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Evaluation Of Goverment Involment Mechanisms

Evaluation Of Goverment Involment Mechanisms

This section begins with an evaluation of theories of government involvement in insurance markets. The discussion then turns to an evaluation of the principal mechanisms for government involvement and recommendations for improving the markets for insurance against catastrophes. 

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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