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A constant refrain from opponents of tax cuts is that the federal budget surplus should be "invested" in programs such as Social Security, Medicare, and education. Planning responsibly for the future, they insist, requires that government spend the surplus rather than return it to the taxpayers. But when it comes to planning for natural disasters, Washington has developed a policy whose costs are so prohibitive that the private sector cannot even attempt prudent planning for the future.
A constant refrain from opponents of tax cuts is that the federal budget surplus should be "invested" in programs such as Social Security, Medicare, and education. Planning responsibly for the future, they insist, requires that government spend the surplus rather than return it to the taxpayers. But when it comes to planning for natural disasters, Washington has developed a policy whose costs are so prohibitive that the private sector cannot even attempt prudent planning for the future. The federal government should join other economically advanced countries in lifting taxes on money set aside by insurance companies to pay for catastrophic losses.
The present danger. As this is being written, Hurricane Floyd is bearing down on the Florida coast. One hopes—as one always hopes on such occasions—that the toll in human misery will be minimal. But soon enough, a natural disaster will occur somewhere in the United States that will cause property damage on a scale that is barely imaginable. Indeed, major earthquake fault lines run not only the length of California, but through large, populous sections of the Midwest as well. Southern Florida’s population has roughly tripled since 1960, and the total number of people living along the Gulf and Atlantic coasts has increased by more than 50 percent. These areas, always highly susceptible to windstorms and flooding, have lately become more so. Hurricane damage for the 1990s is already 30 percent higher than for the 1970s and ’80s combined. Hurricane Andrew, which struck Southern Florida in 1992, caused $15 billion in losses and drove several insurers into insolvency. Still, the insurance industry as whole managed to absorb the losses caused by Andrew, and in the end most insurance claims were paid.
With the transformation of insurance regulation over the last several decades, the government itself has become a major threat to insurer solvency.
Had Andrew drifted 40 miles north to Miami, the story would have been different. According to the National Center for Atmospheric Research, the last major hurricane to hit Miami, in 1926, caused about $1.4 billion worth of damage (adjusted for inflation). Experts say that Andrew would have caused insured losses of $50 billion or more, leaving the Florida economy crippled and up to 36 percent of all insurers insolvent. Even the largest companies would be hard put to cope with losses of that magnitude.
Property-casualty insurance is regulated primarily by the states, although the federal government possesses regulatory authority over the insurance market, which it has exercised on several occasions. The fundamental tension between government regulators and the insurance industry boils down to this: While the state and federal governments seek to maintain the availability of catastrophe insurance at a price that homeowners can afford, insurers must increase their prices for catastrophe insurance and reduce their exposure to risk in order to remain profitable and solvent in the event of a major catastrophe. This conflict has led members of Congress to introduce legislation establishing a supplemental federal catastrophe reinsurance mechanism. Meanwhile, regulators and legislators in high-risk states have responded to the current crisis by restricting insurers’ ability to increase rates, and thwarted their attempts to reduce their exposure to loss in catastrophe-prone regions. To the extent that such an approach temporarily ensures the availability of catastrophe insurance at affordable prices, it will yield short-term political gains for government officials. But over the long run, price controls and coverage mandates will distort the market and exacerbate the catastrophe risk problem.
Counterproductive taxation. Rather than coercing insurers through the stick of regulation, government could play a far more constructive role by offering insurers and their customers the carrot of tax relief. As matters stand now, federal tax policy discourages insurers from setting aside large reserves for disaster-related claims. In a disaster insurance contract, insured policyholders entrust their premium dollars to an insurance carrier for safekeeping until those funds are needed to compensate a loss. But federal tax policy treats those premium dollars as income for insurance companies, to be taxed like any other form of corporate income. The funds that policyholders have prudently earmarked to manage their catastrophe risk are thus taxed twice—first as the policyholder’s personal income and again as insurance company "profits." In addition to being unfair to disaster insurance policyholders, this use of the taxing authority severely limits the degree to which disaster insurance is able to manage the risk associated with large-scale catastrophes. The tax burden on an insurer that accumulates funds sufficient to cover claims resulting from a mega-catastrophe would simply be too great.
The Policyholder Disaster Protection Act. Since most insurers naturally want to avoid insolvency, common sense suggests that they would voluntarily increase their catastrophic reserves if they were not forced to pay taxes on funds earmarked for major catastrophic losses. A bill introduced in the House of Representatives shortly before Congress adjourned for its August recess provides just such an incentive. The "Policyholder Disaster Protection Act," sponsored by Rep. Mark Foley (R-Fla.) with bipartisan support, would allow insurers to set aside portions of policyholder premiums in a tax-deferred disaster protection fund. Each insurer would accumulate a reserve in accordance with its needs, but would be subject to a maximum or "cap" tailored to the specific exposure of that insurer. Income on the funds would remain in the reserve on a tax-sheltered basis until the cap is reached. The reserve could then be used to offset losses attributable to certain specified perils, whenever total losses exceed a predetermined threshold or "trigger."
Once upon a time, the primary goal of insurance regulation was to maintain insurer solvency. Nowadays, insurance regulation intrudes into areas—controlling prices and mandating coverages, for example—that would be unthinkable in most other sectors of our market economy. With the transformation of insurance regulation over the last several decades, the government itself has become a major threat to insurer solvency. One way to fix that is to exempt policyholder premiums from the punishing effect of federal taxation.