Are state-backed insurance schemes the wave of the future?

By Robert Hartwig
April 9, 2007

The government's role in insurance markets is a matter of increasing importance and controversy. Historically, state insurance departments have regulated insurers and insurance markets, overseeing solvency, rate and form regulation, and consumer protection. More recently, however, the state itself is being called upon to perform the function of insurer or reinsurer.

Events including the 9/11 attacks, and record 2004 and 2005 hurricanes have accelerated the call for direct government participation in insurance. From 1969 to 2005, catastrophic losses represented 6.5 percent of U.S. P/C insurers' impairments. From 2003 to 2005, that figure increased to 8.6 percent and appears to be on the rise. From Jan. 2006 to Jan. 2007, 11 of the 16 recorded impairments were associated with cat loss, tracing back to financial weakness spawned by the '04/'05 hurricanes. Katrina also pushed most of the state-run residual market property plans in affected states into deficits in 2005. The National Flood Insurance Program paid about $20 billion in claims in 2005, indicating a need for a taxpayer-financed bailout of at least $18 billion.

Some government participation in insurance markets, such as the provision of terrorism insurance, is at the invitation of insurers. Other actions have been greeted with hostility and skepticism by reinsurers and some primary insurers. Yet economic and political forces are coalescing into calls for a greater role for states and the federal government, which will have an array of implications for private insurers, reinsurers, regulators and buyers of insurance.

Supporters of a state role believe a presence is necessary because of concerns about:

Insurability

- There is a question of whether some risks are fundamentally insurable, suggesting a role for government. Looking at 9/11 as an example, the attacks created $35,600 million in losses, including insured losses for property, workers' comp, business interruption, life and other liability. The long return period for terrorism events suggests difficulty in estimating frequency, making expected loss calculations difficult. That creates a classic insurability problem.

Magnitude and severity of loss

- Certain losses are so large only the state can manage them. Even with the Terrorism Risk Insurance Act and its Extension, some terror attack scenarios in major cities such as New York and San Francisco consume several times the industry's estimated TRIEA-exposed 2005 surplus of $151 billion. The take-up rate for workers' comp terror coverage is 100 percent, indicating the need for coverage.
Natural cat exposures are not going away either, with more people moving into risky, coastal areas. Property owners in many cat-prone areas have a low cost of living, low real estate costs with rapid price appreciation, lower taxes, and rapid job growth. Because government leaders are loathe to pass laws that would negatively impact economic development, the situation creates opportunities for greater losses. Thus states, by allowing and enabling nearly unfettered development in areas vulnerable to major cat loss, are principal contributors to their own residents' insurance woes, bearing greater culpability than Mother Nature herself.

Price and availability

-- There are concerns over prices charged by private insurers and reinsurers. In some cases, insurers are scaling back their exposure to the market. Consumers are concerned about whether they can purchase coverage at an "affordable" price.

Government participation via aid

- Some states already provide economic relief. Federal aid is routinely authorized, after even very modest-sized disasters. But such aid is not an efficient solution. Congress authorized $110 billion in aid for Katrina, more than the total of all federal aid for the 9/11 attacks, the 2004 hurricane season, Hurricane Andrew and the Northridge Earthquake combined.
While some argue that there is a clear need for a state-backed system to insure against natural catastrophes, Florida recently expanded its role in insurance and reinsurance in ways that caused deep concern. The legislature doubled the exposure of the Florida Hurricane Catastrophe Fund to $32 billion, displacing private reinsurers. Florida Citizens, an insurer of last resort, now can compete with private insurers by lowering rates and eligibility standards. Changes also increased the exposure of policyholders to post-cat assessments and taxes; created disincentives for insurers to offer policies through institution of an "excess profits law;" and threatened Florida's credit rating, because a major event could result in a simultaneous issuance of $40 billion-plus debt from the cat fund, Citizens and guarantee fund, among other things.

The concern with Florida's changes are that risks are now almost entirely borne within the state. Virtually nothing is reducing vulnerability. There is an increased likelihood of large future assessments on policyholders and a potentially crushing debt load for the state. Thus, the state may be forced to raise taxes to avoid credit downgrades. It is also likely that politically important Florida would seek a federal bailout. Policyholders may see minimal price drops because the "savings" came from canceling recent/planned rate hikes and overpromising by politicians. Residents in lower-risk areas, drivers and business liability policyholders will resent subsidies to coastal dwellers. And, the governor's emergency order for rate freezes/rollbacks is viewed as unfair and capricious.

Despite those fears, Florida's cat financing system could be exported to other states as a model. Already, Louisiana, South Carolina, Massachusetts and others are considering state/regional cat funds. Several bills also have been introduced to facilitate a national cat plan . To date, however, most states appear to be rejecting Florida's approach in favor of programs that use tax incentives to encourage mitigation.

Government involvement in insurance is being sought as a solution to surviving disasters. Given concerns about private insurer and reinsurer displacement, program entrenchment, and risk off-loading as states look to avoid fiscal crisis and debt downgrades, state-backed insurance schemes may not be the wave of the future just yet.

This was excerpted from "State-Backed Insurance Schemes: The Role of Insurers," a presentation Dr. Robert P. Hartwig, president and chief economist for the Insurance Information Institute, compiled for the Insurance Institute of London.