[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

                              ----------                              
                                                                   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

                              ----------                              


                       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.
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    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\
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    \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.
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          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].


                                  
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