GOVERNMENT INSURANCE

1. GOVERNMENT INSURANCE

2. What is it??

3. A tool through which governments compensate individuals or firms for losses from certain specified events • Eligible recipients are usually charged a fee, or premium, to participate • Participation is often mandatory • Government insurance programs can be operated directly by government agencies or indirectly with the aid of private insurers. • Whether directly or indirectly involved, government typically bears the financial responsibility for covering any claims that exceed the pool of resources assembled in the program

4. Defining Features of Government Insurance • The risk of suffering a potential financial loss, usually of a relatively large amount, is shifted from a single household or firm to a central organization ie. Government agency • The potential loss is transferred through a technique called risk pooling (next slide explains risk pooling) • The insured pay a small fee called a premium to the government insurance program. • In return, the insurer agrees to pay up to a pre-specified amount to the insured when the event causing the covered financial loss occurs and the insured submit a claim. • Up until this point, same features are share with private insurance… What differentiates government insurance from private insurance: • Because of certain unique powers of government, such as its ability to tax and compel participation in government programs, government insurance tends to be offered for risks against which private firms way be unwilling to insure (example flood insurance) • Private firms offer insurance to earn profits, insurance is often used by government to achieve other economic or social goals such as raising the income of certain constituents

5. What is risk pooling? • Shifting risk from one party to another (ex. From a car driver to a car insurer) • Risk pooling involves a group of individuals or firms agreeing to split losses when a particular event, such as a car crash occurs • The margin of error becomes smaller as the group sharing losses gets larger (So many people involved in the pool, chances are low that any one participant will suffer an extreme loss decreases after the participant enters into a risk).

6. Direct vs. Indirect Government Involvement • Direct Government: collects fees, managines the resulting resources, settles claims • Indirect Method: Government enlists private agents to carry out some of the basic tasks-risk collection, risk management, and claim settlement.

7. Relation to Key Tool Features • Directness-measures the extent to which the entity authorizing or inaugurating a program is involved in executing it. (When directly run, the gov’t designs the program and retains the powers that determine potential gov’t loss • Automacity-measures the extent to which a tool utilizes an existing administrative structure to produce its effects rather than having to create its own administrative apparatus • Coerciveness-Measures the extent to which a tool restricts individual or group behavior as opposed to merely encouraging or discouraging it.(Gov’t can reward those insured with subsidies, but can also punished the “undeserving” by reducing their financial benefit • Visibility-Measures the extent to which the resources devoted to a tool show up in the normal budget process (Insurance is one of the LEAST visible policy tool. Feds do not report claims on taxpayers until losses occur

8. Design Features • What will be insured?? What will not? Ex. U.S. Federal crop insurance covers damage from weather but not poor plowing. Also covers damage to wheat, but not lettuce… • How much loss protection to be offered? • The gov’t insurance program must cap the coverage supplied, but cap can change. US deposit example • Establishing if Losses are Shared • Theory that when an event happens the insured should bear some loss…Why? If the insured face a cost to make an insurance claim, they have an incentive to remain vigilant and avoid actions that increase the chance of making a claim. • Total amount of loss is capped by government. • Insured may have to pay a co pay or deductible

9. Design Features (cont.) • Who is eligible to participate? • Government insurance programs do not significantly restrict eligibility (Bank deposit example vs. lettuce grower) • Premiums vs. Cost • The essence of insurance is the transfer of a large potential loss in exchange for the payment of small premiums. Implicit is the notion that premiums will bear some reasonable relation to expected claims. • Government insurance often seeks to achieve social goals through the insurance tool. • The government can deliver subsidies to targeted groups by not charging the insured the amount needed to cover future claims. This undercharging represents a subsidy since no private firm would offer insurance at below market premiums.

10. Pattern of Tool Use • Government insurance usually provided at a very large scale • In the US, exposure is in the trillions! • Provision of insurance is restricted to a select group of risks • Included are risks that certain types of firms will go insolvent and the risk that certain natural or man-made disasters will damage property (Usually provided by National Government rather than state) • Trends-government insurance programs are large and continue to grow. Two biggest programs insure depositors and second protects households and businesses against a variety of natural disasters. • Government who is insuring is exposed to possible huge loss

11. Firm Insolvency • Two Types • 1) Insurance for depositors against the failure of their financial intermediaries, including commercial banks, firms that specialize in housing finance such as thrifts, and cooperative intermediaries such as credit unions. (100K guarantee to depositors) • 2) Insurance for pensioners against the insolvency of the firm that had promised them pension benefits. (When a firm terminates a pension plan that has assets insufficient to cover its liabilities, the federal pension insurer becomes the plan’s trustee, takes over plan assets, and pays the pension to plan participants

12. Natural and Man-Made Disaster Insurance: Two Types • 1) Crop Insurance-protects agricultural producers against losses from low yield and crop quality due to adverse weather and unavoidable damage fro insects and disease • 2) Natural Disaster (Flood Insurance)--covers losses to property from floods

13. U.S. State and Local and International Government Insurance • U.S. State governments provide insurance against failure of a financial firm. • International--hard to generalize other countries’ programs, but they generally mirror that of the United States

14. Insurance Program Mechanics Writing the Insurance Contract/Rules • First, policymakers establish the general rules on risks to be covered, eligibility, forms of risk sharing etc. when designing insurance program. • These features cannot remain ambiguous because insurance programs are legally enforced. • The contract and program rules allow the insured/insurer to understand what is expected of each other. • Hence, language is important. Legal staff is involved, administrative procedures, etc

15. Pricing • Premium rates may be the most important factor • (An insurance program cannot finance itself unless assessments charged equal expected costs) • Pricing influences those insured--A lower than appropriate premium may encourage the insured to take on too much risk • Traditionally, government insurance programs charge flat rate premiums • Even today, most U.S. insurance programs still rely on flat rate premiums in order to subsidize the insured • In extreme cases, state insurance programs do not charge premiums but try to raise revenue as needed • Some government insurance programs have taken steps to price factoring risk-based premiums

16. Distribution • Used when gov’t insurance programs must sell their products • When insurance is voluntary, selling method is the same as established by private firms • Gov’t crop and flood insurance rely on private companies to distribute product • Private firms also answer questions based on policies, etc for gov’t • With increased technology, many alternatives for private insurers to offer products--(ex. Call centers and internet) • Government must verify that third parties who sell their insurance do not violate industry and legal guidelines

17. Underwriting: Will insurance be offered and in what form? • At some point, the insurer must apply its contract and pricing schedule to a particular firm or household • Programs that use the private sector provide detailed guidance about how to apply the policies and procedures of the program • Nonetheless, underwriters must use subjective judgment--It would cost government too much money if they second-guessed each decision of private agents • Some practices may include screening, credit reports to get client info

18. Administration of Insurance, Investing Premiums, and Reviewing Claims • Administration aka “back office” functions--management inflow and outflow of info and funds • Examples are accounting, customer service, premium collection, disbursement of claims premiums • Investing Premiums- Government insurance programs must determine how they invest the funds they receive • Unlike private companies, government can invest in its own debt because of its ability to tax and thus raise funds to pay off insurance claims if they exceed collections in any given year • Reviewing claims- Must determine the validity of claims and the amount the insurer owes the insured party (Called claims adjustment) • This can be done by private entities or government • Monitoring and Response- must be reviewed in case insurance for particular households or groups changes over time • Finally, managing capital is important--How much $$ to hold? Insurer must have enough money on hand to pay claims

19. Tool Selection • Three major reasons why governments establish and manage insurance programs 1) to overcome market failures 2) to achieve broader social goals such as the prevention of banking panics 3) to Foster favor with influential interest groups

20. Market Failure Rationale • Basic premise of insurance is that a number of people who are in the same pool will not submit a claim at the same time as others in the pool • If many in the same pool all submit claims, risk for the insurer could be catastrophic • Examples of this: In the event of flood, earthquake, crop failure • If this does happen, government can borrow $ that they can repay by means of taxes • Government can also force participation which will diversify the time of a disaster or loss • Some factors that are uncontrollable (moral hazards). Ex: if a family builds a house closer to a river despite flooding threat

21. Broader Goals • Ultimate goal for government insurance is the potential to serve a larger societal goal • Ex of Deposit Insurance- Banks cannot sell their assets quickly enough to pay off all depositors at the same time. Banking panic can cause mass public hysteria. • Governments also justify insurance as being a cheaper method of providing government services than alternative tools. (It is cheaper for government to charge premiums than provide after-the-fact insurance when a disaster occurs such as flooding). Providing insurance allows government to make rules and restrictions for those insured, ex building codes, etc • Government insurance can lead to “good of the nation”. If private ships, airplanes are insured, they are more prone to government use in wartime efforts

22. Political Rationale • Several attributes that make gov’t insurance popular for elected officials and beneficiaries • Indirect nature of some government programs can provide benefits to policymakers. • Low visibility- The public budget and the budget process put a spotlight on the costs of many tools of government. • Costs of the program show up in the budget when the government makes a payment to the firm or a person submitting a claim. • The premiums show up in the budget when paid • Policymakers can find this attractive as it appears that the program is a moneymaker • Self-Financing- The insured pay the government a nominal amount for insurance provided makes this tool attractive to policymakers. NFIP example page 206 in Salomon. • Political Benefits of Indirect Government- benefits to other stakeholders in the political process-ex: private insurance firms in distribution and adjustment creates money and business • Local governments benefit and support government insurance- Ex, the flood insurance program provides subsidies to some property owners in flood plains, encouraging development and property tax revenue

23. Providing Insurance in an Environment of Correlated Losses, Adverse Selection, and Moral Hazard • Virtually all government insurance programs have the problem of correlated losses exposing the insurer to very large losses • If this happens, it can be hard to set a fair premium if losses occur in bunches • Moral Hazards… • The insurer can share losses through caps, deductibles, copayments • The insurer can refuse to cover certain claims that occur due to certain actions- ex of a beneficiary killing insured for policy money • Insurer can sharply raise premiums after a claim

24. Other Management Challenges • Lack of Demand--Flood and crop insurance are voluntary purchases to some degree • Participation rates for both have been below desired levels • Also, those targeted for government insurance traditionally have received federal support even without purchasing insurance. • Ex. Disaster insurance limited the incentive for agricultural producers to purchase insurance • Individuals also convert the low chance of loss from disasters to zero loss • Government has combated this by marketing efforts to show loss from floods, etc • Lack of Data- It is hard to predict the likelihood of a disaster • In addition, there will be no information on how the provision of insurance will make future results different from past results • Challenges on Third Party Provision- It is hard for government to rely on third parties to “do the right thing,” and support the reason the program was started • Ex.- Reimbursement rates. Crop insurance program reimbursement is based on premium income. This gives companies incentive to sell to large firms, leaving out small “mom and pop” farmers

25. Providing Insurance in a Public-Sector Environment • Responsiveness-Insurance programs require frequent modifications to keep losses within desired ranges • Elected bodies are not often capable of making timely decisions to keep program in decent fiscal shape • Personnel--Government insurance programs require personnel with analytical, back-office, and distribution skills. • Private pays more-This could make it hard for government to find and retain employees

26. Overall Assessment • Mixed Results • Many social and larger economic goals achieved • However, many managerial and political challenges • Many success stories- protects households and firms from financial loss • Examples of flood insurance and depositor insurance • However, these may be viewed differently. If a household or firm suffers a loss, the loss gets transferred to the government. In turn, government must pay for these losses and charge others in society • Under pricing could lead to excessive risk taking. Example of crop planting in areas than cannot support plant growth • Some analyses suggest that government insurance programs have led to societal losses. Losses could exceed benefits

27. Efficiency, equity, and Legitimacy • Efficiency--the ability of insurance to act as the lowest-cost method for achieving goals remains an open question • Equity--A government can structure the program to target those most deserving • The often indirect method by which governments provide subsidies through insurance is inconsistent with efforts to target benefits to the deserving as traditionally defined. • Such is the case with the farmer that plants high risk crops. • Legitimacy--Government insurance programs are typically rare in the U.S. and abroad, although the scope of the few programs that exist is large. The fact that the insured pay premiums help clarify legitimacy (vs. grant programs)

28. Real Life Example Floodsmart.gov Floodsmart.gov: frequently asked questions