HAMILTON Prosperity and Growth PROJECT

THE Advancing Opportunity, HAMILTON Prosperity and Growth PROJECT P O L I C Y B RIE F NO . 2 0 0 8 - 0 3 J U NE 2 0 0 8 Financing Losses from Catastrophic Risks THE TERRORIST AttACKS OF SEPTEMBER 11th and Hurri- cane Katrina together claimed over 4,000 lives and destroyed parts of New York, Washington, and Louisiana. Beyond the human toll, they also created large financial losses borne by families, businesses, and insurance companies. This process led insurance companies to reduce coverage for future disasters and raise premiums. The government responded by attempting to use regulations and subsidies to keep insurance markets functioning. This ad hoc process created uncertainty about who would benefit, helped some industries but not others, and furthered the perverse in- centives to rebuild in dangerous areas without taking the full cost of these actions into account. In a discussion paper for the Hamilton Project, two economists—Kent Smetters of the Wharton School at the University of Pennsylvania and David Torregrosa of the Congressional Budget Office—find that government intervention in the catastrophe insurance market has unintended consequences that, in the long run, may exacerbate the problems of low supply and high prices, leaving Americans unprepared for future disasters. Any solution must involve reforming and improving government’s role to promote legitimate government interests while minimizing counterproductive long-term impacts. Smetters and Torregrosa evaluate four possible ways to promote a more stable market for catastrophe insurance: establishing a federal insurance charter, changing the regulatory accounting treatment of risk transfer arrangements, reforming the taxa- tion of earnings on insurance companies’ reserves, and auctioning off federal reinsurance. WWW.HAMILTONPROJECT.OR G The Brookings Institution 1775 Massachusetts Avenue NW, Washington, DC 20036 F INANCING LOSSES FROM CATA STROPHIC RISKS Although intermittent natu- Given these concerns, the government has histori- THE ral and man-made catastro- cally intervened in the catastrophic insurance market CHALLENGE phes are inevitable, they are in order to increase supply and maintain low prices, also very difficult to foresee especially after major high-cost events. These policies and prepare for. The two greatest U.S. disasters of the include subsidizing premiums, mandating that private 21st century—the terrorist bombings of the World insurers offer catastrophe insurance at low prices, and Trade Center and the Pentagon in 2001 and Hurri- providing public alternatives to private insurance. cane Katrina in 2005—caused roughly $80 billion in Although such policies increase the affordability of privately-insured losses and many tens of billions of insurance in the short run, Smetters and Torregrosa dollars of losses that were covered by the government argue that in the long run they can have the unin- or borne by the affected individuals and businesses. tended consequences of reducing private sector sup- Faced with these immense losses, insurers reacted as ply and discouraging businesses and individuals from they have traditionally done after catastrophic events: taking steps to mitigate risks themselves. Further, the by reducing the supply and increasing the price of new authors argue that the consistent problems of low catastrophe insurance policies. supply and high prices might be exacerbated by traditional regulatory rules that have failed to keep up with The recurring cycle of decreased supply and in- the pace of innovation in the insurance industry. Such creased price following catastrophic events makes policies include accounting regulations that limit the it difficult for businesses and homeowners to find usefulness of hedging mechanisms and corporate tax affordable insurance. Government has tried in vari- policies that increase the price of catastrophe insur- ous ways to break this cycle. And indeed it has sev- ance compared to non-catastrophe insurance. eral good reasons to intervene. For one, decreased catastrophic insurance coverage would have signifi- A recent example of the government subsidizing pre- cant negative spillover effects for the economy as a miums is the Terrorism Risk Insurance Act (TRIA) whole. Uninsured households wiped out by catas- of 2002. TRIA requires insurance companies to offer trophes could be pushed into bankruptcy and de- terrorism insurance, heavily subsidized by the govern- fault on their mortgages, potentially causing a cas- ment, that pays 85 percent of an insurer’s losses after cading effect in a geographic region akin to that seen the insurer pays a deductible. The government would during the current subprime crisis. Nondiversified recoup any outlays after an event by levying taxes on businesses would also face large unexpected losses, insurers and policyholders. The act also puts the gov- reducing overall economic activity. In many cases ernment into the reinsurance business—the practice these concerns motivate the government to man- of selling insurance to primary insurers themselves. date that businesses and households purchase catas- Between 2003, shortly after TRIA was enacted, and trophe insurance, which in turn increases pressure the first half of 2007, the share of companies buying on the government to ensure that such insurance is terrorism insurance shot up from 27 percent to 64 available and affordable to all. percent. In addition to the negative externalities of low insur- At the state level, some governments also regulate the ance coverage, the government has an interest in re- prices that insurers can charge, often setting rates be- ducing its own de facto exposure to catastrophic risk. low the competitive level. Such state regulations can Through emergency relief allocations, the govern- create a disconnect between the price of insurance and ment spends billions of dollars covering uninsured its underlying cost. All states but Texas require insur- losses from natural and man-made catastrophes. ance companies to offer workers’ compensation, with P OLIC Y BRIEF NO. 20 0 8 - 03 | JUNE 20 0 8 THE HAMILTON PROJECT Well-intentioned government rates and benefits determined by state legislatures.I n- surers must offer coverage with the same terms and policy can have the perverse rates to workers everywhere within the state, from sparsely populated farmland to heavily-occupied of- effect of increasing risks, fice buildings. reducing the availability of Policies that subsidize insurers’ losses, such as TRIA, or mandate low prices, such as state regulation, shift insurance, and shifting the cost of insurance to taxpayers and to companies and households less exposed to catastrophic risk. In costs to taxpayers. addition, by artificially lowering the cost of insurance contracts, such policies encourage inefficient construction in areas at greatest risk because households and businesses do not bear the full cost of the added risk. This perverse incentive could actually increase to the high prices and low supply of catastrophe insur- the eventual total loss to society from a catastrophic ance. First, accounting and legal regulations have not event. And even with government subsidies, Smetters kept up with the pace of innovation in the reinsurance and Torregrosa argue, companies may find they can- market. Reinsurance is when a primary insurer itself not afford to supply insurance at the low government- buys insurance. Under common accounting regula- regulated prices. tions, a primary insurer that buys reinsurance gets credit for reducing its exposure, which it can record When government subsidies are not enough to entice on its books. But this type of traditional reinsurance private insurers into the market, or when mandated has become increasingly expensive after recent cata- low prices keep them from offering insurance to cer- strophic losses. Insurers are now turning to alternative tain customers they deem too risky, policymakers have instruments for reinsurance. Unlike traditional rein- often intervened by providing catastrophe insurance surance, which pays out based on the primary insurer’s through the public sector. Florida has a state-spon- actual losses, these alternative instruments pay out ac- sored plan for hurricane insurance and California has cording to easily observable indices that are correlated a plan for earthquake insurance. Public programs to with insured losses (such as the Richter scale for earth- provide affordable insurance certainly help those they quake losses or wind-intensities for hurricane losses). directly serve, but these benefits must be weighed The advantage of these forms of reinsurance is that against their downsides. Just as with subsidies and price they do not require reinsurers to monitor the prac- mandates for private insurance, publicly provided and tices of the primary insurance company or to charge financed insurance creates moral hazard by giving a deductible to discourage moral hazard. Instead, they risky buyers a distorted price signal and encouraging simply require reinsurers to take bets on the probabili- more construction in areas at risk of disasters. Public ties of various events, opening up participation to a provision can also crowd out the private sector, reduc- wider range of actors in capital markets. ing long-run private supply and increasing the burden on taxpayers and less-risky insurance buyers. The problem, however, is that under current accounting guidelines put forward by the National Association Regulatory and Tax Distortions of Insurance

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