New GAO Study: U.S. Needs Government Help to Insure for Catastrophes and Terrorism

A new U.S. government report indicates that the private U.S. insurance industry would be placed under enormous strain without government intervention if there were a major terrorist or catastrophic event or series of events.

It also finds that the U.S. has let a significant portion of its catastrophic risk and terrorism risk go uncovered and that some European countries do a better job of guaranteeing protection.

The report from the General Accountability Office found that although the private insurance industry was able to withstand the 2004 hurricane season, its capacity has not been tested by a major catastrophe, one with only a 1 to 4 percent chance of occurring. The study indicates that such a serious event could severely disrupt insurance markets and impose recovery costs on governments, businesses and individuals.

“Such a catastrophe or series of catastrophes could result in significant disruptions to insurance markets. In addition, it is not clear how state governments and insurers would react to such a scenario, restore stability to insurance markets, and ensure the continued availability of critical insurance coverage, or whether they would have the capacity to do so,” according to the report.

In the event of a major catastrophe, the report suggests, the government could also be called upon to provide financial assistance to insurers and policyholders in addition to traditional obligations, such as repairing public facilities and providing temporary assistance to affected individuals.

The report has been shared with Congress, the National Association of Insurance Commissioners, and with the U.S. Treasury Department, which is preparing its own study, and is likely to be cited in the ongoing debate over whether and how to renew the Terrorism Risk Insurance Act in the U.S. This federal terrorism insurance program is scheduled to expire at the end of 2005 unless Congress acts.

The insurance industry commended the report for supporting a federal government role in terrorism coverage, although not necessarily in catastrophe risks.

The report “restates the case” for a U.S. government role in insuring for terrorism, Scott Duncan, director of public affairs, Property Casualty Insurers Association of America, told Insurance Journal, pointing to the part where the GAO suggests that reinsurance “would likely dry up” if TRIA is not renewed.

Duncan drew attention to the fact that in European countries insurers can exclude terrorism coverage if there is no government backstop, whereas in the U.S. insurers must still cover workers compensation with or without a federal government program in place.

Dennis Kelly of the American Insurance Association said the report should be a “big help” in making the case for a public-private partnership in providing terrorism coverage. The European examples provide “real world” information that should be instructive for policymakers, he added.

Kelly, AIA director of federal media relations, also referred to the reinsurance markets, noting that even with TRIA they have not come back to pre-9/11 levels. The scarcity of reinsurance was among the conditions that prompted TRIA in the first place, he added.

Both spokesmen noted that there are some in Washington, including Rep. Tom DeLay (R-Texas), who believe there should be a private market solution to terrorism coverage, and maintained the industry is trying to come up with some answers for these policymakers.

The GAO report questions the effectiveness of relying upon the catastrophe bond market or tax-exempt reserving to enhance insurance capacity in the U.S. Catastrophe bonds are not widely accepted in the industry at this time, especially not for terrorism risks, the report found. Also, while some believe that tax-deductible reserves could enhance industry capacity, the report suggests they may not materially enhance capacity since the reserves may substitute for reinsurance.

The GAO compared how the U.S. deals with insuring catastrophes with how several European countries do. It found that European governments tend to be more involved in assisting the private insurance industry to meet the capacity needs of natural catastrophes and terrorism than is the case in the U.S.

France, Spain, and to some extent Switzerland (but not Germany, United Kingdom and Italy) have adopted national programs to address a range of natural catastrophe risk, whereas the U.S. government does not have a comparable program except for its flood program. These six countries all use their tax codes to encourage insurers to establish reserves for potential catastrophic events.

Spain, Germany, France and the United Kingdom each has some form of national public insurance program that works with the private sector to provide terrorism coverage, similar to the Terrorism Risk Insurance Act, or TRIA, in the U.S.

But TRIA is a temporary program that some policymakers want to be closed down if and when a private market for terrorism insurance is established, whereas the European programs are generally considered long-term.

The report discusses what might be benefits and drawbacks to the various European approaches. Spain and France, for example, mandate national programs for natural catastrophe risk as well as for terrorism risk to help ensure that coverage is widely available and accessible in the event of a catastrophe or an attack. However, this requires “significant government intervention in insurance markets, such as setting premium rates, which may not be actuarially based. Consequently, the capability of governments and insurers to control risk-taking by policyholders and minimize potential government liabilities may be limited, although some governments have tried to minimize this liability by implementing loss prevention programs.”

In contrast, according to the GAO, the purely voluntary national terrorism program in Germany and the private sector approaches in Switzerland and Italy have not yet been successful in ensuring that policyholders have terrorism coverage. Many policyholders choose not to purchase terrorism coverage because they view their risks as acceptably low or the premiums for terrorism coverage as too high, similar to the experience in the U.S. under TRIA.

In an appendix focusing on TRIA, the report concludes that TRIA has “limited insurers’ financial exposure to terrorism risk but a significant portion of catastrophic risk goes uncovered.”

Under TRIA, primary insurers are required to make terrorism coverage available to all commercial risks. In 2005, they are responsible for losses from a terrorist attack up to 15 percent of their direct earned premiums and then another 10 percent above that amount, while the federal government is supposed to cover the remaining 90 percent.

TRIA does not apply to reinsurers. But the report reiterates an earlier finding that “reinsurers have cautiously reentered the market for terrorism insurance” and are offering coverage up to the limits of primary carriers’ exposure under TRIA. However, the report further notes, very few primary carriers appear to be buying this reinsurance because many of their customers choose not to buy terrorism insurance or the carriers consider it too expensive.

Without TRIA, the report suggests, reinsurers may not return to the terrorism market. Reinsurers claim that they cannot estimate potential losses without a pricing model that can estimate both the frequency and severity of terrorist attacks, something current models cannot do in part because they lack sufficient historical data.

The report cites industry surveys indicating that only from 10 percent to 30 percent of commercial policyholders are purchasing terrorism coverage. Some industry experts believe that the buying patterns reflect adverse selection, where those most at risk in urban or other high-risk locations are the only ones buying coverage.

“The potential negative effects of low purchase rates would become evident only in the aftermath of a terrorist attack and could include more difficult economic recovery for affected businesses without terrorism coverage,” the report says.

The same type of adverse selection occurs in the sales of earthquake and flood insurance because coverage is mostly voluntary in the U.S., according to the report. In Florida, where insurers and mortgage lenders require property owners to buy wind protection, most homeowners and businesses have wind coverage.