-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-175T		

TITLE:     Terrorism Insurance: Alternative Programs for 
Protecting Insurance Consumers

DATE:   10/24/2001 
				                                                                         
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GAO-02-175T

   Before the Subcommittee on Capital Markets, Insurance, and Government
   Sponsored Enterprises, Committee on Financial Services, House of
   Representatives Testimony

   United States General Accounting Office

   GAO For Release on Delivery Expected at 1: 30 p. m. EDT on Wednesday
   October 24, 2001

   TERRORISM INSURANCE Alternative Programs for Protecting Insurance
   Consumers

   Statement of Richard J. Hillman Director, Financial Markets and Community
   Investment

   GAO- 02- 175T

   Page 1 GAO- 02- 175T

   Statement Terrorism Insurance: Alternative Programs for Protecting
   Insurance Consumers

   Mr. Chairman and Members of the Subcommittee: The tragic events of
   September 11, 2001, bring to light numerous areas of concern within the
   financial services sector, especially as threats of future terrorist
   attacks continue. One area of concern voiced by various industry groups
   and the Congress is how the insurance industry should respond to risks
   posed by potential terrorist attacks and the extent to which the
   government should play a role alongside the industry to address these
   risks. We appreciate the opportunity to discuss this issue.

   Prior to September 11 th , insurance coverage for losses from terrorism
   was included as a normal feature of insurance contracts. According to
   industry analysts, this was because insurers* experience suggested that
   domestic exposure to terrorism, both in the number of occurrences and the
   magnitude of losses, was limited. The September 11 th attacks have changed
   insurers* perception of their potential risk exposure. Insurance companies
   have indicated that they will pay their share of the losses from these
   tragic events. However, both insurers and the reinsurers who share the
   industry*s risks, have indicated that they don*t know how much to charge
   for this coverage going forward because they cannot predict future losses.
   As a result, it has been reported that industry leaders may exclude
   insurance for terrorism from future insurance contracts unless the federal
   government provides some form of assistance to the industry.

   A financially strong insurance industry is essential to the smooth
   functioning of the economy. Industry officials have indicated that
   insurance coverage for catastrophic events such as a major terrorist act
   is necessary for investors and other financial decision- makers to be
   willing to provide capital to promote continued economic growth and
   stability. If the federal government chooses to provide financial backing
   to this industry, the primary driving force should be to safeguard the
   economy*s access to necessary insurance protection. At the same time, care
   needs to be taken to ensure that the interests of both the federal
   government and American taxpayers are safeguarded, and that the industry
   is assuming its fair share of risks.

   Any mechanism established by the federal government to support the ability
   of individuals and businesses to get insurance for terrorist acts should
   address several significant concerns. Most importantly, the program should
   not displace the private market. Rather, it should create an environment
   in which the private market can displace the government program. Second,
   it should be temporary, at least initially. Finally, any program should be
   designed to ensure that private market incentives for

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 2 GAO- 02- 175T

   prudent and efficient behavior are not replaced by an attitude that says,
   *Don*t worry about it, the government is paying.*

   In the aftermath of the September 11 th terrorist attacks, the Congress is
   considering whether and how to provide financial backing to the insurance
   industry so that insurance is available for losses due to terrorist acts.
   As requested, we will present (1) features of several existing insurance
   programs, both domestic and international; (2) alternative mechanisms for
   funding insured losses; and (3) some broad principles or guidance that the
   Congress may wish to bear in mind as it considers possible ways to support
   the insurance industry in case of future catastrophic losses due to
   terrorist acts. My observations are based on publicly available
   information on a variety of insurance programs within the United States
   and other countries and from prior GAO work.

   Today, a number of insurance programs exist in the United States and other
   countries to help ensure that insurance will be available to cover risks
   that the private sector has been unable or unwilling to cover by itself,
   including losses from catastrophic events and terrorism. Certain insurance
   programs are completely controlled and managed by the government, while
   others have little or no explicit government involvement. Likewise, in
   many programs the public and private sectors share risks, though in
   several different ways.

   For this testimony, we are highlighting features from selected insurance
   programs, including some established by the federal government as well as
   some from other countries, the states, and others. For example, the
   federal government insures individuals and firms against natural disasters
   under the flood and crop insurance programs and bank and employer
   bankruptcies under the deposit and pension insurance programs. Some
   federal programs cover political risk insurance for overseas investment
   activities, third- party claims for nuclear accidents, and protection
   against war- related risks. Other countries and organizations have also
   developed insurance programs covering catastrophic or terrorist events.
   These programs can provide useful insights in developing an appropriate
   insurance mechanism to cover losses from terrorist acts.

   For government insurance programs, the question of long- term cost and
   program funding needs to be addressed before the program is established.
   Some federal insurance programs have the statutory intent to provide
   subsidized coverage, while others are intended to be self- funding. As
   noted in some of GAO*s previous work, whatever merits the federal Features
   of Selected

   Insurance Programs Covering Catastrophic or Terrorist Events

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 3 GAO- 02- 175T

   government has as an insurer, the same characteristics that inhibit
   private insurance firms from covering certain events could also make a
   federallysponsored insurance program a costly undertaking. 1

   In some cases, the federal government subsidizes insurance programs in
   order to achieve a public policy objective. For instance, catastrophic
   coverage under the crop insurance program is subsidized in an attempt to
   reduce reliance on ad hoc disaster assistance. In other cases, the federal
   government may set up premium and fee structures intended to cover the
   full cost of providing insurance. However, regardless of statutory intent,
   if federal insurance is underpriced relative to its long- run costs and
   the federal government pays the difference, a government subsidy results.
   For example, under the Flood Insurance Program, program operating losses
   have been financed through borrowings from the U. S. Treasury or covered
   by appropriated funds.

   The federal government*s size and sovereign power provide it with the
   unique ability to offer insurance when the private market is unable or
   unwilling to do so. Currently, the federal government has a variety of
   mechanisms, including insurance programs, to cover risks that the private
   sector has traditionally been unable or unwilling to cover. Appendix I,
   table 1, highlights key features of several selected programs. We will
   describe some of them further today.

   A system that limits liability and provides indemnification for operators
   of nuclear reactors was established through the passage of the
   PriceAnderson Act of 1957. Specifically, the act limits the total
   liability of individual reactor operators for any accident. First, the
   operators must obtain insurance up to the maximum amount of private
   insurance available to the operator, which is currently about $200 million
   per reactor per accident. In addition, in the event of an accident at any
   single reactor that results in losses exceeding $200 million, all
   operators of the 106 commercial nuclear power reactors in the United
   States would be required to provide additional protection by paying into a
   secondary insurance fund. Depending on the amount of the claims, these
   contributions could be as high as $88.1 million per reactor per accident.
   Following an incident, the operators of commercial power reactors would be
   required to pay as much as $10 million annually for 9 years to complete
   the secondary

   1 Budget Issues: Budgeting for Federal Insurance Programs, (GAO/ AIMD- 97-
   16), September 1977. Selected Insurance

   Programs Established by Federal Statute

   Insurance for Catastrophic Nuclear Accidents

   Features:

   - Mandatory participation

   - Liability of the private sector is limited

   - Implicit government backing

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 4 GAO- 02- 175T

   insurance fund. For the 106 reactors in the United States, the nuclear
   industry*s current exposure to third- party liability claims would be
   approximately $9.5 billion before the Congress intervenes.

   In the event of an accident that involves damages that exceed the amount
   in the secondary insurance fund, the government is not explicitly required
   to fund the balance. Rather, Price- Anderson commits the Congress to
   investigate the accident and to take whatever action it deems necessary.
   This action could include, among other things, appropriating funds or
   requiring the nuclear industry to provide additional funding to satisfy
   remaining claims. No nuclear accidents have occurred since PriceAnderson
   was enacted that cost more than was provided by the available private
   insurance. As a result, the industry has never had to pay into the
   secondary insurance fund, nor has the Congress been required to take
   action on excessive losses.

   The Overseas Private Investment Corporation (OPIC), which began operations
   in 1971, was established to facilitate private investment by U. S.
   investors in developing countries and countries with emerging markets.
   OPIC insurance programs reduce the risk to U. S. investors in these
   countries by offering protection against several political risks. In
   general, the coverage offered by OPIC is more comprehensive both in scope
   and duration than the coverage currently available from private sector
   insurers. OPIC operates as a self- financing government agency. A
   significant portion of its income is derived from premiums and fees, but
   the program is also backed by $100 million in borrowing authority from the
   U. S. Treasury. Premium rates are based on a standard pricing table for
   different business sectors, with adjustments for project- specific risks.
   The risk assessment methods OPIC uses to establish insurance reserves and
   set premium rates rely heavily on expert judgment and are not highly
   quantitative. According to OPIC officials, no standard actuarial model
   exists for quantifying political risks. Over the life of OPIC, the
   government has made money on the insurance provided.

   Insurance Against Overseas Political Risk

   Features:

   - Voluntary participation

   - Federal government is the insurer and risk bearer

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 5 GAO- 02- 175T

   The National Insurance Development Program was established by the Housing
   and Urban Development Act of 1968 (P. L. 90- 448). The program sought to
   ensure the availability and affordability of fire, crime, and other
   property insurance to residential and commercial owners located in
   highrisk urban areas. The act created a Federal Insurance Administrator
   within the Department of Housing and Urban Development to administer the
   reinsurance program, but responsibility was later transferred to the
   Federal Emergency Management Agency. The program was a response to the
   urban riots and civil disorders of the 1960s, when many of America*s
   cities suffered major property losses.

   As a result of these losses, insurers became reluctant to underwrite
   property insurance in communities considered to be at risk for such
   events. The program had two purposes. First, the program encouraged state
   insurance regulators and the industry to develop and carry out programs to
   make property coverage more readily available. Second, it provided a
   voluntary federal program of reinsurance for urban property owner relief
   against abnormally high property insurance rates in private markets. Under
   this program, federal reinsurance was made available to property insurance
   companies operating in states that voluntarily adopted Fair Access to
   Insurance Requirements Plans. Insurers were required to retain a small
   portion of the liability, 2 which had to be paid first in the event of a
   claim. Insurers could transfer most of the remaining risk by making a
   premium payment to the federal government, which then assumed the
   remaining liability. This liability ranged from 90 to 98 percent of the
   remaining insured amount, and coverage increased as losses grew. The
   program was backed by $250 million in borrowing authority from the U. S.
   Treasury.

   The program also included a requirement that states share in program
   losses with the federal government. 3 According to a former program
   official, state sharing of program losses was a feature designed in part
   to keep states from setting property insurance premiums too low. At the

   2 A *net retention amount* of not more than 2.5 percent of the premiums
   paid by owners, calculated on a state- by- state basis, depending on the
   line of insurance offered. Insurers purchasing reinsurance could also be
   assessed an amount in the event of losses in excess of all reinsurance
   premiums paid nationwide.

   3 If federal reinsurance payments exceed premiums from the property-
   casualty companies in a state, the state must pay an amount up to 5 per
   cent of the aggregate property insurance premiums earned in that state
   during the preceding year of those lines of insurance reinsured by the
   federal government.

   Insurance Against Urban Riots and Civil Disorder

   Features:

   - Voluntary participation

   - Encouraged states and the private sector to provide insurance in urban
   areas

   - Offered federal reinsurance for insured property in urban areas

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 6 GAO- 02- 175T

   program*s inception, federal reinsurance was to last less than 5 years.
   However, former officials reported that the program made money because
   claims never reached the anticipated levels and, beginning in the early
   1970s, the program premiums were used to subsidize a crime insurance
   program. Reinsurance was discontinued in 1984 because of the small number
   of insurers participating.

   The National Flood Insurance Program, which was established by the
   National Flood Insurance Act of 1968, makes federal flood insurance
   available to property owners living in communities that join the program.
   Some of the key factors that led to the program*s establishment were
   private insurers* reluctance to sell flood coverage, increasing losses
   from floods because of floodplain encroachment, and high federal
   expenditures for relief and flood control. This program, which is financed
   primarily through premiums, fees, and interest income, aims to reduce
   federal spending on disaster assistance. By design, this program is not
   actuarially sound, because it does not collect sufficient income from
   premiums to build reserves to meet long- term expenditures on flood
   losses. Though the Federal Insurance Administrator is authorized to
   subsidize a significant portion of the total policies in force, its annual
   appropriations do not cover these subsidies. As a result, the Congress has
   appropriated funds for the program from time to time. In addition, the
   Federal Insurance Administration has periodically borrowed from the U. S.
   Treasury to finance operating losses. 4 The program is backed by $1
   billion in borrowing authority from the U. S. Treasury.

   Many other countries have government- sponsored insurance programs that
   cover catastrophes, terrorist events, or both. Some of these programs are
   essentially run by the government, while others have little or no
   government backing. Appendix I, table 2, highlights key features of such
   programs in Israel, Japan, Switzerland, and the United Kingdom. We will
   briefly discuss these programs.

   4 Flood Insurance: Information on Financial Aspects of the National Flood
   Insurance Program, (GAOT-RCED-00-23), October 27, 1999.

   Insurance Against Floods

   Features:

   - Voluntary participation

   - Federal government is the insurer for flood risk

   - Subsidized rates offered to encourage mitigation

   Selected Insurance Programs of Other Countries

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 7 GAO- 02- 175T

   Japan*s earthquake insurance program, originally conceived in 1966, arose
   out of a major earthquake in that country in 1964. The insurance is
   purchased as a supplement to residential fire insurance and covers homes
   and household goods. Private insurers and the government share in any
   losses that result from a disaster according to a three- tiered payment
   system. Under the first tier of coverage, private insurers are responsible
   for the first $625 million 5 of damages before government assistance is
   triggered. This initial amount effectively acts as a deductible. Losses
   above this amount trigger a second tier of coverage, for damages up to
   $6.821 billion. The Japanese government pays 50 percent of the losses in
   this second tier. The third tier of coverage involves losses of between
   $6.821 billion and $34.166 billion, with the government paying 95 percent
   of losses exceeding $6.821 billion. The Japanese government receives
   reinsurance premiums from primary insurers, but its total liability is not
   necessarily limited to the total amount of premiums received.

   Japan*s program has several distinguishing features. First, the private
   sector is responsible for the initial portion of losses. This feature
   helps to ensure the development of a private market for earthquake
   insurance that is unencumbered by a monopoly. Additionally, industry pool
   arrangements are mandated under the program. The government takes on an
   increasing share of losses as they rise, up to a maximum cap on the total
   amount of exposure, but the private sector still bears some cost even at
   higher levels. This feature helps to ensure that risk of disaster is
   spread throughout the entire country and economy. Finally, the Japanese
   program was not established to provide coverage for all potential losses,
   but rather as a first step toward providing some level of coverage, with
   the government and private sector working together.

   5 Dollar figures presented are based on the conversion of yen to dollars
   from documents on the program provided by Japan*s Board of Audit.

   Japan*s Insurance Against Earthquakes

   Features:

   - Mandated insurer participation

   - Private/ public risk sharing

   - Government share increases as losses increase

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 8 GAO- 02- 175T

   The United Kingdom*s Pool Reinsurance (Pool Re) program was established in
   1993 to provide insurance against losses and damages caused by terrorists
   attacks on industrial, commercial, and residential properties located
   within the British mainland. There are several distinct layers of
   coverage. All policyholders who buy basic property coverage from insurers
   have the option of buying additional coverage from the same insurers to
   protect against terrorism. Insurers are responsible for the first 100,000
   pounds of coverage per coverage type, with no reimbursement from the
   government. Claims exceeding 100,000 pounds are paid from premiums
   accumulated within a pool made up of insurance companies and Lloyd's
   syndicates. (The British government and the insurance trade group
   established a mutual company from these companies and syndicates to
   provide terrorism reinsurance.) If the pool of funds is exhausted, all
   participating insurers face a call of up to 10 percent of the premiums
   they have collected during the year. Beyond the 10 percent call, the pool
   investment income is tapped, and the government meets any claims in excess
   of this. According to United Kingdom officials familiar with the program,
   the government has not yet had to bail out the pool as the reinsurer of
   last resort.

   Israel has two programs for covering losses resulting from a terrorist
   attack. The first is the Property Tax and Compensation Fund, which covers
   property and casualty insurance. The second is the Law for the Victims of
   Enemy Action, which covers life and health insurance. The Israeli
   government funds and administers both programs. Under the Property Tax and
   Compensation Fund, the Israeli Income and Property Tax Commission levies a
   national property tax predominantly on Israeli businesses. The commission
   pays claims on property damages that are the direct result of a hostile
   terrorist attack (including losses of business inventory), on the basis of
   the market value of a property immediately before the attack. All indirect
   damages, including those for businessinterruptions, must be covered
   through private insurance. Private supplemental coverage or additional
   state coverage can be purchased to cover the difference between a
   property*s current market value and the cost of rebuilding (known as the
   replacement value). State coverage is capped by implementing regulations.

   The second program, the Law for the Compensation of Victims of Enemy
   Action, is a state- run program administered by the National Insurance
   Institute (NII) and is also funded by the government. The NII is similar
   to the U. S. Social Security Administration. Coverage is provided for
   medical care, lost wages, extended payments to the families of attack
   victims, and personal injury. Coverage also extends to visitors and
   tourists who are in

   United Kingdom*s Insurance Against Terrorist Events

   Features:

   - Voluntary participation

   - Created because of withdrawal of private reinsurance

   - Insurers pay 110 percent of premium received before government pays

   Israel*s Insurance Against Terrorist Attacks

   Features:

   - Mandatory participation

   - Government bears all risk

   - Funded by tax revenues

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 9 GAO- 02- 175T

   Israel. Coverage amounts for this program are again determined by
   implementing regulations.

   Switzerland*s Catastrophe Insurance program was established to insure
   against natural disasters, including storms, hail, floods, landslides, and
   avalanches. Earthquakes are not covered under this program. This program
   does not set up a separate catastrophic insurance fund, but instead
   obliges insurers to include coverage for specified catastrophes in fire
   insurance policies for buildings and their contents at a statutorily fixed
   rate. These compulsory premiums are the sole means of financing the
   catastrophe insurance program. Although this scheme does not set up a
   separate catastrophe insurance fund, Swiss insurers have created a
   reinsurance pool where these additional premiums are deposited. Membership
   in this pool is optional for insurers, but currently 85 percent of claims
   are ceded to it. Should claims exceed the funds in the pool, the
   difference would be payable from the insurers* capital and assets. There
   is no government involvement or exposure associated with the operation of
   the program, since the Swiss government does not provide any guarantee.
   For this reason, the private sector has an incentive to reduce risks.
   Insurers that participate in the pool are also subject to a cash- call in
   proportion to their participation in the pool to cover claims that exceed
   pool capacity.

   Other insurance programs that may provide useful insights in developing
   insurance coverage for terrorist acts include those established by state
   governments and private sector entities. Appendix I, table 3, highlights
   the features of several state and private sector insurance programs, and I
   will describe these programs here.

   Switzerland*s Insurance Against Selected Catastrophic Events

   Features:

   - Mandatory participation

   - No government risk exposure

   Insurance Programs Sponsored by States or Other Entities

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 10 GAO- 02- 175T

   Every state has guaranty funds to protect policyholders when an insurance
   company fails. These funds exist for property- casualty as well as
   lifehealth insurers. While there are differences between the funds for the
   two insurance sectors, in general they operate similarly. Insurance
   guaranty funds are not really funds. In nearly all states, the money used
   by guaranty funds to pay policyholders of failed insurers is collected
   through postfailure assessments. After an insurance company is found to be
   insolvent by a state regulator, the regulator and the guaranty funds in
   each state where policies were sold determine by how much the failed
   company*s policyholder claims exceed the value of the company*s assets.
   The guaranty funds then provide sufficient funds to ensure that all claims
   are paid (up to each state*s statutory limits). Guaranty funds are not
   operated by state governments, nor are they funded by public money (i. e.,
   there is no explicit subsidy).

   However, the funds were created by statute and operate as part of the
   insurance regulatory system. Even though no appropriated funds are used to
   fund the guaranty funds, insurers do not bear the entire cost of guaranty
   fund assessments. While tax treatment varies among states, many states
   allow the insurers to offset their premium taxes for assessments paid to
   guaranty funds. Where this tax credit is permitted, insurers can usually
   reduce their premium tax bill by 20 percent each year for 5 years. Other
   states allow insurers to recoup assessments by increasing or adding a
   surcharge to policyholder premiums.

   The California Earthquake Authority was established to insure California
   residents against losses caused by earthquakes. The Earthquake Authority
   was set up by state statute. The state of California, however, does not
   contribute any funding to the authority. After the Northridge, CA
   earthquake in 1994, insurance companies determined that the premiums they
   had been charging for earthquake coverage were inadequate. Furthermore,
   the companies did not know how to set an actuarially sound price.
   Insurance companies attempted to stop selling insurance against earthquake
   damage, but were opposed by the state. After negotiations, insurers were
   permitted to exclude earthquake coverage from their property- casualty
   policies if insurance companies representing at least 70 percent of the
   market agreed to participate in the Earthquake Authority.

   Participation meant agreeing to pay an initial assessment totaling $717
   million plus two additional assessments of $2.15 billion and $1.434
   billion after certain levels of earthquake- related losses occurred. Thus,
   potential Earthquake Authority losses are to be funded by a multilayered
   financing arrangement involving insurer contributions, premiums,
   conventional

   State Insurance/ Guarantees Against Insolvent Insurers

   Features:

   - Mandatory participation

   - Funded by post event assessments

   - Operated by industry

   - No explicit subsidy

   California*s Insurance Against Earthquakes

   Features:

   - Participation based on statutory requirements

   - Funded by assessments on insurance companies

   - No public funding

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 11 GAO- 02- 175T

   reinsurance, and pre- established debt financing. In early 2000, these
   layers totaled about $7 billion. In the event that all authority funds
   were expended, claims payments would be prorated. The Earthquake Authority
   currently provides virtually all of the earthquake insurance available in
   the state of California.

   The International Group of Protection and Indemnity Clubs (Group) includes
   the 14 protection and indemnity associations or *clubs* that insure about
   90 percent of the world*s seagoing tonnage. The individual clubs are
   nonprofit- making mutual insurance organizations that cover third- party
   risks of shipowning members. The American Steamship Owners Mutual
   Protection and Indemnity Association, Inc., known as the American Club,
   was established in New York State in 1917 and is the only U. S. domiciled
   member. 6 The American Club has no government subsidy. The Group arranges
   collective insurance and reinsurance that covers risks such as those
   arising from oil spills and other polluting substances. The program uses
   primarily a prefunded approach to pool funds through advance calls of
   premium. The advance premiums paid by shipowners are 80 percent of
   estimated claims for the policy year. Premiums are invested by the Group.
   Should loss experience prove higher than anticipated, the program also
   encompasses other reinsurance and a post assessment call feature.

   The pooling arrangement is a four- layered system. Claims of less than $5
   million are essentially risk of loss retained by the club member
   shipowners. The program then enables the pooling of claims from $5 million
   to $30 million between clubs based on a formula incorporating tonnage
   size, premium income, and claims record. The next layer, called *excess of
   loss reinsurance,* is reinsurance purchased by the Group for third- party
   claims incurred in a single incident in excess of $30 million* up to $1
   billion in the case of oil pollution liabilities and up to $2 billion for
   all other liabilities. Finally, the program encompasses an *over spill*
   layer to cover claims in the $2 billion to $4 billion range. This layer is
   funded through a post assessment of club members.

   6 The American Club became a signatory to the Pooling Agreement in
   February 1998. Prior to that, the American Club was reinsured with the
   Group via the London Club. Protection and Indemnity is the traditional
   name for insurance to cover ship owners and ship chartering firms against
   their legal liabilities to third parties.

   Ship Owner Insurance For Ocean Pollution

   Features:

   - Voluntary participation

   - Risks are pooled and funded by pre and post assessments

   - No government involvement

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 12 GAO- 02- 175T

   In order to pay claims when an insured event occurs, a mechanism must
   exist to ensure that the funds will be available when they are needed.
   Currently, there are two possible models for such a mechanism. First,
   insurers can prefund for expected losses by estimating potential
   liabilities (establishing a reserve liability) and collecting assets
   (premiums) to pay claims when an insured event occurs. Alternatively,
   under certain circumstances, after an insured event when losses are known
   with certainty, assessments can be levied to provide the necessary funds.
   Both models, and in many cases a combination of the two, are widely used
   in the insurance industry.

   The deposit insurance provided by the Federal Deposit Insurance
   Corporation (FDIC) is an example of a prefunded system. Banks pay premiums
   into a fund. When a bank fails, the deposit insurance fund is used to make
   up the difference between the bank*s remaining assets and customer
   deposits, up to a legal limit. Of course, if the deposit insurance fund
   falls below a certain level because of large payouts, banks must pay
   additional amounts into the fund to ensure that sufficient funds are
   available for future failures. In contrast, most of the state insurance
   guaranty funds described earlier are examples of post assessment plans.
   After an insurance insolvency, the remaining insurance companies in each
   state where the company operated are assessed the difference between the
   failed insurer*s legal obligations to its policyholders and its assets.
   Some of the programs described earlier in this statement include a
   combination of both prefunded and post assessment mechanisms, including
   the British Pool Re and the California Earthquake Authority.

   For ordinary, noncatastrophic events, insurance companies set up reserves
   (liabilities) that measure their expected losses 7 and set aside assets to
   offset those liabilities. For catastrophic events, when both the timing
   and magnitude of losses are difficult or impossible to predict, insurance
   companies generally do not set up reserves. 8 These losses are

   7 For a reserve to be established by an insurance company, the losses must
   have already occurred (either reported but unpaid, or incurred but not
   reported), or be *probable* and *estimable.*

   8 Accounting standards and tax law discourage the establishment of
   *contingency reserves.* That is, insurers must usually build such
   contingency reserves from after- tax income (retained earnings). As a
   result, it is unusual for insurers to establish contingency reserves for
   events like hurricanes, since it is impossible to measure either the
   probability of such occurrences or the expected loss that is likely to
   occur during the current accounting period, irrespective of the long- term
   predictability of the event. Alternative

   Mechanisms for Funding Insured Losses

   Prefunding Versus Post Assessment

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 13 GAO- 02- 175T

   generally paid out of the company*s ongoing premium stream, the company*s
   capital, or both. If income from premiums is too low or losses are too
   high, an insurer*s capital can be depleted, and the insurer may become
   insolvent. In the long run, if an insurer does not become insolvent, it
   can recoup catastrophic losses by adjusting the premium rates charged to
   policyholders. Thus, even insurance companies postfund some of their
   insured losses. Both prefunding and post assessment are reasonable ways to
   fund the exposure to losses from large catastrophic events, including
   terrorism. Both mechanisms have advantages and disadvantages. Used
   together, they could provide a multilayer mechanism for funding levels of
   risk exposure that otherwise could limit the availability of needed
   insurance.

   Insurance companies that insure catastrophes can also reduce the potential
   for insolvency by purchasing reinsurance. The insurer remains liable for
   any claims when they are presented, but is later reimbursed by the
   reinsurer for the portion of the liability that was reinsured. The problem
   for the insurer then becomes one of liquidity rather than solvency. Of
   course, over time both the insurer*s and the reinsurer*s solvency depend
   on a reasonable correspondence between premium income (plus investment
   income) and losses.

   Reinsurers remain in business if the direct insurer can charge premiums
   that provide sufficient income to pay claims and related expenses and to
   record a profit. If a reinsurer does not believe an insurer is capable
   setting a price commensurate with the risk, or of generating enough
   premium income to pay those risks, it will not reinsure that business.
   According to the insurance industry, it is now facing that situation in
   the aftermath of the September attacks. One possible solution would be for
   a group of insurers to establish a pool to take the place of the unwilling
   reinsurers. In this case, losses from any terrorist event that affect only
   one or a few members can be spread across the entire pool, reducing the
   likelihood that individual members will become insolvent. However, while
   the pool may take the place of the reinsurers, the pool faces the same
   difficulties in establishing catastrophic (contingency) reserves as the
   individual insurers. It would also be holding the same risks that the
   reinsurers were unwilling to accept. Hence, the desire to add the
   government to the equation.

   The federal government could help the insurers in a number of ways. It
   could allow the pool to build tax- free, multiyear reserves for potential
   losses that do not have a measurable probability or estimable value. Such
   a pool arrangement has been used in Britain for the purposes of increasing
   pool assets for catastrophic losses. This tax- free status would increase
   the Reinsurance: A Further

   Means of Protection How the Federal Government Can Support Insurers Facing
   Catastrophic Losses

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 14 GAO- 02- 175T

   pool*s ability to pay for future terrorist events. However, if the insured
   event occurs before the pool builds up substantial reserves, or if the
   prices insurers are charging for coverage turn out to be too low, the
   pool*s reserves would still be depleted. If so, the member insurers would
   still risk insolvency, since they would be obligated to pay all legitimate
   claims whether they could recover the funds from the pool or not. To
   alleviate this possibility, the government could also stand behind the
   pool as a riskbearer. In this case, if the pool*s assets were depleted,
   the government would assume the contingent liability, using its resources
   to pay additional losses and reducing the risk of insolvency for the
   insurance companies.

   The government could also fund its contingent liability to the pool in a
   variety of ways. It could charge the pool a premium for the
   reinsurancelike protection it provides, accumulating a fund it could use
   to pay for losses. Of course, any premiums charged to the pool would
   reduce the pool*s assets and accelerate both the time when the government
   would have to begin covering losses and its total exposure. Alternatively,
   the government could fund its losses out of tax revenues, either with or
   without repayment requirements.

   Given that the problem currently facing the insurance industry is an
   inability to correctly price the risk of a terrorist act, prefunding may
   not generate sufficient funds to fully pay potential insured losses from
   major terrorist events. A postfunding (post assessment) mechanism could be
   used either to substitute for or to augment a prefunded reserving
   mechanism. Post event assessments could be a feature of the pool, of the
   government mechanism, or both. Pool Re, the British plan for public/
   private sharing of terrorism risk, includes a call on each memberinsurer
   after the private pool is exhausted, in an additional amount equal to 10
   percent of the total premium that insurers collected for terrorism
   coverage. Alternatively, the government could pay that portion of the
   losses that exceed the pool*s resources and then assess the member
   companies over time in order to recoup part or all of its expenditures. In
   this variant, the government would be lending the insurance companies part
   or all of the cash needed to meet liquidity demands resulting from the
   terrorist event, but not bailing the industry out.

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 15 GAO- 02- 175T

   At this point, we would like to discuss some broad principles that we have
   drawn from lessons learned over several decades of supporting
   congressional efforts to assist industries and firms in moments of crisis,
   including the savings and loan industry and, most recently, the aviation
   industry. 9 These principles may provide guidance as you consider whether
   the government should take actions to ensure the continued availability of
   insurance and reinsurance for terrorist- related acts. We believe that the
   following three principles are key to such efforts:

    Clearly define the problem to be solved.  Ensure that the program
   protects the government and taxpayers from

   excessive and unnecessary losses.  Avoid a self- perpetuating program,
   that is, the government*s involvement

   should be temporary. The industry and federal government need to work
   together to clearly define the specific nature of the problems confronting
   the industry, separating short- term needs from long- term challenges and
   wants from genuine needs. It seems clear, given insurers increased
   recognition of their exposures in the aftermath of the unprecedented
   events on September 11, 2001, that coverage for terrorist acts is not now
   amenable to normal insurance underwriting, risk management, and actuarial
   techniques. As a result, insurers and reinsurers are concerned about their
   ability to set an appropriate price for insurance coverage for terrorist
   acts. Given this uncertainty if this kind of insurance were to be offered
   at all, it is likely that either the prices insurers set would be
   prohibitively high or so low as to invite insolvency. However, even if we
   conclude that insurers cannot price and, therefore, cannot sell this kind
   of insurance, defining the nature of the problem facing both the economy
   and the insurance industry is a critical first step. Many important
   questions need to be addressed. Among them are:

    What is the appropriate definition of a terrorist act?  How would the
   lack of insurance coverage for terrorist events affect other

   sectors of the economy?  What are the public policy objectives to be
   achieved by an assistance

   program? 9 Commercial Aviation: A Framework for Considering Federal
   Financial Assistance (GAO- 01- 1163T, Sept. 20, 2001). Principles to
   Consider

   When Providing Financial Assistance

   Defining the Problem the Industry Faces

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 16 GAO- 02- 175T

   Whatever program or mechanism is put in place, protecting the government*
   and, therefore, taxpayers* from inefficiency and excessive costs needs to
   be a primary objective. When the government becomes involved in providing
   insurance, it is usually because the private insurance market is having
   difficulty underwriting and pricing certain risks. For instance, some
   risks are difficult to predict and can be catastrophic in size.
   Additionally, some risks may not be independent* that is, the losses may
   strike a large number of insured individuals or entities at the same time.
   Furthermore, spreading the risk to a large and diverse population may be
   difficult. This difficulty sometimes results from adverse selection, which
   occurs when those with the highest probability of loss tend to purchase
   insurance, while those with the least risk opt out.

   While these factors may provide a basis for government intervention in the
   market, they also complicate efforts to measure the government*s exposure
   to loss. Nevertheless, the government can take steps to control and limit
   losses. For example, any program should have keep market incentives where
   they belong* with private firms. As long as private firms have their own
   money at risk, the private market is a better choice than the government
   for handling traditional insurance functions such as setting prices,
   underwriting policies, and handling and adjusting claims. If the
   government is bearing all or most of the risk, private firms will not have
   the same incentives to maximize efficiency.

   Thus, any government program must be structured to ensure that private
   insurers have the same incentives they would have if the government were
   not involved. For example, firms should have an incentive to set the best
   prices they can (even in an environment of insufficient information), to
   require risk mitigation on the part of their customers in exchange for a
   reduced premium, and to carefully investigate losses to ensure that claims
   payments are appropriate. Creating a mechanism that places part of each
   company*s capital at risk* as well as premium income* could serve to
   maintain the correct incentive structure. If insurance companies believe
   that their own exposure to losses is insignificant, they are not likely to
   behave the same way they would if their own money was at stake.

   Finally, in the current crisis environment any government solution should
   be temporary and needs to be revisited periodically. Congress may decide
   that ensuring the continued ability of the insurance industry to serve all
   its customers is in the national interest. However, given the lack of
   information about the scope and nature of the long- term problem, it does
   not seem prudent to establish such assistance in a program that may
   Protecting the Government

   From Excessive Losses Reevaluating Future Government Involvement

   Statement Terrorism Insurance: Alternative Proposals for Protecting
   Insurance Consumers

   Page 17 GAO- 02- 175T

   become permanent. However, government programs that are not carefully
   designed tend to become self- perpetuating. We can find examples of such
   programs in our own government experience and in some of the foreign
   programs we have described today. Fortunately, several strategies are
   available to minimize the possibility that a program will perpetuate
   itself. First, government bureaucracy should be kept to a minimum. An
   established bureaucracy tends to find reasons for its own continued
   existence. Second, any program should have an exit strategy from the
   beginning. An exit plan will provide the insurance industry and program
   administrators with congressional guidance on how the industry should
   emerge from the assistance program. Finally, a primary goal of any federal
   insurance program must be to create an environment in which the private
   market can and will be reestablished.

   The government may have an important role to play in helping the insurance
   industry establish insurance coverage for losses from terrorist acts. GAO
   believes that should any assistance program be established it would be
   most successful if based on the principles we have described today.
   Following these principles will help ensure that assistance addresses
   market problems, protects taxpayers from excessive and unnecessary losses,
   and does not displace the private market for providing such insurance
   coverage.

   Mr. Chairman, this concludes my statement. We would be pleased to respond
   to any questions that you or other members of the Subcommittee may have.

   For further information regarding this testimony, please contact Richard
   J. Hillman, Director, or Lawrence D. Cluff, Assistant Director, Financial
   Markets and Community Investment Issues, (202) 512- 8678. Individuals
   making key contributions to this testimony included James Black, Emily
   Chalmers, Darryl Chang, Ryan Coles, Rachael Demarcus, Jeanette Franzel,
   Thomas Givens III, Rosemary Healy, Ronald Ito, Stefanie Jonkman, Monty
   Kincaid, Barry Kirby, Robert Pollard, and Angela Pun. Conclusions

   Contacts and Acknowledgments

   Page 18 GAO- 02- 175T

   Appendix I: Summary of Alternative Programs

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

   Program Description Government subsidy Sources of financing

   Castrophic Nuclear Accidents Insures operators of commercial power nuclear
   reactors from large liability claims from a major nuclear accident
   regardless of cause such as terrorism, negligence, and natural disasters.

   Unclear Operators of commercial power nuclear reactors obtain maximum
   amount of private insurance available. After an accident occurs, they pay
   into a secondary insurance fund.

   Overseas Private Investment Corporation (OPIC) Political Risk Insurance

   Insures the investments of U. S. companies in developing countries against
   several political risks, including expropriation, currency
   inconvertibility, and political violence.

   No. Self- financing but guaranteed by the full faith and credit of the U.
   S. government.

   Premiums, insurance claim recoveries, and interest earnings.

   National Insurance Development Program

   (Riot Re) Insures against property losses

   due to riot and civil disorder. Provides owners with affordable insurance
   in high- risk urban areas.

   Provided federal reinsurance mechanism. Capped Treasury borrowing
   authority at $250 million.

   Deposited insurer premiums into a Treasury account. Required states to
   provide funds for program losses.

   National Flood Insurance Insures buildings and contents against losses due
   to flooding in communities nationwide that enact and enforce appropriate
   flood plain management measures.

   Yes Premiums, interest earnings, and appropriated funds.

   Bank Insurance Fund Insures deposits up to a specified amount. Deposits up
   to a specified

   amount, backed by the full faith and credit of the U. S. government.

   Premiums, recovery of assets acquired in receivership, deposit assumption
   transactions, and interest earnings. Aviation War- Risk Insurance Insures
   against losses resulting

   from war, terrorism, and other hostile acts when commercial insurance is
   unavailable on reasonable terms and conditions and continued air service
   is in the interest of U. S. policy.

   No. Self- financing from premiums for assumption of anticipated risks.

   Premiums, interest earnings, and one- time registration fees for
   nonpremium insurance.

   Federal Crop Insurance Insures against crop damage from unavoidable risks
   associated with adverse weather, plant diseases, and insect infestations.

   Yes Premiums and appropriations. 2

   1 Sources of information for these program summaries included (GAO/ AIMD-
   97- 16) and various publicly available documents describing the programs.

   Appendix I: Summary of Alternative Programs Page 19 GAO- 02- 175T

   Program Description Government subsidy Sources of financing

   Maritime War- Risk Insurance Insures losses resulting from war, terrorism,
   and other hostile acts when commercial insurance is unavailable on
   reasonable terms and conditions and continued service is in the interest
   of U. S. policy.

   No. Self- financing from premiums for assumption of anticipated risks.

   Premiums, interest earnings, binder fees, and claim reimbursements.

   National Credit Union Share Insurance Insures member shares

   (deposits) up to a specified amount.

   Deposits backed by the full faith and credit of the U. S. government up to
   a specified amount.

   Premiums, interest earnings, and 1- percent deposit from insured credit
   unions.

   Pension Benefit Guaranty Corporation Insurance Insures retirement benefits
   of

   workers and beneficiaries covered by private sectordefined benefit pension
   plans.

   No. Self- financing from premiums paid by employers on behalf of their
   employees.

   Premiums, assets from terminated plans, and investment income.

   Savings Association Insurance Fund Insures deposits up to a

   specified amount. Deposits backed by the full faith and credit of the U.
   S. government.

   Premiums, recovery of assets acquired in receivership, deposit assumption
   transactions, and interest earnings. Service- Disabled Veterans Insurance
   Provides life insurance to

   veterans with service connected disabilities.

   Yes Premiums, interest on policy loans, policy loan repayments, and
   appropriations.

   National Vaccine Injury Compensation Provides compensation for

   vaccine- related injury and death.

   No Excise tax on manufacturers and interest earnings.

   2 The Federal Crop Insurance Corporation is authorized under the Federal
   Crop Insurance Act, as amended, to use the funds from issuance of capital
   stock, which provides working capital for the Corporation.

   Appendix I: Summary of Alternative Programs Page 20 GAO- 02- 175T

   Table 2: Summary of Insurance Programs Sponsored by Other Countries 3

   Program Description Government subsidy Sources of financing

   Japan*s Earthquake Insurance

   Provides a public/ private, threetiered payment system for damages
   resulting from an earthquake.

   Not presently known Participating insurer and reinsurer premiums; some
   government tax revenue.

   United Kingdom*s Pool Re

   Insures against losses resulting from terrorism. Self- financing from
   premiums,

   pool members, and the government as last source of funds.

   Premiums, collections from pool members, investment income, and government
   contributions.

   Israel*s Insurance for Victims of Enemy Action

   Provides government- funded property/ casualty and health/ life insurance
   for victims of a terrorist attack.

   Yes Government property taxation, and premiums for additional state
   coverage. Although not explicitly stated, general tax revenues stand
   behind the primary funding sources. Switzerland*s Catastrophic Insurance

   Insures against losses from natural disasters (excluding earthquakes).

   No. Intent was that it would be self- financing from premiums for
   assumption of anticipated risks. If claims exceed premium payments, the
   difference would be payable from the insurer*s capital and reserves.

   Premiums on buildings and their contents.

   3 Information on these program summaries was collected from a United
   Nations document and various publicly available sources describing the
   programs.

   Appendix I: Summary of Alternative Programs Page 21 GAO- 02- 175T

   Table 3: Summary of Insurance Programs Sponsored by States or Other
   Entities 4

   Program Description Government subsidy Sources of financing

   State Insurance Guaranty Funds Protects policyholders when an

   insurance company fails. No. However, in some states companies can deduct
   assessments from state taxes or recoup by increasing insurance premiums.

   In all states but New York, insurers are only assessed after a failure
   occurs. In New York, insurers pay a premium into a state guaranty fund,
   similar to the way federal deposit insurance is funded. California
   Earthquake Authority Insures California residents and

   businesses against losses associated with earthquakes.

   No subsidy. Funding is provided by a multilevel mechanism, including
   insurance premiums, insurance company assessments, and debt financing. The
   International Group of Protection and Indemnity Clubs Insures shipowners
   against

   third- party claims for oil spills and other risks

   No subsidy. Member contributions via pre and post- funding mechanisms.

   Workers Compensation Residual Market Reinsurance Pool

   National Council on Compensation Insurance (NCCI) is operating mechanism
   for paying claims from a pool fund.

   No subsidy. Premiums and additional contributions from member carriers in
   the state when pool funds cannot pay claims.

   4 Information on these program summaries was collected from various
   publicly available documents describing the programs.

   (250056)
*** End of document. ***