the coverage provided by the national facility. Absent any
major loss after one year, this facility would have accumulated
about $30 billion in added capital plus investment earnings of
approximately $750 million. Investments could be limited to US
government obligations. If no losses occurred, the facility
would have private funding of $100 billion in less than 3.3
years.
10. To allow for coordination between companies to
participate in the facility and to coordinate with each other
to manage the terror risk, participating companies and the
facility itself would receive an exemption from anti-trust laws
as applicable to these specific activities.
11. State regulations regarding rates and coverages for
terror risk would be preempted until the Federal backstop
capacity is no longer in place.
12. Senior management's compensation would include a
substantial bonus if Federal risk is reduced and other
management goals are met. The management goals would include
(other suggestions welcomed):
Minimizing Federal exposure through securitizing
risk through issuing catastrophe bonds or buying reinsurance.
Efficient operations.
Timely payment of claims.
Accurate and fair claims administration.
13. To avoid any potential conflicts of interest, a
Supervisory Board would be composed of the Treasury and
industry officials with consumer and taxpayer representatives.
The chairman and majority control of the Board would remain
with Treasury officials until the industry has contributed $75
billion in capital and the facility had accumulated that much
capital. At that time, the chairmanship and control of the
board would switch to industry representatives.
14. The facility must at all times maintain an independent
risk management function for controlling risk assessment, risk
management, pricing, money management and claims assessments.
It would report to management and the Board.
15. A mediation panel would quickly resolve any disputed
claims for terror losses in a fair and inexpensive way. This
would ensure that victims would receive quick payment of
disputed claims and minimize non-productive litigation. Quick
and fair resolution will lead to more certainty in pricing
insurance for future events and will therefore both reduce the
ultimate cost of such events and allow the private sector to
more quickly reenter the market.
16. If losses were minor, the facility would disband after
three years. If the facility disbands, then its capital
(including accumulated investment income), after payment of
Federal income taxes at the then-prevailing corporate tax rate,
would be distributed to each company according to the amount
invested. Using this formula, if the facility had $100 billion
in capital for distribution, the Government would receive
approximately $35 billion prior to the return of the funds to
the contributing insurers. The after-tax capital would then be
distributed to the insurance companies with a requirement that
it be placed in a special tax-deferred reserve fund at each
company. These reserves could only be used to pay for man-made
or natural mega-catastrophe losses in a manner similar to the
provisions of the Policyholder Disaster Protection Act (HR
785), by Representatives Foley and
Matsui.
A facility of this type would require a small number of very
capable people to operate; probably outsourcing most labor and computer
intensive functions so as to keep fixed overhead at a minimum. All
administrative and operating expenses could be paid using a very small
percentage of the accumulated funds.
At a minimum, this new facility should be the provider of terrorism
coverage for all commercial enterprises and subject to mandatory
participation by all property and casualty companies. Carriers could
provide coverage themselves for personal lines risks or for risks
outside the precise coverage definition approved by Treasury if they
want to, (perhaps even take reserves offshore,) but they would still
need to pay for this facility if they conduct any business in the
United States.
The Insurance Industry Proposal
We are strongly opposed to the industry bill as presented in its
most recent draft, which is riddled with both short and long-term
flaws. It is completely contrary to at least principles 1-10 listed
above on pages 2-4.
The proposal appears to create an unlimited liability for the
Federal government for terror risks. The legislation also covers an
unclear amount of war risks. As noted previously, the Federal
government must have complete flexibility during war because the most
important function of our government is to defend the country. We
cannot and must not create an entitlement program to insure against all
terror or war risks, which may cripple the financial capacity of the
government to win the war.
This proposal initially offers no payment to the Federal government
for its reinsurance capacity, and it is quite possible that no payment
would ever be forthcoming. We are strongly opposed to any such
giveaway. Just because it is difficult to properly charge for the risk
doesn't mean that nothing should be charged.
The pool concept is fundamentally flawed, and there are better
alternatives. It allows companies to be looser in their underwriting
and increases moral hazard problems compared to alternatives. Companies
could shift risk in an undetectable manner to the pool.
Another key concern is that the proposal would set up a permanent
bureaucracy that would greatly expand its mission over time,
concentrating risk and displacing a healthy reinsurance market.
This facility would have enormous advantages that no other firm
could match, including tax-free reserving, explicit access to Federal
credit and a location in one of the least-regulated states in the
country. At the end of its ``life'' there is to be a report on the
state of capacity in the industry, not just for terror, but for other
large risks currently handled by the private sector such as natural
disasters.
We understand that the proposal has a sunset clause, but are not
reassured. Once federal programs start, they rarely disappear, and this
entity will have powerful allies who will likely seek to dump their
other least attractive risks on the taxpayer. Important sectors of the
industry have been trying for years to push legislation through the
Congress to set up a natural disaster insurance corporation, and this
entity could well take on that role as it is about to supposedly
expire.
The inherent advantages of the proposed ``Homeland'' insurance
entity would make it almost impossible for the private sector to move
back into the business of insuring against terror risks as it could not
compete against Homeland's awesome advantages in amassing tax-free
reserves and accessing Federal credit.
Conclusion
Proposals for Federal insurance for terror and war risks are both
politically and economically risky and should be subjected to extensive
examination and comment before being enacted into law. We strongly urge
the Committee to remember that even the best-intentioned programs can
have budget-busting consequences. In this case, a poorly designed
program would also place more lives at risk and conceivably harm the
financial ability of the government to defend the country. Congress
must move carefully in this highly complex area to ensure that it does
not create a fiscal disaster, unwisely interfere with private markets
or violate sound insurance principles.
Senator Dorgan. Mr. Keating, thank you for your testimony.
Thank you for being here.
Next, we will hear from Ms. Diane Koken, Commissioner of
Insurance for the Commonwealth of Pennsylvania. Ms. Koken.
STATEMENT OF MS. DIANE KOKEN, COMMISSIONER OF INSURANCE FOR THE
COMMONWEALTH OF PENNSYLVANIA,
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS
Ms. Koken. Thank you very much. In addition to being
Commissioner of Insurance in Pennsylvania, I am also chair of
the Northeast Zone of NAIC, and I am here today to testify on
behalf of the National Association of Insurance Commissioners.
I would like to make three basic points. First, the NAIC
and its members believe there is presently a need for the
federal government, working with the state regulatory system,
to provide appropriate financial backup to the private
insurance market in order to assure that our nation's economy
does not falter due to a lack of insurance coverage for
terrorism.
Although the NAIC has not endorsed a specific proposal for
federal assistance at this time, we have adopted a set of 19
guiding principles that we believe form the basis for any
successful federal program.
Second, we believe federal assistance should be a
relatively short-term solution to stabilize the commercial
marketplace while it regains the risk assessment and pricing
equilibrium needed for private insurers to underwrite terrorism
exposures. Thus, any federal terrorism program should be
limited in scope and duration, and should also include a
national definition of terrorism.
Third, a federal assistance program should maximize the use
of market forces to add efficiency and reduce the risk of
losses from terrorism and the potential cost to federal
taxpayers.
The United States insurance system remains fundamentally
sound. Let me start by saying the NAIC does believe the
insurance industry is well-capitalized and financially able to
withstand the pressures created by the terror attack on
September 11. The United States insurance industry has a $1
trillion business, with assets of more than $3 trillion.
Preliminary loss estimates of $30 billion to $40 billion
represent just 3 to 4 percent of the premiums written in 2000.
As regulators, my colleagues and I will continue monitoring
the process on behalf of consumers to make sure that insurance
promises are kept. To do our job, we are backed by an
impressive array of human and technical resources, including
the NAIC and 51 insurance departments that collectively employ
more than 10,000 people. We would urge congress to structure
any federal assistance program to take full advantage of the
existing state regulatory system. We have the mechanisms in
place to monitor insurers' solvency and handle claims payment
issues.
Congress should not disrupt the power of private market
competition. There are three important market factors for
congress to keep in mind. First, following the September 11
attacks, government and commercial facilities across America
have added security measures to help prevent acts of terrorism
and limit potential damages. As commercial risk managers review
these new precautions, it seems likely that they will become
more inclined to offer terrorism insurance because the
possibility and extent of potential insured losses occurring
will be greatly reduced.
At that point, we expect market forces will start working
to fill the gap by making terrorism insurance available through
private industry. The NAIC recommends that congress build in
strong incentives for insurers or companies receiving federal
assistance to implement and maintain effective risk management
measures to prevent acts of terrorism from occurring.
Second, the private market instills policyholder discipline
to avoid insurance claims through the concept of co-insurance.
Co-insurance means that policyholders are liable to pay part of
any losses covered by insurance before expecting a recovery
from an insurer. This concept is commonly understood by
everyone owning a car or a home who agrees to bear a cost of a
deductible.
Third, the scope and duration of any federal assistance
program will itself become a factor in the private insurance
market. The NAIC urges you to keep in mind the federal
government policy regarding terrorism insurance assistance will
not occur in a vacuum. The extent of the federal influence on
private market insurance products can be expected to be
directly commensurate with the size, details, and length of the
federal assistance program. state actions are not driving the
market demand for terrorism insurance.
The NAIC and its members have recently been asked to
explain how requirements of state law impact the market demand
for terrorism insurance. Many people in congress think that
states require private businesses to carry insurance against
terrorism and that failure of the private insurance market to
offer terrorism coverage will result in violating state laws
and regulations. This is a misunderstanding of what state laws
require and what state insurance regulators do. To our
knowledge, no state currently requires that business entities
maintain insurance against acts of terrorism. It is important
to understand that state insurance regulators do not normally
get involved in the details of property casualty insurance
policies for large, sophisticated business operations. These
are considered to be the product of free market negotiations
among sophisticated insurance underwriters, brokers, and
professional corporate risk managers who rely upon the
traditional powers of buyers and sellers to bargain for the
best deal they can get.
The NAIC and state regulators believe the insurance
industry remains strong, and that it retains tremendous
resiliency to recover from the September 11 attacks and adjust
its business practices to new conditions in the marketplace. We
are working together to help assure that any glitches which
occur do not disrupt the process of getting people's lives back
in order and America's business back to work. The NAIC and its
members plan to work closely with congress and fellow
regulators so that the needs of the individual Americans and
the nation's economy are met in a timely way.
Thank you very much.
[The statement of Ms. Koken follows:]
Prepared Statement of Diane Koken, Commissioner of Insurance for the
Commonwealth of Pennsylvania, National Association of Insurance
Commissioners
Introduction
My name is Diane Koken. I am the Commissioner of Insurance for the
Commonwealth of Pennsylvania, and I also serve as chair of the National
Association of Insurance Commissioners' (NAIC) Northeast Zone
comprising 10 states and the District of Columbia. Speaking for myself
and fellow members of the NAIC, we appreciate the opportunity to
testify regarding the potential role of the federal government in
making sure that insurance against acts of terrorism remains available
to American consumers and businesses.
Today, I want to make three basic points:
First, NAIC and its members believe there is presently a
need for the federal government, working with the state
regulatory system, to provide appropriate financial back-up to
the private insurance market in order to assure that our
nation's economy does not falter due to a lack of insurance
coverage for terrorism. Although NAIC has not endorsed a
specific proposal for federal assistance at this time, we have
adopted a set of 19 guiding principles that we believe should
form the basis of any successful federal program. A copy of the
NAIC's guiding principles is attached at the end of my
testimony.
Second, we believe federal assistance should be a
relatively short-term solution to stabilize the commercial
marketplace while it regains the risk assessment and pricing
equilibrium needed for private insurers to underwrite terrorism
exposures. Thus, any federal terrorism insurance program should
be limited in scope and duration.
Third, a federal assistance program should maximize the use
of market forces to add efficiency and reduce the risk of
losses from terrorism and the potential costs to federal
taxpayers.
The United States Insurance System Remains Fundamentally Sound
Let me start by saying that NAIC believes the insurance industry is
well-capitalized and financially able to withstand the pressures
created by the September 11th terrorist attacks, despite losses
projected to exceed $30 billion. The United States insurance industry
is a $1 trillion business with assets of more than $3 trillion.
Preliminary loss estimates of $30 billion to $40 billion represent just
3 to 4 percent of the premiums written in 2000.
America's insurance companies have time and again shown their
ability to respond to huge disasters and successfully recover. Adjusted
for inflation, Hurricane Andrew in 1992 caused $19.7 billion in insured
losses, and California's Northridge Earthquake in 1994 cost $16.3
billion in insured losses. As with previous disasters, we believe
insurers affected by the recent terrorist attacks will be able to pay
their projected claims, as they themselves have said.
Insurance is the sale of a promise to pay claims when losses occur.
As regulators, my colleagues and I will continue monitoring the process
to make sure that insurance promises are kept. To do our job, we are
backed by an impressive array of human and technical resources,
including the NAIC and fifty-one state insurance departments that
collectively employ more than 10,400 people and spend $910 million
annually on insurance supervision. In addition, at this time state
insurance guaranty funds have the capacity to provide up to $10 billion
to compensate American consumers in the event of insurer insolvencies.
We would urge Congress to structure any federal assistance program
to take full advantage of the existing state regulatory system. We have
the mechanisms in place to monitor insurer solvency and handle claims
payment issues.
Congress Should Not Disrupt the Power of Private Market Competition
The international commercial property/casualty insurance market is
very powerful, dynamic, and competitive. As a free market, it responds
to new information quickly, and sometimes with great volatility. Like
the stock exchanges, insurance market participants often react in
unison to reach the same conclusion at the same time with regard to
what products are viable and profitable, meaning that the price and
availability of specific products will rise and fall in conjunction
with the industry's collective willingness to sell them. Substantially
negative information, such as the September 11th terrorist attacks, can
disrupt the entire market until new information becomes available that
makes insuring terrorist risks acceptable.
Given sufficient time to adjust, however, the commercial insurance
market has found ways in the past to assess and insure extremely large
and difficult risks that were initially considered uninsurable. During
the 1980's and 1990's, the insurance industry weathered enormous
financial losses from asbestos, medical malpractice, and environmental
pollution claims against corporate policyholders that were not foreseen
by insurers. In those instances, insurers said they had not reasonably
expected to be held responsible for such colossal claims, and therefore
had not collected sufficient premiums or established sufficient loss
reserves to cover them.
In the short term, the insurance market responded to huge
environmental exposures with policy cancellations, coverage
limitations, exclusions, and increased prices, as is being threatened
now with regard to terrorism risk coverage. In the longer term,
coverage for these risks became available through a combination of
aggressive risk management, self-insurance, captive insurance pools,
other alternative risk-sharing mechanisms, and renewed interest by
commercial insurers as they gained confidence in their abilities to
adapt their policies and pricing to a level where they could underwrite
the business profitably. Ultimately, the creativity and competitive
discipline of the market overcame its initial period of contraction and
volatility to provide viable insurance solutions for enormous risks
that were previously considered uninsurable.
The business of insurance is about measuring risks and selling
promises to cover them at a reasonable profit. Insurance experts who
perform these tasks are exceptionally talented. Over time, they have
demonstrated a remarkable ability to adapt to unforeseen circumstances,
while making available the insurance products that are essential to the
growth and productivity of American business. As expected in a free
competitive market, individual companies may stumble, falter, and even
fail when substantial adversity strikes, but the United States
insurance industry as a whole has a long and proud record of finding
ways to overcome new obstacles while advancing its business goals and
serving the interests of the insurance-buying public.
Thus, the NAIC believes Congress should begin its consideration of
federal assistance to the insurance industry by recognizing the
strength and adaptability of the private insurance markets. Federal
actions that unduly disrupt or interfere with private market forces are
likely to end up causing more harm than good for American consumers and
federal taxpayers.
Appropriate Federal Government Action Can Help the Private Market
Recover
State regulators know from their own experiences that government
action can help the insurance market recover when it becomes
overwhelmed by changing risk factors or catastrophic losses. When the
psychology of the market results in industry reactions that harm the
public, government has unique powers to alter the insurance marketplace
for the benefit of consumers. We have found that successful government
assistance involves tailoring actions to fix specific problems and
keeping the program as narrow as possible.
Hurricane Andrew provides a useful example of limited government
intervention that works. Following the tremendous losses from this
hurricane in 1992, commercial reinsurers restricted their coverage for
windstorms and raised prices. This caused a corresponding reaction from
primary insurers, who moved to raise prices, cancel coverage for
coastal properties, and increase deductible amounts for consumers
having significant hurricane exposure. Within a couple of years,
normalcy returned to the reinsurance market, and then to the primary
market. The Florida Insurance Department assisted with the recovery of
the industry by introducing a moratorium on policy cancellations and
beginning the discussion of the need for a state catastrophe pool. The
Florida legislature later adopted a Hurricane Catastrophe Insurance
Pool that provides a state-based backstop for catastrophic windstorms
in Florida. These collective actions have resulted in a robust and
competitive market for homeowners insurance in the State of Florida.
In the present situation, we believe the federal government can add
certainty to the market for terrorism insurance using its unique
powers. For example, Congress can establish a uniform national
definition of ``terrorism'' so that everyone is very clear what will
trigger insurance coverage for acts of terrorism. Providing a temporary
financial back-stop for terrorism insurance coverage is another useful
step, as long as it does not allow what some have called ``cherry
picking'' by insurers seeking to have the government cover just the
most risky policies.
State insurance regulators believe the current situation affecting
the availability of insurance for acts of terrorism is similar in
nature to other catastrophic events. Due to the magnitude and
unpredictable nature of terrorism as it is currently perceived by
insurers, a temporary level of federal assistance to spread risk
appropriately should provide time for the marketplace to adjust its
thinking about how insurance coverage for terrorist acts should be
handled. If the federal government and business customers make quick
progress in lessening exposure from acts of terrorism, the insurance
industry may start providing the coverage American businesses and
families demand. Enacting a temporary federal solution will provide the
necessary time to craft a more thoughtful long-term solution.
Important Market Factors for Congress to Keep in Mind
As Congress considers what type of federal assistance may be
appropriate to steady the commercial market while it adjusts to new
demands, the NAIC recommends that you keep in mind three very important
factors. These factors will greatly affect the costs of any federal
program, as well as its lasting impact on America's consumers and
private insurance markets.
First, risk management precautions that reduce the likelihood of
losses from terrorist attacks will have a large impact on the
willingness of private insurers to offer terrorism insurance coverage
to customers. Risk management--meaning the implementation of safety and
security measures to prevent harm--is a standard part of insuring
commercial and government facilities that are most susceptible to
terrorist attacks. Large firms have professional risk management
departments whose mission is to reduce a company's exposure to
potential accidents and intentional harm, thereby improving the
company's chances to get insurance at the lowest rates possible.
Following the September 11th attacks, government and commercial
facilities across America have added security measures to prevent acts
of terrorism and limit potential damages. As commercial risk managers
review these new precautions, it seems likely they will become more
inclined to offer terrorism insurance because the possibility and
extent of potential insured losses occurring will be greatly reduced.
At that point, we expect market forces will start working to fill the
gap by making terrorism insurance available through private industry.
The NAIC recommends that Congress build-in strong incentives for
insurers or companies receiving federal assistance to implement and
maintain effective risk management measures to prevent acts of
terrorism from occurring. In that way, the federal government will be
building upon standard risk-reducing steps that are well-accepted in
the private marketplace for insurance products.
Second, the private market instills policyholder discipline to
avoid insurance claims through the concept of co-insurance. Co-
insurance means that policyholders are liable to pay part of any losses
covered by insurance before expecting a recovery from an insurer.
Obviously, the higher the dollar amount covered by the policyholder
himself, the greater will be his incentive to take steps to avoid
losses. This concept to commonly understood by everyone owning a car or
a home who agrees to bear the cost of a ``deductible'' before receiving
payment from an insurance company.
Co-insurance should be considered by Congress as an important
market discipline tool that works equally well with government
programs.
Third, the scope and duration of any federal assistance program
will itself become a factor in the private insurance market. Even
though Congress is considering special government assistance intended
to operate as a supplement to normal business channels, the very fact
that government will pay certain costs of a commercial business becomes
a factor to be taken into account when private market decisions on
terrorism insurance are made.
The NAIC urges you to keep in mind that federal government policy
regarding terrorism insurance assistance will not occur in a vacuum. It
will become a private market consideration affecting prices and
availability of insurance, and it may impact insurance products having
nothing to do with terrorism. The extent of the federal influence on
private market insurance products can be expected to be directly
commensurate with the size, details, and length of the federal
assistance program.
State Actions Are Not Driving the Market Demand for Terrorism
Insurance
The NAIC and its members have recently been asked to explain how
requirements of state law impact the market demand for terrorism
insurance. Many people in Congress apparently think that states require
private businesses to carry insurance against terrorism, and that
failure of the private insurance market to offer terrorism coverage
will result in violating state laws and regulations. We believe there
is a misunderstanding of what state laws require and what state
insurance regulators do.
Let me say clearly that states do not drive the private market for
terrorism insurance. To our knowledge, no state currently requires that
business entities maintain insurance against acts of terrorism. In
fact, the NAIC recently performed an electronic search of state laws
and regulation for references to ``terrorism''. We found nothing.
Furthermore, it is important to understand that state insurance
regulators do not normally get involved in the details of property/
casualty insurance policies for large business operations. These are
considered to be the product of free market negotiations among
sophisticated insurance underwriters, brokers, and professional
corporate risk managers who rely upon the traditional powers of buyers
and sellers to bargain for the best deal they can get. The state
regulatory interest in such large transactions is mainly that they not
impair the overall financial health of an insurer, since monitoring
insurer solvency is a major responsibility of regulators.
Banks and investors typically use their private market influence to
require that large business and government entities maintain adequate
property/casualty insurance coverage against foreseeable harm. As a
result of September 11th, foreseeable harm may now start to include
possible terrorist acts in addition to normal hazards. However,
terrorism coverage would usually be just one part of a comprehensive
insurance package that insurers want to sell. Their desire to avoid
terrorist risk exposures may be offset by their need to include it in
order to sell a package of insurance coverage judged to be profitable
overall.
State Actions Having a Limited and Indirect Impact on Terrorism
Insurance
What, then, is the impact of state laws on terrorism insurance?
Primarily, it falls into three areas--workers' compensation
requirements, policy form regulations, and rate regulations. We believe
these areas have a limited and indirect effect upon the price and
availability of terrorism coverage in commercial property/casualty
policies for large business projects that significantly affect the
American economy.
It is important to recognize that states do not initiate market
requirements in these areas, but only react to market forces that
threaten to deny consumers fair insurance coverage. In normal practice,
for example, an insurer would ask a state regulator for permission to
exclude a specific type of coverage, such as terrorism, when the
insurer issues a policy to customers. The regulator may have general
authority under state law to deny the insurer's request for the
coverage exclusion as a matter of public policy, and thus force the
insurer to include terrorism coverage when it sells an insurance
policy. However, the insurer makes the ultimate decision as to whether
it will offer an insurance policy at all, and can refuse to offer
insurance policies in the state if terrorism coverage is not excluded.
If enough insurers threaten to withdraw from a state's insurance
market, state regulators will be under tremendous pressure to grant an
exclusion for terrorism in order to keep insurers in the market
providing other types of insurance.
Workers' Compensation Requirements
State workers' compensation laws were developed early in the
20th Century. In the late 1800's and early 1900's, the number
of occupational injuries and illnesses occurring in the
American workplace was hindering the Industrial Revolution.
Businesses were asking how they could assure that working men
and women who are injured on the job get the care they need,
while protecting industry and commerce from the financially
crippling and demoralizing prospect of employees suing their
bosses for every work-related injury. The question was answered
with the state workers' compensation system, which covers
employees' medical expenses and lost wages for work-related
injuries and disease, regardless of who was at fault. In
return, employees are limited to the benefits provided by the
workers' compensation system as their exclusive remedy.
State workers' compensation laws require a set of benefits
that are guaranteed by employers to their employees who are
injured on the job. Insurers play a key role in the delivery of
the benefits promised by employers. Typically, insurers assume
by contract the obligation to provide the employer's share of
medical benefits, rehabilitation benefits, and survivor's
benefits in exchange for premiums the employer pays the
insurer. Since state law obligates the employer--and therefore
the insurer that has assumed the employer's obligations--to
provide the benefits specified in a state's Workers'
Compensation Act, the insurer cannot introduce either an
exclusion for war or an exclusion for terrorist acts.
As a no-fault safety net for workers' injuries on the job,
state workers' compensation laws do not permit coverage
exclusions as a matter of public policy. Workers' compensation
insurance is one part of the commercial coverage maintained by
significant employers.
State Policy Form Regulations
Many states have statutory authority over insurance contract
language through general policy form regulations. These
requirements typically prohibit contract language that is
misleading, illusory, inconsistent, ambiguous, deceptive, or
contrary to public policy. Since no currently enacted state
laws specifically prohibit an insurer's request to exclude
coverage for terrorist acts, states would have to rely upon the
general provisions above if they seek to deny an insurer's
request to exclude terrorism coverage. Under state law, an
adverse regulatory decision can be challenged by an insurer
through the state insurance department's administrative
process, with the right of appeal to state courts.
State insurance regulators are also charged with solvency
oversight of insurers. Thus, an action to deny an exclusion of
terrorist activities under general policy form provisions could
cause financial difficulties for insurance companies. However,
it is ultimately the insurer's choice whether to provide
coverage for a specific business event or peril. Primary
insurers may be hesitant to exclude coverage for terrorist acts
because they know their business and individual customers will
want assurances that the coverage is provided. Reinsurers do
not directly deal with businesses and families, and therefore
do not face the same pressures to provide terrorism coverage.
State Rate Regulations
State rate regulations are primarily focused on protecting
small businesses and individual policyholders. For commercial
lines insurance products, only 13 states still require that the
insurance department exercise prior approval requirement for
most rate changes. The remaining 38 jurisdictions have some
form of competitive rating mechanism that allows insurers to
file and use rates, or use them even before they are filed with
insurance regulators. Moreover, in recent years insurers have
been successful in convincing state legislatures to create rate
regulation exemptions for large commercial policyholders. The
NAIC does not believe that state rate regulations are
preventing insurers from charging adequate rates for terrorism
insurance.
Conclusion
The NAIC and state regulators believe the insurance industry
remains strong, and that it retains tremendous strength to recover from
the September 11th attacks and adjust its business practices to new
conditions in the marketplace. State insurance regulators are working
together to help assure that any glitches which occur do not disrupt
the process of getting people's lives back in order and America's
businesses back to work. The NAIC and its members plan to work closely
with Congress and fellow regulators, as set forth in the Gramm-Leach-
Bliley Act, so that the needs of individual Americans and our Nation's
economy are met in a timely way.
Guiding Principles for Federal Legislation Related to Property and
Casualty Insurance Coverage for Losses Caused by Terrorism
The insurance industry has repeatedly encountered new, unexpected,
and severe risks in the past and has always, given reasonable time and
experience, been able to develop creative ways to price its products.
However, certain events may exceed the capacity and willingness of the
property and casualty insurance industry to provide future coverage for
terrorism exposures. State insurance regulators recognize that federal
legislation is urgently needed to provide a federal backstop to
buttress the ability of the property and casualty insurance industry to
protect Americans from financial losses associated with terrorism,
while at the same time safeguarding insurer solvency so that insurance
companies can continue to meet all of their other claims obligations.
Outlined below are the governing principles and essential elements of
any federal disaster insurance legislation that state insurance
regulators support. The National Association of Insurance Commissioners
(NAIC) urges Congress to take immediate action to enact legislation
consistent with these principles.
For purposes of this document, the use of the word ``terrorism''
includes the war risk for workers' compensation that insurers are
required to provide coverage for as a result of statutory provisions
contained in state workers' compensation laws.
A. The Role of a Federal Government Program
1. Federal legislation in this area should ``sunset'' at a
date certain of limited duration after enactment in order to
allow a reevaluation of the need for and design of the program.
2. To take advantage of the substantial experience of state-
based insurance regulation, the expertise of the NAIC should be
made available to any federal program in this area and
consideration should be given to including representatives of
the NAIC as members of the governing body of such a program.
B. The Content of a Federal Program
3. Federal legislation should supplement but not replace
other private and public insurance mechanisms where those
mechanisms can provide coverage more efficiently.
4. Federal legislation should include clear and non-ambiguous
definitions of terrorism to be applied to all policies
nationwide.
5. Rates should consider all reasonable factors that can be
feasibly measured and supported by theoretical and empirical
analysis, including relative risk.
6. Federal legislation should encourage loss reduction and
hazard mitigation efforts.
7. State residual market mechanisms and other pooling
mechanisms providing coverage should be allowed to participate
in any program established by federal legislation but in such a
way as to not create incentives for business to be placed in
those residual markets.
8. Federal legislation should recognize that terrorism
exposures subject insurers to potential ``adverse selection,''
i.e., entities with lower risk are less likely to voluntarily
purchase coverage, while those with greater risk are more
likely to purchase coverage. If possible, the federal program
should encourage the inclusion of both low-risk and high-risk
entities to promote greater risk spreading in a way that does
not subject risk-bearing entities, including the federal
government, to adverse selection.
9. Federal legislation should address coverage and cost for
all risks exposed to terrorism, regardless of geographic,
demographic or other classification, such as ``more-at-risk''
or ``less-at-risk.''
10. There should be a safety net protection, within
reasonable limits, for any private program created by federal
legislation in the event of the insolvency of the program or
its participants.
11. Tax law changes should be encouraged to avoid penalties
on and encourage the accumulation of reserves for the portion
of terrorism losses insurable in the private marketplace.
12. Federal legislation should not unnecessarily preempt
state authority.
C. Participation in the Program
13. Federal legislation should encourage individuals and
businesses to maintain private coverage for terrorism exposure.
14. Federal legislation should promote or encourage awareness
that coverage is available for any property and/or casualty
risk that meets reasonable standards of insurability.
15. Federal legislation should encourage or mandate that
eligible entities participate in the program or run the risk of
losing access to federal disaster assistance.
D. Administration of the Program
16. There should be an appropriate balance of the different
private and public interests in the governance of regulatory
oversight over the program.
17. Federal legislation should recognize the expertise of the
states in insurance regulation with respect to such areas as
licensing insurers, solvency surveillance, oversight of rates
and forms in most jurisdictions, licensing producers, assisting
policyholders and consumers during the claim settlement process
and performing market conduct examinations.
18. To more efficiently achieve the objectives of any federal
terrorism program, there should be coordination of state and
federal regulatory responsibilities.
19. Jurisdiction over insurer claim settlement practices
should remain with the states.
Senator Nelson. (presiding) Mr. Keating, later on, when we
get to questions, I want you to talk about what appropriate
role you think the federal government would play, and Ms.
Koken, if you will discuss later on the question of the concern
of the State Insurance Commissioners of basically federalizing
insurance regulations.
Mr. Hawkins.
STATEMENT OF MR. PHILLIP L. HAWKINS, CHIEF OPERATING OFFICER,
CARR AMERICA REALTY CORPORATION
Mr. Hawkins. Good afternoon. Thank you for the opportunity
to be here today. I am Phil Hawkins, Chief Operating Officer of
CarrAmerica Realty Corporation, a New York Stock Exchange
company that owns, develops, and operates office properties in
14 markets throughout the United States.
I am intimately familiar with the impact of terrorist
threats from some private properties, since CarrAmerica is one
of the largest commercial landlords in downtown Washington,
D.C. and owns and operates office buildings across the street
from the Old Executive Office Building.
I am here today as a member of the National Association of
Real Estate Investment Trusts, and on behalf of a number of
real estate organizations and trade groups that are separately
submitting written testimony.
The tragic events of September 11 have triggered a
withdrawal of virtually all new property and casualty insurance
coverage relating to terrorism. While this will become more
readily apparent throughout the economy on January 1, when
approximately 70 percent of the policies on commercial
properties are scheduled for renewal, it is already causing
significant problems in pending real estate transactions.
As the COO of CarrAmerica, I know from my more than 20
years of experience that it is not possible to buy, sell, or
finance property unless it is adequately covered by insurance.
A significant percentage of privately owned properties which
are open to the public, including shopping centers, office
buildings, and hotels, will need to renew their insurance
coverage on January 1.
Many of these owners have been advised that their policies
may not be renewed, or that the new policies will exclude
exposures currently insured, including terrorism. These owners
have also been advised that while they will have to absorb
significant increases in their premiums, they will also bear
expanded uninsured exposures due to new policy exclusions.
Without adequate insurance, it will be difficult, if not
impossible to develop, operate, or acquire properties,
refinance loans, and to sell commercial-backed securities.
The disappearance of coverage for terrorist acts on real
estate and its effects on other businesses could several
disrupt the economy. It will not only affect real estate owners
and lenders, but also, most importantly, the tenants who lease
facilities, their employees and customers, as well as anyone
who rents an apartment. I am very concerned about the short and
long-term future of the real estate industry unless the federal
government creates some type of mechanism to help provide this
coverage.
Up to September 11, property and general liability policies
typically covered losses, including business interruption costs
stemming from terrorism and similar acts. However, as confirmed
by recent insurance industry CEO's testimony, future policies
will exclude coverage for terrorism and sabotage, in addition
to the current exclusion for acts of war.
Additionally, they stated that reinsurance for terrorism
and sabotage is currently unavailable in the marketplace.
Without reinsurance, there will likely be no primary insurance
covering losses caused by terrorism. As a result, the real
estate and construction industries, which account for over a
quarter of the Nation's gross domestic product, could face
severe economic dislocation in the coming months if the federal
government does not immediately address insurance-related
issues tied to terrorism.
The federal government needs to help ensure that commercial
property owners and other businesses can continue to obtain
insurance coverage to losses related to terrorism in the
future. It will become an increasingly larger problem if it is
not resolved prior to the expiration of the many policies that
terminate on January 1. Necessary characteristics of a workable
plan include the following.
First, duration. Because real property is a long-lived,
fixed asset, it is generally financed for a long term,
typically 10 to 30 years. Thus, if the program created is of
insufficient length, it may not provide sufficient stability in
the long term. Any program created must be of sufficient
duration to provide reasonable certainty for these long-term
owners, lenders, and investors. If congress decides to adopt a
program of just 2 to 3 years, it is important to provide the
President with the flexibility to extend the program if he
makes a finding that the private markets cannot offer terrorism
coverage at that point.
Second, definition of terrorism. The line between terrorism
and acts of war has been blurred significantly since September
11. President Bush and the news media have been focused on our
current war against terrorism. The real estate industry is
concerned that any future incidents in this ongoing conflict
may be considered an act of war by the insurance industry and
therefore excluded from coverage. Accordingly, any program
created must cover an expansive notion of terrorism so that
future events along the lines of September 11 and other similar
acts are covered and are not excluded from coverage in the
future.
Third, deductible limits of coverage. The real estate
industry is concerned that a dramatic and insupportable
increase in deductibles to property owners could be tantamount
to no insurance coverage at all. For example, if a real estate
owner plans to acquire a $10 million property with $3 million
of equity and $7 million of debt, a total loss under an
insurance policy with a deductible of $3 million or more could
effectively wipe out that real estate owner's equity and would
likely not result in an investment in the property. The same
result would likely arise if the insurer kept the policy limit
at $7 million. That would not protect the owner's equity.
Fourth, disclosure of premium cost. With property and
casualty insurance rates already predicted to sky rocket prior
to the attack on America, insurers should be required to
disclose the cost of coverage before any misunderstanding as to
the program's impact on overall insurance rates. Otherwise, it
will be impossible to discern the actual increase in the policy
as a result of the difficulty in writing terrorism coverage and
the increase as a result of other market conditions. Our
congress must not fail to act. Our industry welcomes the
opportunity to work with the administration and congress to
achieve a workable solution to this immediate problem this
year, and our company wants to get back to its core mission of
creating a better place to live, learn, work, travel, and play.
Thank you.
[The statement of Mr. Hawkins follows:]
Prepared Statement of Philip L. Hawkins, Chief Operating Officer,
CarrAmerica Realty Corporation
Thank you for the opportunity to be here today. My name is Phil
Hawkins, and I am the Chief Operating Officer of CarrAmerica Realty
Corporation, a New York Stock Exchange company that owns, develops and
operates office properties in 14 markets throughout the United States.
I am intimately familiar with the impact of terrorist threats on
private property since CarrAmerica is one of the largest commercial
landlords in downtown Washington, D.C. and owns and operates office
buildings across the street from the Old Executive Office Building. I
am here today as a member of the National Association of Real Estate
Investment Trusts and on behalf of a number of real estate
organizations and trade groups that are separately submitting written
testimony.
The tragic events of September 11th have triggered a withdrawal of
virtually all new property and casualty insurance coverage relating to
terrorism. While this will become more readily apparent throughout the
economy on January 1st, when approximately 70 percent of the policies
on commercial properties are scheduled for renewal, it is already
causing significant problems in pending real estate transactions.
As the COO of CarrAmerica, I know from my more than 20 years of
experience that it is not possible to buy, sell or finance a property
unless it is adequately covered by insurance. A significant percentage
of privately owned properties which are open to the public, including
shopping centers, offices and hotels will need to renew their insurance
coverage on January 1st. Many of these owners have been advised that
their policies may not be renewed or that their new policies will
exclude exposures currently insured including terrorism. These owners
have also been advised that while they will have to absorb significant
increases in their premiums, they will also bear expanded uninsured
exposures due to new policy exclusions.
Without adequate insurance, it will be difficult, if not
impossible, to develop, operate or acquire properties, refinance loans,
and to sell commercial-backed securities. Disappearance of coverage for
terrorist acts on real estate and its effect on other businesses could
severely disrupt the economy. It will not only affect real estate
owners and lenders but also their tenants who lease facilities, their
employees and customers as well as anyone who rents an apartment. I am
very concerned about the short and long-term future of the real estate
industry unless the Federal government creates some type of mechanism
to help provide this coverage.
Before September 11, property and general liability policies
typically covered losses including business interruption costs stemming
from terrorism and similar acts. However, as confirmed by recent
insurance industry CEOs' testimony, future policies will exclude
coverage for terrorism and sabotage in addition to their current
exclusion for acts of war. Additionally, they stated that reinsurance
for terrorism and sabotage is currently unavailable in the marketplace.
Without reinsurance, there will likely be no primary insurance covering
losses caused by terrorism. As a result, the real estate and
construction industries, which account for over a quarter of the
nation's gross domestic product, could face severe economic dislocation
in the coming months if the federal government does not immediately
address insurance-related issues tied to terrorism.
The Federal government needs to help ensure that commercial
property owners and other businesses can continue to obtain insurance
coverage for losses related to terrorism in the future. It will become
an increasingly larger problem if it is not resolved prior to the
expiration of the many policies that terminate on January 1. Necessary
characteristics of a workable plan include the following:
--Duration: Because real property is a long-lived fixed asset, it is
generally financed over a long-term--typically 10-30 years.
Thus, if the program created is of insufficient length, it may
not provide sufficient stability in the long-term. Any program
created must be of sufficient duration to provide reasonable
certainty for these long-term owners, lenders and investors. If
Congress decides to adopt a program of just 2 to 3 years, it is
important to provide the President with the flexibility to
extend the program if he makes a finding that the private
markets cannot offer terrorism coverage at that point.
--Definition of Terrorism: The line between ``terrorism'' and ``acts
of war'' has been blurred significantly since the September 11
attacks on the World Trade Center and the Pentagon. President
Bush and news media have been focused on our current ``war
against terrorism.'' The real estate industry is concerned that
any future incidents in this ongoing conflict may be considered
an ``act of war'' by the insurance industry and therefore be
excluded from coverage. Accordingly, any program created must
cover an expansive notion of terrorism so that future events
along the lines of September 11 and other similar acts are
covered--and are not excluded from coverage in the future.
--Deductible/Limits of Coverage: The real estate industry is
concerned that a dramatic and unsupportable increase in
deductibles to property owners could be tantamount to no
insurance coverage at all. For example, if a real estate owner
plans to acquire a $10 million property with $3 million of
equity and $7 million of debt, a total loss under an insurance
policy with a deductible of $3 million or more could
effectively wipe out the real estate owner's equity and would
likely not result in an investment in the property. The same
result would likely arise if the insurer capped the policy
limit at $7 million that would not protect the owner's equity.
Accordingly, any program created must carefully consider
apportionment of loss exposure among property owners, lenders,
insurers and the Federal government.
--Disclosure of Premium Cost: With property and casualty insurance
rates already predicted to skyrocket prior to the attack on
America, insurers should be required to separately disclose the
cost of terrorism coverage to avoid any misunderstanding as to
the program's impact on overall insurance rates. Otherwise, it
will be impossible to discern the actual increase in the policy
as a result of the difficulty in writing terrorism coverage and
the increase as result of other market conditions.
Our Congress must not fail to act. Our industry welcomes the
opportunity to work with the Administration and Congress to achieve a
workable solution to this immediate problem this year and our company
wants to get back to its core mission of ``creating better places to
live, learn, work, travel and play''.
Senator Nelson. Mr. Hawkins, you need available and
affordable insurance is basically your testimony.
Mr. Hawkins. Yes.
Senator Nelson. You do not care how that is among the
various proposals that have been proffered here?
Mr. Hawkins. I am not a student of the various proposals,
quite honestly. We just need a mechanism to ensure that
affordable insurance is available, because that has a direct
impact not only on us as owners but, frankly, on our tenants.
The cost of the insurance is really passed through to them
directly by contract, so yes.
Senator Nelson. Mr. Moss.
Mr. Moss. Thank you, Mr. Chairman.
Senator Nelson. Excuse me. Senator Fitzgerald.
Senator Fitzgerald. I would like to ask a quick question of
Mr. Hawkins before we go on to the next witness. At your
business, CarrAmerica Realty Corporation, in many of your
commercial office building leases do you have a clause
permitting you to pass through increases in the cost of real
estate taxes to your tenants?
Mr. Hawkins. Yes.
Senator Fitzgerald. Do you also have a clause providing
that you may pass through the cost of an increase in property
and casualty insurance?
Mr. Hawkins. Yes, sir.
Senator Fitzgerald. So you can pass the cost of your
increased premiums through to your tenants?
Mr. Hawkins. Yes.
Senator Fitzgerald. Okay. Are there any buildings that you
own where you cannot pass that cost through to your tenants?
Mr. Hawkins. Well, there are two issues. One is, any cost
increase in the short run will definitely impact the existing
tenants in those businesses. 80 percent of our tenants are
small businesses, 40 employees or less, so that cost is passed
to them immediately and directly.
Over time, though, as those tenants have choices, unless
all insurance goes up identically they will certainly move from
one part of the country to another, one city to another,
whatever.
Senator Fitzgerald. They might be working out of their
homes, too.
Mr. Hawkins. Cost of rent will go up.
Senator Fitzgerald. So basically, all of those increased
premiums that you would incur would be passed along to your
tenants.
Mr. Hawkins. By contract, yes.
Senator Fitzgerald. I just want to be clear on that.
Senator Nelson: Mr. Moss.
STATEMENT OF MR. DAVID MOSS, ASSOCIATE PROFESSOR, HARVARD
BUSINESS SCHOOL
Mr. Moss. Thank you, Mr. Chairman. In his letter, Senator
Hollings asked me to consider, ``the role the federal
government should play, if any, in identifying terrorism
related risks''. As it happens, I have just finished writing a
book exploring the government's role as a risk manager, and
tracing the history of that role here in the United States. So
I want to start by saying just a little bit about what the
historical record suggests.
One thing my research makes clear is that there is nothing
at all unusual about the government getting involved in
allocating or absorbing private-sector risk. Policymakers at
the state and federal levels have been managing all sorts of
risks since the very earliest days of the Republic, in policies
ranging from limited liability law to federal deposit insurance
to Social Security. I would be glad to explain it in greater
detail, if you are interested. But suffice it to say here that
the current notion of involving the federal government in the
management of terror-related risks would in no way constitute a
radical departure from the path of American policymaking.
What the historical record also makes clear, however, is
that some risk-management policies have worked considerably
better than others. The biggest problems, in my view, have
involved open-ended government guarantees, which actually end
up encouraging risky behavior. I am afraid our experience with
federal disaster policy is a case in point.
The bottom line is that government can play an extremely
constructive role in managing risk when the private market
falters. And it has done this in many different circumstances.
But we have to be very careful in the way we structure these
policies so as not to distort incentives and reduce safety.
That in a nutshell is what the historical record tells us.
Now, the problem at hand is that terror-related losses, as
you well know, could become uninsurable in the aftermath of
September 11, with insurers and reinsurers threatening to
withdraw from the private market altogether. This in itself is
obviously a serious problem. But in addition, as others have
mentioned and as the Secretary has mentioned, the collateral
economic damage from a breakdown in the insurance market could
be immense.
So how do we address this? Ideally, I think we should work
to fashion a public policy that ensures a working market for
terror risk, but with as little subsidy as possible. I want to
emphasize that again, because I think it may have been lost. We
want to ensure a working market for terror risk, but we want to
do it with as little subsidy as possible. At least, that is
what I believe. And this means steering clear of open-ended
federal guarantees like the ones implicit in federal disaster
policy and the ones, unfortunately, that the Banking Committee
and the White House seem to favor in this case.
Not only are these sorts of guarantees expensive, they are
potentially dangerous as well. They are also remarkably
difficult, if not impossible, to eliminate once they are in
place.
Instead of open-ended guarantees, therefore, I believe we
should try to follow a more explicit model of reinsurance for
terror-related risks, where the government would demand risk-
based premiums in return for the coverage it provides. I think
we can do that.
I have outlined a specific policy proposal in my written
testimony. But before I conclude, I want to highlight three
primary advantages of this reinsurance approach. First, I am
confident that the creation of a well-structured federal
reinsurance program would solve the central problem we face
today by ensuring that private coverage against terror risk
would continue to be written in the coming months and years. I
think we can solve that problem.
Second, this reinsurance approach (where premiums were
demanded in return for the risk that was covered) would exploit
the inherent strengths of the private market. It would place
private insurers on the front lines, which is where they
belong, tapping their enormous capabilities in risk assessment,
risk monitoring, and policy administration. But perhaps most
important of all, unlike any of the other major proposals under
consideration, it would ensure that nearly all of the risk
being covered was appropriately priced in the private market,
minimizing any distortion of market incentives. I believe this
is absolutely critical. It is not only a question of cost and
fiscal responsibility. It is absolutely critical because the
proper incentives are what make us safe. Distorted incentives
invite unsafe construction, they invite second-rate security
operations, and they invite a whole host of other problems that
would compromise our safety. Getting the prices right, the
price of insurance right, means safety, pure and simple.
Finally, under the public reinsurance plan I am proposing,
the federal government's role would automatically recede if
private insurers and reinsurers chose to assume more of the
risk on their own. We would not even need a sunset provision.
So it would complement, not replace the private market. I would
be glad to explain that, further, if necessary.
Obviously, no plan is perfect. But I favor a program of
reinsurance for terror-related risks because, in my view, it
would combine the best of both public and private. It would
draw on the government's unique and rather extraordinary
strengths as a risk manager, but it would do so without short-
circuiting either the essential capabilities or, and I think
this is most important, the relentless discipline of the
private market.
I think it would come as close as is possible at the
present time to making this broken market whole and therefore
restoring a precious source of security in our economic life.
Thank you.
[The statement of Mr. Moss follows:]
Prepared Statement of David A. Moss, Associate Professor, Harvard
Business School
Thank you Senator Hollings and Senator McCain for the opportunity
to address the committee today.
I. The Government's Role as a Risk Manager
In his letter of invitation, Senator Hollings asked me to consider
``the role the Federal government should play, if any, in indemnifying
terrorism related
risks. . . .''
Since I have just finished writing a book that traces the history
of government efforts to manage risk, let me start by saying just a
little bit about what the historical record suggests.\1\
---------------------------------------------------------------------------
\1\ David A. Moss, When All Else Fails: Government as the Ultimate
Risk Manager (Cambridge: Harvard University Press, forthcoming 2002).
---------------------------------------------------------------------------
Contrary to popular wisdom, government involvement with private-
sector risks is nothing new. American lawmakers have been managing all
sorts of risks since the earliest days of the Republic. Many of these
government policies are so firmly entrenched that we take them for
granted. Limited liability, for example, was first enacted at the state
level beginning in the early nineteenth century and has since emerged
as one of the hallmarks of modern corporation law. Yet limited
liability is really nothing more than a simple risk management device,
shifting part of the risk of corporate default from shareholders to
creditors. Federal deposit insurance is another major risk management
policy. Inaugurated during the Great Depression, this federal program
safeguards individual depositors by spreading the risk of bank failure
across all depositors and potentially across all taxpayers as well.
Other notable risk-management policies include federal bankruptcy
law, workers' compensation, unemployment insurance, old-age insurance,
product liability law, state insurance guaranty funds, federal foreign-
investment insurance, and federal disaster relief. Still other examples
involve federal caps on liability, such as the cap on nuclear power
liability enacted in 1957 (Price-Anderson) and the cap on credit card
liability established in 1970. One thing that these diverse policies
have in common is that they all reallocate private-sector risks.
In a great many cases, such risk-management policies were
introduced because lawmakers concluded that private markets for risk
weren't functioning adequately on their own. As early as 1818, for
example, Representative Ezekiel Whitman of Massachusetts focused on the
problem of uninsurability as a reason for enacting a special bankruptcy
law for merchants. ``Every effort of the merchant is surrounded with
danger . . .'' he noted. ``Gentlemen have said that the merchant may
insure. . . . He may insure against sea risks and capture. But are
these all the risks to which the merchant is liable? Indeed they are
not. The risks which overwhelm him are more frequently and almost
always, those against which he can have no [private] insurance.''\2\
Such logic--emphasizing the government's role as a risk manager in a
world of imperfect markets for risk--has helped to produce some of our
most enduring and vital public policies, from bankruptcy law to Social
Security.
---------------------------------------------------------------------------
\2\ Quoted in Moss, When All Else Fails, chap. 5. Although a
federal bankruptcy law was not passed in 1818, the logic that
Representative Whitman articulated helped to form the foundation of
modern bankruptcy law. ``A right to a fresh start,'' writes bankruptcy
scholar Douglas Baird, ``. . . is a kind of insurance. All debtors pay
a higher rate of interest at the outset and, in return, the creditor
bears part of the loss that arises when a particular debtor falls on
hard times'' [Douglas G. Baird, The Elements of Bankruptcy (Westbury,
NY: Foundation Press, 1993), p. 33].
---------------------------------------------------------------------------
Based on this history, I think it is fair to say that the prospect
of involving the federal government in the management of terror-related
risks would in no way constitute a radical departure from the path of
American policymaking.
What the historical record also makes clear, however, is that some
risk-management policies have worked considerably better than others.
Policies like limited liability law, federal deposit insurance, and
even the cap on credit card liability have worked remarkably well. Some
others have worked less well. Federal disaster policy, for instance,
has probably proved unnecessarily costly by encouraging construction in
hazard-prone areas.
There are many factors that serve to distinguish relatively
successful risk-management policies from less successful ones. But
perhaps the most important factor is the degree to which risk taking
can be effectively monitored within the confines of the policy.
Whenever risk is shifted from one party to another--whether through an
insurance contract, some other financial transaction, or a government
program--the party that sees its risk reduced may have an incentive to
engage in additional risk taking. Economists call this moral hazard.
Private insurers have long recognized that controlling moral hazard
requires that they carefully monitor their clients. In writing
commercial fire insurance, for example, they may require the regular
inspection of sprinklers and other safety devices. The same basic
principle applies in the case of government risk management as well.
Unless some sort of monitoring--either by public or private actors--is
built into a risk management policy, moral hazard is liable to spin out
of control.
Fortunately, this sort of monitoring is built into a large number
of our risk management policies. In some cases, incentives are created
for private actors to do the monitoring. Limited liability for
corporate shareholders works well because, in most cases, corporate
risk taking is effectively monitored by private creditors, such as
bankers and bondholders. In other cases, the government itself does the
monitoring. Federal deposit insurance provides a good example, since
government regulators help to limit potential moral hazard by actively
monitoring bank risk. Significantly, one of the most striking failures
of federal banking policy came in the 1980s, when federal oversight of
the S&L's was relaxed at the same time that federal insurance coverage
was actually increased. For the most part, however, federal monitoring
of bank risk has proved reasonably effective over the years.
Unfortunately, effective risk monitoring has never been a major
part of federal disaster policy, leaving it exceptionally vulnerable to
moral hazard. To be sure, the emergency appropriations that Congress
has consistently approved in the aftermath of major disasters have
relieved--and even prevented--a great deal of suffering and distress;
and they have helped facilitate and accelerate recovery in devastated
areas. But there has been precious little success in fashioning a
disaster policy in this country that would help to control reckless
building and other risky behavior that ultimately compound disaster
losses. Indeed, the disaster relief itself has probably increased this
sort of behavior.
In the wake of the great Mississippi flood of 1993, which triggered
over $6 billion in federal relief, Representative Fred Grandy of Iowa
observed, ``We're basically telling people, `We want you to buy
insurance, but if you don't, we'll bail you out anyway.''' Similarly,
Representative Patricia Schroeder of Colorado noted that as ``we watch
this tremendously awful flood scene unravel in the Midwest . . . we are
going to have make some very difficult choices. One of the main choices
will be: Do we help those who took responsibility, got flood insurance,
put up levees, tried to do everything they could; or do we help those
who did not do that, who risked it all and figured if all fails, the
Federal Government will bail them out.''\3\ Sadly, federal disaster
policy has never adequately addressed this challenge.
---------------------------------------------------------------------------
\3\ Quoted in Moss, When All Else Fails, chap. 9.
---------------------------------------------------------------------------
It is said that the path into the harbor is marked by sunken ships.
My hope is that Congress and the President will successfully navigate
around the defects of federal disaster policy in crafting a program
that facilitates the efficient management of terror-related risks in
the aftermath of September 11th. If the federal government is going to
assume responsibility for bearing some part of the risk that is
currently borne by private insurers, it is essential that the resulting
public policy provides for the effective monitoring of risky behavior--
either through outright regulation or, better yet, well structured
incentives.
The history of risk management policy demonstrates unmistakably
that government can serve an enormously constructive role as a risk
manager. But the historical record also provides a warning about the
problems that can ensue from open-ended risk-absorption policies that
impose little in the way of discipline and ultimately look more like
simple subsidies than anything else. This, it seems to me, is the
proper context in which to take up the problem at hand.
II. Insurance After September 11th: Defining the Problem
One of the many ramifications of the horror of September 11th is
that the market for insurance against terror-related risks has been
severely disrupted. Some say it is on the verge of collapse. A report
put out by Tillinghast-Towers Perrin estimates that insured losses
stemming from the September 11th attack will be between $30 and $58
billion, making it ``the largest single-event loss in history.''\4\
---------------------------------------------------------------------------
\4\ Tillinghast-Towers Perrin, Why Do We Need Federal Reinsurance
for Terrorism? (October 8, 2001).
---------------------------------------------------------------------------
An event of this magnitude affects the insurance market in two
separate, though related, ways. First, our expectations about future
losses stemming from terrorist attacks obviously increase
substantially. And this implies that even if insurance and reinsurance
providers were willing to continue covering terror-related risks, with
no disruption in service, the cost of such coverage would rise sharply
for many policyholders. There can be little doubt that the cost of
insuring a skyscraper like the Sears Tower should increase
substantially as a result of our new knowledge about the risks of
terrorism. In some cases, insurance could prove prohibitively
expensive, destroying the economic viability of certain business
endeavors.
A second--and even more disturbing--consequence is that terror-
related risks could be rendered uninsurable in the private marketplace.
The magnitude of the September 11th catastrophe has forced insurers and
reinsurers to think seriously about previously unimaginable events (or
series of events), some of which could conceivably swamp their
reserves. Although the combined resources of the insurance industry are
obviously very large, they are nonetheless finite.
A closely related concern is that there is now enormous uncertainty
about how to estimate the probabilities of future terror-related
losses. According to most insurance textbooks, one of the preconditions
for insurability is that expected losses can be estimated with a fair
degree of confidence. ``For an exposure to loss to be insurable,''
reads one prominent textbook, ``the expected loss must be calculable.
Ideally, this means that there is a determinable probability
distribution for losses within a reasonable degree of accuracy. . . .
When the probability distribution of losses for the exposure to be
insured against cannot be accurately calculated, the risk is
uninsurable.''\5\
---------------------------------------------------------------------------
\5\ James L. Athearn, S. Travis Pritchett, and Joan T. Schmit, Risk
and Insurance, 6th ed. (St. Paul: West Publishing Company, 1989), p.
57. On the fundamental distinction between risk (which is measurable)
and uncertainty (which is not), see Frank H. Knight, Risk, Uncertainty,
and Profit (Chicago: University of Chicago Press, 1971 [1921]), esp. p.
233.
---------------------------------------------------------------------------
In explaining their intention to withdraw from covering terror-
related risks in the absence of government backing, many insurance and
reinsurance executives have cited precisely this combination of
factors: the extraordinary magnitudes of potential losses involved and
the near impossibility of accurately estimating loss probabilities.
Said the Chubb Corporation's Chairman and CEO Dean R. O'Hare at a
recent congressional hearing, ``The industry has a specific amount of
capital and cannot insure risks that are infinite and impossible to
price.''\6\
---------------------------------------------------------------------------
\6\ ``U.S. Securities and Insurance Industries: Keeping the
Promise,'' Hearing of the House Financial Services Committee, September
26, 2001.
---------------------------------------------------------------------------
The business community thus faces two distinct problems in
obtaining coverage for terror-related risks in the wake of September
11th--high cost on the one hand and uninsurability on the other. Even
under the best of circumstances, such coverage would likely become far
more expensive than it was before the tragedy, raising costs for many
businesses and potentially forcing some under water. Under the worst of
circumstances, such coverage would be unobtainable at any price,
severely disrupting numerous markets but especially real estate.
Assuming that federal lawmakers wished to address either one of
these problems, the former (high cost of terror insurance) would
require some sort of government subsidy, whereas the latter
(uninsurability) would require the government to act as a risk manager,
perhaps providing terror insurance itself or facilitating its provision
in the private sector. Although these two problems--high cost and
uninsurability--are obviously linked in the current crisis, I believe
it is useful to think about them separately when contemplating a
potential policy response.
III. Fashioning a Policy Response
Ideally, I believe we should work to fashion a public policy that
ensures a working market for terror risk with as little subsidy as
possible. That is, we should try to address the sources of
uninsurability, to the extent that they exist, while working hard to
avoid any action that would make the private costs of terror-related
risks look smaller than they really are.
To return for a moment to the example of federal disaster policy:
one of the consequences of repeatedly providing ad hoc disaster
coverage (relief) that is not tied to any sort of premium is that it
ends up encouraging construction in unsafe areas, such as flood zones.
That is because those who live in these areas often do not have to bear
anything like the full actuarial costs. Federal disaster policy, in
other words, helps to manage a wide range of risks, some of which might
otherwise be uninsurable in the private marketplace. But it also ends
up subsidizing those in the highest risk areas, since federally covered
losses are funded not out of experience-rated premiums but rather out
of general government revenues. Although some degree of subsidy is
probably inevitable in any public policy designed to address disaster
losses, our own federal disaster policy seems to carry the practice to
an undesirable extreme.
In constructing a federal policy to facilitate the coverage of
terror-related risks, one way to avoid these pitfalls would be to
follow a more explicit model of insurance or reinsurance, where the
government demands risk-based premiums in return for the coverage it
provides. Although private insurers and reinsurers have expressed
doubts about their ability to cover future terror-related risks, the
federal government is ideally suited to underwrite precisely this sort
of risk. Unlike private entities, the federal government is well
positioned to absorb even massive losses because it enjoys the power to
tax as well as a near-perfect credit rating. If the premiums it had
collected were not sufficient to cover a particular loss, whether
because of simple bad luck or misestimation of the risk, it could
always draw the needed funds from general revenues and then recalibrate
its insurance (or reinsurance) program after the fact. As FDR's
Secretary of Labor, Frances Perkins, once said of the Social Security
old-age-insurance program, ``we have the credit of the Government as
the real underlying reserve. That is what gives this stability.''\7\
---------------------------------------------------------------------------
\7\ Quoted in Moss, When All Else Fails, chap. 7.
---------------------------------------------------------------------------
One of the biggest challenges in constructing a federal program for
insuring or reinsuring terror risk would be to figure out how best to
set premiums, so as to avoid excessive cross-subsidization and thus the
distortion of traditional market incentives. Another challenge would be
to structure the program so that the federal role would automatically
shrink if private insurers and reinsurers ever demonstrated a
willingness to reassume the burden.
One option, which I favor, would be to establish a new federal
reinsurance program for terror-related risks. Primary insurers that met
appropriate standards would be permitted to reinsure terror risk with
the federal government. Under such a program, a primary insurer might
be allowed to pass (at its discretion) between, say, 20 and 80 percent
of its terror-related risk--along with the same percentage of the
premiums it charged--to the federal government. Ideally, the primary
insurer would also be able to purchase some sort of federal stop-loss
protection on the portion of risk it retained.\8\
---------------------------------------------------------------------------
\8\ Public reinsurance programs of this sort have been tried, often
with considerable success, in other countries. Most notable are
Britain's Pool Reinsurance Company, which covers terrorism risk, and
France's Caisse Centrale de Reassurance, which covers natural
catastrophe risk. On the former, see Tillinghast-Towers Perrin, ``Pool
Re and Terrorism Insurance in Great Britain,'' October 2001; and on the
latter, see David A. Moss, ``Courting Disaster? The Transformation of
Federal Disaster Policy since 1803,'' in Kenneth A. Froot, ed., The
Financing of Catastrophe Risk (Chicago: University of Chicago Press,
1999), esp. pp. 345-351.
---------------------------------------------------------------------------
There are three main advantages of this federal reinsurance
approach:
First, by allowing insurers to cede a substantial portion of
terror risk to the federal government and by setting an
absolute ceiling on their terror-related losses (through stop-
loss protection), a federal reinsurance program would ensure
that coverage against terrorism would continue to be written in
the aftermath of September 11th.
Second, this approach would exploit the inherent strengths of
the private market. Since primary insurers would remain
responsible for writing terrorism policies, setting premiums,
and retaining at least a portion of the risk, a federal
reinsurance program would make effective use of their
unparalleled capabilities in risk assessment, risk monitoring,
and policy administration. Perhaps most important, nearly all
of the covered risk--even that portion ceded to the government
reinsurer--would be appropriately priced in the private
marketplace, thus minimizing any distortion of vital market
incentives. Developers who wished to build skyscrapers or other
structures that insurers deemed unusually vulnerable to
terrorist attack might be deterred from doing so by the
prospect of exceptionally high insurance premiums. As a result,
there would be little need for additional federal regulation to
monitor risk taking and control moral hazard. Risk-based
premiums, combined with monitoring by private insurers, would
likely prove sufficient.\9\
---------------------------------------------------------------------------
\9\ By contrast, a government policy that simply capped insurer
liability at some arbitrary figure (such as $10 billion) without
assessing a premium for the associated government guaranty would
encourage insurers to underprice terror risk, thus inviting the
construction of new buildings and the pursuit of other business
activities that under normal market conditions might have been deemed
too dangerous (i.e., too vulnerable to terrorist attack) to be
economically viable. By distorting critical market incentives, in other
words, such a policy could compromise our safety.
---------------------------------------------------------------------------
Finally, under a public reinsurance plan of this sort, the
federal government's role would automatically recede if private
insurers and reinsurers chose to assume more of the risk. Not
only would participating insurers be free to increase their
retention levels as desired (up to 80 percent), but they would
also be free to withdraw from the program entirely or to obtain
coverage from private reinsurers if the latter ever reentered
the market. Competition, in other words, would be encouraged
rather than stifled.
While no plan is perfect, I favor a program of federal reinsurance
for terrorism-related risks because, in my view, it would combine the
best of both public and private, drawing on the government's unique
strengths as a risk manager without short-circuiting either the
essential capabilities or the relentless discipline of the private
market. It would come as close as is possible at the present time to
making a broken market whole and restoring a precious source of
security in our economic life.
Senator Nelson. Thank you, Mr. Moss. Mr. Plunkett.
STATEMENT OF MR. TRAVIS PLUNKETT, LEGISLATIVE DIRECTOR,
CONSUMER FEDERATION OF AMERICA
Mr. Plunkett. Thank you, Mr. Chairman, members of the
committee. Thank you for holding this hearing on such an
important topic. I am Travis Plunkett. I am the Legislative
Director for the Consumer Federation of America.
I will be offering my comments today for our Director of
Insurance, Bob Hunter, who is unfortunately out of the country.
Bob is uniquely qualified to comment on the various reinsurance
proposals you have heard, because he developed the rate
structure for the Federal Riot Reinsurance Program Senator
Fitzgerald mentioned as a Federal Administrator. He is also a
former State Insurance Commissioner.
Let me be clear about our position. The Consumer Federation
does support a federal backup of the insurance business for the
peril of terrorism. We have offered several principles in our
written testimony that should be used to measure whether any
plan for terrorism coverage is fair to consumers and taxpayers.
Measured against these principles, both versions of the
administration plan as well as the industry plan have serious
flaws.
First, they do not require actuarial soundness. Indeed,
insurers would pay nothing for reinsurance for at least the
first year of the industry program, and never under the initial
administration approach. Based on news reports, it appears that
the revised Treasury plan, the compromise legislation we have
heard about today, will require first dollar federal coverage.
That is better, but the plan still is an unwarranted handout
and a burden on taxpayers if it does not mandate the payment of
premiums by the industry or any loan repayment requirements.
There is absolutely no reason not to make the taxpayer
whole when property casualty insurers are still well
capitalized, have a very large surplus, and the target risks
that would be insured are relatively large and wealthy.
Second, none of the plans that have been offered are simple
enough to be up and running on January 1 of next year, when the
bulk of private reinsurance against the perils of terrorism
expired. The insurer plan is worse than the administration
plan, in that it proposes an end of rate regulation and would
override any remnant of state or federal antitrust laws. They
also want to sweep tort reform into their proposal. Another
important point is neither insurer nor administration plans
assure affordability or availability of coverage to reasonably
secure risks.
The Consumer Federation has offered what we believe to be a
better approach that is elegantly simple. Since the vast
majority of insurers could withstand at least another event of
the magnitude of the September 11 tragedy, God forbid, we are
sure that the plan need not cover first dollar losses. CFA
proposes that a retention for each insurer of 5 percent of
surplus be used. This protects weaker insurers from insolvency
risk and minimizes interference with insurance pricing
decisions.
Terrorism, and we agree with much of what you have heard on
the definition of terrorism, would then have to be carefully
defined, and a federal official should determine the
availability of loans by the government to insurers under this
definition. If a terrorist attack occurs and an insurer suffers
a claim greater than 5 percent of surplus retention, the
insurer would then be eligible for federal low or no cost
loans, the term of which would be negotiated up to 30 years.
this would spread the cost over time, an important goal. For
each insurer, the discounted value of the loan would be limited
to an additional 5 percent of that insurer's surplus. This
limit is needed in order to make sure that individual company
balance sheets are not affected by very large losses due to
terrorist activity.
Amounts of money loaned in excess of 10 percent of surplus
by a company would be repaid to the U.S. Treasury through a
property casualty insurance industry-wide loan repayment
mechanism. This loan repayment would be collected over a number
of years sufficient to minimize the rate impact to consumers,
who will ultimately pay the cost of the program. Congress
should set the maximum surcharge, perhaps at 2.5 percent per
year, until the loan is repaid. The surcharge would be
collected by the states as a piggyback on their premium tax
mechanism and forwarded to the Treasury.
This plan--and this is a very important point. It leaves
the regulation of insurance fully in state hands. The states
should be required to assure both availability and
affordability of the terrorism risk using their usual
regulatory methods, including pooling by state if necessary.
Any plan approved by congress should require state
commissioners to ensure that pre-September 11 policy terms are
maintained to ensure availability, and should allow
Commissioners meaningful authority to assure that rates are
affordable.
Further, the states should be asked to assure that the plan
enhances security through discounts or other incentives.
Congress could set goals for the states in this effort. This
requires little, if any new state bureaucracy, because this is
what they already do. The plan requires only a handful of
people at the federal level to monitor the request for loans,
right up to loan documents, et cetera.
We think this plan is fair and the most effective proposed
to date, because it protects both the industry and consumers
and it makes taxpayers whole, eventually. It is not a handout,
it is not a bailout, and perhaps most importantly it can be
fully operational on January 1 of next year.
Thank you, Mr. Chairman.
[The statement of Mr. Plunkett follows:]
Prepared Statement of Robert Hunter, Director of Insurance, Consumer
Federation of America
Good day Mr. Chairman and members of the Committee. I am Bob
Hunter, Director of Insurance for the Consumer Federation of America. I
previously served as Texas Insurance Commissioner and, of particular
relevance to today's subject, as Federal Insurance Administrator under
Presidents Ford and Carter.
I served at FIA between 1971 and 1980. My first task was to assist
in establishing the Riot Reinsurance Program under the provisions of
the Urban Property Protection Act. I strongly encourage you to look at
the Riot reinsurance program for guidance in your current important
effort for reasons I will cover in the next few minutes.
In the late 1960s, the nation faced great uncertainty from a form
of terror from within. There were an awful series of riots in the land.
If this were not bad enough for the people in the inner cities who were
at the equivalent of what we now call ``ground zero,'' the reinsurers
panicked and began to cut off reinsurance protection from the American
primary insurance market. The primary insurers, without their layoff
arrangements were poised to pull out of the inner cities. Then lenders
would have to call mortgages . . . the set up for a true crisis.
Congress, wisely, stepped in, creating the riot reinsurance
program. The program adhered to good insurance principles, requiring
the government to charge full actuarial rates for the reinsurance and
making sure that claims were appropriate for payment.
I was tasked with the job of coming up with actuarially sound rates
for the riot reinsurance program. This was about as fearful a job as I
ever faced. There was great uncertainty. But actuarial soundness is not
defined as precise prices. It relates to procedures such as using the
best information available, making reasoned judgments and basically
doing your best. We did that, full well expecting to be too high or too
low since future events such as riots are hard to predict.
I met with insurers, actuaries from the actuarial societies and
other interested parties and came up with prices. Insurers thought they
were OK since they bought the reinsurance. The taxpayer was protected
and, indeed, profited from the transaction.
Sound insurance principles require proper prices and require
adequate supervision of the claims payment process.
CFA SUPPORTS A FEDERAL REINSURANCE PROGRAM FOR
TERRORISM
CFA supports a sound program of reinsurance for the terrorism risk
underwritten by the federal government.\1\ I attach a list of
principles CFA developed for Congress to consider when developing the
program. Foremost among the principles are that the insurance industry
must be able to purchase affordable reinsurance and that the taxpayer
be protected.
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\1\ This testimony relates to property-casualty insurance. The life
insurance industry has requested a Commission to study if they need
back-up. CFA believes that a Commission is not needed. The life
insurance industry should make its case for when they might need help
and Congress should call hearings to critique that analysis. CFA looks
forward to participating in that separate process.
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INTERIM TERRORISM INSURANCE PROPOSAL
CFA understands that creation of the permanent plan we espouse
below might take more time than we have to protect insurers as of
January 1, 2002, when most reinsurance runs out. We therefore suggest
that an interim, actuarially sound plan be developed.
Simply, we believe that most insurers could withstand at least
another event of the magnitude of the September 11th tragedy. So we do
not think that the interim plan should cover first dollar losses. CFA
proposes that a retention be used for each insurer of 5% of surplus, as
of December 31, 2001.
``Terrorism'' must be defined for this interim plan and should be
determined by a federal official.
If a terrorist attack occurs and an insurer suffers claims greater
than the retention amount, the insurer would be eligible for federal
low or no interest loans, the term of which would be negotiated up to
30 years. This would spread the cost over time, an important goal. For
each insurer, the discounted value of the loan would be limited to an
additional 5% of surplus.
Amounts of money loaned in excess of the 5% of surplus by company
would be repaid to the U.S. Treasury through a property-casualty
insurance industry-wide loan repayment mechanism. This loan repayment
would be collected over a number of that are sufficient to minimize the
rate impact on consumers (Congress should set the maximum surcharge,
perhaps at about 2.5% per year, until the loan is repaid). The
surcharge would be collected by the states as a piggyback on their
state premium tax mechanism and forwarded on to the U.S. Treasury. This
step is needed in order to make sure that individual company balance
sheets are not impacted by very large losses due to terrorist activity.
This plan leaves the regulation of insurance fully in state hands.
The states should be required to assure availability and affordability
of the terrorism risk, using their usual regulatory methods, including
pooling by state if necessary. Further, the states should be asked to
assure that the plans enhance security through discounts or other
incentives. Congress could set goals for the states in this effort.
This requires little if any new bureaucracy since much of this sort of
work is already part of the state insurance department responsibility.
NEEDED PROTECTIONS FOR THE TAXPAYER
Any longer term plan should protect consumers and taxpayers in the
following manner:
First, insurance companies should pay full actuarially sound
rates for any reinsurance protection they enjoy. Any plan that
requires no premium is not actuarially sound. The insurers need
a plan to protect their interests--they do not need a hand out.
Insurers should be loathe to set a precedent where inadequate
premiums are acceptable when they are paying the premium, if
they do not expect consumers to press for inadequately priced
home, auto, life and other coverages. When the insurers offer
free insurance to us, we will consider free reinsurance for
them.
Free insurance is particularly galling in year one of the
coverage. Don't forget the insurers made contracts with
Americans to cover terrorism fully. These contracts are being
entered into even as we speak. So, for a year for policies
being written today and for an average of about six months for
policies already in force, there would be terrorism coverage
even if Congress did nothing. To come in after-the-fact and
give away insurance to the industry, which is a very healthy
industry \2\ even after September 11th, would be foolish.
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\2\ At year-end 2000, the property/casualty industry had surplus of
$321 billion and net premium written of $303 billion. The rule of thumb
for a very safe industry is a ratio of $1 of surplus for each $2 of net
premium written. Thus, the industry had ``excess'' surplus of $170
Billion. ($321-$303/2). So, even if the industry has another WTC event,
God forbid, they can afford it.
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Actuarial soundness is possible. The taxpayer can be assured
that, over time, the program would, at worst, cost the taxpayer
nothing. Here is how to do it:
Congress should require actuarially sound
reinsurance premiums. That does not mean precision, it means
doing the best you can to set a price you think is based on
reason.
The plan should include assessments against the
industry if terrorism reinsurance claims exceed certain dollar
thresholds. During the riot reinsurance days, the industry had
to agree to a 2.5% of their total premium assessment provision
in the reinsurance contract.
The plan should have a provision stating that if
the taxpayer has paid more into the plan than the premiums and
investment of premiums, the premium collection aspects of the
plan will stay in effect until the taxpayer is made whole. Just
as in the riot reinsurance program, the plan can be self-
sustaining over time. Uncertainty will end and the costs
shifted to taxpayers during the uncertain times can be recouped
as certainty returns.
The plan should include a wise pay out plan that
minimizes taxpayer exposure. The second year of the White House
proposal is a good start. That should be the first year of the
program. The industry can easily afford a first layer of
coverage where they are 100% at risk for tens of billions. I
would set it at $35 Billion \3\ for year one. The industry
could easily afford three such events even today.
---------------------------------------------------------------------------
\3\ Some have maintained that this is difficult to do since some
who suffered loss early would be more exposed that those with later
claims. This is a red herring. What you should do, I think, is to
allocate the deductible by insurer based on the sorts of risks they
have and their surplus level. Then a smaller insurer might be paid even
if a terrorist loss was relatively small but in the locus of the
exposure that that insurer wrote.
---------------------------------------------------------------------------
The federal government should have a claims audit
role to assure that only claims that meet the definition of
terrorism and are within the contractual provisions of the
reinsurance policy are paid.
Second, private insurers should not be able to cherry pick
against the taxpayer. By ``cherry picking'' I mean sending bad
risks to the federal reinsurance program and keeping good risks
for the industry accounts. Thus, all primary insurance
companies should be required to participate in the reinsurance
program. At the very least, groups of insurers should not be
allowed to reinsure one company with ``target'' risks (e.g. the
Empire State Building) but not reinsure another company in the
group (say, insuring farm risks).
State Consumer Protections Should NOT be Impacted by any
Reinsurance
Plan
One of the beauties of reinsurance by the federal government
is that it is simply a contractual arrangement with the
insurer, it does nothing to interfere with the carefully
constructed system of state regulation in place.
There Must be a Degree of Bureaucracy to Administer the Program
While it can be minimized, you need staff to develop the
contract and administer the claims payment process. You cannot
just pay claims. If you do, the taxpayer will be ripped off.
You need a small but not insignificant staff (maybe 50?) to do
this job.
The setting of the premium charge and the collection of the
reinsurance premium requires very few staff (maybe 5?).
Availability and Affordability of Insurance Must Be Assured
The reason for Congress to step into this situation with
federal back-up is to make sure that the economy is not frozen
by lack of insurance for the terrorism risk. To write a plan
that does not do the necessary to assure that insurance is
written and the price is reasonable would by foolish.
This means that the plan should include a requirement of
continuation of direct provision of terrorism coverage by
insurers as part of the ``deal'' for taxpayer back-up for those
risks that meet minimum security standards. Further it means
that the rate charged for primary insurance should be
correlated with the reinsurance charges so that there is no
gouging by insurance companies at this time of national
emergency. Congress should not infringe on the ability of state
regulators to assure that price gouging for primary insurance
does not occur.
CRITIQUE OF INDUSTRY PROPOSAL
The Consumer Federation of America strongly opposes the industry
drafted ``Insurance Stabilization and Availability Act of 2001.'' This
proposal is a massive overreach that unnecessarily exposes taxpayers to
billions of dollars in risk. There are several serious problems with
the industry approach:
The bill does not require actuarial soundness. Indeed,
insurers would pay nothing for reinsurance for the first year
of the program, until the mutual insurance company created
under the bill builds up a $10 billion net asset base.
Apparently, this free government reinsurance would even cover
policies already in force for which insurers are fully at risk
today. This is a grossly improper use of taxpayer monies.
Insurers can ``cherry pick'' risks since they could opt in
or out of the reinsurance program at will. One insurer of a
group of companies could be set up to take all of the ``bad''
risks and buy the reinsurance, effectively adversely selecting
against the taxpayer. Further, cherry picking is allowed in
that the insurers can decide whether to reinsure personal risks
and commercial risks separately.
The selection of Illinois as the sole regulator of the new
federally backed mutual insurer puts consumers at risk.
Illinois, unlike most other states, does not control prices.
Congress should not interfere with normal insurance protections
afforded business and personal consumers. If Congress decides
to interfere, a federal agency should be empowered to regulate
the insurers, including the rates charged for the reinsured
coverages, to assure that no price gouging occurs. (Why enact a
terrorism reinsurance program to make insurance affordable and
then let insurers charge whatever they want for the coverage?)
If one state were to be used to regulate the rates and policies
offered (something CFA does not favor), the most advantageous
for consumers would be the largest state, California. Studies
show that California insurance oversight has been the best in
the country over the last decade.
The bill would cover war events only for workers'
compensation. The bill should cover war for all lines of
insurance and the reinsurance program should be so constructed.
The bill waives the application of all federal and state
anti-trust laws. This is unnecessary and inappropriate.
The bill allows territorial differences in pricing, which
means that New York City will likely pay much higher rates than
other cities, particularly if there is no government review of
insurer pricing decisions, as the bill proposes.
There is no guarantee of affordability or availability of
coverage to reasonably secure risks.
We urge you to reject the insurance industry proposal and, instead,
use the very successful Urban Property Protection Act of 1969 as the
precedent for this program, as reflected in the principles developed by
CFA (printed below).
CRITIQUE OF THE WHITE HOUSE PROPOSAL
The White House proposal is flawed for several reasons. First, it
is actuarially unsound. The taxpayer should not give away reinsurance.
Second, the first year pay-out plan shows a fundamental
misunderstanding of insurance. The 80%/20% split starting at the first
dollar of terrorism loss will actually leave the taxpayer exposed to
100% of the risk. This is because the plan will reinsure the
reinsurers. So, the primary insurers will reinsure the 20% the taxpayer
is not on the hook for with the reinsurers. The reinsurers will then
``buy'' (for no premium) the 80%/20% cover. This will increase the
taxpayer share to 96% (100%-[20% 20%]). But that is not the
end of the reinsurance process. The reinsurers will again reinsure
(called ``retrocession'') with other reinsurers (possibly including the
primary carriers themselves). The taxpayer share will then go to 99.2%
(100%-[20% 20% 20%]). If they reinsure again (there
is no limit on how many times the risk can be ping-ponged to lay off
risk on the taxpayer) the taxpayer share would be 99.8%. And so on.
This could be corrected by not exposing the taxpayer to private
reinsurance payouts.
A better approach would be to change the plan to have a large
deductible. As indicated earlier, I think that amount should be $35
billion. Over that, there should be sharing as in year two of the White
House plan . . . but no reinsurance should be allowed on private
reinsurance claims even in that scenario.
The White House plan also does not guarantee affordability or
availability of coverage to reasonably secure risks.
CONCLUSION
Congress can and should back-up the private insurance market with
reinsurance for the peril of terrorism. It can and should do it in a
wise way that protects the taxpayer and, over time, assures that the
taxpayer is reimbursed for the costs of the program so that the cost
goes to ratepayers rather than to taxpayers.
CFA looks forward to working with the Congress on this most
important effort.
Guiding Principles for Insurance Legislation Related to War and
Terrorism
1. CFA supports the concept of federal back-up of the private insurance
industry for the perils of war and terrorism. We suggest the riot
reinsurance program as a precedent for this backup.
2. Legislation should supplement but not replace other private and
public insurance mechanisms where those mechanisms can provide
coverage more efficiently. However, all insurers should be required
to reinsure against the perils of war and terrorism through the
federal government at the outset of the program. In time, as
conditions warrant, private reinsurance should be encouraged. To
avoid undue taxpayer exposure, however, the program should include
a requirement of minimum extended terms for reinsured insurers with
claims paid to allow taxpayers to recoup some of the losses.
3. There should be a reasonable coordination and structuring of state
and federal regulatory responsibilities with respect to a federal
terrorism reinsurance program that achieves the objectives of the
program without unnecessarily compromising or preempting state
regulatory authority and consumer protections. Necessary preemption
of or limits on state regulatory authority should be compensated by
requisite federal oversight.
4. There should be an appropriate balance of different private and
public interests in the governance of regulatory oversight over the
program. Consumers (business and personal), insurers, reinsurers
and state regulators of insurance should be on the board of
advisors for such program.
5. All records relating to the program, including the records of the
reinsured insurance companies should be available for federal audit
and, to the maximum extent possible, made public.
6. Rates for the war and terrorism perils charged for the government
reinsurance should be actuarially sound and should consider all
reasonable factors that can be feasibly measured and supported by
theoretical and empirical analysis.
7. The federal government should assure that the cost of terrorism/war
coverage charged by reinsured insurance companies to the consumer
is actuarially based and correlated in price with the reinsurance
offered by the government.
8. The legislation must clearly define ``terrorism'' and ``war'' and
exclude any coverage beyond those definitions. A top federal
official should determine if a specific event falls into either of
those definitions.
9. Anti cherry-picking provisions such as the following should be
included: Legislation should recognize that many war or terrorism
exposures subject the government to potential adverse selection as
insurers with less catastrophe risk are less likely to voluntarily
purchase coverage, while those with greater risk are more likely to
purchase coverage. If legislation were to create a government
reinsurance program, the program should encourage the inclusion of
both low-risk and high-risk insureds to promote greater risk
spreading in a way that does not subject the government to adverse
selection.
10. Legislation should promote or encourage coverage that is available
to any property that meets reasonable standards of insurability.
Federal security requirements should be met within reasonable time
periods by insured risks and policed by inspection by reinsured
insurers.
11. State residual market mechanisms and other pooling mechanisms for
insurance should be allowed to participate in the entity
established by legislation to provide war and terrorism insurance,
in such a way as to not create incentives for business to be placed
in the residual market. To the extent that a risk meets the minimum
security requirements, it should be able to get war and terrorism
coverage through some source . . . a residual market if necessary.
12. Jurisdiction over claim settlement practices should remain with the
states.
13. Tax law changes should be encouraged to avoid penalties on and
encourage the accumulation of reserves for war and terrorism
losses.
14. Legislation should encourage loss reduction and hazard mitigation
efforts through enhanced security.
Senator Nelson. Thank you, Mr. Plunkett.
We have heard from a multiplicity of interests now, and we
want to hear from the industry, Mr. Vagley representing the
AIA, and Mr. Nutter representing the Reinsurance Association,
so Mr. Vagley, welcome.
STATEMENT OF MR. ROBERT VAGLEY, PRESIDENT, AMERICAN INSURANCE
ASSOCIATION
Mr. Vagley. Thank you, Mr. Chairman. Thank you for this
opportunity to testify before the committee at this critical
time in our Nation's deliberations.
Mr. Chairman, the tragic events of September 11, 2001,
forever changed our collective understanding of and concern
about terrorism. We in our industry lost many valued business
colleagues and dear friends on the attacks on the World Trade
Center and the Pentagon, and no discussion of this subject
should proceed without our heartfelt remembrance of them.
Mr. Chairman, the new post September 11 world is
fundamentally different than that which existed before, surely
for Americans in general, and very specifically for property
casualty insurers and our customers. Current estimates of total
insured losses resulting from the September 11 attacks are
between $30 to $40 billion at the low end, and $60 to $75
billion at the upper end, although the final number could end
up being much higher. It will be by far the most costly insured
event in history. The amount of losses from September 11 may
well exceed the entire U.S. property casualty insurance
industry's net income for the past 3 years.
Notwithstanding the enormity of this loss, the insurance
industry is committed to meeting our promises to policyholders
affected by the events of September 11. We are paying claims
quickly and fully. To date, declared losses total over $20
billion, and we are not seeking any financial assistance to
meet these obligations.
Looking ahead, we are very concerned about what will happen
if, heaven forbid, there are additional terrorist attacks on
our country. The financial capacity of our industry, while
sizable, is limited and finite. Unfortunately, the potential
harm that terrorists can inflict is both totally unpredictable
in frequency and almost infinite in severity. The combination
of these two factors, finite capital and infinite risk, makes
the risk of terrorism uninsurable.
There is another important aspect to this issue. More than
two-thirds of annual reinsurance contracts are renewed each
January 1. Reinsurers already have notified primary carriers
that they intend to exclude or dramatically scale back
terrorism coverage in the reinsurance contracts coming up for
renewal. They are not to blame for this. These risks are no
more insurable for them than they are for us.
Primary carriers do not have the same flexibility as
reinsurers with respect to our own product, because we are
subject to tighter regulatory controls. Any terrorism
exclusions we might choose to introduce must be approved by
individual state insurance departments. If approved, our
customers could find themselves bearing 100 percent of the risk
associated with terrorism.
Certainly, the repercussions of this are clear. However, if
exclusions are denied, insurers will be left to shoulder 100
percent of future terrorist losses which we simply can no
longer afford to do. Our only remaining option, one we would
prefer not to consider, is to withdraw from certain markets
and/or lines of coverage. So in other words, we face a very
difficult dilemma.
How can we remain solvent and still serve the real needs of
our customers for financial protection against terrorism? We
believe the only course of action is enactment of legislation
to create a federal financial backstop for losses that result
from future terrorist attacks. This backstop could be
temporary, but must be enacted before congress recesses for the
year in order to avert the market crisis that will occur by
January 1.
This is not, repeat, not a bailout for the insurance
industry. In fact, the primary beneficiaries of such
legislation would be our customers and the U.S. economy. The
purpose of the legislation would be to ensure that adequate
insurance coverage remains available to American businesses.
There are a few ways in which this could be done. One is the
British-style reinsurance pool concept which we have advanced.
Another is the quota-share approach recently offered by the
administration. A third could involve some sort of industry-
wide deductible or retention.
We are not wedded to the details of any particular
proposal, not even our own, though we do believe it offers the
best hope for restoring this market. However, in order for any
legislative plan to be successful in averting the looming
economic crisis, it must be drafted in a way that improves
predictability, stabilizes the market, and preserves insurer
solvency.
We understand that in all likelihood any new risk-sharing
mechanism for terrorism coverage will include some significant
retention of future losses by private insurers. On that point,
I would like to note that the more risk insurers are required
to retain, the less stability there will be in the marketplace,
and the higher the retention, the higher premiums will have to
be.
Mr. Chairman, terrorism has become uninsurable in the
private marketplace as currently structured. Appreciating that
an immediate stopgap solution may be somewhat imperfect, we
expect that dislocations will still occur as insurers may
cautiously reenter the marketplace. It is our hope that, with
time and experience, we will be able to craft longer term, more
complete solutions that avoid such disruptions.
In the absence of federal legislation to prevent the
complete collapse of the commercial insurance market, entire
sectors of the U.S. economy could be left wholly exposed and
unable to continue the normal course of business. I
respectfully urge you to act quickly and decisively to ensure
that all businesses are able to obtain much-needed protection
against future losses.
Thank you for your attention, and I look forward to
responding to your questions, Mr. Chairman.
[The statement of Mr. Vagley follows:]
Prepared Statement of Robert E. Vagley, President, American Insurance
Association
Chairman Hollings, Ranking Minority Member McCain, Subcommittee
Chairman Dorgan and other members of the Committee, my name is Robert
E. Vagley, and I am president of the American Insurance Association,
the leading property and casualty insurance trade organization in the
United States, representing more than 410 insurers that write over $87
billion in premiums each year. AIA member companies offer all types of
property and casualty insurance, including those most impacted by the
horrific events of September 11: commercial liability, commercial
property, and workers' compensation. Before I begin my formal remarks,
I would like to thank you for holding this important hearing this
morning and for this opportunity to testify before the Commerce
Committee at this crucial time.
The tragic events of September 11, 2001, forever changed our
collective understanding of, and concern about, terrorism on our own
shores. The scope and nature of those attacks were unprecedented in
world history. None of us--neither private nor public sector
interests--had made accommodations for this type of occurrence, because
such things were simply beyond our conception. Unfortunately, we are
now presented with a new view of the very real risks and potentially
infinite costs associated with terrorist acts. The new, post-September
11 world in which we find ourselves is fundamentally different than
that which existed before, for Americans in general, and very
specifically for property/casualty insurers and our customers.
Today, I would like to address two topics. First, I would like to
briefly describe how our industry has responded to the tragic events of
September 11. Then, I would like to share our thoughts on how we can
make certain that insurers are able to continue meeting the
expectations and future needs of our policyholders with respect to
terrorism and the wide range of other risks which we insure.
Current estimates of total insured losses resulting from the
September 11 attacks stand at between $30 billion and $60 billion,
although the final number will not be known for some time, and could
end up being much higher. This makes the September 11 attacks, by far,
the most costly insured event in history. Although no natural disaster
or man-made catastrophe even comes close, for the sake of some
reference, I would note that Hurricane Andrew, which devastated south
Florida in 1992, caused approximately $19 billion in insured losses,
perhaps half to one third of the September 11 losses. Put another way,
the September 11 losses will exceed the entire property/casualty
industry's net income for the past three years (1999, 2000, and 2001).
On that single day, three years of industry profits, including
investment income, were wiped out.
I want to be very clear about our response to the horrific attack
on the World Trade Center. Notwithstanding the enormity of this loss,
the insurance industry has been publicly and steadfastly committed to
meeting our promises to policyholders affected by the events of
September 11. We have not attempted to invoke war exclusions, despite
the militaristic nature of, and rhetoric surrounding, the attacks. We
are paying our claims quickly and fully. We have received claims in
excess of $20 billion to date. And, unlike other industries who were
directly affected by the attacks, we are not asking for any financial
assistance from legislators or regulators to meet our obligations.
Recognizing that the American people and our economy will recover
and move onward, we also are looking ahead. Although the property/
casualty insurance industry can deal with the incredible losses from
September 11, we are very concerned about what will happen if there are
additional, large-scale terrorist attacks in the future. It is critical
that you as public policymakers share our recognition that terrorism
currently presents core challenges to the insurance market that we
cannot meet.
The financial capacity of our industry, while sizable, is limited.
Unfortunately, the potential harm that terrorists can inflict is both
totally unpredictable in frequency and unlimited in severity. As Warren
Buffet, CEO of Berkshire-Hathaway, recently stated, ``Terrorism today
is not at all like terrorism 25 years ago. And now you've got something
where the nature of the risk, the power to inflict damage, has gone up
a factor of--who knows what--10, 50 . . . you can't price for that.''
Put simply, that which is not quantifiable is not insurable in the
traditional sense.
As you probably are aware, more than two-thirds of annual
reinsurance contracts--agreements by which primary insurance companies
purchase their own insurance to adequately spread the risk of large-
scale losses--are renewed each January 1. Reinsurers already have
notified primary carriers that they intend to exclude or dramatically
scale back terrorism coverage in the reinsurance contracts coming up
for renewal. Although the primary insurance sector of the industry is
adversely affected by such decisions, we recognize that this may well
be the reinsurers' only way to protect their own solvency.
Primary carriers, however, do not have the same flexibility as
reinsurers with respect to our own products because we are subject to
tighter regulatory controls. Any terrorism exclusions we might choose
to introduce must be approved by individual state insurance
departments. If approved, our customers could find themselves bearing
100 percent of the risks associated with terrorism. Certainly, the
repercussions of this are clear. However, if exclusions were not
approved, primary insurers would be left to shoulder 100 percent of
future terrorist losses, which we simply cannot afford to do. Our only
remaining option--one we would prefer not to consider--would be to
simply withdraw from certain markets, and/or lines of coverage.
So we face a very difficult challenge: how can we remain solvent,
and still serve the real needs of our customers for financial
protection against terrorism? I am proud to say that insurers are
working hard with you and your colleagues in the House, and with the
Bush Administration, to come up with a public policy solution that will
allow us to continue providing this much-needed coverage to our
policyholders.
We believe that the only course of action is immediate enactment of
legislation to create a federal financial backstop for losses that
result from future terrorist attacks. This backstop could be temporary,
existing only for as long as it is needed. The legislation must be
enacted before Congress recesses for the year, since so many
reinsurance contracts which cover this risk will expire on January 1.
The legislation we are seeking is not, repeat not, a ``bailout''
for the insurance industry. In fact, the primary beneficiaries of such
legislation would be our customers, and the U.S. economy. Ultimately,
the costs of risk must be borne by the policyholders who seek
protection through insurance. Given the unprecedented nature of the
terrorism threat, the best way for this to be done is through a public/
private partnership that allows us to service the coverage needs of our
policyholders while remaining financially strong enough to pay all
potential claims, whether from terrorism acts or the other ordinary and
extraordinary events that affect our business.
The goal of needed legislation is to ensure that adequate insurance
coverage remains available to American businesses. Federal Reserve
Chairman Alan Greenspan recognized this when he testified before
Congress last week, coming to what he termed the ``very unusual
conclusion that the viability of free markets may, on occasion, when
you are dealing with a degree of violence, require that the costs of
insurance are basically reinsured by the taxpayer, as indeed they are,
for example, in Great Britain and in Israel and in other countries
which have run into problems quite similar to ours.''
There are a number of ways in which this could be done. One is the
British-style reinsurance pool concept, and another is the quota share
approach recently suggested by the Administration. A third would
involve some sort of industry-wide deductible or retention. We are not
wedded to the details of any particular proposal; not even our own.
However, in order for any legislative plan to be successful in averting
the looming economic crisis, it must be drafted in a way that improves
predictability, stabilizes the market, and preserves insurer solvency.
No proposal can make the risk of terrorism go away, nor can it make
the cost of insurance against terrorism risk go away. However, the
right legislation can provide a way for the public and private sectors,
on a short-term basis, to co-manage this risk--a risk whose dimensions
changed fundamentally and exponentially on September 11.
What must be in the legislation from our perspective to make it
workable? First, rather than 51 possible separate definitions of
``terrorist act,'' there must be a uniform national definition that
will constitute the terrorism coverage provided by insurance policies
all across America. A broad national definition of terrorism is
essential to avoid non-concurrence of coverages among primary insurers,
reinsurers and the federal backstop. Such uniformity cannot be achieved
if states retain the authority to approve or disapprove policy forms in
this narrow area.
Second, insurers must be able to quickly include the price for
terrorism coverage in their insurance policies, rather than be required
to go to every state insurance regulator and seek that regulator's
approval for the terrorism rate in every property/casualty line. Even
with a federal terrorism reinsurance program that provides a partial
backstop, individual insurers' retention for terrorism risk will be
expensive, given the huge uncertainties and potentially large losses we
collectively face as a nation. States cannot take the attitude that
``terrorism can't happen in our particular backyard,'' and therefore
suppress rates. Mindful of the general prerogatives of state insurance
regulators in the rate-setting arena, there must be language in place
that preserves rate review by the appropriate state regulator, but does
not subject the rates to any review or approval prior to or in
connection with the timely introduction of those rates into the
marketplace.
Third, we recognize that any federal terrorism reinsurance program
will include a number of important details with respect to the
mechanics of reimbursement and other issues. These details must be
drafted and implemented in a way that is workable for insurance
companies and our regulators.
We understand that, in all likelihood, any new risk sharing
mechanism for terrorism coverage will include some significant
retention of future losses by private insurers. On that point, I would
like to note that the more risk insurers are forced to retain, the less
stability there will be in the marketplace. Also, the higher the
retention, the higher prices will have to be.
Terrorism has become uninsurable in the private marketplace as
currently structured. Period. Appreciating that an immediate, stopgap
solution may be somewhat imperfect, we expect that dislocations will
still occur as insurers cautiously re-enter the marketplace. It is our
hope that, with time and experience, we will be able to craft longer-
term, more complete solutions that avoid such disruptions.
In the absence of federal legislation to prevent the complete
collapse of the commercial insurance market, entire sectors of the U.S.
economy could be left wholly exposed and unable to continue the normal
course of business. I urge you to act quickly and decisively to ensure
that all businesses are able to obtain much-needed protection against
future losses.
I thank you for your attention and look forward to responding to
your questions.
Senator Nelson. Thank you, Mr. Vagley. Mr. Nutter.
STATEMENT OF MR. FRANKLIN NUTTER, PRESIDENT, REINSURANCE
ASSOCIATION OF AMERICA
Mr. Nutter. Thank you very much. I am mindful of the hour,
and my position on the panel.
Senator Nelson. You go ahead, and you take the allotted
time, and then we are going to get into a good discussion here.
Mr. Nutter. I appreciate that.
The Reinsurance Association of America represents domestic
U.S. reinsurance companies. Reinsurance is effectively the
insurance of insurance companies. It is commonly associated
with natural disasters, hurricanes and earthquakes. The
chairman is well aware of the role that insurance and
reinsurance has played in dealing with that. As compared to the
primary insurance market, some estimates are that the losses
associated with the events of September 11 will fall 60 percent
in the reinsurance market. This shows the role that reinsurance
plays in dealing with catastrophic events.
I will not repeat, but certainly would associate with the
comments that Bob Vagley made about what this industry is
seeking. We are certainly seeking no compensation, no program,
no financial assistance for the events of September 11. What I
would like to comment on are various references that have been
made to the asset base or the capital base of the industry and
how it relates to this issue. No insurance or reinsurance
premiums were collected for the acts of terrorism that occurred
on September 11. All of the losses will be paid out of the
capital account of the industry.
As has been mentioned, I think by you, Mr. Chairman, the
industry's capital base is about $300 billion, but these losses
fall not evenly across that capital base, but fall mostly on
commercial insurers and reinsurers. That capital base really
falls to about $125 or $126 billion for those companies that
will bear the greatest portion of this loss. Some estimates are
the capital base is lower than that.
That capital base clearly can fund the September 11 losses,
and it will fund them, but the companies in the industry will
look at these losses and reevaluate a variety of underwriting
principles. Certainly with respect to the size, scope, and
frequency of these kinds of insured losses, greater capital
allocation will be necessary. Risk-based standards applied by
insurance commissioners are likely to incorporate terrorism
risks that they have not previously applied. Even the notion of
the correlation of risk that we did not contemplate before but
that we now see in an act of terrorism will have to be
rethought.
The industry cannot absorb losses of this nature with any
frequency. The potential unlimited size of the exposure, the
frequency of the exposure, and the scale make it very
difficult. As Mr. Vagley has said, it is probably an
uninsurable risk. We have then to look to other ways of dealing
with this. Insurance, as has been said by many witnesses, is
the grease that operates to lubricate the American economy. We
are here to find ways to continue to provide insurance and
reinsurance to our clients.
The best way is that the federal government should be an
insurer of last resort, a reinsurer, if you will. We also are
not currently wedded to any specific approach, but we do
recognize the urgency of this problem. As has been mentioned,
many reinsurance contracts do renew at year end, and frankly,
the reinsurance community is looking to the Congress to take
action. That will have a direct bearing and significant bearing
on what they do with respect to providing coverage for
terrorist acts.
We would like to work with the committee, and certainly
work with the congress in finding solutions. We do think that
it is important that in any such legislation that provides that
the federal government is a reinsurer of last resort, that some
clear definition of terrorism is made, some establishment of a
framework for the regulation of rates at the State level is
made, and the basis upon which insurers and reinsurers will
retain risk on their own account should be clarified.
With that, Mr. Chairman, I will close and welcome any
questions from the committee.
[The statement of Mr. Nutter follows:]
Prepared Statement of Franklin W. Nutter, President, Reinsurance
Association of America
The Reinsurance Association of America represents U.S. domestic
reinsurers, which collectively underwrite more than 70 percent of the
U.S. reinsurance market. Reinsurance is the insurance of insurance
companies. It is the financial mechanism by which insurers spread the
risk of loss throughout the world's capital markets. One of the most
frequently used purposes of reinsurance is to absorb losses from
catastrophic events such as hurricanes, earthquakes, and in the case of
September 11, acts of terrorism. Some have estimated that 60 percent of
the losses paid by our industry from the events of September 11, will
be paid by reinsurers.
The U.S. insurance and reinsurance industry will be able to meet
its policy and contract obligations and pay the losses arising out of
the September 11 terrorist attacks. Insurers and reinsurers do not need
financial assistance from the federal government for those losses, and
they aren't asking for any.
The terrorist attacks of September 11, 2001 resulted in
unprecedented losses of life, personal injury and property damage. It
is difficult to estimate the total injured losses that the U.S.
property and casualty insurance and reinsurance industry will
ultimately pay as a result of those terrorist attacks. In addition to
the normal problems involved in estimating large or catastrophic
losses, in this case there may be liability issues that may take time
to fully resolve.
Some recent analysts' reports have suggested that $30 billion to
$40 billion is a reasonable range of estimated total insured losses
(property, casualty, life and health) from the September 1 terrorist
attacks. Some analysts have even suggested that the total insured
losses could exceed the range of numbers I just mentioned. Put in
perspective, the insured losses from the terrorist acts of September 11
could exceed the combined insured losses from the last five major
natural catastrophes (hurricanes Andrew and Hugo, the Northridge,
California and Kobe, Japan earthquakes and European windstorms Lothar
and Martin).
Before September 11, the threat of terrorism within our borders
seemed remote. Because of that, no insurance or reinsurance premiums
were collected for terrorism coverage, and no assets or reserves were
allocated to terrorism exposures. The industry did not underwrite for
the risk of terrorism. That means that the September 11 terrorism
losses must be paid from the industry's capital account. The total
capital and surplus of the U.S. property and casualty insurance and
reinsurance industry at June 30, 2001--including both personal lines
and commercial lines writers--was $298 billion. That figure includes
$26.6 billion of capital in separately capitalized U.S. domestic
professional reinsurers.
That total industry capital consists of required regulatory risk-
based capital, as well as the additional capital need to support
operating and investment risks and to meet the reasonable expectations
of policyholders and claimants, rating agencies, stockholders and
others.
The exposure to loss from the September 11 terrorist attacks is not
spread evenly across the total insurance industry capital base. The
great bulk of those losses will fall on the capital base of the
commercial lines insurers and reinsurers.
After subtracting personal lines capital, the Berkshire Hathaway
capital that isn't allocated to the affected lines, and the pre-
September 11 third quarter declines in common stock values--the
affected property and casualty commercial lines insurers and reinsurers
(U.S. and non-U.S.) had a September 10 estimated combined total capital
base of $126 billion. Tillinghast, in a just-released study for the
American Insurance Association, noted that the September 11 losses
might rest on an even smaller capital base--perhaps $80 billion to $100
billion.
Several conclusions can be drawn from this:
First, the commercial lines capital base can obviously fund a
total September 11 insured loss of $25 billion to $40 billion--
or an even larger loss from that event.
Second, many actuarial and underwriting principles and
practices will have to change. While not a complete list, here
are five things that will change:
We will have new and different notions about the
size, shape and trends of insured losses and the required risk
loads.
Most lines of business will require a greater
capital allocation.
Risk-based capital standards will be revised by
regulators and rating agencies to incorporate terrorism risk.
The cost of capital for the insurance business
will, other things being equal, go up.
We need to rethink risk diversification or its
opposite, the correlation of risk.
Third, the commercial lines capital base cannot absorb
another sizable terrorist event without seriously compromising
the ability of the property and casualty commercial lines
industry to meet its commitments for losses arising from other
underwriting and balance sheet risks.
The simple fact is that, on its own, the U.S. insurance and
reinsurance industry can't afford to take on the potentially unlimited
exposure to loss arising from insuring against terrorist acts. No one
at present can reasonably predict either the number, scale or frequency
of future terrorist attacks we might face before our war on terrorism
is won.
We support and applaud the steps that the federal government is
taking to combat terrorism. But until those efforts have borne the
fruit of significant reduction in the potential for terrorist attacks,
it is close to impossible for many insurers and reinsurers to
responsibly underwrite or assume terrorism risk. We simply can't
evaluate the frequency and severity of terrorism losses using
traditional underwriting and actuarial techniques. There are no models
that would let us price the risk with confidence.
That is why as an industry we need to explore alternative ways to
cover losses arising from terrorism.
The September 24, 2001 edition of The Wall Street Journal featured
this quote from Warren Buffet, Berkshire Hathaway's chairman:
I think in the future, the government is going to have to be
the ultimate insurer for acts of terrorism. . . . An industry
with very large, but finite, resources is not equipped to
handle infinite losses.
In some very important ways, insurance is the grease that
lubricates the American economic machine. Insurance and reinsurance
coverage for terrorism risks is necessary for our economic recovery--so
that lenders will lend, and builders will build, and employers will
hire.
Going forward, we need to find a way to provide insurance against
terrorist acts that assures both the continued financial viability of
the U.S. insurance and reinsurance industry, and the continued
availability and affordability of the wide range of products and
services provided.
In a rare--if not unique--show of unity, the property and casualty
insurance and reinsurance industries universally agree that the best
way to do that is to have the federal government act as the ``reinsurer
of last resort'' for terrorism insurance and reinsurance coverage,
similar to the plan used in the United Kingdom.
Federal Reserve Chairman Alan Greenspan appears to agree. On
October 17, 2001, he said:
What hostile environments do is induce people to withdraw, to
disengage, to pull back. It's quite conceivable you could get a
level of general hostility that would make viable market
functioning very difficult . . . I can conceive of situations
[where] the premiums that would be necessary to enable a
private insurance company to insure against all those risks and
still get a rate of return on their capital would be so large
as to inhibit people from actually taking out that insurance. .
. .
Therefore you're led to what is an unusual conclusion that
the viability of free markets on unusual occasions, when you
are dealing with violence . . . [that it is necessary that] the
costs of insurance are reinsured by the taxpayers . . .
Free markets and government reinsurance, in this very unusual
circumstance they are indeed compatible . . .
(Source: Bloomberg)
It is increasingly clear that state regulators, the Administration,
members of Congress, and a broad swath of Americans and American
businesses also agree that we need a solution.
All of these interests may not currently agree on the exact way to
structure that federal insurer role--we've all heard the several
proposals that have been advanced. But there is nearly universal
agreement on the fact that this is a significant and urgent problem
that needs to be solved before Congress recesses.
While the size and scale of the September 11 terrorist attacks are
unprecedented, there are precedents for government involvement--here
and abroad--in the solution of temporary insurance market disruptions.
The federal government ran an insurance program during World War II.
FAIR plans were developed to deal with insurance scarcity in the wake
of the 1960's urban riots. More recently, the United Kingdom and other
countries have developed government-backed solutions to terrorism
insurance.
When the need for these kinds of programs abates, they should be
terminated.
We're eager to work with this Committee, other members of Congress,
the Administration, state insurance regulators, and others to find a
solution that makes sense for the country and for the faltering
economy, which badly needs an injection of confidence. The solution
must also make sense for policyholders and claimants, for the insurance
industry and its regulators, and for you. Insurance is, after all, a
critical part of the central nervous system of this economy and this
society.
We are not looking for any financial assistance for the insured
losses flowing from the tragic events of September 11. We are looking
for a way forward to serve our clients by protecting against the
financial consequences from acts of terrorism, fulfill our role in the
economy, and to protect our solvency.
We believe that a public private partnership premised upon the
federal government as a reinsurer of last resort provides the best
approach. Legislation creating such a mechanism should clearly define
terrorism for this purpose, should establish a framework for regulation
of rates for state insurance commissioners and provide the basis upon
which insurers retain risk on their own account.
Insurers believe that acts of terrorism have become uninsurable in
the traditional sense. Only a public/private partnership, even one that
is transitory in nature can address this problem.
I'm grateful for the opportunity to speak to you today, and would
be pleased to answer any questions you may have.
Senator Nelson. Thank you all for excellent presentations.
I thought I was escaping from the state level of insurance
regulation to the high councils and marble corridors of the
federal government, where I would not be facing the question of
insurance, and yet here we are.
Senator Boxer has a commitment then she has to leave. You
are recognized.
Senator Boxer. Thank you so much, and I just want to say
how lucky we are to have you here, because this is in many ways
a complicated issue, although I sense it is being made a little
bit more complicated than it should be made, but we will see.
First, I want to compliment the insurance industry, because
I want you to know, when I heard you say we are going to cover
these losses, we are okay, we are healthy, we are strong, I
felt really good about that, and I felt that it did add a
certain level of calm and peace to people who were suffering so
much that this was one less thing they had to deal with, so I
do want to say that I am appreciative of that, and I am glad of
that, and you did not come running here for September 11.
I want to talk about the future, because I do not think it
should be all that confusing, and here is what I am going to
do. I want to explain what we do in California vis a vis
earthquakes, and then what I would love to do, because I do not
want to take the time of my chair today, is if you would
promise me to explain what you like about this plan, what would
not work, how you would change it, or if you just think the
whole thing does not apply. But rather than go through it as a
dialogue, I would prefer to speak first, and then I will leave
and leave the rest to my colleague from Florida.
Here is what happened after the horrible Northridge,
California earthquake in 1994. Insurance companies determined
that the premiums they had been charging for earthquake
coverage were inadequate. Furthermore, the companies did not
know how to set an actuarially sound price, which is something
we are discussing here today. Insurance companies attempted to
stop selling insurance against earthquake damage, and I can
tell you that really created havoc in our state. People were
just so upset, Mr. Chairman. Here they had this earthquake, and
now they were going to lose all future coverage.
The state said, unh-unh, you cannot do that and still
function in the state. You are going to have to figure out a
way to do this. So there were negotiations between the
legislature and the Governor, the insurance companies, and
after the negotiations, insurers were permitted to exclude
earthquake coverage from their property casualty policies if
insurance companies representing at least 70 percent of the
market agreed to participate in the California Earthquake
Authority, so this California Earthquake Authority was set up
to participate. It meant agreeing to an initial assessment
totaling $717 million, plus two additional assessments of $2.1
billion and $1.4 billion after certain levels of earthquake-
related losses occurred. Thus, potential earthquake authority
losses are to be funded by multilayered financing arrangements
involving insurer contributions, premiums, conventional
reinsurance, and preestablished debt financing.
Now, in early 2000, these layers totaled about $7 billion.
Now, the state of California does not put any money into this,
and in the event all the authority funds are expended, claim
payments would be prorated. The Earthquake Authority currently
provides all of the earthquake insurance available in the
state.
Now, I do not think this goes far enough. I think the
federal government should do more, et cetera, et cetera, but
what I would like--and I am not to get into it now--if you
could critique the ideas of this proposal, because it does
appear to be working.
In closing, Mr. Chairman, let me say this. I want to help,
but I cannot sit by and watch the taxpayers be taken advantage
of. I cannot. I will not. That is not why I am here. Other
people may be able to, but I cannot, so I am really hoping that
we come up with a plan, all of us, that everybody feels good
about, that yes, the taxpayers will be there as a last resort,
not first resort, that we will be there to help, and I think
that--the comments of Mr. Keating and Mr. Moss and Mr. Plunkett
reflect where I am coming from on this.
I think we can do what we have to do, Mr. Chairman, but we
need to be mindful that we do not want to interfere too much. I
mean, after all, that is what we are told all along. You do not
want to set up an artificial situation here, and I was taken by
what Mr. Moss said. I think it was Mr. Moss who said, you do
not want to take incentives away.
For example, if you just have the insurers feel, that they
do not have to worry about this any more and only have a little
bit of liability, and believe that Uncle Sam has most of it,
and then somebody does not really insure their property. Let us
say it gets to the point where insurance companies will be
telling their people, we think you ought to have 24-hour
security guard, and somebody does not do it, and as a result
some damage is done; we have lost our guard because we do not
have those financial incentives.
I sense that maybe we were a little more critical on this
committee than other committees have been so far. So I hope, as
a result of this hearing that we can get to the table and work
with you. I hope we can. We need to do something. I think we
have some models we can follow.
And again, Mr. Chairman, I am really glad you are here now,
because you are going to be one of my leaders on this, that is
for sure.
Thank you.
Senator Nelson. Thank you, Senator Boxer.
Well, we have quite a number of proposals on the table. We
have the administration's plan, we have the industry's plan, we
have the National Taxpayers Union plan, we have the Consumer
Federation of America's plan. I would like the National
Association of Insurance Commissioner's commentary on what
would you like to see the Congress pass to address the
terrorism insurance?
Ms. Koken. Senator Nelson, it is a pleasure to be here,
particularly with you chairing the meeting. The NAIC has
developed guiding principles that we think are important, but
we have not at this point endorsed any one particular program.
We believe that certain aspects are critical. We believe in a
sunset, and that it is important that this does not destroy the
competitive marketplace, which we think functions best.
At the same time, we do have concerns about the
affordability and the availability, but we believe that the
state system needs to be kept an important part of whatever the
solution is. The system is in place, and we believe that we are
very concerned about not only the claims-paying ability of the
companies and their ability to follow through with paying
claims, and the availability to consumers, but also the very
important factor of solvency monitoring, which is something
that the state system works very hard at doing, and so we would
like to be part of any process.
Senator Nelson. So in that regard, let me ask Mr. Nutter
and Mr. Vagley, as I understand your proposal, it basically
would take to the federal level a lot of the functions that are
now done at the state level that Ms. Koken says the NAIC would
oppose. Would you comment on that?
Mr. Vagley. Yes, I would say that is not a fair
characterization of our proposal, Mr. Chairman. Our proposal
really in many respects met the design that you and Senator
Boxer described. It was based on the British model, and on
models that other countries have adopted when they
unfortunately experienced terrorism at home. And the U.K.
developed a model called Pool Re, which we in effect sought to
emulate by developing our own proposal. It would create a
private mutual insurance company that in fact would purchase
reinsurance from the federal government. I suspect that
proposal was too complicated to consider at this late hour,
given the emergence of January 1 and the economic dislocations
that might occur then, but it did in many respects meet the
goal that you had outlined.
I think except for two narrow areas, Mr. Chairman, we would
not propose removing or eliminating the State regulatory body
for its assigned mission. The only areas we have called
attention to, and I believe these areas have met with
concurrence from the state regulatory community, although Ms.
Koken certainly is more capable to speak to that than I, one
had to do with the definition of terrorism, whatever the
definition is, if it is narrow, if it is broad, it should be
identical in all policies and all states,and we should not be
confused, and policyholders should not be confused by 51 or
more different definitions of terrorism.
Then the other area really had to do with pricing the
product, Mr. Chairman. We just did not want to be caught up in
product approval regimes where we have pending actions before
state regulatory bodies for months and years while the risk of
terrorism continued.
Senator Nelson. And in fact, then, what Ms. Koken was
talking about, that state insurance regulators ought to stay in
control of the financial wherewithal of the companies as well
as what the rates are. In your proposal, that is done by the
federal government, as I understand it. The Treasury Department
would oversee the pool, the government reinsurance pool. You
would sell terrorism policies from that pool, and the pool
would be responsible for paying the terrorism claims, and the
premiums collected by the pool would be set by whom?
Mr. Vagley. By the federal government in the proposal you
are describing, Mr. Chairman, and I should have added, I should
have footnoted my comment that there have been several
evolutions of that proposal over time, and they seem to be
morphing in whatever is the current discussion. With respect to
the current debate, the only areas of state authority that
would be affected, as I understand it, would be the definition
of terrorism, and there the goal would be consistency, and with
respect to pricing the product, and that matter would be left
to the states, but basically on a final use approach with a
general standard of rates not being inadequate, unfairly
discriminatory, or excessive.
Senator Nelson. I take it your latest proposal is that the
terrorism insurance would be determined by the federal
government, in this case the Treasury Department or some
derivative thereof, and the insurance premiums would be
determined by that agency as well.
Mr. Vagley. Again, I guess I should emphasize our proposal
has been overtaken by time.
Senator Nelson. Is that your proposal?
Mr. Vagley. That was the proposal that we advanced several
weeks ago, I think in the several evolutionary stages of the
debate. That proposal seems to have little, if any, political
traction.
Senator Nelson. Well, what are you advocating now?
Mr. Vagley. As I indicated in my testimony, Mr. Chairman,
we are advocating anything, any proposal--we are not wedded to
any particular proposal--any proposal that will allow the
industry to ease its way back into underwriting this product,
and that will provide some stability in the commercial
insurance marketplace, and there are several proposals on the
table, and obviously Congress is free to consider all of them
on its own.
Mr. Nutter. Mr. Chairman, if I could just supplement that.
Obviously you are looking at references to an AIA proposal of
some weeks ago. As Insurance Commissioner, you are probably
familiar that it is not uncommon for the industry to come
forward with four or five very good ideas, but in competition
with each other. About 10 days ago, we worked with the AIA and
the other trade associations in the industry to come up with a
consensus proposal that is state-based. A pool with state rate
regulation as described by Mr. Vagley, a single definition of
terrorism at the federal level. It really has a much more
state-based approach than what you are describing. If we need
to provide to the committee a more current approach that
represents a consensus among the industry's trades, we will do
so.
Senator Nelson. Well, one of the ideas that is being
proffered now is that the first dollar loss due to terrorism
would not be borne jointly by the insurance industry and the
federal government, but rather up to a certain level would be
borne by the insurance industry. Is that something that you
would favorably consider?
Mr. Vagley. I think that certainly is a proposal that is on
the table, Mr. Chairman, and may be the reigning proposal as of
today. Currently I think our focus is restoring responsibility
to the marketplace. I would say to those developing those
proposals there are better alternatives, including the pool
proposal we advanced, and the quota share proposal that the
administration advanced.
Simply in terms of allowing underwriters to get their arms
around the risk, I think a retention proposal suffers from the
significant disability that the Secretary pointed out, which is
the misfortune for those who are under the deductible. I mean,
who insures this year's tower, when in fact the total loss on
that tower might be whatever its total value is. We are
operating in a new risk paradigm. No one in our industry, or I
dare say our country--perhaps some--could have foreseen how our
assessment of risk would change from September 10 to September
11.
Our underwriters used to look at a building like the World
Trade Center, and it would be valued in total for $3 or $4
billion, and they would assume that the probable maximum loss
in that building, insuring it through fire or other disaster,
would be $300 or $400 million. With deep respect to those who
were lost in that building, I think if it were reconstructed,
underwriters would look at a $4 billion building and say,
probably maximum loss is $4 billion.
Senator Nelson. Now, that is what the Secretary was talking
about, but that is a 100-percent risk premium, and that is just
simply not the business of insurance. You cannot go and charge
a $4 billion insurance premium to cover a $4 billion building.
Mr. Vagley. That is exactly right. That is why we are here.
Senator Nelson. Well, let me have you critique Mr.
Plunkett's plan, the Consumer Federation of America's plan.
Mr. Vagley. As I understand Mr. Plunkett's plan, and there
was possibly more detail in there that I could comprehend----
Senator Nelson. It was the same one offered last week by
Bob Hunter, the Consumer Federation.
Mr. Vagley. Assuming that, I think that it is in effect a
loan program, and once you reach a certain threshold of pain on
a company by company basis, that company would have some access
to some lending authority, presumably the lending authority of
the federal government. Well, that is an interesting concept,
but it does not change the risk paradigm for an underwriter.
The underwriter has still got to assume that that company is
eating all of the loss.
Whether it pays for that loss out of its capital account or
through borrowed funds, those funds may be repaid, so I think
the plan fails, because it does not change the risk paradigm.
Therefore it does nothing, and we are better off without a
program like that, because it would raise expectations that we
cannot meet.
Senator Nelson. So you would like to basically--you would
rather shift the terrorism risk to a pool of all insurance
companies together, and the cost for that pool you might want
to consider shared with the federal government, and that any of
the costs of that pool to you, the industry, you would pass on
to the consumers.
Mr. Vagley. Actually, Mr. Chairman, the pool concept that
we developed would have operated as a mutual insurance company.
The industry would have been able companies like the ones I
represent, would have been able to come in and negotiate with
this mutual insurance company that would have been called
Homeland Security, or Pool Re, or something like that, and
basically spread its risk, mutualize its risk, as Secretary
O'Neill said, throughout the rest of the industry.
Senator Nelson. That means you put the risk back on the
policyholders.
Mr. Vagley. No. What that means is, you spread that risk
throughout the entire industry, so instead of an underwriter
bearing 100 percent of the risk, the underwriter might cede off
95 percent of that risk and retain 5 percent of it, and that is
a much more digestible economic proposition than hanging on to
100 percent of the Sears Tower.
Senator Nelson. Right, and your example, if you take 5
percent of the risk and you have 95 percent of the risk in the
pool, that then is shared by the entire consortium that is
participating in that pool.
Mr. Vagley. That is correct, and for that privilege the
ceding company would pay a reinsurance fee to the pool.
Senator Nelson. And of course, who pays? The consumer pays
in the end, which is what the consumer is going to pay in the
end whether they be labeled taxpayer or insurance consumer.
Mr. Vagley. Well, if the consumer is a policyholder, the
policyholder pays for insurance, that is right.
Senator Nelson. Do you think the industry is going to
approach this whole thing, that the whole thing is a 100-
percent risk?
Mr. Vagley. No. I think the industry----
Senator Nelson. What is actuarially sound in determining a
premium.
Mr. Vagley. Mr. Chairman, I will tell you that there is no
actuarially sound experience that we have. Six weeks after
September 11. Now, 2 years from now, or 3 years from now, with
the benefit of hindsight and some experience, I would think our
actuaries would be better suited to answer that question, but
our risk paradigm changed in the 24 hours between September 10
and September 11. Our industry absorbed $40 to $60, $70 billion
worth of losses on no premium paid because we honestly did not
believe on September 11 that we could have conceived a risk of
this nature, and yet we did, and so our risk paradigm has
changed, and so we need to reflect that in our own experience,
and frankly that analysis has not settled down yet.
Senator Nelson. Nor will it for some number of years, and
just on that score, let me ask you, then, how would, in this
limited new experience in this strange new world, how would you
come up with a pool concept whereby the insurance companies
would have 5 percent and the pool would have 95 percent?
Mr. Vagley. Well, it actually functions that way, Mr.
Chairman. The British experience is illustrative. The British
government created a mechanism after the IRA attacks, I
believe, in the early nineties. The United Kingdom has never
spent a pound to pay back to the insurance industry. That pool
has been a self-funding mechanism, and the insurance process
will work so long as that risk can be spread. That is why
insurance companies go to reinsurance companies to insure
themselves. That is why individuals come to us to insure
themselves, so that that risk need not be borne by them, so it
can be spread through the entire mechanism. That is how the
pool concept would have worked.
Senator Nelson. Mr. Nutter, you have been trying to speak.
Mr. Nutter. I wanted to add a point of clarification. The
pool concept that Bob is describing is not unlike the
transformer mechanism that was the Florida hurricane fund,
really a mechanism by which all companies operating in that
case in the Florida market could pool their risk that none of
them had such a concentration of risk that it made it
threatening to their solvency, or that would in fact affect the
rates of individual consumers.
The other thing that has not been said that needs to be
said, because it was asked several times of the Secretary, is
that our concept had the pool paying the federal government for
the reinsurance level that it provided so we looked at this on
what we believed to be sound economic grounds so that the
consumer, yes, paid for his insurance, but the pool then really
moderated the effect of that, and then the pool paid for the
cost of reinsurance the federal government provided.
Senator Nelson. By the way, is this one of the few times
the reinsurance industry and the insurance industry have been
on the same page?
Mr. Vagley. It is unusual.
Senator Nelson. Mr. Nutter, I think you were referring to
the Florida Windstorm Insurance Foundation when you were
referring to the hurricane fund. Let us make sure instead of
the Florida hurricane catastrophic fund you were referring to
the Windstorm Association.
Mr. Nutter. I was referring to the Windstorm Association,
and of course the role the hurricane fund plays in providing
reinsurance through a quasi-governmental organization. This
would be different from what we proposed, which is entirely a
private sector mechanism subject to state regulation.
Senator Nelson. And having raised that, I want the record
to reflect that originally that pool in Florida was created as
a consortium of some 250 or 300 insurance companies to insure
the highest wind risk in the highest areas. It was the Florida
Keys.
Ultimately, it was expanded to the Barrier Islands, but
later on the industry wanted to basically take huge chunks of
mainland and put all of the hurricane wind risk over into that
pool instead of the companies themselves taking that risk,
continuing that risk as they had borne for some period of time.
When the Department of Insurance and legislature would not let
that occur in the state of Florida, what we saw the course of
time, with reinsurance reinvigorated because of active
competition in the market forces, and given greater incentives
to offset losses through the Florida hurricane catastrophic
fund, we saw then the market for homeowners insurance come back
to life.
What I want to make sure here is that there is not going to
be any terrorism insurance come January 1, and that we are not
suddenly dumping all of the terrorism risk away from the
insurance industry, which clearly would be the nicest for the
industry, but after all the insurance industry is in the
business of insuring risk. So let us see if we can find this
happy balance.
Now, I would like to have Mr. Keating from the National
Taxpayers Union, how about you critiquing the Consumer
Federation of America's plan, and critique the industry's plan.
Mr. Keating. Well, I think the Consumer Federation of
America plan is probably better than the plans advanced by the
administration. Probably our key concern with the plan is that
it would probably never disappear. There would not be more
assumption of risk over time by the private sector. It is just
kind of a loan program. It has its pluses, but we would like to
see something with built-in incentives for the industry to
monitor its risk, as Mr. Moss said. I would associate many of
our beliefs and thoughts with what he said here at the hearing.
As far as the industry plan, I think they are
mischaracterizing it to say that they were going to pay for
federal reinsurance. At least the bill that I saw in its most
recent draft, I think October 10, specifically excluded payment
for federal reinsurance unless there were certain levels of
capital. Maybe there is another bill that I have not seen since
then, but that was the last one that I have seen, and I think
that is a mischaracterization of the proposal to say it is
always paid for, therefore, we could not support that approach.
Also, we could not support the idea that something would be
chartered in a state, yet the federal government and the
federal taxpayer is on the hook for the payments from the
corporation. If there is going to be a federal backstop, or
federal guarantee, we think there has to be federal oversight,
instead of just state oversight.
Senator Nelson. So of the three plans, the administration
plan, the Consumer Federation plan, and the industry's plan,
you favor the Consumer Federation plan the best of the three?
Mr. Keating. Of those three. Now, my written statement has
another approach which we obviously would favor more than the
others. That being said, I must say--and it sounds like
Professor Moss has a plan, too, I would love to see.
Senator Nelson. I am getting to him.
Mr. Keating. Perhaps he has come up with something better
than what anyone else has proposed. I like his characterization
of what we need to see, We need to see the right incentives to
allow the private sector to come back in and manage these
risks. They are going to do a better job than the federal
government and the political system over time, and that is
important not only for fiscal soundness, but for human life and
property.
So these are all very important issues. I think our plan is
probably superior to the others, but he may have one that is
even better. We are open-minded about this.
Senator Nelson. Professor, share with us, and pull that
mike over to you.
Mr. Moss. I believe I know about all of the plans, I
understand that reasonable people are trying to solve this
problem, and I appreciate that very much. What I have tried to
think about is the very simplest thing we could do, especially
since time is of the essence, and it seemed to me that a very
simple plan would be this: each insurer could be allowed to
cede some level of terror risk, let us say, between 20 and 80
percent of its terror risk to the federal government; and
whatever proportion of risk it chose to cede, it would be
required to cede the same proportion of premium. That is the
plan.
If you wanted to make it a little bit more complicated, if
you wanted to inject a subsidy, you could reduce the amount of
premium they cede by some percentage. But that is just a modest
variation on the plan. It seems to me the advantage of this
approach is that it would price the risk. You would allow the
insurance industry to move these enormous risks and the
enormous uncertainty off their books for the moment, but they
would have to pay for it.
In fact, countries that have done this with natural
disaster risk have seen that over time the industry decides--
well, we start by wanting to cede all the risk it can, let us
say 80 percent. But it does not take long for insurers to say,
now, we would like to cede 70 percent, and over time 60, 50,
and finally you get down to the bottom end. That is what we
have seen in other countries that have done similar things.
So my sense is that this plan would--if not disappear
altogether--it would recede over time on its own accord. Most
importantly, I think it would essentially solve the problem at
hand without distorting the market in some of the ways that the
other plans might inadvertently do.
Senator Nelson. So your suggestion, you use the figures
just as an example, 20/80, so you are talking about first
dollar coverage?
Mr. Moss. That is right.
Senator Nelson. So you are talking very close to the
administration's plan?
Mr. Moss. No, I do not think that is right. They charge a
price of zero for government coverage. I think that is the
critical mistake in the administration's plan. I think we
should charge the full risk premium. The insurers can set
whatever premium they want, but they have to cede a portion of
that premium commensurate with the amount of risk they cede. If
they cede 80 percent of the risk to the federal government,
they should cede 80 percent of the premium. Therefore, they
will have to charge a higher premium than if the government
absorbed their risk for free.
Senator Nelson. And until we can determine what is an
actuarially sound premium for that risk, what would, under your
plan, determine that premium?
Mr. Moss. My personal opinion is that the insurer is in the
best position to set that premium, perhaps with some guidance
from the state regulators. So I would let them set within some
reasonable bounds any premium they would like to set, as long
as they are willing to cede the portion of the premium that
corresponds to the risk they are ceding to the federal
government.
Now, I understand that may not be politically acceptable,
and that there may need to be a deductible. If there is a
deductible or retention of, say, $10 billion or $4 billion, or
whatever the potential retention is, then the government would
have to get in the business of setting the price and saying how
much it is going to charge for the reinsurance.
I am a bit uncomfortable with that, which is why I would
rather do this without a retention, without a deductible--
essentially co-insurance. But I think if you did want a
deductible or retention, we could try to work out the pricing.
It would just be more complicated. My sense is we should just
try to do the simplest possible thing, and that is what I have
tried to propose.
Senator Nelson. Okay. Mr. Plunkett, would you critique
that?
Mr. Plunkett. I think our assessment would be that his
principles are correct, and very briefly I think we would say
that we would like to see the details that he is looking at
properly in terms of pricing and shifting risk as much as
possible to an industry that is in fairly good financial shape.
Regarding first dollar coverage, if they do pay a premium,
I think we would be less concerned. One of our guiding
principles from the beginning has been actuarial soundness, and
the basic tenet of actuarial soundness is that they pay
something for the product that they are buying, and that the
premium be equitably assessed. I think it has promise.
I think there are a number of proposals that--we are not
wedded to our proposal as long as certain principles are met.
I would like to say, if I could, in response to the
critique you heard of our plan, that it certainly does spread
risk. For instance, above the retention that we propose in the
5 to 10 percent range based on the surplus of our company we
are spreading the risk to the taxpayer, because they are
loaning these companies money. Then above 10 percent you are
spreading risk to all the ratepayers, because they will,
through the surcharge on the state premium tax, pay whatever is
loaned above 10 percent of losses back, and I might add that
that in our opinion is a much fairer way in terms of
apportioning risk to do it, because the folks who are paying
the premiums, are obviously those who would assume the highest
risk and are paying the highest premiums. Also, they will pay
the most on the premium surcharge, and that is certainly a
fairer way to do it, if you are requiring that loans be paid
back, than to have it paid by taxpayers.
Senator Nelson. Professor, one thing that his plan does is
that it, from the very first dollar in a very difficult
determination of what should be the premium. Part of what Mr.
Plunkett is saying is that in effect the consumer is not going
to pay a premium unless there is a loss, and then that loss is
passed on to the consumer, and the case was, he said, loans
were made, and those loans were made or repaid over the course
of 20 or 30 years, but those loans would not be made unless the
terrorism loss occurred, which gives you a little more
stability, because I think Mr. Nutter and Mr. Vagley have
pointed out, how in the world do you determine what is an
actuarially sound premium right now for the terrorism risk.
Mr. Keating. May I comment on this plan briefly?
Senator Nelson. Yes, Mr. Keating.
Mr. Keating. I like the plan very much as described here. I
have to think about it some more and ask some of our advisors
what they think about it, too. But my first impression is that
one of the major strengths of this plan is that it keeps the
incentives right, and that people who are pricing this product
are going to have the most incentive to do as much research as
possible to properly price this project to attempt, where
possible, to avoid concentration of risk.
I mean, we are talking about covering a building that is a
$4 billion building, no one should have a concentration of risk
like that, and I would presume that you are going to see the
risk chopped up into smaller pieces where people can digest
them and price them, because across the country I do not think
anyone is thinking our whole country is going to be destroyed
by terrorist attack. We hope we do not see the kind of thing we
saw in New York last month, but I think his proposal gets a lot
of it right. I like it very much.
My only caution would be, if state regulators are somehow
distorting the prices that might be charged, that could be a
real problem in getting these prices set properly, so we would
want to avoid the federal government--if the federal government
is going to be taking a premium regulated by some State entity,
that could pervert, I think, some of the very positive aspects
of the proposal.
Mr. Plunkett. It absolutely is appropriate, and this is
something we would want to look at carefully, and Professor
Moss' proposal as well. If the government is picking up some
portion of losses, it is absolutely appropriate to go through
the states, because they regulate insurance, to look at
affordability and accessibility. That is a key part of the
concern for us, and it certainly would be appropriate in any of
these proposals for the states to do that.
Now, we all understand it needs to be done quickly. We
understand what the concern is with the policies expiring at
the end of the year. I do not think anyone would suggest that
lollygagging would be a good idea, but it certainly is
absolutely appropriate.
Senator Nelson. And not to throw a monkey wrench into this
thing, but we have not even discussed what are we going to do
about business interruption insurance, so indeed, we have got
to start working overtime to get this thing underway.
Well, I want to thank you for a most enlightening and most
engaging panel to discuss a very difficult issue, and on behalf
of our chairman and Ranking Member, Senator McCain, our Ranking
Member, and Senator Hollings, our chairman, I want to thank you
all very much for your participation.
The meeting is adjourned.
[Whereupon, at 5:10 p.m., the committee adjourned.]
A P P E N D I X
Prepared Statement On Behalf of the Following Associations and Their
Members:
American Council for Capital Formation
Associated General Contractors of America
American Resort Development Association
Building Owners and Managers Association International
International Council of Shopping Centers
Mortgage Bankers Association of America
National Apartment Association
National Association of Industrial and Office Properties
National Association of Real Estate Investment Trusts
National Association of Realtors
National Multi Housing Council
Pension Real Estate Association
The Real Estate Board of New York
The Real Estate Roundtable
Mr. Chairman, we commend you for the much-needed attention that you
and the Committee are bringing to this important issue by holding a
hearing today. It is clear that the Committee clearly recognizes the
importance of this issue and its potential effect on the U.S. economy.
We thank you for your leadership in addressing insurance-related
problems as a result of the events of September 11, and we also
appreciate the White House efforts to remedy a potential insurance
coverage crisis. The real estate and construction industries, which
account for over a quarter of the nation's gross domestic product,
could face severe economic dislocation in the coming months if the
federal government does not immediately address insurance-related
issues tied to terrorism.
To continue to operate in the normal course of business, these
industries need to continue to have insurance for risks that have
traditionally been insurable, including damage associated with
terrorism. The insurance industry recently testified before the full
Committee that without Federal support, it will not be able to provide
terrorism coverage in the future. Further, as the nation expands its
mission against terrorism, the line between terrorism and war will
likely become increasingly blurred from an insurance standpoint.
The Problem
On September 26, the CEOs of several major insurance companies
testified before the House Financial Services Committee that the
insurance industry expects to be able to pay claims associated with the
September 11 terrorist attacks. However, they also said that insurers
would not be able to provide terrorism coverage for future terrorist
acts. The reason is that reinsurance for terrorist risks is generally
unavailable in the current marketplace.
We take the insurance industry's warnings seriously and the
Congress must as well. The lack of adequate reinsurance in the current
market means that coverages our members need could very soon become
unavailable to large segments of the U.S. economy. A significant
percentage of owners of commercial properties open to the public,
including shopping centers, offices, apartments and hotels, renew their
insurance coverage on January 1 of each year. Many construction
projects, including a number of new power plants, are slated to begin
early and throughout next year. Many of the owners and developers
already have been advised that their policies may not be renewed or
that their new policies will exclude terror/war risks. Further, some
owners have been advised that their current coverage may be terminated
before their policies were set to expire, after the insurers provide
the required advance notice (usually 90 days).
On October 15, a senior Bush Administration official said:
``Without coverage against terrorist acts, banks will not lend to new
construction; it will be difficult to sell major projects such as new
pipelines, new power plants, skyscrapers. So we do think there is a
problem that needs to be addressed.'' We could not agree more.
Mr. Chairman, the property owners among our members (including many
pension funds that provide retirement security for their workers and
families) cannot buy, sell, or finance the acquisition or construction
of a commercial building unless it is covered by adequate insurance.
Before September 11, adequate insurance was readily available. Neither
property nor general liability policies in the U.S. excluded losses
stemming from terrorist attacks. They excluded only acts of war. It now
appears that terrorism coverage will not be available and that war risk
coverage, which did not previously seem imperative, is now necessary to
the extent any future attacks could be viewed as war-related.
The real estate and construction industries are leading pillars of
the U.S. economy. Without adequate insurance, it will be difficult, if
not impossible to operate or acquire properties, to construct new
properties, to refinance loans, or sell commercial mortgage-backed
securities (of which $350 billion is currently outstanding).
Disappearance of coverage for terrorist acts could severely disrupt the
U.S. economy.
The effects on our members of losing their insurance coverage are
potentially severe. First, building owners and operators will be fully
exposed to property damage losses from terrorist attacks and will be
powerless to do anything about it. Worse, some state insurance
regulators may not permit insurers to exclude terrorism coverage,
raising the possibility that insurers will withdraw completely from
such states and leave our members without any coverage at all.
Second, our members will also be exposed to third-party liability
claims for terrorism and war risks. Without adequate insurance, they
will be forced to choose between incurring these risks or closing their
buildings to avoid them.
Third, virtually all of our members have clauses in their financing
agreements requiring that minimum levels of insurance coverage on the
property be in place. Without the required coverage, lenders would be
free to foreclose because the loan would be in default without required
insurance. Even more importantly, without adequate insurance coverage,
lenders would not approve new loans to finance new construction or
property sales, or refinance existing debt. This lack of liquidity
could lead to the same severe problems the real estate and construction
industries confronted after the savings and loans crisis when property
values fell more than 30% largely because sources of capital dried up.
Any similar liquidity crunch could have severe consequences on
employment and state and local property and sales tax collections.
Further, portfolio lenders would be confronted with the possibility
of limiting operations. The ability to finance commercial real estate
transactions by institutional investors such as pension funds and life
insurance companies would be at risk. These mortgage lenders have a
fiduciary duty of prudence in investing money, and investing funds
without adequate insurance would breach this duty. A lender refusing to
make a loan without adequate insurance is not being arbitrary, it is
acting in the best interest of the investor, whose money the lender is
investing.
Fourth, the property owners among our members are likely to find
that they cannot complete their construction projects, or begin new
projects, until terrorism coverage can be restored. Lenders are
unlikely to approve construction loans until our members can obtain
builders risk insurance that is broad enough to cover acts of
terrorism. This will affect not only our members, but also the U.S.
economy as a whole. As you know, the construction industry is enormous
and our economy was already struggling at the time of the terrorist
attacks. The volume of construction that our members were putting into
place had already begun to decline. Without government action to
resolve this insurance problem, many construction workers are at risk
of layoffs.
Fifth, apartment residents would see higher housing costs as real
estate operating costs would increase significantly in the absence of
continuing coverage of acts of terrorism. Even before September 11,
multifamily owners and operators were facing year-over-year increases
of 25-100% in their property and casualty insurance costs. Typically,
these significant operating cost increases are reflected in higher
market rents, especially in major urban markets with strong renter
demand. In the absence of federal government involvement to provide for
continuing coverage of terrorist acts, apartment renters, many of them
low- and moderate-income families, will be forced to absorb a
disproportionate share of heightened insurance costs and more-limited
coverage. Federal government risk-sharing and the continued provision
of coverage for acts of terrorism are needed to help moderate the
impact on housing costs that renters will face as a result of the
events of September 11.
Sixth, loss of coverage may lead to an increase in the cost of
mortgage financing, especially in the commercial mortgage-backed
securities (CMBS) market, as the result of an additional, difficult-to-
quantify catastrophic risk to the real estate assets serving as
security for the CMBS offerings. CMBS offerings are usually priced in
the same manner as bonds and other fixed-income securities, heavily
dependent on credit ratings issued by the major securities-ratings
agencies. The rating agencies, and the fixed-income investment
community in general, are very sensitive to any possible circumstances
that could impair the cash flow available for payment of the securities
in question. Of course, uninsured damage caused by terrorism could, as
we have all seen, terminate, interrupt, or otherwise materially impair
cash flow; that risk would loom particularly large to the extent that
it is difficult to quantify.
An increase in the cost of mortgage financing could, in turn, cause
otherwise viable projects not to be undertaken, and reduce income
throughout the industry, leading to further lessening of demand and
economic activity.
The war exclusions that have been included in our members'
insurance policies for years mean that our members have always been
exposed to losses resulting from acts of war. They cannot purchase war
risk coverage separately in the market. This has not previously been a
major concern because it was thought that the likelihood of losses
related to acts of war on U.S. soil were quite remote. However, the
events of September 11 and subsequent U.S. military activities in
Afghanistan will cause the property owners among our members, and
possibly their lenders, to reconsider whether it is acceptable to be
exposed to such risks. The line between acts of war and acts of
terrorism is in danger of blurring and our members cannot afford to be
exposed to either risk. Henceforth, they must have adequate insurance
protection for both risks. As of now they do not.
With many real estate businesses facing insurance policy
cancellations and modifications on or before January 1, and both power
plants and other construction projects ready to begin, the government
must act now. Without government action, our industries will likely
face the prospect of breaking promises to lenders, partners and others,
of operating without necessary insurance coverage, and of watching the
construction of new facilities slow down. Since operating a business
without adequate insurance in many cases is not feasible, and is
certainly unwise, real estate businesses will confront the possibility
of ceasing or limiting operations until insurance once again becomes
available. Without Federal action, the ability to finance, construct,
buy or sell properties across the nation may be at risk.
Proposed Solution
We understand that the Committee will wish to ensure that the
Federal government does not take action that will ultimately interfere
with or displace the private insurance markets. We share that concern.
However, it is not clear when, or if, the private insurance markets
will be able to meet our members' needs for terrorist insurance
coverage.
The Federal Government must play a role in ensuring that commercial
property owners can continue to obtain coverage for damage for acts of
terrorism. This is especially true in the near-term while we wait to
see whether and how the private markets will adjust to the new post-
September 11 realities and risks. Further, given the increasing
possibility that a court could conclude that future damages caused by a
terrorist actions is excludable as damages resulting from a state of
war, the Government must also play a role, at least in a standby
capacity, in ensuring the availability of coverage for damages arising
from the actions undertaken by terrorists such as al Qaeda or their
allies.
There is ample precedent for the Federal Government filling the
insurance or reinsurance gap: (1) crime and riot insurance programs
were created for urban business owners following the social unrest of
the late 1960s and early 1970s; (2) flood and crop failures are insured
under Federally sponsored programs; (3) standby war risk coverage
already exists for certain aviation and maritime operations (including
a post-September 11 expansion of the aviation war risk program); and
(4) during World War II, the Government authorized a program,
administered by private insurers, which insured property against
``enemy attack.''
The insurance industry has put forward a proposal to establish a
special, state-chartered reinsurance company that would accept
terrorist risks from companies wishing to cede risks to it. That
company would then reinsure 95% of these terrorism risks to the federal
government. That proposal builds upon a model in the United Kingdom
where a special reinsurance pool for terrorist risks was created in the
early 1990s in the wake of IRA bombings in the City of London. The U.K.
Government provides a backstop to that pool, but has not been called
upon to pay any losses to date.
The Bush Administration has outlined a proposal to deal with the
current problem that would involve a three-year program under which the
Federal Government and the insurance industry would share, in declining
proportions each year, the risks of terrorist acts. While the details
of this proposal must be made clear, including the scope of acts
covered within the definition of terrorism, we believe it represents a
positive step towards addressing this issue.
We commend both proposals to your careful consideration. In the
end, however, we emphasize that the problem must be addressed in a
satisfactory and timely manner. A critical criterion in measuring the
effectiveness of any solution is whether the financial community will
continue to provide capital necessary to buy, sell, construct or
refinance properties. Since real estate is a long-lived asset, real
estate financing tends to be long-term. Accordingly, the finite
duration of federal involvement must not prevent lenders from making
these long-term commitments. Further, the insurance industry's primary
coverage should not be rendered immaterial by unrealistic retention
amounts (i.e., deductibles) imposed on insureds.
The Congress must not fail to act. The real estate and construction
industries welcome the opportunity to work with the Administration and
Congress to achieve a workable solution to this immediate problem this
year. To discuss these issues in greater detail, please contact Tony
Edwards at NAREIT at (202) 739-9400 or [email protected] or Chip
Rodgers at The Real Estate Roundtable at (202) 639-8400 or
[email protected].