Here are excerpts:
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At a Glance
In some insurance markets, the federal government and private insurance companies share the financial risk of covering insured parties. In this report, the
* For terrorism insurance, the federal government assumes most of the catastrophic risk by reinsuring (that is, by supplying insurance for insurers) against the risk borne by private insurers. By reinsuring against only the catastrophic risks rather than bearing all the risk, the government decreases its budgetary costs. (Catastrophic risks stem from events that have a low probability of occurring but that are very consequential when they do occur.) The government is required to recover most or all of its outlays by assessing a tax on all commercial policyholders after a terrorist attack occurs.
* For crop insurance, the government and private insurers share in the gains and losses from the insurance policies. In general, budgetary costs can be lower when risks are shared than when the government bears all the risk. But in the federal crop insurance program, risk sharing increases budgetary costs because private insurers are allowed to selectively retain most of the premiums and the opportunity for gains on low-risk policies.
* For flood insurance, the government initially assumes all the risk associated with covering policyholders and then transfers some of it to private companies and investors by purchasing reinsurance and using catastrophe bonds (securities that allow the government to forgo scheduled payments of interest and principal, in part or in full, in the event of specified losses from floods). Because the government must pay market prices when it transfers the risk, that form of risk sharing increases expected budgetary costs.
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Contents
Summary … 1
What Is the Government’s Role in Insurance Markets? … 1
How Is Risk Shared in the Government’s Terrorism, Crop, and Flood Insurance Programs? … 1
How Does Risk Sharing Affect the Budget? … 2
The Government’s Role in Insurance Markets … 2
Private Insurance Markets … 3
Federal Insurance Programs … 6
Risk Sharing in Insurance Markets … 7
The Government as Insurer of
Coinsurance of Gains and Losses in the Federal Crop Insurance Program … 11
Reinsurance Policies Purchased by the National Flood Insurance Program … 14
Budgetary Effects of Risk Sharing … 20
Measuring the Cost of Federal Insurance Programs … 20
Measuring the Costs of Risk Sharing in Federal Insurance Programs … 22
List of Tables and Figures … 26
About This Document … 27
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Notes
Unless this report indicates otherwise, all years referred to are federal fiscal years, which run from
Numbers in the text and tables may not add up to totals because of rounding.
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Summary
In three federal programs providing terrorism, crop, and flood insurance, the government and private companies share the financial risk of covering policyholders. In this report, the
What Is the Government’s Role in Insurance Markets?
Insurance markets in which the federal government plays a significant role are generally those involving risks that are very large or highly correlated (meaning that many policyholders can experience losses simultaneously, as with pension and deposit insurance). For risks that are small and diversifiable, as with auto and life insurance, for example, private insurers can spread risk across all policyholders and absorb losses by setting risk-based prices. Risk sharing happens when private firms and investors can only assume some of the risks, or when the government helps make coverage widely available by subsidizing rates. In some cases, risk sharing can have lower budgetary costs than relying on federal assistance after a catastrophic event.
How Is Risk Shared in the Government’s Terrorism, Crop, and Flood Insurance Programs?
Although federal programs providing terrorism, crop, and flood insurance all involve sharing risk with private-sector companies, the risk sharing is structured differently in each program./1
In the terrorism insurance program, the government reinsures private insurers against catastrophic risks; in the crop insurance program, the government and private insurers share premiums and the gains and losses from policies; and in its flood insurance program, the government purchases reinsurance from private insurers./2
Insurers bear much of the risk of losses on commercial policies from terrorist attacks because of the sizable deductibles they pay before the losses trigger the reinsurance and because of the copayments they make above the amount of the deductible. Lawmakers have gradually increased insurers’ deductibles and copayments since TRIA was enacted. The government is responsible for initially covering the remainder of the losses. Under the law, the government charges no premiums for its reinsurance but is required to recoup most of its outlays for losses by assessing a tax on all commercial policyholders after a terrorist attack. The
1. The government also shares credit risk with the private sector in many programs, including mortgage finance, but this report focuses only on insurance. The report does not address federal health, life, or social insurance programs.
2. Reinsurance is insurance for insurance companies. It is a risk-sharing mechanism whereby insurance providers (called primary insurers) purchase policies from other insurers (called reinsurers) to insulate themselves, at least partly, from the risk of a major claims event. The primary insurers pay premiums to the reinsurer, and the reinsurer pays a claim to the primary insurer when claims from an event (or during a specified period) exceed some threshold (the primary insurer’s deductible) specified in the reinsurance contract.
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Under the reinsurance contracts, reinsurers agree to reimburse the government for a share of catastrophic losses above a very high deductible, and capital market investors effectively do the same through the securities they purchase. Although this type of risk sharing has encouraged a bigger role for the private sector in the flood insurance market and reduced the variability of the NFIP’s annual costs, it has an expected budgetary cost.
How Does Risk Sharing Affect the Budget?
The risk-sharing mechanisms in the terrorism, crop, and flood insurance programs each affect the federal bud- get (see Table 1). The government budgets for federal insurance programs on a cash basis, which measures the inflows from premiums and fees and the outflows for claims over a 10-year period. A federal insurance program’s net effect on the budget is calculated as the difference between its cash inflows (from premiums, fees, and other income) and its cash outflows (primarily to pay claims for covered losses) when they occur.
* For terrorism insurance, risk sharing in the form of federal reinsurance causes budgetary costs to be lower than they would be if the government assumed all the risk. By shifting risk to private insurers through deductibles and copayments, the government reduces its projected outlays. Under current law, the government would recoup most of its outlays by assessing a tax on policyholders after a terrorist attack, though the government has not paid any claims, and such assessments have never been made.
* For crop insurance, risk sharing tends to make the budgetary cost higher than it would be if the program was wholly federal. That is because the risk sharing allows private insurers to retain the majority of premiums and gains (or losses) from low-risk policies while passing on most of the risk of losses from high- risk policies to the government.
* For flood insurance, risk sharing has an expected budgetary cost as measured on a cash basis. The government must pay private companies and investors an amount that includes market-based compensation for reinsuring risk, but the cost of that compensation is not passed on to NFIP policyholders.
The Government’s Role in Insurance Markets
Well-functioning insurance markets can promote economic efficiency and improve policyholders’ and policymakers’ understanding of risks. By reimbursing policyholders for losses, insurance protects businesses and individuals and thus reduces the need for assistance from the government when major losses occur.
The government generally plays a significant role in insurance markets when the risks are very large or highly correlated. When risks are highly correlated, many policyholders may suffer losses simultaneously, so private insurers are often reluctant to make coverage widely available. In such cases, there can be a significant difference between the amount of losses people incur and the amount of losses covered by insurance because of incomplete insurance markets (that is, markets in which coverage is not widely available for all risks).
Governments play varying roles in insurance markets. In wholly private insurance markets, private insurers price and sell insurance policies, provide coverage to policyholders, and absorb all losses. Those markets, including auto and life insurance markets, are subject to government regulation only at the state level. Other insurance markets, such as the markets for deposit insurance and pension insurance, are wholly public in that the federal government provides coverage to beneficiaries without the involvement of any private insurers./3
In some cases, however, the federal government and private insurers share the financial risk of covering insured par- ties. Such public-private risk sharing can make insurance affordable and widely available by encouraging private insurers to offer coverage for risks they otherwise would not have covered or to charge lower premiums for insurance coverage, which motivates more property owners and business owners to purchase policies.
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Table 1: Effects of Risk-Sharing Mechanisms on the Federal Budget
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Insurance can also encourage individuals and businesses to engage in activities that involve risk if they know they will be protected from some losses in the case of a bad outcome. That risk taking could be efficient or inefficient from an economic standpoint, depending on the type of risky activity that is undertaken and how the insurance is priced. For example, underpriced flood insurance can lead to excessive real estate development in high-risk coastal areas, which increases losses from floods at taxpayers’ expense./4
Conversely, underpriced federal terrorism insurance supports continued business activities in areas perceived to be at high risk and thus helps preserve agglomeration economies. (Those economies arise from clusters of activities in an area to support more innovation and the exchange of new ideas, goods, and technologies.)
When the government operates insurance programs, it can sometimes reduce its exposure to risk by transferring some risk to private insurers. However, private companies require market-based compensation in exchange for accepting risk. In some cases, government insurance pro- grams crowd out private insurance coverage when they charge premiums that are lower than private companies could charge to cover their expected losses and earn a profit.
Private Insurance Markets
In private insurance markets, policyholders make payments (called premiums) to insurance companies,…
3. This report does not address the government’s social insurance or health insurance programs (such as
4.
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…which in turn assume responsibility for losses above a threshold amount (called a deductible) specified in the policy. In some cases, insurers require policyholders to share in some of the losses above the deductible by making copayments. Premiums are typically set to cover the company’s expected payouts on policies and their administrative and operating expenses, as well as to compensate shareholders for their financial investments in the company.
Shareholders will invest in insurance companies only in return for an expected profit that is commensurate with the riskiness of the coverage the company offers. Thus, insurance companies charge premiums that include compensation to shareholders for the risk that they might experience unexpected losses. Insurers invest their share- holders’ funds in liquid financial assets (including stocks and bonds) to cover the potential costs associated with larger-than-expected claims on their policies. (Because the return on those assets is procyclical, meaning that returns generally increase when the economy expands and decrease when the economy slows, insurers’ capital fluctuates, as does their willingness to assume risk.) Primary insurers that initially take on risk can transfer (or reinsure) some of the risk to other insurance companies (called reinsurers) that operate globally to efficiently diversify their risks. Primary insurers purchase private reinsurance to reduce their risk of catastrophic losses, which might threaten their solvency, and to limit the amount of capital they need to raise from shareholders.
Competition motivates private insurers to price their coverage on the basis of their expected costs when their risks are transparent and diversifiable. They try to set risk-based premiums (subject to the approval of state regulators), deductibles, and copayments that give policyholders an incentive to mitigate risk. (By contrast, federal insurance programs have weaker incentives to use risk-based pricing and sometimes are explicitly subsidized to make insurance more affordable.)
When insurers face risks that are hard to estimate, they are likely to limit coverage or charge much higher premiums than if they have good information about the risk./5
And when the risk of losses cannot be diversified or is highly uncertain, insurers can either restrict coverage or choose not to offer coverage at prices that are attractive to most people and businesses. For example, because insurers have limited information on which to base their premiums for the growing risk of cyber insurance, they have only been able to meet some of the demand for it./6
Cyber insurance covers Internet-based risks and those related to information technology and privacy, including data theft, malware, and denial-of-service attacks (which flood a network or device with so many malicious requests that it cannot properly function). The cost of cyber coverage is typically several times that of coverage for other risks, and less coverage is available (that is, policy limits are lower)./7
Insurance companies try to reduce their total exposure to risk by diversifying the policies they hold, but they nonetheless face the risk of higher-than-expected losses from factors that can trigger claims on many of their policies at once. For example, natural disasters can affect a wide geographic area and result in unusually large numbers of claims.
The Importance of Risk-Based Premiums. When insurance prices are tied to costs, they convey valuable information to policyholders, both households and busi- nesses, about the risks they face, encouraging them to make more economically efficient choices. For example, when insurance companies offer lower premiums (or discounts) to homeowners who have a fire extinguisher and smoke alarms, the companies communicate the cost of fire risk to policyholders and encourage them to take steps to reduce that risk. Similarly, when property casualty companies offer businesses a discount on their insurance premiums in exchange for developing a continuation-of-operations plan to respond to natural disasters, they encourage them to prepare for such events.
5.
6. Cyber insurance is usually sold as a stand-alone policy with lower coverage limits than other lines of insurance. Such explicit coverage is often referred to as affirmative coverage and is separate from other property and casualty coverage. Just under half of all
7.
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When risks are well understood and uncorrelated, private insurance efficiently pools risks, as auto insurance illustrates./8
The likelihood of one policyholder generating a loss is largely unrelated to the likelihood that many other policyholders will generate losses at the same time. As a result, losses are spread over time in a predictable pattern rather than concentrated within a short period. Insurance companies also have access to demographic and geographic information, as well as information about people’s driving history, which helps the companies understand the risks associated with insuring par- ticular policyholders. Additionally, insurers can increase the premiums charged to individual policyholders if they generate a claim, motivating them to drive more safely. During the height of the coronavirus pandemic, some auto insurers refunded premiums because people were driving much less than in the past, which lowered the risk of accidents.
Sources of Imperfections in Insurance Markets.
Multiple factors contribute to market imperfections that limit the availability of private insurance. One condition for perfect competition is that exchanges are based on complete and accurate information that is known to buyers and sellers. Imperfect information can result in moral hazard and adverse selection. Insurance markets can also be incomplete when there is a large gap between the potential for insured losses and the available cover- age because the risks are large, uncertain, and hard to diversify.
Moral hazard occurs when insurance lowers policyholders’ incentives to engage in loss-mitigating behavior because the insurer will be responsible for most of the losses. Additionally, private insurance markets may face weak demand if households and businesses believe that the government will provide financial assistance in the event of a loss, regardless of their insurance coverage.
Adverse selection occurs when the pool of policyholders consists largely of individuals and businesses that are at relatively high risk of generating losses, rather than a mix of low- and high-risk policyholders. For example, someone who expects to live longer than average might be more likely to purchase life insurance annuities, which provide annual payments in retirement. (The longer a person lives, the greater the payout from the annuity.) Thus, the pool of policyholders would have higher-than-average life spans.
Private insurers can take steps to limit moral hazard and adverse selection. One general strategy to lessen moral hazard and adverse selection is to tie premiums to experience, so that submitting a claim leads to higher rates for the policyholder. Another strategy is to cap the amount of coverage. Furthermore, insurance companies can reduce moral hazard by using deductibles and coinsurance (whereby policyholders share in a portion of losses above the deductible) and by offering discounts for mitigation measures (or including covenants that require them), such as installing fire extinguishers, smoke detectors, and security systems, which lower expected claims. To reduce adverse selection, risk-based pricing can be used to encourage low-risk potential customers to purchase insurance. Adverse selection can also be significantly mitigated when either governments or lenders mandate coverage, which lowers rates.
Private insurers may also limit coverage when the risks are potentially catastrophic and cannot be well diversified./9
For example, pandemics can affect many countries at the same time and result in large losses. Since the 2003 outbreak of Severe Acute Respiratory Syndrome (SARS), most insurers have explicitly excluded pandemic-related risks from their business interruption…
8. Insurance can have high administrative costs. One study found that the industry’s productivity is lagging behind that of other industries and that its cost performance has not improved in more than a decade. See
9. The federal tax code and private-sector accounting standards do not permit insurers to recognize insured losses until those losses have been incurred. As a result, a timing mismatch arises between the insurers’ income and the associated losses from catastrophic events, which makes capital less efficient when held against catastrophic events. See
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…coverage./10 As a result, when commercial businesses faced shutdown orders from the government during the coronavirus pandemic, their lost income and operating expenses were not insured. In contrast, business interruption coverage remains widely available to cover lost income when a business or property suffers physical damage from a fire, hurricane, or flood.
Federal Insurance Programs
Unlike private insurers, federal insurance programs (and the risk-sharing mechanisms they use) have principal goals unrelated to making a profit. The government might operate an insurance program because a certain type of private insurance coverage does not exist or is not widely available, or because the government seeks to provide coverage at lower prices than private insurers are willing to offer. In some federal insurance programs, the government uses risk sharing to reduce its exposure to risk, to make its annual losses less volatile, or to encourage private insurance companies to participate in an insurance market.
The federal government offers insurance against a range of risks, including floods, crop failures, terrorist attacks, and failures of financial institutions and private-sector pension plans. The government has an interest in sup- porting the development of insurance markets for two main reasons. In some sectors of the economy, insurance coverage can reduce uncertainty about the recovery from an unforeseen adverse event by reimbursing policyholders for losses, making the economy more resilient. That social benefit of insurance helps businesses maintain solvency and the benefits of employer-employee matches in labor markets in the face of undiversifiable risks.
In addition, a public-private insurance program can reduce the likelihood of costly federal assistance in the wake of a catastrophe. If losses were not widely covered by private insurance, the government might feel compelled to intervene after a catastrophe by providing supplemental disaster assistance using procedures outside the normal budgetary process. (For example, the government has historically made payments to individuals and businesses following natural disasters or other unexpected adverse events.) Thus, widely available coverage reduces demand for supplemental disaster assistance.
Pricing in Federal Insurance Programs. The government can attempt to cover the risk its insurance pro- grams face by charging policyholders premiums that are high enough to cover the cost of losses, which are estimated using methods that account for the differing probabilities of various outcomes./11
Although private insurers generally rely on risk-based pricing to help control losses (by offering discounts to policyholders who take steps to lessen or prevent losses), the government is much less reliant on it. The government may depart from risk-based pricing for two reasons. One reason is that it may seek to make insurance affordable, which often results in explicitly subsidizing coverage./12
Even when the government seeks to cover the costs of an insurance pro- gram, it may set rates on an average-cost basis or set rates that cover only broad categories of risk, which may result in low-risk policyholders subsidizing high-risk ones. A second reason is that the government may not have the information necessary to set risk-based prices because of a lack of data. When prices are not risk-based, losses may occur because of a lack of cost-effective risk mitigation. The National Flood Insurance Program, for example, has historically operated at a deficit because the government has charged premiums that are too low to meet the program’s expected costs./13
Some flood insurance policies are explicitly subsidized, and others-which the NFIP formerly estimated to be “full risk” policies-have been…
10. Business interruption insurance typically covers only losses that result from physical property damage. See
11. The use of risk-based premiums, deductibles, and copayments can be considered risk-sharing mechanisms in which the federal government shares risk with policyholders. However, the focus of this report is on the government’s risk sharing with private insurance providers, not with policyholders.
12. An alternative approach would be to provide income-based vouchers that target assistance while retaining risk-based pricing to encourage mitigation. See
13. Government Accountability Office,
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…implicitly subsidized, which the program is now trying to correct./14 Through its system for rating risks, Risk Rating 2.0, the NFIP is moving toward a pricing method that assesses the risk of each insured building on the basis of its individual characteristics instead of using flood zones as the primary indicator of risk. The new method accounts for flood risk from a broader range of sources than the old method and uses additional variables to assess risk, such as the types and characteristics of the bodies of water nearest to the insured building. Risk Rating 2.0 also relies on a more detailed set of structural and engineering characteristics to determine risks. Those changes will raise premiums for roughly three-quarters of the NFIP’s policies. Premiums will decrease for the remaining one-quarter of policies, in part because those policies were, in effect, cross-subsidizing the others./15
When the NFIP faces shortfalls, it is authorized to bor- row up to
Exposure to Market Risk. In its insurance programs, the government is exposed to market risk when claims are correlated with the performance of the economy./17
For example, the
Similarly, financial institutions are more likely to fail during economic downturns, especially during or after a financial crisis, and thus the
The
14. Lawmakers are phasing out some of the explicit subsidies. For more information, see
15. Under Risk Rating 2.0, annual premium increases are still constrained by law to between 5 percent and 18 percent for primary, single-family residences. See
16.
17. Market risk is a component of financial risk that remains even with a well-diversified portfolio and is correlated with macroeconomic conditions. Private investors charge a risk premium for bearing market risk.
18.
19.
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(Continues with Part 2 of 2)
The report is posted at: https://www.cbo.gov/system/files/2022-11/57615-Public-Private-Risk-Sharing.pdf
Congressional Budget Office: 'How CBO Analyzes Public-Private Risk Sharing in Insurance Markets' (Part 2 of 2)
Kevin A. Henry, Kidnap & Ransom Specialist, Joins Great American’s Fidelity / Crime Division
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