Public Policy Analysis & Opinion
By Kevin P. Hennosy
WHAT IF WE SPREAD THE RISK OF FINANCIAL LOSS?
A federal reinsurance backstop is a centrist approach that could address several coverage problems
About 115 years ago, the United States constructed a central banking function that we know today as the Federal Reserve System, or “The Fed.” Policymakers with responsibility for the insurance sector could learn from the history that led to the formation of The Fed.
Before creation of The Fed, the U.S. economy suffered repeated and severe economic contractions triggered by financial market panics. Relatively small financial losses following the collapse of a single firm could shake the confidence of investors and speculators, which triggered panics in financial markets.
Could the TRIA backstop provide a model for spreading catastrophic risk on a national scale? Could a federal insurance backstop serve as a “reinsurer of last resort”?
The resulting panic would restrict capital formation for vast sectors of the economy far beyond the importance of the first firm to collapse. The failure of the Ohio Life Insurance and Trust Company triggered the panic of 1857. The panics of 1873 and 1893 resulted in broad-based economic contractions, and both were known as “The Great Depression” until commentators applied the same name to the 1929 contraction.
Financiers understood that an infusion of funds after a catastrophic event could preserve confidence in markets and forestall an economic collapse. The financial sector labored for decades to police those panics through the rapid response of private “pools” of money, which amounted to impromptu insurance mechanisms.
In 1890, the most famous of these organized pools was established after the failure of the brokerage firm Decker, Howell and Company. That failure raised concern over the solidity of The Bank of North America, which suffered a run on its accounts that threatened the bank’s service to large commercial clients. To address the growing panic, the banker J. P. Morgan organized a group of eight banks to create a pool of money to invest in The Bank of North America. Morgan marched across the floor of the New York Stock Exchange brandishing buy orders to catch the attention of the panicked market. The Morgan Pool’s actions restored confidence in the threatened bank, and that, in turn, restored confidence in capital markets.
Yet as the economy grew, it quickly became more difficult for any financier or allied group of financiers to organize a pool of money fast enough or large enough to restore market confidence.
In 1907, a possible attempt to corner the copper market by F. Augustus Heinze and Charles Morse triggered a run on the banks with which they did business. A run on the Knickerbocker Trust Company ensued when newspapers reported that the bank’s president was a friend of Morse.
Again, financiers looked to J. P. Morgan for leadership and his ability to organize assets. At first Morgan refused to provide support. Then he asked for a review of the Knickerbocker’s books, which could not provide a definitive statement on its condition. Morgan again withheld support, and the run spread to other banks.
The disruption in the banking sector began to affect stock market operations, which relied on short-term loans from private banks.
Morgan changed his mind about intervention when the run spread to the Trust Company of America. He organized his financial support with that of the member banks of the New York Clearing House, but the bank run continued.
Morgan then organized capital to lend on the floor of the New York Stock Exchange to ensure that the stock market did not freeze and fail. Morgan’s actions worked; the financier’s biographer Ron Chernow, however, notes that Morgan realized how close he came to failure.
The economy was just too large for one man to garner countercyclical funds to calm a panic or restore liquidity. As financiers and policymakers realized this, the long-resisted calls for an American central bank grew louder. The banking sector needed a “lender of last resort.” In December 1913, President Woodrow Wilson signed the enabling act, which created The Fed.
The creation of The Fed was a centrist endeavor. Congress rejected a proposal to convene a private cartel of large banks empowered to self-regulate their sector. At the same time, Congress rejected progressive calls to establish a fully public system of banking and currency.
The American insurance sector would benefit from a catastrophe insurance mechanism such as The Fed serves for the banking sector. Such a mechanism would not replace the private sector but would spread the risk of extraordinary financial losses that insurers and reinsurers avoid today.
This is not a new concept. For example, since November 26, 2002, the Terrorism Risk Insurance Act (TRIA) has provided a financial backstop to the private insurance sector for claims arising from certified acts of terrorism. Insurance carriers and allied professionals welcomed TRIA as a means to transfer and spread the risk of financial loss across the American population.
Of course, terrorism is not the only source of risk that generates claims that private insurers deem “uninsurable” without a backstop. Think of examples related to catastrophic weather, earthquakes, pandemics, and even healthcare. Each of those catastrophic perils presents the risk of massive losses that carriers and reinsurers recognize as too heavy to bear.
The concept of a federal reinsurance facility first came to my mind during the chaos of the solvency crises of the late 1980s and early 1990s. In 2002, as a consumer advocate at the National Association of Insurance Commissioners (NAIC), I supported the TRIA proposal for addressing terrorism risk when most consumer groups opposed it. When Hurricane Katrina forced local governments to order business closures, and those businesses received denials of coverage under business interruption insurance, I once again thought about the TRIA model.
Could the TRIA backstop provide a model for spreading catastrophic risk on a national scale? Could a federal insurance backstop serve as a “reinsurer of last resort”? TRIA is not a perfect fit, but why not use it as a starting point for discussion?
Other proposals for a federal reinsurance backstop receive serious consideration from policymakers.
On May 7, 2020, Colorado insurance commissioner Michael Conway sent a letter to his state’s congressional delegation “to establish a federal reinsurance program and provide more financial assistance to those receiving tax credits in the individual market.”
While Commissioner Conway does not base his suggestions on the TRIA model, he makes clear that state reinsurance programs can improve with the addition of a federal reinsurance facility.
The commissioner emphasized that the Colorado domestic market is “stable” and that insurers benefit from a state reinsurance pool; he added, however, that a federal reinsurance program would improve the system:
A federal reinsurance program can help provide funding to the twelve states that currently have their own reinsurance programs. A federal reinsurance program should also provide funding for the remaining thirty-eight states, as well as the territories, to establish their own reinsurance programs or have the federal government run a reinsurance program for them.
Throughout his letter, Commissioner Conway made clear that now is the time to act because of the COVID-19pandemic. The Commissioner continued:
As state budgets are impacted by the pandemic, federal funding to help support and establish reinsurance programs will allow states to prioritize other vital areas that need relief while utilizing federal funds for our reinsurance programs. That will become even more important as more people begin to turn to the individual market if they lose their employer-based coverage during this economic downturn.
Individuals, businesses, and the economy as a whole all suffer from the lack of countercyclical revenue in the aftermath of financial loss. In many cases, a private sector insurance policy can provide those funds to facilitate economic recovery.
Yet insurance carriers and private reinsurers reject certain catastrophic risks through exclusions or restrictive policy language. When those exclusions and restrictions prove effective, the risk of financial loss does not disappear. Customers still suffer loss, and recovery from those losses slows. Individuals suffer hardship and bankruptcy, businesses close, and the economy fails to rebound.
In addition, customers begin to lose confidence in insurance products. Customers expect payment of their claims, and when an exclusion dashes that expectation, the customer’s confidence in the next insurance purchase diminishes.
Insurance is a business based on trust. When the insurance sector allows trust to diminish in order to deny coverage in the face of customer expectation, it brings to mind the old agricultural warning about the folly of “consuming your seed corn.”
If private sector insurers and reinsurers deem that they cannot support the risk of business interruption claims for the pandemic-driven, government-ordered business closures through “all-risk” commercial policies, why should that risk stay with the business owner? Why not use the TRIA model and transfer it to a federal reinsurance facility?
Certainly a federal reinsurance facility would not take all risks. Just as private reinsurers demand certain policy constructions from primary carriers, so could a federal reinsurance facility make demands of member carriers. The Fed requires certain public interest-oriented behaviors from member banks before granting them access to The Fed’s “Window”; a federal reinsurance facility could do the same.
Not all carriers may choose to become members of a federal reinsurance facility, but they will compete against member insurers that offer more comprehensive policies. From there, this centrist approach steps back and lets the market sort it out.
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.