Evaluation Of Goverment Involment Mechanisms
Theories of Government Involvement
Three primary theories of public policy are
relevant in evaluating the role of government in
addressing market failures in the insurance industry: laissez faire, public interest, and market
enhancement.
Laissez faire theory maintains that
any market-based equilibrium, however imperfect,
provides a more efficient allocation of resources
within the economy than an equilibrium involving
government intervention.
From this perspective,
government intervention in markets results primarily from rent-seeking behavior of special interest
groups (e.g., Stigler, 1971).
Thus, industry calls
for government protection against catastrophic
risk are viewed as opportunistic attempts to secure
an ex ante wealth transfer from taxpayers.
Several types of inefficiencies can arise from
government insurance programs.
Provision of
subsidized insurance is likely to crowd out private
attempts to enter the market, permanently lockingin an inefficient solution to financing catastrophe
losses. Government programs tend to develop
constituencies that engage in intensive lobbying
to maintain government support, strengthening
concerns about rent-seeking by special interests.
Subsidized insurance also tends to create moralhazard problems whereby policyholders underinvest in loss prevention.
Government insurance
also may create resource allocation problems if
subsidized terrorism insurance leads to overbuilding of building types and locations that are
relatively vulnerable to terrorism. Actuarial pricing of government insurance can alleviate some of
these problems.
However, because the design of
government programs is determined by politics
rather than the operation of markets, even unsubsidized insurance programs are not likely to represent the most efficient solution.
The public interest theory of regulation
contests the laissez faire view (e.g., Musgrave
and Musgrave, 1984). This theory suggests that
market failures can lead to suboptimal allocation
of resources and that government intervention
targeted at addressing the market failures can
improve welfare.
Although laissez faire policy
suggests that private sector coordination is optimal, public interest theory suggests that, in specific instances, the government can improve upon
the market equilibrium by substituting for private
sector coordination.
Proponents of public interest
theory, therefore, maintain that the information
asymmetries and bankruptcy costs associated with
the market for terrorism insurance may necessitate
the role of the government in “completing” the
market for terrorism insurance.
The third view of public policy intervention,
the market-enhancing view, takes a middle position (e.g., Lewis and Murdock, 1999). The marketenhancing view recognizes that market failures
can create suboptimal allocations of wealth and
that private sector coordination is not always effective.
This view holds that public policy should
facilitate the development of the private market
but should not create new governmental institutions to substitute for private solutions.
The marketenhancing policy recognizes that government
(de)regulation can help facilitate the creation or
enhancement of private institutions for solving
market failures, such as how the federal government facilitated mortgage securitization markets.
Mechanisms for Government Involvement
This section first considers natural catastrophes and then analyzes terrorism. The private
insurance market seems to have difficulty in providing adequate coverage for the largest natural
catastrophes.
Projected catastrophes, such as a
$100 billion California earthquake or Florida
hurricane, are large relative to the resources of
the insurance industry; and holding additional
equity capital in the industry to shield against
such events does not seem to be feasible (Jaffee
and Russell, 1997).
GAAP accounting rules do not
allow insurers to establish reserves for events that
have not happened. Similarly, insurers are not
permitted to take tax deductions for events that
have not yet occurred, requiring that capital to
pay for catastrophe claims has to be accumulated
out of after-tax income.
In addition, large pools of capital tend to attract corporate raiders and
may induce management to engage in negative
net-present-value projects.
Raising capital to pay
losses following a large-loss event also is difficult
because informational asymmetries between
capital markets and insurers regarding loss
exposure and reserve adequacy raise the cost of
capital to potentially prohibitive levels.
Thus,
private insurance markets tend to be much more
efficient at cross-sectional rather than cross-time
diversification.
There are several possible solutions to the
cross-time diversification problem.
Because the
resources of capital markets are more than adequate
to fund large catastrophes, a market-enhancing
approach would be for the government to facilitate
the growth of the insurance-linked securities
market.
This is an attractive solution because it
could be implemented without committing tax
dollars to paying for catastrophe losses.
There are
several areas where removal of remaining regulatory and bureaucratic barriers as well as simplification and clarification of rules and approval
procedures would facilitate the securitization of
catastrophic risk.
The GAAP consolidation rules
should be clarified and codified for CAT-linked
securities, and such securities should be given
conduit status for federal income tax purposes.
State insurance regulations should be clarified
and streamlined to reduce transactions costs and
enhance the speed to market of new securities.
Even if all regulatory impediments were
removed, the CAT bond market still might not
attain sufficient size to fund major catastrophes.
However, it is also possible that “critical mass”
would be reached, where scale economies and the
ability to form worldwide CAT bond portfolios
would reduce transactions costs and spreads to
the point where the market would rival the assetbacked securities market.
The costs of relaxing
the regulatory and accounting rules are low, so
it would seem to be worthwhile to conduct the
experiment.
The federal government could play
a major role by creating a task force to coordinate
with Congress, the Financial Accounting
Standards Board, and the National Association
of Insurance Commissioners to bring down the
regulatory barriers.
A somewhat more intrusive solution to the
time diversification problem would be to exploit
the federal government’s ability to implement
intergenerational diversification through federal
borrowing.
Unlike private insurers, the federal
government can effectively accomplish cross-time
diversification because it can raise money following a disaster by borrowing at the risk-free rate
of interest.
The government’s ability to timediversify led to a Clinton administration proposal
for government intervention in the market for
catastrophe property insurance (Lewis and
Murdock, 1999), whereby the federal government
would hold periodic auctions of catastrophe
excess-of-loss (XOL) reinsurance contracts to
insurers and reinsurers in loss layers where private
market reinsurance is not available.
The auctions
would be conducted subject to a reservation price
sufficient to support the expected loss and expense
costs under the contracts as well as a risk premium
to encourage private market “crowding out” of
the federal reinsurance.
If a catastrophe were to
occur that triggered payment under the contracts,
the federal government would finance the loss
payments by issuing bonds.
Although the proposal
was not adopted, it could provide a model for a
different type of federal involvement in the terrorism insurance market consistent with the marketenhancing view of regulation.
However, given
that securitization offers a viable private market
solution, it would be advisable to give higher
priority to exploring that option.
Another alternative to government intervention to enhance the private market would be to
permit insurers to accumulate tax-deductible
reserves for catastrophe losses, a proposal that
has been advocated by the insurance industry
for at least a decade.
One obvious problem with
the proposal is that it would reduce federal tax
revenues, when other solutions such as securitization are available that would not have this effect.
Another problem is that there would be no way
to prevent insurers from reducing reinsurance
purchases in such a way as to substitute taxadvantaged reserves for other forms of hedging, with little or no net gain in risk-bearing capacity.
Finally, a tax-subsidized reserving program would
have a crowding-out effect on the securitization
market.
As mentioned above, state governments have
intervened to “make markets” in catastrophe
insurance in California, Florida, and other states.
These might be considered market-enhancing
efforts, except to the degree that they involve an
element of coercion.
That is, insurers are required
to participate in the California and Florida programs if they wish to continue to participate in
the states’ other lucrative insurance markets, such
as the market for automobile insurance.
It is likely
that less insurance would be available in these
states, at least on a cyclical basis, if the statemandated plans had not been adopted. However,
it is also possible that the private market would
provide adequate coverage if insurance prices
were deregulated, allowing the market to clear.
The periodic difficulties in private markets for
natural catastrophe coverage provide additional
impetus for developing the CAT bond market
because insurers might be more willing to write
coverage on a voluntary basis if more reasonably
priced diversification mechanisms were available
for mega-catastrophes.
The market response to the increasing frequency and severity of catastrophe insurance
losses since the 1990s has potentially quite significant implications.
In spite of the lack of federal
government intervention in the market for natural
catastrophe insurance, the private market for
natural catastrophe insurance did not collapse
completely.
Although insurance and reinsurance
prices rose following Andrew and Northridge,
significant amounts of new equity capital flowed
into the industry and reinsurance prices eventually declined (Guy Carpenter, 2005).
For the
most part, insurance continued to be available in
disaster-prone areas, such as Florida, and private
insurers eventually re-entered the market for
California earthquake insurance.
There is evidence
of continuing market anomalies, however, such as
the skewness of reinsurance toward the coverage
of relatively small catastrophes and the thinness
of reinsurance coverage for mega-catastrophes
(Froot, 2001).
Nevertheless, private markets for
natural catastrophe insurance have continued to
function with reasonable efficiency in the absence
of federal support.
Terrorism, and particularly mega-terrorism
events, pose more-difficult problems for private
insurance markets than natural catastrophes mega-terrorism events potentially cause much
more extensive losses than natural hazards; the
frequency and severity of terrorist events are difficult to estimate, both inherently and because
much of the most useful information is confidential for national security reasons; and terrorists
can adjust strategies and tactics to defeat efforts
to protect against terrorism and mitigate loss
severity.
The same factors that make terrorism
difficult to insure and its similarity to war risk
may rule out terrorism-risk securitization, at
least on a large scale.
Among the other obstacles,
the existence of terror-linked securities might
influence target selection by terrorists, and terrorists and their sympathizers could attempt to
profit by trading in terror-linked securities.
Consequently, even if government provision of
insurance against natural catastrophes is not
needed, there may be a legitimate role for government in the market for terrorism insurance.
The
experience under TRIA provides somewhat mixed
messages on the need for a government role the
stock market reacted negatively to the adoption of
TRIA but survey evidence strongly suggests that
TRIA succeeded in making terrorism coverage
widely available.
There are various mechanisms for government
to become involved in the terrorism insurance
market. Because there is great uncertainty surrounding the insurability of terrorism risk, a guiding principle of any government involvement
should be that programs be designed to not crowd
out the private market.
This necessitates that the
program be explicitly priced and that the price be set above the expected value of loss. One possibility would be to adapt the Clinton administration proposal and auction off federally backed
XOL terrorism reinsurance contracts.
Another
would be a reinsurance program patterned after
TRIA but with a positive premium charge and
continuing increases in insurance industry
deductibles to encourage the private market to
develop gradually.
Another important problem is how to handle
CBRN hazards.
Under TRIA, the federal policy
approach is to “look the other way” and to permit insurers to exclude CBRN hazards to the
extent they were excluded from non-terrorist
commercial coverages. In this respect, CBRN
hazards are being treated similarly to war risks.
If an XOL reinsurance or TRIA-like program is
to be implemented going forward, a case could
be made for including CBRN hazards.
Because
government is likely to compensate CBRN victims
after the fact, it might make sense to handle as
much compensation as possible through a formal
insurance program rather than as disaster relief.
As Katrina has shown, the federal response to a
disaster can be chaotic and inefficient, whereas
private insurers are very effective at settling claims
and have incentives to settle them efficiently provided the government insurance has appropriate
deductibles and copayment provisions to control
moral hazard.
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