Terrorism Insurance: Alternative Programs for Protecting	 
Insurance Consumers (24-OCT-01, GAO-02-199T).			 
								 
Prior to September 11, 2001, insurance coverage for losses from  
terrorism was a normal feature of insurance contracts. The	 
September 11th attacks have changed insurers' perception of their
perceived risk exposure. Both insurers and reinsurers  indicate  
that they do not know how much to charge for this coverage and	 
since they cannot predict future losses they may exclude	 
insurance for terrorism from future contracts unless the federal 
government provides some guidance to the industry. A number of	 
insurance programs now exist in the United States and other	 
countries to  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. For government insurance programs, the question of	 
long-term cost and program funding needs to be addressed before  
any program is established. Some federal insurance programs have 
a statutory intent to provide subsidized coverage, while others  
are intended to be self-funding. 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.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-199T					        
    ACCNO:   A02365						        
  TITLE:     Terrorism Insurance: Alternative Programs for Protecting 
Insurance Consumers						 
     DATE:   10/24/2001 
  SUBJECT:   Insurance regulation				 
	     Interagency relations				 
	     Liability insurance				 
	     Risk management					 
	     Terrorism						 

******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO Testimony.                                               **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
******************************************************************
GAO-02-199T
     
Before the Senate Committee on Banking, Housing and Urban Affairs United
States Senate Testimony

United States General Accounting Office

GAO For Release on Delivery Expected at 10: 00 a. m. EDT on Wednesday
October 24, 2001

TERRORISM INSURANCE Alternative Programs for Protecting Insurance Consumers

Statement of Thomas J. McCool Managing Director, Financial Markets and
Community Investment

GAO- 02- 199T

Page 1 GAO- 02- 199T

Statement Terrorism Insurance: Alternative Programs for Protecting Insurance
Consumers

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

Prior to September 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- 199T

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

In the aftermath of the September 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- 199T

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

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

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

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

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

Programs Established by Federal Statute

Insurance for Catastrophic Nuclear Accidents

Features:

- Mandatory participation

- Liability of the private sector is limited

- Implicit government backing

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 4 GAO- 02- 199T

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

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

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

Insurance Against Overseas Political Risk

Features:

- Voluntary participation

- Federal government is the insurer and risk bearer

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 5 GAO- 02- 199T

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

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

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

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

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

Insurance Against Urban Riots and Civil Disorder

Features:

- Voluntary participation

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

- Offered federal reinsurance for insured property in urban areas

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 6 GAO- 02- 199T

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

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

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

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

Insurance Against Floods

Features:

- Voluntary participation

- Federal government is the insurer for flood risk

- Subsidized rates offered to encourage mitigation

Selected Insurance Programs of Other Countries

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 7 GAO- 02- 199T

Japan?s earthquake insurance program, originally conceived in 1966, arose
out of a major earthquake in that country in 1964. The insurance is
purchased as a supplement to residential fire insurance and covers homes and
household goods. Private insurers and the government share in any losses
that result from a disaster according to a three- tiered payment system.
Under the first tier of coverage, private insurers are responsible for the
first $625 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- 199T

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

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

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

United Kingdom?s Insurance Against Terrorist Events

Features:

- Voluntary participation

- Created because of withdrawal of private reinsurance

- Insurers pay 110 percent of premium received before government pays

Israel?s Insurance Against Terrorist Attacks

Features:

- Mandatory participation

- Government bears all risk

- Funded by tax revenues

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 9 GAO- 02- 199T

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

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

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

Switzerland?s Insurance Against Selected Catastrophic Events

Features:

- Mandatory participation

- No government risk exposure

Insurance Programs Sponsored by States or Other Entities

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 10 GAO- 02- 199T

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

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

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

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

State Insurance/ Guarantees Against Insolvent Insurers

Features:

- Mandatory participation

- Funded by post event assessments

- Operated by industry

- No explicit subsidy

California?s Insurance Against Earthquakes

Features:

- Participation based on statutory requirements

- Funded by assessments on insurance companies

- No public funding

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 11 GAO- 02- 199T

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

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

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

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

Ship Owner Insurance For Ocean Pollution

Features:

- Voluntary participation

- Risks are pooled and funded by pre and post assessments

- No government involvement

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 12 GAO- 02- 199T

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

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

For ordinary, noncatastrophic events, insurance companies set up reserves
(liabilities) that measure their expected 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- 199T

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

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

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

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

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

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 14 GAO- 02- 199T

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

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

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

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 15 GAO- 02- 199T

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

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

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

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

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

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

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

When Providing Financial Assistance

Defining the Problem the Industry Faces

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 16 GAO- 02- 199T

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

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

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

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

From Excessive Losses Reevaluating Future Government Involvement

Statement Terrorism Insurance: Alternative Proposals for Protecting
Insurance Consumers

Page 17 GAO- 02- 199T

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

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

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

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

Contacts and Acknowledgments

Page 18 GAO- 02- 199T

Appendix I: Summary of Alternative Programs

Table 1: Summary of Insurance Programs Sponsored by the Federal 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- 199T

Program Description Government subsidy Sources of financing

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

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

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

National Credit Union Share Insurance Insures member shares

(deposits) up to a specified amount.

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

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

Pension Benefit Guaranty Corporation Insurance Insures retirement benefits
of

workers and beneficiaries covered by private sectordefined benefit pension
plans.

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

Premiums, assets from terminated plans, and investment income.

Savings Association Insurance Fund Insures deposits up to a

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

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

veterans with 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- 199T

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- 199T

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.

(250057)
*** End of document. ***