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U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.

    The committee met, pursuant to call, at 9:30 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.

    Present: Chairman Leach; Representatives McCollum, Roukema, Lazio, Kelly, Weldon, Cook, Hill, LaFalce, Vento, Kanjorski, Kennedy, C. Maloney of New York, Roybal-Allard, Barrett, Watt, Bentsen, Kilpatrick, J. Maloney of Connecticut, Hooley, Weygand, and Sherman.

    Chairman LEACH. The hearing will come to order.

    The committee meets today to hear testimony on H.R. 219, the Homeowners' Insurance Availability Act of 1997, which was introduced by Housing Subcommittee Chairman Rick Lazio. The Housing Subcommittee reported the bill on February 4, 1998, with bipartisan support.

    The legislation, along with that of a similar proposal of Committee Vice Chairman Bill McCollum, highlights a growing problem in some States where homeowners' insurance has become difficult, if not impossible, to obtain at affordable rates.

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    For example, after the 1994 Northridge Earthquake in California, 95 percent of the homeowners' insurance markets shut down. In 1992, Hurricane Andrew in Southeast Florida cost $33 billion and, according to the Florida Department of Insurance, created an environment where cancellations of homeowners' policies and retreat from the State by insurance companies were at hand.

    Moreover, a 1996 study indicated that the number of insurance underwriters dropped within the last ten years by 31 percent in Florida, 29 percent in Texas, 23 percent in California and 15 percent in Pennsylvania. These conditions precipitated the creation of State insurance programs to meet the gap between homeowners' and participating insurers. Despite withdrawals from the insurance market, the property casualty industry nearly doubled its capital and surplus since 1992 and experienced record market profits in 1997.

    While there may be competing philosophical views regarding the nature and role of the Federal Government, all parties would agree that the problem of insurance availability in disaster-prone areas is real and is worthy of congressional attention.

    Traditionally, the issue of natural disaster assistance has been under the purview of another committee that primarily focused on the Stafford Disaster Assistance Act, mitigation of natural hazards through building and zoning code enforcement, as well as Federal incentives to expand capital in the reinsurance capital markets.

    The Banking Committee's interest centers on the fundamental question of whether there is an appropriate Federal role in intervention in capital markets to ensure the availability and affordability of homeowners' insurance in disaster-prone areas, while at the same time meeting actuarial standards that avoid the creation of imprudential Federal contingent liabilities.
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    The Housing Subcommittee held two hearings on this issue, and Mr. Lazio, Mr. McCollum and I have had many conversations with both Secretary Rubin and Secretary Summers, who have committed to working with the committee in perfecting the legislation before we move to a full committee markup.

    In addition to Mr. Summers, a broad spectrum of witnesses representing every sector and voice interested in this legislation will be before us today. I am hopeful that following this hearing, the committee will produce a bill that ensures an open market for homeowners' insurance while at the same time protecting the Federal Government from unreasonable financial exposure. I believe the subcommittee reported bill is a viable foundation and worthy of the full committee's consideration.

    Mr. LaFalce, the Democratic Ranking Member, is recognized for opening remarks.

    Mr. LAFALCE. Thank you very much, Mr. Chairman. I am very, very pleased that you are bringing this important issue to the attention of the full committee. I believe the Federal Government could play an appropriate role in helping consumers access affordable disaster insurance, but when the Federal Government should be involved in an effort and how the Federal Government should be involved are key questions we need to really deliberate about.

    I am concerned, though, that few Members might have the time to sit through five panels, and that is what we have before us today. As for those who are able to stay for the duration of five panels, I am concerned that they might hear repetitive answers from a number of the witnesses today. I am not sure the panels are as balanced as they could be.
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    For example, I would like to hear from some official from the State of New York or another State that has conducted studies of the market of disaster insurance and made a determination that creation of a specialized pool to diversify risk is unnecessary. I think that perspective might have been helpful. And I would also like to have heard from witnesses from Consumers Union and the Consumer Law Center who have also studied this issue.

    The only consumer witness, I believe, who is appearing today is on the fifth panel, and I don't know how many Members we will have at that time. Key witnesses who can explain private market alternatives to the approach taken in the nature of H.R. 219, Mr. Nutter of the reinsurance industry and Mr. Lewis of Ernst & Young, will not be appearing until the fourth panel.

    Having said that, I do want to say how much I look forward to hearing from all the witnesses and then especially the Treasury Department today. They have given considerable thought to the appropriate Federal role in providing disaster insurance, and I agree with much of their written testimony. The committee should be looking very closely at how we can support the existing disaster insurance market, including the reinsurance industry, in capital markets.

    Whatever we do, we must take every precaution not to replace the existing market participants, and instead we must determine how we can foster growth within the market. In addition, we must sunset the Federal program when the private market can cover the losses associated with the 1-in-100 year event. In addition, we must determine how we may inject the Federal Government in the market without exposing a national risk and the undue risk of loss.

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    I also look forward to the testimony at the end of the day from the Consumer Federation of America, which can assist us in developing a Federal program that guarantees that more consumers will have access to affordable disaster insurance. Likewise, I am interested in whether the Federation believes the bill goes far enough in directing States to set aside funds for mitigation programs.

    Mr. Chairman, again I want to thank you very much for convening this hearing to help shed light on this very important topic, and I look forward to hearing from all the distinguished witnesses before us. Thank you.

    Chairman LEACH. Thank you, Mr. LaFalce.

    Mr. McCollum.

    Mr. MCCOLLUM. Thank you very much, Mr. Chairman. I want to thank you for holding this hearing today, as well, and I want to compliment my good friend Mr. Lazio for bringing this bill forward, H.R. 219, today. I, as you may know, introduced a companion bill, H.R. 230, and have sponsored Mr. Lazio's bill as well.

    The bottom line is we do have 1-in-100 year events that occur in catastrophic cases involving hurricanes, earthquakes and so forth, and we have no way of dealing with that in terms of the insurance structure of the Nation. Reinsurance, while available on a limited basis, is not there for the companies that have exposure for these catastrophic events. You just simply can't buy it today. And not having reinsurance for very large losses that are potentially out there is driving up the cost of homeowners' insurance policies in my State and elsewhere.
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    In addition to that, there is a question of whether or not there will be sufficient available insurance in States like California, Florida, and many others that are exposed to these kinds of large events. If at some point in time a couple of these storms come through or the big earthquake, the big banana, hits that never has up the middle of the country through Missouri and Illinois and so forth, insurers are exposed to enormous risks and may well go further than they have already in attempting to remove themselves from those markets.

    So I think it is very important there be a reinsurance market. The private industry ideally would be providing that, and I agree with Mr. LaFalce that we ought to get to the point some day where we do have everything in the private market again. But for right now, what this hearing is about today is to help us, I think, find a method of dealing with how we go through the process of providing in the interim the reinsurance that is not there.

    The primary purpose of the bill that is before us today is to back up State catastrophic funds while introducing an auction component on a State-by-State basis. The question is, in part, whether the framework of the bill today that we are hearing is the exact right mix. Will the insurers fully participate in the auction market that is envisioned in those States which will conduct an auction market? Does there need to be an opportunity for a State where there is a catastrophic fund, more fully than perhaps is in the bill, or in some alternative way to provide auction opportunities for insurance companies themselves to buy in those States of Florida, Hawaii and California that already have the catastrophic funds? Are the excess-of-loss contracts appropriate? Will the trigger mechanisms be at the right level, what is the right level to trigger the payout of monies, and are there problems with the caps that we place on the amount of money the Federal Government would be supporting in terms of the losses above a certain trigger point?
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    This is not a simple matter in terms of technically how you do this, and I again commend Mr. Lazio and his subcommittee for bringing forth a product to try to get to this point today. And I hope today, Mr. Chairman, the witnesses we have will help us sort out the problems with the current legislative proposal, ways we can improve it, but most of all give us the insight into how we can move, finally, a bill that provides a final product to the desk of the President for signature for this Congress that will give us the relief that is necessary in the reinsurance market for homeowners' catastrophic events, such as windstorm and so forth.

    While I have the microphone, I would like to acknowledge the fact that three Floridians will be testifying at one point or another: Donald Dowdell, the Deputy General Counsel for the Department of Insurance from Florida; Rade Musulin of the Florida Farm Bureau Insurance Company; and Cathy Whatley on behalf of the National Association of Realtors.

    Mr. Chairman, I imagine this being submitted and admitted without a need for this, but I would like to ask unanimous consent for the statement of the American Insurance Association that is not appearing before us today, but they have asked their statement be admitted into the record, and I would like to ask it be done.

    Chairman LEACH. Without objection.

    Mr. MCCOLLUM. Thank you, Mr. Chairman.

    Chairman LEACH. Thank you for that very thoughtful statement.

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    Yes, please, go right ahead.

    Ms. ROYBAL-ALLARD. First of all, let me begin by commending the Chairman for holding this very timely and important hearing. It is certainly an issue that is extremely important to the State of California. And I would like to give a special acknowledgment to my California colleague, Mr. Fazio, who has really been a leader on the issue of disaster insurance, as well as to recognize Ms. Heimbuch, representing the Western League of Savings Institutions, and David Knowles, California's Chief Deputy Insurance Commissioner, who will be testifying later.

    Their attendance reinforces the critical need for Congress to address the issue of affordable and accessible disaster relief insurance in this country. In my home State of California, the Whittier, Loma Prieta and Northridge Earthquake caused billions of dollars of damage to uninsured property and many uninsured homeowners were unable to pay for the damages, especially the uninsured victims of the Northridge Earthquake. These borrowers were forced to abandon their homes, resulting in severe losses to lending institutions such as those belonging to the Western League of Savings, who were forced to foreclose on these abandoned homes.

    These earthquakes also caused billions of dollars of damage to insured property. These losses had a profound effect on our State's insurance market, and subsequently the availability of earthquake insurance to homeowners.

    In the wake of the Northridge Earthquake, California passed legislation that required insurance companies to offer earthquake insurance with their homeowners' insurance policy. The result was that many companies simply stopped selling homeowners' insurance to avoid losses that may be caused by future earthquakes.
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    In order to fill the void left by the insurance companies' departure, the State created the California Earthquake Authority. While this agency increased the availability of earthquake coverage, many of our State's residents are still unable to afford the exorbitant premiums and the high deductibles that are offered by the CEA.

    As we in California know, Congress must act to make disaster relief insurance both more affordable as well as accessible. I commend Mr. Lazio and Mr. Fazio for working so diligently to address this great problem. However, my chief concern in creating a Federal reinsurance program is that the risk and costs are not shifted to the Nation's families.

    Any piece of legislation should ensure that homeowners, including low- and moderate-income families, have access to affordable coverage. Federal policy should also ensure that all parties involved take a proactive approach to minimizing the effects of disasters before they occur. Therefore, strong pre-disaster mitigation measures should be included in any Federal legislation that Congress ultimately approves.

    And, finally, it is critical that we not only meet the needs of our residents, lenders and insurers, but that we find the appropriate balance for the involvement of the Federal Government.

    I feel confident that this committee, working in cooperation with the panelists and the consumer groups, will craft effective and meaningful legislation. I look forward to hearing from the panelists, and once again, Mr. Chairman, I would like to thank you for holding this hearing.
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    Chairman LEACH. Thank you, Ms. Roybal-Allard.

    Mr. Lazio, the distinguished introducer of this legislation.

    Mr. LAZIO. Thank you, Mr. Chairman. Let me begin by thanking you for your continued and sustained support for our efforts to provide homeowner insurance availability to some of the more vulnerable areas of our Nation. I know without your support we would not be at the point of considering a legislative solution this year.

    I also want to thank my good friend and colleague, Bill McCollum, for his work and dedication to the issues surrounding this legislation and, in general, natural disasters. Certainly his continued support has been critical in bringing this to the point where we are discussing some of the solutions today.

    The Homeowners' Insurance Availability Act of 1997, H.R. 219, is a bipartisan culmination of years of debate among the Congress, the Administration, the insurance industry and consumer groups on how best to provide protection for homeowners living in areas at risk of earthquakes and hurricanes. I also want to note that Mr. Fazio of California has been an ally and partner throughout this process, and the technical support, certainly over the last couple months, of Mr. Summers, and the support of Mr. Rubin has helped us arrive at this point.

    The first half of the 1990's left parts of the country devastated by natural disasters causing more than $30 billion in insured losses in California and Florida alone. During that time, the Federal Government spent more than $50 billion in natural disaster assistance across the country. Obviously not all of that would be mitigated with the approach contained in H.R. 219.
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    Testimony before the Housing Committee in this Congress warned that the East and Gulf Coasts of the United States are entering a prolonged period of more frequent and more destructive hurricane activity. Within the next ten years, almost 75 percent of our population will be living within 100 miles of a United States coastline. Experts are predicting it may only be a matter of time before a single storm causes $50 billion in damages.

    In this environment we find evidence of insufficient capacity to provide insurance to homeowners in these affected areas. Families living on both coasts, from New York to Washington State, and families living in earthquake-prone regions from Tennessee to Missouri, are facing the same problem. Many are finding it difficult, if not impossible, to obtain adequate insurance protection for their homes. We must ask ourselves one simple question: Should we wait unprepared for the inevitable and throw a crisis-driven solution in the wake of some massive catastrophe, or should we plan for our future now?

    Our proposal recognizes that there is indeed a potential crisis of homeowners' insurance availability in affected areas across the country. It recognizes that currently the private market is unable to provide the kind of protection consumers need in some of the country's most vulnerable areas.

    Should any solution at the Federal level be a surgical strike targeted to encourage and complement the existing industries? Absolutely. Should any Federal solution be temporary in nature, without intruding upon the private sector? Yes. Does our proposal strike an appropriate balance between the need for greater protection for homeowners and the belief that the most efficient and most effective solutions in the end reside in the private market? Yes, I believe it does.
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    But as we move forward, we should be careful to remember that our proposal is at heart not about the capital markets or the insurance industry. It is about unprotected families who without some relief risk losing what is oftentimes their greatest investment, their homes.

    Washington cannot and should not solve the problem directly. Insurance is best regulated at the State level where the unique needs of communities are better understood. Our proposal honors this principle. Where the industry and States are unable to absorb the very low-probability, high-cost disasters, the Federal Government has an appropriate role to play. And let me be clear: Under this proposal, qualified State programs and insurance companies that do business in those States must absorb 99 percent of the risk before Federal reinsurance would be forthcoming.

    In fact, this legislation as presently drafted would not have been triggered by either Hurricane Andrew or the California Northridge Earthquake because of the growing capacity of those two funds. But by providing an umbrella of Federal protection against the mega-catastrophe, our legislation gives the industry some assurances of continued solvency, thereby providing insurance companies greater ability and encouragement to protect against lower level risks.

    Mr. Chairman, I am hopeful that with your support and the continued input of the Administration, we will be able to move forward with legislation in the weeks to come before the beginning of the hurricane season. The worst case scenario would be to wait for the inevitable catastrophe to hit before we react, without having done our due diligence and having prepared ourselves, and having a structure in place to provide piece of mind both to the homeowners, most importantly, and also a comfort level to insurance companies to assure liquidity.
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    Let me again thank you for holding this hearing, and I look forward to today's testimony.

    Chairman LEACH. Mr. Watt.

    Mr. WATT. Thank you, Mr. Chairman. I will be brief because I would like to get to the witnesses.

    There are two assumptions that generally get made that I want to talk about in this context. Most people view me as the raving liberal, but on the Judiciary Committee I am actually known as the States' rights advocate, and I think more and more people are coming to learn that I am a strong believer in the market.

    Notwithstanding those two things, however, it has long been my belief that one of the areas that the Federal Government has an important role in is this area that we are least able to contemplate as the private insurers when acts of God occur, although insurance, I am sure, is about risk, is to some extent about assessment of risk that can be contemplated.

    So I believe there is a role for the Federal Government in this area. I am not sure that this is the bill or not, because I am not on the subcommittee that marked it up and I am not familiar with the provisions of the bill. But it is for that reason that I want to applaud the Chairman for conducting this hearing to give all of the Members of the Banking Committee the opportunity to understand more about this bill, and whether this is the particular bill that we should lobby behind or whether there is some other bill that might be more appropriate.
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    In that context, I am looking forward to hearing the testimony and getting to understand more about this bill and the arguments on both sides of this issue, so that we can try to address a problem that I think is incumbent on the Federal Government to address, because we are a United States and various different areas of the country can get hit without being able to contemplate the kinds of disasters that we are here to talk about.

    So I want to thank the Chairman for the hearing, and I yield back the balance of my time.

    Chairman LEACH. Thank you very much, Mr. Watt.

    Mrs. Kelly, would you like to make an opening statement? You are recognized.

    Mrs. KELLY. Thank you, Mr. Chairman. I would like to thank you, Chairman Leach, and Ranking Member LaFalce for calling today's hearing on disaster insurance.

    As a Member of the Subcommittee on Housing, I am familiar with the need for the Federal Government to step in at some high level of catastrophe when the private sector has reached its limit. Of course, that begs the question, what is that number, the limits of the private sector coverage.

    Today we have H.R. 219 before us. There are some real merits to the approach of H.R. 219 which I am sure we will explore in detail. We will also continue to take a very close look at and incorporate parts of my friend Mr. McCollum's legislation on the same issue, H.R. 230. Mr. McCollum's approach has a great deal of merit, and I hope that today we can continue to explore these ideas to make improvements to H.R. 219.
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    While disaster insurance is certainly a national issue we need to work on, I can't help always coming back to how this legislation would affect New York homeowners. In the past few months I have had some conversations with different New Yorkers and agencies to better understand their views. As Mr. LaFalce said, there are a number of agencies in New York that have done some studies. And to share these views with the committee, I ask unanimous consent to have the Temporary Panel on Homeowners' Insurance Coverage report to Governor Pataki dated February 1, 1998, made a part of the record.

    Chairman LEACH. Without objection, so ordered.

    Mrs. KELLY. Thank you, Mr. Chairman.

    I also ask unanimous consent to have a Study of Market Dynamics and Homeowners' Insurance Policy dated February 15, 1998, authored by the New York State Insurance Department, made a part of the record.

    Chairman LEACH. Without objection, so ordered.

    Mrs. KELLY. Thank you.

    These two reports have some very compelling conclusions, one being, the availability of homeowners' insurance in New York City, Westchester County and Long Island, including shoreline communities, has improved in the last two years. The conclusions of these very recent reports certainly have my attention, and I look forward to exploring these with our witnesses.
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    I want to thank all of the witnesses for joining us here today to share their views with us, and look forward to continuing to work with all of my colleagues from both sides of the aisle as we look to make improvements to this legislation. Thank you very much, and I yield back the balance of my time.

    Chairman LEACH. Well, thank you, Mrs. Kelly.

    Ms. Hooley.

    Ms. HOOLEY. Thank you, Mr. Chairman. I ask consent to enter my full statement into the record, and I will be very brief.

    Chairman LEACH. Without objection, so ordered.

    Ms. HOOLEY. First of all, I would like to start by stating my strong support for passing some kind of Federal legislation to increase the availability of homeowners' insurance in the United States. I represent an area in Oregon that is prone to natural disasters, and certainly have a great interest in passing a bill that would increase that accessibility and affordability for homeowners. I appreciate the willingness of the Chair to work with me to resolve a problem in my State, particularly by considering the inclusion of volcanic disasters as a peril covered by this legislation.

    I am aware that staff has been working with me on a reasonable solution, and I am hopeful the committee will decide to include coverage for volcanic disasters in the final version of the legislation. I look forward to continuing the conversation as we move closer to markup.
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    Today, however, I am anxious to hear from our distinguished witnesses as we proceed with a thorough examination of this legislation. While I have cautiously supported this legislation at this point, I intend to keep an open mind as we continue to work on a bill that is truly beneficial for Oregonians and all citizens who live in disaster-prone areas.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, Ms. Hooley.

    Mr. Cook, do you have an opening statement?

    Mr. COOK. No, thank you, Mr. Chairman.

    Chairman LEACH. Thank you.

    Ms. Kilpatrick.

    Ms. KILPATRICK. Mr. Chairman, I would like permission to submit my written statement for the record.

    Chairman LEACH. Without objection.

    There being no other committee Members who have opening statements, I would like to invite the first panel to come to the table.
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    By way of introduction, first let me welcome you all. Mr. Fazio has long been involved in the efforts to reduce the costs of natural disasters and protect families at risk, and along with Mr. Lazio and Mr. McCollum, Mr. Fazio is an original cosponsor of the legislation under consideration today, and we welcome you.

    Representative Jo Ann Emerson has continued the efforts of her late husband to bring greater attention to the need for more affordable and more available homeowners' insurance for families who live in disaster-prone areas, and also is a cosponsor of the legislation before us, and we welcome you, Jo Ann.

    Mrs. EMERSON. Thank you.

    Chairman LEACH. Congresswoman Christian-Green has also been a very strong advocate of affordable disaster insurance, and next to the State of Iowa, she is representing one of the more beautiful States in the country. And your appearance before us is welcome. I think it is probably the first for several of you, and we welcome you before our committee.

    Vic, as a long time friend and colleague, as our senior Member present, why don't you begin?


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    Mr. FAZIO. Thank you, Mr. Chairman. I want to thank you and Mr. LaFalce and the other Members of the committee for holding this hearing on H.R. 219, the Homeowners' Insurance Availability Act, and as I look at the list of Members of this panel, it is pretty evident that this committee has made a very serious commitment to focus on the issues of natural disasters by involving representatives from the Administration, several States, and affected industries.

    I particularly want to pay a tribute to Rick Lazio and to Bill McCollum, who have really worked with us to make this a bipartisan bill. It isn't obviously anything but a regional bill in the minds of some people. I think it is truly a national bill, one that really needs to be looked at by all Members as an important contribution to the public safety of the citizens of this Nation.

    It really means a lot to me to be here with Jo Ann because I inherited my cosponsorship from Norm Mineta and Bill Emerson, who took the lead on this over a number of years. And I have been to Donna Christian-Green's district and I have seen the devastation that hurricanes bring, and it is appropriate that we have a cross-section of people here at this time.

    The most earthquake-prone regions of the country are not just California, but as Darlene said, the Northwest, and as Jo Ann's presence indicates, the Tennessee Valley. We have a tremendous potential threat all across the country.

    I want to acknowledge and thank Deputy Treasury Secretary Larry Summers for his willingness to engage in an open-ended dialogue with the Congress and the industry as well. The Administration faces the challenge of dealing with many complex issues relating to natural disasters. Dealing with extreme financial challenges that come with each crisis is one of the most critical. Deputy Secretary Summers has honored this responsibility throughout these discussions, and I know that the minute details of the legislation will continue to be refined here today and in the future.
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    But I would like to offer my support for a Federal insurance backstop for natural disasters from a more specific point of view, and that is as a Member from a district in northern California. Our State has experienced more than its fair share of disasters. The Northridge and Loma Prieta earthquakes are of recent memory. The floods that have ravaged my district in 1995 and 1997 are just a few. This year's El Nino season has brought southern California a significant hit as well.

    And although this bill would not deal specifically with floods, its attention to providing homeowners access to affordable insurance so that they are covered in the event of hurricanes and earthquakes is a positive first step toward addressing the enormous problem of dealing with natural disasters, disasters that, as recent tragic events in Alabama, Georgia and Tennessee have shown us, have become an increasingly harsh reality.

    By law, insurance companies in California also are required to offer earthquake insurance. After paying for the huge number of claims that resulted from the Northridge Earthquake in 1994, insurers became increasingly concerned that another earthquake would exhaust their available resources. This concern has prompted many companies to stop selling homeowners' insurance. Many began notifying existing policyholders their insurance would not be renewed. The situation in our State was mirrored in other States with a high occurrence of natural disasters.

    In disaster-prone areas throughout the country, 93 percent of companies that write homeowners' insurance have stopped selling new policies because of the risk of insolvency in their areas. Far too often those who are affected the most by this retreat of insurers are residents in the most at-risk communities who have lost access to homeowners' insurance for disasters.
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    The California Earthquake Authority was created by our legislature in 1996 to resolve the crisis. It represents an effective partnership between the State government and the private sector. It is administered by a five-person board comprised of elected officials. The funds available to pay claims come from premiums paid to insurance companies and reinsurance purchased by the CEA. No public money, including funds from the State's general fund, is pledged to cover losses incurred by the CEA policyholders.

    Their policies are sold through private insurance agents, and policyholders must purchase earthquake insurance from the company that carries their regular property insurance. The CEA has a $10 billion claims-paying capacity. However, if we experience a disaster and residential damage exceeds $10 billion, consumer claims could not be paid in full and residents would receive pennies on the dollar.

    State and Federal funds have been a traditional source of help for public agencies and individuals after earthquakes and other disasters. Over the last several years, as I am sure the committee knows, the Federal Government spent more than $50 billion in natural disaster assistance. We can do a lot better by enabling States such as mine, that have set up a mechanism to address this problem, to purchase reinsurance contracts from the Federal Government.

    In the event of a disaster exceeding the CEA's claim-paying capacity, the Federal backstop will prevent an enormous amount of funds from being expended from the general treasury. But I don't want to overemphasize that because, more importantly, it will ensure that homeowners' claims will be paid in full while promoting insurers to renew offering policies in high-risk areas and encouraging consumers to take steps to protect themselves by purchasing them.
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    Mr. Chairman, I will stop at this point because there is a lot more to be said, but I think the proactive approach of the Federal Government here in the long run will not only save us money but will do a great deal to serve the public interest that we are elected to provide for.

    I think the committee is clearly serious about this issue. I know it is complex, I know there have been at least superficially some divisions in the ranks, but I think this committee is capable of putting together a consensus bill that will spread the coverage across the country as States step up to the plate first themselves. I think it is a shared responsibility, and one I am happy to see this committee is willing to take up.

    Chairman LEACH. Thank you, Mr. Fazio.

    Mrs. Emerson.


    Mrs. EMERSON. Thank you, Mr. Chairman. Thank you for holding this hearing today. I am pleased to have the opportunity to follow-up on the previous testimony I gave before the Housing and Community Opportunities Subcommittee regarding H.R. 219.

    As I indicated to Members of that subcommittee, I am by no means a policy expert on the different proposals that have been introduced to address the decreasing availability of homeowners' insurance in disaster-prone areas. However, as a representative of a district that is highly disaster-prone, I am very much aware of the impact that disasters have on this country, its citizens and the communities, both large and small, in which they strike.
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    Missouri's 8th Congressional District faces a number of different natural disaster threats. The flood-prone Mississippi River comprises the entire eastern boundary of my 26-county district. A string of tornadoes recently ravaged close-lying neighborhood communities in southern Illinois, Tennessee and Arkansas. And perhaps most frightening of all, the entire east side of the district is located along an earthquake fault known as the New Madrid fault.

    During the winter of 1811 to 1812, an earthquake along this fault with aftershocks ranging between 8.0 and 8.6 devastated a very large region of the United States. Fortunately, at that time there were very few communities in the area and the loss of life was relatively low. Today, however, the area is populated with major urban areas like Memphis to the south and St. Louis to the north.

    The scary thing is, most credible scientists who study this fault line say there is a greater than 50 percent chance we will experience another major earthquake or catastrophic event in the next 50 years. The potential destruction of another New Madrid fault quake could easily total $100 billion, with thousands of lives lost.

    While natural disasters cannot be prevented, we can take steps to minimize the financial and physical damage they cause. As you all know, year after year after year after year, we in Congress have to consider legislation to provide supplemental appropriations for post-disaster assistance. Since 1983, disaster assistance has totaled or cost the taxpayers approximately $75 billion, of which nearly half has gone toward residential loss.

    In terms of homeowners' insurance, we know it has become harder to get adequate insurance coverage in some disaster-prone areas of the country. In the past, homeowners in my very rural district enjoyed low earthquake insurance rates. These policies are now beginning to reflect the real risk, and many insurance companies have substantially increased their rates or just refused to write it at all.
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    Just for example, and I am not complaining specifically about mine, but in the last year my homeowners' insurance has quadrupled in its yearly premium. I have heard from constituents who have made it clear that it is becoming increasingly difficult for them to afford appropriate insurance, particularly those who live on fixed incomes. I think it is time we take a responsible approach to getting a handle on the uncontrollable cost of natural disasters.

    As you all know, Bill worked very hard in the last Congress to move the issue forward and came very close. I want to thank you, Mr. Chairman, as well as my colleagues Mr. Lazio and McCollum, for also recognizing the importance of addressing the affordability and availability of homeowners' insurance for folks who live in high-risk areas. I am particularly pleased that you, Mr. Chairman, have seen the need to hold a full committee meeting, because this is the furthest step that has ever been taken on this type of legislation, and I sure hope that it represents an important signal that we will in fact take this legislation up in the 105th Congress.

    And I want to reiterate something my colleague from California said. I do think this is a national problem, and I realize those folks and those colleagues of ours who live in States that are not prone to disaster—I hope that they will understand the need for us to do something in a Federal way, certainly through the taxpayer supplemental appropriations bills that we have to come up with every year. The folks in their States are paying for natural disasters, so we need a national solution to this.

    But, again, Mr. Chairman, I want to thank you for allowing me to testify today. I pledge to do whatever I can to help you and all of our colleagues find a solution to this very critical problem. Thank you.
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    Chairman LEACH. Thank you, Mrs. Emerson.

    Ms. Christian-Green.


    Ms. CHRISTIAN-GREEN. I want to also thank you, Chairman Leach and Ranking Member LaFalce and Members of the Banking Committee, for holding this hearing and for the opportunity to testify in support of H.R. 219, legislation which, if enacted, would begin to address a problem that those of us from disaster-prone areas face, the lack of affordable disaster insurance.

    I want to take this opportunity also to thank Chairman Lazio and my friend, Vic Fazio, for the wisdom and bipartisan leadership you have shown in introducing H.R. 219 and moving it to this point today, and Mr. McCollum also for your leadership in this regard.

    While it is true H.R. 219 does not address all of the various concerns regarding lack of disaster insurance, it does, however, provide us with a good start. I am very proud, Mr. Chairman, to represent the people of, as you have said, one of the most beautiful places under the American flag, the U.S. Virgin Islands.

    We live in an area that has seen its share of violent hurricanes, two major storms within six years, and is threatened every year. Prior to 1989 we were spared for over 60 years of being hit by one of these storms. Then in September of 1989 Hurricane Hugo hit, with sustained winds in excess of 200 miles per hour. It was the worst disaster FEMA responded to until that point, and the islands were changed forever, as were many lives.
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    Devastation brought by the storm was astronomical, but if having to deal with recovering from a major disaster was not enough, the experience of Hurricane Hugo left the Virgin Islands with even a more ominous legacy. It almost completely wiped out the availability of affordable windstorm insurance in our Territory. Then, as if to add insult to injury, just as the islands were beginning to recover from the legacy of Hurricane Hugo, we were hit with a second devastating storm in September of 1995, Hurricane Marilyn.

    Mr. Chairman and colleagues, I experienced both of those hurricanes and I hope and pray I will never have to go through that experience again. I cannot begin to tell you, Mr. Chairman, the level of concern and anxiety Virgin Islanders feel today concerning the lack of affordable homeowners' insurance. It continues to be among the top two or three concerns raised to me by my constituents, many of whom could not qualify for needed SBA disaster loans to repair their storm-damaged homes because they could not afford the required insurance.

    Even though windstorm insurance is for the most part generally available on the Virgin Islands today, because of its prohibitive cost a huge segment of my constituents sadly remain uninsured and at the mercy of nature. Many of them believe or at least hope that since it was 60 years before we were affected by a major hurricane, it will be another 60 years before we will be hit by another storm of such magnitude. With more pressing and immediate needs, they are rolling the dice, using their scarce dollars elsewhere and not spending it on expensive windstorm insurance, in the hope that their 60-year bet will pay off.

    Mr. Chairman, we need H.R. 219 or a similar proposal so that the Virgin Islands and other similar disaster-prone areas can begin to address the problem of the lack of available disaster insurance. In recent years it seems as though our country faces some new disaster every day. Whether it was the floods of South Dakota last year, or recent El Nino-driven tornadoes in the South, or the interminable rains in the West, the cost to taxpayers in addressing these disasters is approaching a point of unaffordability, even for the Federal Government, where it is putting a serious strain on our budget.
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    This is an important issue, as has been said, not only to my constituents but to the entire country. That is why I pledge to work with you, Chairman Leach, Chairman Lazio, as well as my colleagues, Mr. Fazio and Mr. McCollum, and all other Members of Congress who are concerned about the lack of affordable homeowners' insurance in disaster-prone areas and want to do something about it.

    H.R. 219 is a good start because it would reduce the escalating cost of disasters to the Federal Government by encouraging more private insurers to sell standard homeowners' policies that include protection against natural disasters to residents of areas such as the U.S. Virgin Islands. I thank you again, Mr. Chairman, for the opportunity to make this statement, and I would be happy to answer any questions that you might have.

    Chairman LEACH. Thank you very much.

    Mr. McCollum.

    Mr. MCCOLLUM. Thank you, Mr. Chairman. I just want to compliment all three of the witnesses. Each has contributed significantly to the debate and movement of this legislation at this point.

    And while Rick Lazio and Bill McCollum get a lot of discussion and names mentioned in this, there is no question the late Bill Emerson, Jo Ann, your husband, made a huge difference in the ability of us to even be here today, and we are all very proud of that heritage and want to make sure we put the ball across the goal line.
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    Vic Fazio, you made this is truly bipartisan effort. California is affected in a major way every year and all of us know that, as is Florida. But as has been pointed out so much, Dr. Green, in all of the things that you said, the issue is truly national.

    Jo Ann, as you have said, every State has a role to play in this. So I just want to compliment you. I don't want to ask questions because I know that we share the same common bottom line and it wouldn't be productive for me to be taking up time asking questions. But thank you, and I think this bill should be dedicated to the memory of your late husband.

    Mrs. EMERSON. Thank you very much.

    Chairman LEACH. Mr. LaFalce.

    Mr. LAFALCE. Thank you very much, Mr. Chairman.

    I thank all three of the congressional witnesses, and I look forward to working with you in a very, very constructive way. You have taken the leadership in identifying the problem and coming forth with solutions.

    I call your attention to the testimony of the Treasury Department today, which I think is very constructive. I call your attention to the testimony of the Consumer Federation of America, and I look forward to working with you to incorporate the principles that the Administration and these consumer groups believe imperative in any legislation that is to proceed through the legislative process and be enacted into law. We want not simply a bill, but a good bill that effectuates good public policy, and I think that is achievable. I look forward to working with you on that effort.
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    Chairman LEACH. Mr. Lazio.

    Mr. LAZIO. Let me just say we are going to be hearing a lot today about reinsurance, fair plans, the capital markets and CAT funds. But what these witnesses have brought to us, both in terms of their drive to get something done and their dedication to be part of the process, is the real life cost that natural disasters bring, the loss of lives, the devastation to know that your home is gone, maybe your only investment and your only source of savings.

    Congresswoman Emerson was talking about her premiums quadrupling. Many families will be completely overcome by that scenario, and they are just people who live in areas that are prone to natural disasters. And so the human cost is important to keep in mind. It is hard to calculate, I think.

    You know, people presume if FEMA comes in after a storm that it makes people whole if they don't have insurance. The reality is most people get no more than a couple thousand dollars, and they have their entire principal investment, their home, wiped out because they have not had the availability of insurance.

    So I thank these three outstanding witnesses for bringing the human cost to the consideration of this committee.

    Chairman LEACH. Ms. Kilpatrick.

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    Ms. KILPATRICK. Thank you, Mr. Chairman, and to our colleague witnesses for your testimony.

    In the three areas represented, did I understand that it is maybe both or either of these scenarios, unable to get insurance because it is not offered, cost-prohibitive because some can't afford it? If you would go down, is it all of those or neither of those or something else we are dealing with this morning?

    Mr. FAZIO. I think it is a number of things. In some cases it is not available. In some cases it is available now but not going to be reissued when the policy runs out. In some cases, the increase in the premium is so large that it is unaffordable for people. It particularly works a hardship on the people who need it most, who would have the hardest time recovering if they were uncovered by insurance but who would therefore find it most expensive to remain covered. So it is a series of those issues.

    Ms. KILPATRICK. In the instance where people have it, particularly in California, and when they renew the policy and it is no longer offered, what is the reason given for it no longer being offered?

    Mr. FAZIO. I would leave that to the insurance companies to perhaps explain to you, but the bottom line is there is simply no way the companies believe they can assume the risk, and therefore they are telling people that they simply are going to have to look to the Government to help them, or their own resources, which far more than Government are what people fall back on when, frankly, they are hit by the kind of disasters we are talking about. Most of the money that we use to recover comes out of our own pockets.
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    Ms. KILPATRICK. And do you believe that the insurance companies who have written these policies in the past, and over some several years have not had the disasters and now they have them from time to time—we have no control over that, it is a God thing—are they right, in your opinion, are they right for not continuing to offer that coverage?

    Mr. FAZIO. I would love all the companies to continue to offer policies, but they are in the business of responding to their stockholders or their mutual participants, and they are not going to make risk decisions that are going to be detrimental to those interests. They no longer see the ability to have any kind of profit emerge from sales in many of these markets.

    Ms. KILPATRICK. Thank you.

    Mrs. EMERSON. In my district, for example, it is more of a matter of affordability. A couple of years ago, if you remember, we had the New Madrid Earthquake scare and, you know, they were making T-shirts, ''This is where the New Madrid Earthquake is going to happen,'' and we were all watching with bated breath as the earthquake was supposed to happen in a certain time period and it didn't happen.

    But, coincidentally perhaps, earthquake insurance rates have in fact gone up since that time, and as I said, mine specifically quadrupled over the last year. While I can't complain about that, it was very low to begin with, and now I am still able to afford it on the salary we make which is very generous, but those folks in my district who are on fixed incomes find it increasingly difficult, and I realize that it is a risk that is being prepared for.
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    On the other hand, let me just make a comment, if I could, that I think it is real important for all of the stakeholders, I mean people who live in States, consumer groups and insurance companies and reinsurance companies and everybody, to have a seat at the table and to work together to find compromises so that we can in fact come up with legislation. Certainly there has been a lack of will on the part of the people, as I said earlier, in States who are not directly impacted by natural disasters. But one way or the other, they end up paying, so I hope all the stakeholders will in fact sit down at the table and work out a compromise so that we can try to avoid these situations and the lack of availability and affordability in the future.

    Ms. KILPATRICK. In Michigan, for the first time in my lifetime there was a tornado last July 2nd in parts of my district. So I guess in El Nino we don't know what is going to happen.

    Mrs. EMERSON. No, and it is very scary. I was driving and I was 15 minutes ahead of a tornado in my district the other night, and it is a very scary feeling. Fortunately I made it home, but you just never know when it is going to strike or where.

    Ms. CHRISTIAN-GREEN. In the Virgin Islands, some of our insurance companies went out of business, some left the Territory and stopped providing insurance. For a while after both storms we had no windstorm coverage. We now have it, but the cost of premiums is too high for most people to be able to afford it.

    Ms. KILPATRICK. Thank you very much.

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    Chairman LEACH. Mrs. Roukema.

    Mrs. ROUKEMA. Thank you, Mr. Chairman. I will decline, but I do appreciate the contribution of the Members on this subject. As Mr. Lazio stated, we need the human component and a deep understanding of that, and I thank you.

    Chairman LEACH. Are there other Members?

    Yes, Mr. Weygand.

    Mr. WEYGAND. Thank you, Mr. Chairman.

    I want to thank the Members for testifying here today. I think any of our States that have been hit by hurricanes, tornadoes or floods, and my State is no different than many of yours, we are very sensitive to this issue. Many of the homeowners in the southern part of my State, in my district, have had the same kind of problems.

    I was very fortunate the past January to visit the Virgin Islands, and Donna was a gracious host. When you go there you see the devastation that has occurred and the people trying to rebuild their homes. They are doing so because they did not have the availability of homeowners' insurance and they are doing it on their own, at great cost to themselves and they are taking a very long time to recover. That is devastating.

    When you hear about a major flood, a storm or a hurricane or a tornado, people focus on the storm, but a lot of times the focus should also be on the cost to people not directly effected by the flood or hurricane or tornado. The concept of a bigger insurance pool and reinsurance really being the basis of this bill. The support for our homeowners that are in very devastated areas is important, so I compliment the sponsors here today and the Chairman for the work they have done on it.
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    I know that Rick's district in Long Island and my district in Rhode Island, and Bill Delahunt and Barney Frank in Massachusetts, we get hit all the time with hurricanes. We know what you are talking about, and we are very sensitive to it and appreciate your work on this. Thank you.

    Chairman LEACH. Thank you.

    If there are no more questions, let me just conclude by saying, and this is going to be a little presumptive, but as I look at this panel, I don't know three more decent and thoughtful Members of Congress, and we are very appreciative of your attendance. Thank you.

    Chairman LEACH. Our next witness is the Honorable Deputy Secretary of the Treasury, Larry Summers.

    Let me just say first, the committee is appreciative of the work that has gone on at the Department of Treasury on this issue and the input of the Secretary. I hope as we go forward, that it will be understood that the committee would want to listen very carefully to the input of the Department of the Treasury as we proceed to the markup process.

    Secretary Summers, please proceed.


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    Mr. SUMMERS. Thank you very much, Mr. Chairman.

    I have a longer statement which I will submit for the record.

    Chairman LEACH. Without objection, it will be put in the record, and if you will hold for one second, I would like to ask unanimous consent that opening statements of any and all Members be placed in the record, and Members who may not be Members of the committee as well.

    Without objection, so ordered.

    Mr. Summers, please.

    Mr. SUMMERS. Thank you. I would like to extend my compliments to you and to Congressmen Lazio, McCollum, Fazio, and many others who have shown leadership on what I think is a vitally important issue.

    My purpose here today is to convey that we see much promise in the current legislation as a means of addressing the many problems that currently exist relating to the availability and price of insurance and reinsurance for disaster risk. We do, however, have important concerns with specific provisions relating to making sure the taxpayers' interests are fully protected, that any approach we follow rely as much as possible on market forces and not substitute public activity where the private market can do the job.

    Natural disasters pose a particularly difficult economic problem. They are extremely infrequent but when they take place have extraordinarily high costs, and it is difficult to estimate with precision the probability of loss and, with precision, the consequences of a natural disaster. For these reasons, prices can be high in relation to expected losses, referred to in the insurance industry as actuarial risk, and coverage in the aftermath of an event may pose a particularly difficult problem for private markets.
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    And indeed reinsurance prices have come down recently, but for the largest disasters continue to be in the neighborhood of four times actuarial risk. That is, to compensate for a 1 percent probability event, one has to pay a premium of approximately 4 percent.

    The rationale for prudent Federal involvement comes from that high price, and it comes from the realities that the Federal Government, by virtue of the scale of its operations, has capacity for diversification across the population and across the economy; that by virtue of its permanence, it has capacity for diversification over time in terms of the ability to accumulate funds or to borrow if disaster occurs before funds have been accumulated; and because of the reality that in the event of a disasters the Federal Government is likely to pickup some portion of the cost in any event.

    But what is crucial is that that role be a limited role; that experience with Federal interventions in the credit and insurance markets teach us that it is crucial that we be hardheaded, that we assure the Federal Government is fairly compensated for any value that it provides, that we recognize the fast-changing and maturing state of the capital markets, and that we not allow a Federal role to preempt a more appropriate role for private markets.

    These considerations lead us to four principles: Government should provide disaster insurance when it can do so temporarily and on substantially more favorable terms than the private market. It should do so in a manner that avoids imposing net costs on taxpayers, or an adverse deficit impact. It should do so in a way that harnesses existing market forces to the maximum extent and encourages their further development. And it should be prepared to put itself out of the business of doing so when that is appropriate.
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    We believe H.R. 219 provides a foundation that could, with suitable modifications, be made consistent with these principles, though this does not preclude other approaches. In particular, we continue to view industry excess-of-loss contracts as a potentially valuable way of providing disaster reinsurance to a much broader class of counterparties than State funds. Indeed, an approach that seems promising to us is one that would marry the best ideas of H.R. 219 and H.R. 230. It would be a substantial improvement to the current legislation, to ensure that the playing field is kept level as between State programs and other potential customers of disaster reinsurance.

    We do believe that H.R. 219 is a constructive and creative response to a serious situation: the difficulty faced by State funds in purchasing extensive reinsurance against low-probability risks, either because the reinsurance is simply unavailable or because premiums are high. But we have concerns that the pricing decision be sufficiently insulated from political pressures to remain objective.

    I suggest that the Secretary should be only able, and I think this provision has been recognized, to adjust the commission's estimate of expected loss upward, and there be clarification of factors to be taken into account in setting the risk load. We have concern that it improve availability and not favor State programs over other possible vehicles for delivery of insurance to homeowners. To this end, we suggest modification to provide for the sale of excess-of-loss contracts to all entities on an unrestricted basis, and we believe consideration should be given to auction mechanisms wherever possible.

    Finally, we believe that public involvement needs to be carefully circumscribed, that the program should be sunsetted, that trigger points should be set with a view to the rapid development of the capital market so as not to supplant that capital market, and that the public entities should be authorized to underwrite no more than some specified fraction of the risk faced by any given State fund.
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    There are a set of more technical suggestions involving questions relating to multiple perils and the way in which State funds operate that are addressed in an appendix to my testimony.

    Budgetary treatment of this legislation will be a complex and highly technical subject, but we would hope that legislation could be worked in such a way that it would accomplish our goals without burden to the taxpayers or adding to the budget deficit.

    Let me just say in conclusion, Mr. Chairman, that this is an issue that we have recognized as very important for some time. The Administration, as you know, issued a 1995 policy paper on this vital subject.

    The panel before me laid out in very clear and stark terms, I think, the human impact that disasters can have and the importance that adequate insurance can have. If we are to wait before acting until a disaster comes, I think we will all feel that we have not served wisely. As the President has said in a very different context, the right time to fix the roof is when the sun is shining. That is why we believe that the current legislation provides a useful vehicle for further progress, thought and development in this area, and we look forward to working with you to improve it.

    Thank you very much.

    Chairman LEACH. Well, I would thank you for your very forthcoming testimony, and simply reiterate again that as this moves forward, we will be paying a great deal of attention to the Treasury recommendations; and my personal view is, the more constructive the approach, the more attention that the committee gives to the Treasury.
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    Mr. McCollum.

    Mr. MCCOLLUM. Thank you, Mr. Chairman.

    I greatly appreciate, Dr. Summers, your testimony today, and what I think is a fairly strong statement of support for the direction, in general, that we want to head, as Mr. Lazio and I have been working on it. But I would like to ask a question that gets to the heart of what is the central issue here in terms of what we deliberate on in modifying H.R. 219 or not.

    In the way the version of the bill is at the present moment, as I understand it, the catastrophic reinsurance would go to State-sponsored funds or to States who would set up an auction system; but in any event, the reinsurance would be State by State and through a State-sponsored program.

    You said in your testimony, in addition, as I indicated before, we believe the legislation should be modified to provide for the sale of excess-of-loss contracts to all entities on an unrestricted basis.

    Some of the witnesses who are going to come along later are going to be supportive of keeping it the way it is; some are going to be supportive of going to an excess-of-loss system. One who favors going to the excess-of-loss contracts is suggesting that that methodology will provide a vehicle for insurers and reinsurers to create a secondary market, and that it is more favorable to the private marketplace.

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    First of all, I don't think everybody here knows what an excess-of-loss contract is, and I wondered if you would explain to the committee what you think of as an excess-of-loss contract, and how you would envision—I know there are no details here, the Administration doesn't have a legislative proposal, but how you would envision our modifying this or, more importantly, why you think that we should modify H.R. 219 to provide an unrestricted basis for people to be able to purchase, insurers to be able to purchase such contracts.

    So if you could, define what an excess-of-loss contract is and the rationale of why you think that would be a preferable or needed modification to the bill.

    Mr. SUMMERS. An excess-of-loss contract, Congressman McCollum, I think of as a contract which provides for a slice of reinsurance, for example—and there is no significance to the numbers I am choosing—that would provide for reinsurance on catastrophes in excess, nationwide, of $20 billion and less than $30 billion. That would be a contract that would cover—it is called excess-of-loss because it is the excess above $20 billion.

    Frequently, as these are thought of, they are thought of with a cap, so that would be $10 billion of potential liability; and one could imagine auctioning off a portion of that 1 percent. If you auctioned off 1 percent of it, you would be auctioning off $100 million of potential liability and a contract that perhaps would pay $50 million if there was $25 billion worth of damage, $75 million if there was $27.5 billion worth of damage and so forth.

    And the excess-of-loss proposals typically envision that the contracts pay out above some threshold for some defined area and class of catastrophes and that the contract would be auctioned off and then would be purchased by those who wished, for one reason or another, to hedge against insurance that they had provided.
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    The very substantial appeal of the XOL approach is that it is, in a sense—small ''d''—democratic. It provides for anyone who wants to be in the insurance business to be able to hedge and it doesn't target any particular class of actors. And that is why we think it is very important that in any ultimate proposal there be an excess-of-loss element, so that it would be desirable to provide for that kind of reinsurance.

    The other issue, and I suspect it is an issue frankly that Congressman Lazio can speak to much more knowledgeably than I can, is the reality that in several States there exist State funds that are providing an important service, are playing an important role, and that it is important that whatever approach we take be one that is consistent with that. And if, for example, the concern has been expressed that what was available was a national fund, or even a State fund, or even a regional fund that did not match the set of liabilities that a State fund had, then it would be rather difficult for the vehicle to be constructive for the State fund.

    So, I think what is necessary—and I do not have a specific formula to suggest to you here today—is some synthesis that achieves both the objective of being able to provide support for a State fund, but also in no way encouraging, as the only way to get support, other States to set up State funds or tilting the playing field in favor of the State fund approach.

    Mr. MCCOLLUM. I know my time has expired, and I concur, being from a State like Florida that has one of these funds, I don't want to do anything to undermine that fund. But if you had excess-of-loss contracts, would there be an ability to have a private marketplace for the sale of—a secondary market for the sale of those bonds that would be created by this?
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    Mr. SUMMERS. I think—in a general way, I think the presence of excess-of-loss contracts would in all likelihood be quite conducive to the further development of what is already a rapidly growing private capital market in these kinds of instruments.

    Mr. MCCOLLUM. Thank you very much. Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, Mr. McCollum.

    Mr. LaFalce.

    Mr. LAFALCE. Thank you very much, Mr. Chairman.

    Secretary Summers, thank you for your thoughtful testimony. It is very helpful to the committee that Treasury has now come as far as they have come in supporting the concept of Federal involvement and articulating some principles that must be included within legislation if we are to have sound public policy. But I would hope that Treasury could now go beyond that articulation of principles and work with the committee in the fashioning of legislation and the drafting of legislation itself.

    I think H.R. 219, as reported by the subcommittee, falls short of meeting those principles, and that is why, for example, the consumers group opposes it as it presently stands. They have articulated principles which I believe in large part mirror the principles that you have articulated, as I view them. I think there is a tremendous similarity of an identity of viewpoint.
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    I actually think you are closer to Mr. McCollum's H.R. 230 than you are to H.R. 219, or some merger of the two with an inclusion of the principles. So I almost think it would be helpful to almost virtually start from scratch, to the extent Treasury could assist us in drafting legislation, I think that you would expedite the process tremendously, so I would encourage you to do that.

    Now, if there is difficulty in winding your way through the OMB process, then I would suggest you give us a bill, but with as many technical and improving amendments as is necessary to make a whole bill consistent with the principles. That's all I have to say.

    Mr. SUMMERS. Thank you. Thank you very much, Congressman.

    I am told that the principles that I have suggested are indeed quite similar to the principles, as we see it, that the consumer groups have testified.

    I don't have a view here now about the precise modalities, but we certainly would like very much to be as cooperative as we can be with the committee as this process moves forward. And I might just say, because I know many of them are represented in this room, that I think this is a process that none of us in the Government will be able to complete well without very extensive consultation with the various stakeholders in this whole process, both in the primary insurance market, the reinsurance market, the capital markets, which are so promising for this issue, State governments, and so forth.

    Mr. LAFALCE. And I want to reiterate that there is a tremendous diversity of opinion among the States as to the appropriate approach, and there is a tremendous diversity of opinion among the totality of the insurance industry as to the appropriate approach. There is not monolithic State thinking, there is not monolithic insurance thinking on this issue at all, and we need to be aware of that as we draft legislation, not to make everybody happy, but to effectuate sound public policy.
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    Mr. SUMMERS. I agree with you, Congressman, and I think that has much to do with the fact that this is not the first Congress in which this issue has been raised, but I would hope that all the various parties might recognize a common stake in finding a solution and that none would let the very best be the enemy of the good.

    Chairman LEACH. If the gentleman will yield, let me just reiterate part of what Mr. LaFalce has said, A, that there is a terrific appreciation for the movement and involvement of the Department of the Treasury.

    We are going to be moving on a reasonably proficient basis toward markup, and in that regard, the more definitive the assistance of the Department of the Treasury, the better. And so I would like, I mean, just very precisely, A, to request very specific legislative language from the Department, and B, to ask if the Department is prepared to provide such.

    Mr. SUMMERS. Mr. Chairman, we want to be as cooperative as we can. Whether we are prepared in a formal way to provide the legislative language is something I think would have to be considered very carefully from a range of points of view. But certainly in terms of providing the kind of substantive input that would allow a discussion of how the existing vehicle could be improved to reflect these concerns, I think we are prepared to be very active.

    Chairman LEACH. I am appreciative of that. And I know of the reservations you have, but let me also be very definitive in suggesting, we are dealing with an area of legislation that is relatively novel to the Congress, and it involves very precise legislative craftsmanship, as well as generalized principles. And so, as you understand, the committee has been asking for over a year for a direct input from the Department of the Treasury.
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    And we are very appreciative of the statement today and the testimony today, and the generalized principles, but we also are requesting, you know, as forthcomingly as the committee can, for substantive input of a legislative language nature. And Mr. LaFalce has referenced a problem, all departments have, with regard to OMB clearance, which is sometimes awkward.

    On the other hand, all departments, generally speaking, when requested by committees, are prepared to forthcomingly come up with specific language and specific approaches, and so I would be very hopeful that this Treasury would be as forthcoming as is generally the case.

    Mr. SUMMERS. I appreciate what you are saying, and we will be as forthcoming as we can be, and I think we appreciate very much the faith you show in us by recognizing what I think is a very capable technical staff at the Treasury who can do this; and I would only express the hope—and I say this not totally seriously, Mr. Chairman—that on all the other difficult issues that we face, there could be a similar coveting of the Treasury's input. There are other matters within the committee's jurisdiction in which we would be delighted to suggest legislative language if we expected it would be put in place.

    Chairman LEACH. As you know, this committee has voted 40 to 9 on the IMF bill.

    Mr. SUMMERS. Absolutely. And for that we are very appreciative.

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    Chairman LEACH. There is no such thing as quid pro quos from one issue to another, but this committee is dedicated to a professional appraisal of the issues. And frankly, it has been my long-term assessment of the Department of the Treasury that it is an institution with enormous professional capacities, and we look to the Department of the Treasury for advice and judgment on a spectrum of issues, and we will deal with the Department as professionally as we can.

    Mr. SUMMERS. I appreciate that. And it has now been over five years that I have been at the Department of the Treasury; and since then I think we have very much valued on a whole range of subjects, both domestic and international, our professional interaction with you, Mr. Chairman, and with the committee, with the committee more generally, and we will be as helpful as we can be.

    Chairman LEACH. Thank you.

    Mr. Lazio.

    Mr. LAZIO. Thank you, Mr. Chairman.

    I want to thank the Secretary for his constructive comments today and for his commitment to the process, and I want once again to associate myself, as I did earlier during the course of this hearing, with your comments regarding the fact that now is the time to address the concerns that you have aired and others have aired. It is not for us to drag our feet or wait until hurricane season or a natural catastrophe is upon us, where the political pressure will be overwhelming to try and react in a manner that may not provide us with enough time to vet these issues and to work out the concerns that you and others have aired. I am a big proponent of being preventative now, to move forward, to be proactive to deal with this problem.
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    As you mentioned, this has been the subject of several Congresses over several years; and in the last Congress as a matter of fact, Senator Stevens had a version of the bill, which he believed had broad-based support, which he later found out that was not the case. And so, in the sense of clarity and constructive engagement, it is very, very important. I also want to associate myself with Chairman Leach's comments with respect to those.

    Obviously, by virtue of your comment about the need to move now and not wait for the inevitable disaster to hit, you believe that there is an appropriate role for the Federal Government to play in providing the incentive for liquidity in the insurance marketplace, the homeowners' insurance marketplace. Let me ask you if you can confirm that and ask you, as a follow-up, in the course of your answering that question, what your view is of the current capacity of the reinsurance industry on a regional basis, and of the capital markets to deal with the concentration of risk as a result of one of these natural disasters.

    Mr. SUMMERS. I think there is a role for the Federal Government, Congressman Lazio, and I would characterize the capacity of the reinsurance and capital markets as substantial, growing, and not totally adequate; and that is why I see a role for the Federal Government. But that is also why I think we have to think very, very carefully about the dimensions of that Federal role, the dimensions in scale and also the dimensions in time.

    I think we are all familiar with Federal interventions to improve the function of the financial markets that perhaps outlived their rationale; and I think that is something to which we need to be very sensitive in thinking about proposals in this area. And I think we do need to look carefully at issues of trigger, issues of fraction of insurance provided, issues of discrimination, who has access to benefits, in order to assure that we are pursuing an approach that does what we need to do, but doesn't do more than we need to do.
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    Mr. LAZIO. I think I would agree with that, and I think H.R. 219 honors those principles of having respect for the private sector, not wanting to substitute for present capacity and envisioning a temporary role for the Federal Government. I would remind you of the role the Federal Government had in the 1960's, with urban unrest and the fact that there was a problem with insurance capacity in many of our urban areas after some of the riots; and the Federal Government did come in and provide some assurance to the market, and within a few years, it was no longer necessary and the private sector grew back into it. And it is not the model—the end result—we would like to see happen to provide enough incentives for the private sector to grow, but as you say, understand it is not adequate in many cases, grossly inadequate, particularly in some of the urbanized areas in the West that are highly prone to natural disasters, to absorb that level of loss.

    Mr. SUMMERS. After we discussed this question, Congressman, you sent me a very thoughtful letter describing a number of examples in which adjustments had been made when their need was not there and suggesting that in a number of cases what was seen as perhaps inappropriate today was not actually a case of long-term political distortion, but was, rightly or wrongly, a case of original intent. And I think that is a very important perspective on this.

    I do think we need to be careful, because this is the only place where I might have a slightly different view than the way in which you spoke. It characterized the private market as substantial and growing, and so I think it is important that we recognize that present capacity will soon be growing, and we need to be careful not to cut that growth off, but I think this is a matter for working things out.
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    Mr. LAZIO. I agree, and I would mention in the context of the State programs, for example, California or Florida, there is an enormous capacity to grow both the capital market and reinsurance industry role in those plans before we even get near to triggering a Federal backstop, so there is enormous growth potential in both industries.

    Chairman LEACH. Thank you, Mr. Lazio.

    Mr. Kennedy.

    Mr. KENNEDY. Thank you very much, Mr. Chairman.

    First of all, I want to welcome my good friend and constituent—I guess you still vote in the 8th District—not that that is going to matter a lot to me in the next few months. So now I can say whatever I want here, right, Larry?

    But, Mr. Chairman, I first of all, want to thank you for holding this hearing and I apologize for having to be at another hearing earlier today. But I want to just suggest that we ought to move with caution on this whole issue of how to proceed with regard to the concerns of these major catastrophes that could take place.

    I think everyone who is concerned about this issue, first of all ought to recognize that the reinsurance companies themselves indicated to me in a series of meetings that this is an issue they feel they can handle themselves. So that is one set of issues. You know, whether or not that is true is something that can be looked at. But the fact of the matter is they do indicate they can make up much of this gap.
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    Second, I think we don't ever want to get ourselves into a situation where we are privatizing the profits of the insurance industry and then publicizing the losses of the insurance industry. I think that is an overall concern that I hope the Administration keeps at the forefront of its agenda.

    And third, I think that there is a question of whether or not—if we are going to move forward with the whole issue of catastrophic insurance, whether or not this isn't something that everybody in the country has to participate in. Because if you limit it basically to the three States where these catastrophes are most likely to exist and leave it only to the private sector or to, as this bill that is before us calls for, leave it to the individuals that would be affected in those States to pay for it—they simply won't buy the insurance. That is the experience that has been borne out in the California example. We should also recognize that if the State of California, the State of Florida or some other State gets hit by one of the catastrophes, we view this as a national issue and it is something we are going to have to come to grips with.

    So what I would like to just get your reaction on, Mr. Summers, is your general concern about those three basic issues in terms of reinsurance, of whether or not the Government ends up picking up the tab for something that private industry ought to, and of whether or not we really have to look at a national base in order to make this insurance actually affordable for people in the local communities.

    Mr. SUMMERS. Congressman Kennedy, I would agree very much with your call for caution, and I think the degree of caution that we have displayed in getting to this point has been frustrating for some. I think there is no question that the reinsurance industry can and does play an absolutely crucial role, and I think that, as the committee will hear, I think, later in the day from the representatives of the capital markets, they too have a very substantial contribution.
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    It is our judgment, as I think it is the judgment of many in the reinsurance industry, though not all, that with respect to the largest catastrophes, there is a role for a kind of Federal backstop, at least on a temporary basis, because unlimited capacity is not there in the reinsurance industry.

    The national-local question is a very difficult one, the premise on which I think the bill is constructed, and in a way, the premise on which my comments are constructed is that it is not our goal to have subsidy; it is our objective that market forces operate and that those who are purchasing insurance in California should pay a premium that reflects risks in California, and similarly for those in Kansas, and similarly for those in Somerville. But the difficulty is when, because of limits in the capacity to bear risk and the scale of the market, that premium exceeds by a factor of four or more what the actuarial cost of the insurance is, and that the objective of the Federal Government's involvement in this area would be to bring down that ratio and to bring down premiums and make homeowners' better. But that would not involve any subsidy from other parts of the country to the parts that were most likely to have large catastrophes.

    Mr. KENNEDY. Well, this is the kind of good old Federal money we used to have, Larry. How are we going to get the money to subsidize if you don't get people in Somerville. I don't think the people in Somerville are necessarily going to mind. They are concerned about a massive hurricane hitting Boston, so I am not certain that there is such an unwillingness of people up there to help out in a matter like this.

    Mr. SUMMERS. I think we need to look at that. We need to look at the set of issues closely, and I certainly don't have all of the answers, that the basic source, though, is that, as I have tried to—my written statement tries to say, the Federal Government by virtue of its large scale and diversification in effect can pool risks.
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    Mr. KENNEDY. But you are pooling risks by taking tax money from someone else and putting it into another guy's backyard, right?

    Mr. SUMMERS. I think not, because I think that assuming the pricing is right, over time the premiums that you charge would be lower than the premiums that would have been charged in the absence of this reinsurance, but will still be more than sufficient over time to cover the payouts, the payouts that result.

    Mr. KENNEDY. Mr. Chairman, I know my time has expired, but that sounded like as good a double-speak as I have heard Alan Greenspan give up there. But in any event, it doesn't sound to me as though you can say on the one hand that you are not providing a subsidy from one part of the country to another, and then say that, in fact, if the premiums are over four times what the cost of the disaster might be, therefore, you are going to get the Federal Government to somehow reduce the prices.

    It either is or it isn't. What I am saying to you is, let's be honest and say it is, and then let's go out and tell the people of this country if there is going to be a major disaster anywhere in America that all of us, as fellow Americans, have a responsibility to look out for one another. For a very small premium that can be charged across the entire United States, you can provide this insurance. I think that is a much more safe, secure and fundamentally honest way to move forward, rather than to try to suggest this can be done by going to three States and asking the people of those three States that are, after all, more than likely, having to participate.

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    And in the experience of California, you simply can't price this insurance in a way where the people are going to voluntarily purchase it. So I think there is a flaw in the way this bill has been constructed. I don't think that we are going to be able to make any progress in actually solving the problem. We might pass a bill, but you won't solve a problem the way the bill is currently structured.

    Mr. SUMMERS. I just want to clarify one aspect of that, one aspect of our position. It is not our intent to ask those who are living in less risky parts of the country to subsidize or to cover or to pay taxes in order to bear the risks that those who live in higher-cost parts of the country face. That does mean that what we are limited to is the benefit that can be provided in the riskier areas from the improved risk-bearing capacity of the Federal Government; and as you said, there are limits to how far you can bring down the premium because, after all, it is more likely you will have an earthquake in some parts of the country than others.

    Nonetheless, I think it is our judgment it is possible to bring about some improvement in that way and that that is valuable improvement. There is a much broader and more philosophical kind of discussion about whether nationally, we should have a redistribution from the parts of the country that are less disaster-prone to the parts of the country that are more disaster-prone. One can make arguments on both sides of that.

    That is not what I think is contemplated in the range of proposals under discussion here and that is not something that at this point we would be prepared to endorse. Nonetheless, I think something constructive can be done in what is a relatively small number of States, where the catastrophe risk is so large as to be beyond the potential of the private market. In many other places, the private market is more able to handle the problem.
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    Mr. KENNEDY. All I would say in response is, look at the tables of who participates in California when you actually provide the exact kind of model that this bill calls for on a national basis. People won't buy it because it is too expensive.

    Mr. SUMMERS. Without going into the arguments as to how it would work, if successful, as I understand the philosophy of all of these approaches, it is that by improving the availability and pricing of reinsurance, what one would have is lower-cost primary insurance and, therefore, do two things: One is expand, by reducing the price, the number of people who took advantage of primary insurance; and second, and what I think some day what we may discover is very, very important, ensure that those who have primary insurance actually get the insurance they think they bought, because there is the solvency to meet the obligation, which has been a problem in the past in this country with a number of different classes of financial intermediaries.

    Mr. KENNEDY. Thank you, Mr. Chairman.

    Chairman LEACH. Thank you.

    I do think, though, the committee deserves an unequivocal response on the ancillary question, and that relates to one of the most thoughtful and involved Members of this committee, who is unfortunately giving up his seat. Are you a candidate to replace him?

    Mr. KENNEDY. Come on, Larry.

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    Mr. SUMMERS. It is rare that people do this, but I will make an unequivocal Sherman statement with respect to that particular notion. If nominated, I will not run; if elected, I will not serve.

    Chairman LEACH. Mrs. Kelly.

    Mrs. KELLY. Thank you, Mr. Chairman.

    Mr. Summers, you stated that you see the current situation as substantial and growing but not yet adequate. If the market is substantial and growing, and we don't want to cut off that growth, then how expensive a dwelling loss disaster has to occur before the Government needs to step in? What does Treasury think the number is, $10-, $15-, $25-billion? What is the number?

    Mr. SUMMERS. I don't have a particular number to give you. I think that while we have engaged in a certain amount of consultation, I think before coming to a judgment about a number, it would be appropriate to engage in much more extensive consultation than we have yet had an opportunity to do.

    I think I would say, and I know this is something everyone recognizes is very much fluid, that the $10 billion, on a national basis, figure that was contained in H.R. 230 strikes me as very likely to be too low a figure relative to what I would regard as appropriate and, almost certainly, too low by a significant factor. But just what the right number is I am not prepared to say at this point.

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    Mrs. KELLY. Has Treasury studied this?

    Mr. SUMMERS. Treasury has thought about this and has consulted and received views from a number of corridors and considered it. I am not sure I would want to dignify the work we have done so far as a study, but we have certainly looked at the question.

    Mrs. KELLY. In the process of the help that you volunteered to work with this committee on, perhaps you think you can provide us with some sort of help with a number.

    Mr. SUMMERS. I am sure we can provide the guidance to the committee in setting an appropriate figure, and of course, this is a little more complicated than just providing one number, because it depends on whether one is looking at the Federal level or one is looking at particular States. But I think we can—I would imagine, in working with the committee, we would be in a position to provide guidance on the set of questions around triggers, yes.

    Mrs. KELLY. OK, thank you.

    You mentioned flexibility. I am curious about how that can be achieved to promote a private sector reinsurance growth. Since H.R. 219 has two different approaches, the catastrophic or the State XOL contracts, do you see them as working together or independently? Talk to me a little bit, if you can, to kind of explain to us a little bit more what you mean by ''flexibility'' and how you see that in the framework of H.R. 219.

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    Mr. SUMMERS. I would hope that any legislation that would ultimately pass would include a provision for XOL contracts, whether on a national basis or on a regional basis, which would be eligible for anyone to buy at auction, and that the availability of those contracts would, in turn, make it possible for them to compete in—for those who purchased it—to compete in the downstream insurance market. I don't think that the Federal Government should confine its assistance to particular buyers, as I think any seller knows that it is likely to have its product distributed more effectively if it provides for multiplicity of buyers and competition, rather than a single buyer.

    I think that is the approach that we need—that the Federal Government should take. Just what the right means are is a very complicated subject; I think it is difficult to discuss in this forum.

    Mrs. KELLY. Thank you. One final question. Currently, insurers can deduct losses against profits and save taxes by applying them back 2 years and forward 18. What effect has that had on the Federal tax revenue? And I am curious about whether or not this is adequate to address the routine insurer loss.

    Mr. SUMMERS. I can get you an answer in writing that is more specific than the answer that I can give you here.

    Clearly, when you are dealing with large disasters that would cause the income in one year to be radically different, it is appropriate to have loss carry-forwards and loss carry-backs. So I think there is a question about exactly the right loss carry-forwards and loss carry-backs. Of course, any change in loss carry-forwards and loss carry-backs would represent a budget item that would have to be scored as having an adverse impact on the deficit; and I think a virtue of the kind of approaches that are being discussed here is that they have the potential to be revenue neutral, because a super-actuarial premium is being collected for the Government in return for any insurance that is provided.
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    Mrs. KELLY. Thank you very much. Perhaps we can enter a dialogue about those last two questions at some later date.

    Mr. SUMMERS. I would like that very much.

    Mrs. KELLY. Thank you very much.

    Chairman LEACH. Thank you, Mrs. Kelly.

    Mr. Vento.

    Mr. VENTO. Thanks, Mr. Chairman.

    Mr. Summers, I appreciated your statement. You pointed out that one of the major concerns here is that this would not be—that the actual charge for the policies that are either instituted by the State or the private sector on this, before we get to the reinsurance, be sound. Is that, that they be actuarially sound? I mean, I know there was an amendment offered like that in the subcommittee. Does that satisfy the concern or what do you mean that they be realistic? Obviously, if you are reinsuring, you want to make certain the folks in front of you are real with their money.

    Mr. SUMMERS. I am sorry, Congressman Vento; I am not trying to be evasive, but I am not understanding the question you are asking.

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    Mr. VENTO. Well, your concern was, your first concern was that—in fact, your major concern, I understood; and I can't find it right now.

    Mr. SUMMERS. Oh, I see, that pricing decisions be sufficiently insulated and so forth?

    Mr. VENTO. Yes.

    Mr. SUMMERS. I think there are historical grounds for worrying that when the Federal Government agrees that it is going to provide a service and it is going to charge an appropriate price that covers its costs for its service, that over time the people who are principally interested in the matter are the people who are going to buy the service, and that the political process feels pressure to price it in a way that is attractive to the buyers. And over time, the Federal Government, which thought it was doing something that was going to be revenue neutral, ends up doing something that is quite costly to it. I think we have seen that kind of thing in other Government insurance programs.

    My point was just to emphasize—and I think this is something that is possible to do—that we need to find mechanisms such as a commission that reports, that would insure integrity to the process and would prevent that kind of erosion.

    Mr. VENTO. Well, that is right. I think as we go down the road in the decades to come that the initial insurance, that your reinsuring may end up being more of a mirror than anything substantive. So instead of being a dynamic process, there ends up being a thinner and thinner layer of insurance, and especially with the catastrophic type of events.
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    And I suspect that one of the reasons the various States, with regard to hurricanes and earthquakes, have discontinued this particular insurance activity is because there are almost certain losses based on the tectonic and other meteorological information that is available. It is obviously trying to insure, you know, housing, businesses. I know this is just dealing with residential, but in these various zones, it is just about a sure loser. You would have to charge the type Bs.

    So they have actually withdrawn from some States, and the idea is through this Federal reinsurance, to in fact try to recreate, as it were, to make it possible to have insurance in these instances, is my understanding of this.

    Mr. SUMMERS. That is right. That is right, Congressman Vento, but I would qualify what you said in one way. Where there is a high probability—I am not a geologist or meteorologist, but where there is a high probability of disaster, any actuarial fair premium, if there is a 10 percent probability of a home being destroyed each year, then you would have to charge as a premium at least 10 percent of the value of the home if you were going to have any chance. Where it is that kind of situation, frankly, the bills under discussion here are not going to actually address the problem.

    What these bills are addressed at is a different problem, which is the very large disaster that actually has a low probability, of 1 percent or less, of taking place, but people, knowing if the 1 percent comes up, they will be bankrupted, are very reluctant to write that kind of insurance or charge a very, very high fee for that insurance.

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    And so it is not the general problem of high risk in dangerous areas that can be addressed through a reinsurance approach of this kind; rather, it is the people worried about the 1-in–100 shot, who therefore withdraw from the market.

    Mr. VENTO. I have two concerns, one for the Federal Government, as we are collecting these premiums, that there not be a rebate policy in place and that we have some security, that as we are collecting the premiums—because I think there is a tendency of California, Florida and a few States that are paying this in, to think that it is their money. And I have seen it happen before and there are concerns about that.

    Second, in your statement, the impression I got, and you can correct it if it is wrong—not with a long statement because you don't have a lot of time—but you would like to see this expanded to different categories of catastrophe; that's the way I read one of the lines here.

    And, second, I am concerned about your statement in here about mitigation. I believe that Mr. Maloney offered an amendment on mitigation, and you suggest you do not want a specific percentage of earnings spent on mitigation. OK, that's fine, but I think we need to be concerned about mitigation because, indeed, if one of the other risks in terms of making this actuarially sound is to make certain that construction isn't going on on properties that are likely to sustain substantial damage—we have V zones, we have flood zone protection, and a lot of extra activities; and the message that ought to come out of this legislation is that we do not want to be funding residential, or for that matter, business, if we get to that, structures that are not adequately or soundly constructed for the type of events that occur in a particular location, nor in sites that are highly probable to be subject to types of damage.
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    So those are my concerns, that the money not be rebated and that in terms of the percentage of mitigation that we are not completely ignoring the issue of mitigation actions in terms of construction in activities that we are insuring.

    Mr. SUMMERS. Congressman Vento, I think all of your concerns are very important. One, I do think we have to be very careful with the political mechanisms we take with respect to the premiums, that we understand these are premiums for low probability events, and we don't dissipate them in the period before the low probability event takes place. And there is a reference to that in my testimony, but I think crafting the right kind of institutional approach to doing that is a critical challenge, I agree with you very strongly.

    Mr. VENTO. Rebates would be one way to do it.

    Mr. SUMMERS. I would certainly support that. Other catastrophes, I think the principle should be where it is a low probability, big damage, and therefore difficult for the private market to handle, we should do it, it should in principle be done.

    Where it is a more routine kind of once-every-three-year event, I think we have much more presumption of relying on private market forces. And while we did have some technical concerns about the specific proposal that was put forward, I very much share your view that mitigation is an important piece of this.

    The original legislative process on this had sought to combine approaching the issues that we are discussing here with approaching a range of other issues involving mitigation, and also involving regulation of insurance; and I think the feeling at this point, which I am inclined to share, was that the best prospects for moving ahead were with a vehicle that was focused on, if you like, the capital market and reinsurance aspects.
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    But I very much share your concern and I suspect we could be comfortable with approaches that in some way married some aspect of mitigation to this. Of course, funds that are used, premiums that are used to reinforce structures are not available to then pay for the subsequent disaster, so one has to—although, of course, they reduce the damage from that disaster. So I think one has to be careful with respect to the approach, but the basic direction you are espousing I very much agree with.

    Mr. VENTO. Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you very much.

    Now we would like to turn to one of the committee's insurance experts, who, I suspect, wants to ask about snow slides, but Mr. Hill.

    Mr. HILL. Thank you, Mr. Chairman. Avalanches we will talk about.

    Mr. Summers, first I want to echo the comments of other colleagues about your thoughtful testimony. It seems to me your comments about the fact we have a substantial and growing market for reinsurance and contingent capital, different mechanisms for dealing with the problems of solvency here, I think is accurate.

    The real question is, is there some expectation that is going to be stable? Reinsurance premiums and insurance premiums are extraordinarily volatile. That is the history of this industry. Could you comment on that? I mean, do you believe there is stability in that pricing now or do you have any expectation of any stability in that pricing?
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    Mr. SUMMERS. I think you raise a very, very important point, Congressman Hill. I think it is difficult to fully sort out, in terms of the growth of involvement in reinsurance in the capital markets, how much of it is desirable innovation that will be permanent and how much of it is a response to the fact that after rather difficult years in the early 1990's, from the point of view of catastrophes, the world has been somewhat more fortunate. And certainly, the historical experience is that there is a substantial, if you like, second accident problem; and in the event of a major event, in its wake, I suspect that there would be calibration of all the models and such and that the insurance would be less available than it is—insurance will be less available than it is right now. I think that is another rationale for there being a Government backstop.

    Mr. HILL. This raises the threshold?

    Mr. SUMMERS. I think that is fair.

    Mr. HILL. I guess my starting point for this is, first, do no harm, and I have a concern about whether or not this bill will create an incentive for the creation of more State funds or pools.

    What is your opinion about that? Do you think that this will create an incentive for more State funds and more pools?

    Mr. SUMMERS. I would put it slightly differently, but I would share the concern.
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    I worry that the bill, as it is written, tilts the playing field more than perhaps it should to public sector solutions at the State and local level and that that tilt could be addressed by adding features that provided for excess-of-loss.

    Mr. HILL. Would you share my view that if this does create an incentive for the creation of more funds and pools, that could have an adverse impact on the marketplace responding to, this further response to this issue.

    Mr. SUMMERS. I think there is a real concern there, yes.

    Mr. HILL. You know, we compare apples and oranges here when we look at Florida, California, Hawaii; I mean, these are really different solutions to similar problems, and the only similarity really is catastrophic exposure. But one of the common threads throughout all of those solutions is that they give special tax treatment to the accumulation of reserves for the purposes of building a financing pool to pay catastrophic losses; that is universal in all of those.

    Why wouldn't it be a good idea to create a mechanism to encourage in the private marketplace more favorable tax treatment of the accumulation of reserves that are focused on addressing catastrophic exposures? Wouldn't that level the playing field between the public sector and private sector solutions?

    Mr. SUMMERS. I think there is a case to be made in that direction. It, I think, is limited by two factors. One, any such approach would have budget costs and perhaps quite significant budget costs; and second——
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    Mr. HILL. But scoring shouldn't be the criterion by which we pick a poor solution over a good solution.

    Mr. SUMMERS. But I think the question of whether we are doing something that is diverting resources that could otherwise be used for other purposes, as any kind of tax cut in this area would, that is a different thing than an approach that doesn't impose a cost over time on the Federal Government; and I think it is legitimate to——

    Mr. HILL. This is a zero sum game whether we pay for it through private sector reserves or pooling reserves or whether it comes out of losses that insurance companies would take for tax deductions in the future. I mean, over a long period of time, the amount of money to finance the claims ought to be the same; isn't that accurate?

    Mr. SUMMERS. Well, I think that there is some potential advantage from relying on the Federal Government's ability to spread risk across space and over time. But I think the tax question is—I mean, we have looked at it a bit, and it is something that should be considered in the context of this issue. But the budget set of issues is one set of issues it raises; the other set of issues it raises goes to neutrality of a different sort. You mentioned neutrality between corporate-private approaches and State funds. There are also issues of neutrality between insurance companies in this business, and the insurance companies and other financial entities in other businesses who do pay taxes on accumulated interest; and there are apparently, I am told by the technical experts, difficult issues of balance there.

    But we would certainly agree with you that the tax issues are something that is appropriate to consider in a full look.
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    Mr. HILL. Mr. Chairman, if you would indulge me one last question because this, I think, is really important.

    You made the comment earlier, your goal is not to have the subsidy, yet in your testimony you talk about spreading the risk over the entire population of the Nation, which really supposes a risk transfer. The question I have is, if we are going to spread the risk over the entire population, shouldn't the benefits of this be spread, likewise, over the entire population? Shouldn't the citizens of States that don't, like my State, Montana, which have a catastrophic exposure in terms of the types of perils they are exposed to, but not the size of the economic risk, shouldn't they benefit equally to the people where there is a concentration of values?

    Mr. SUMMERS. I think in terms of speaking about spreading risk, I spoke somewhat imprecisely, and that may be why I wasn't very clear in my conversation with Congressman Kennedy earlier.

    We are not—by spreading risk, when I use the term spreading risk, I am not speaking about having taxpayers in one State subsidize taxpayers in another State. Rather, the notion is that the Federal Government can bear risk more inexpensively because of its charge. Just as a life insurance company that insures 100,000 people can price more effectively than a life insurance company that insures only 100 people, even though it is not subsidizing from one person to another and is charging everyone a premium, based on their assessment of that situation, so also the Federal Government, by virtue of its size, has an advantage in bearing risk. But that does not mean that it is engaged in cross-subsidy.
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    I think the question you get into when you raise—and one can argue this, it seems to me, on both sides. The question you get into when you look at States that have less extreme catastrophes is, on the one hand, I think all of us feel the impulse to provide benefits uniformly and in a nationwide way, and not to buy benefits for some, rather than for all. On the other hand, one of the principles that many of us have embraced here this morning is that the Government should do what the private market can't do, not what the private market is able to do. And for catastrophes of a more predictable sort and of a less extreme and more frequent sort, there is a sense that the Federal Government has much less role in adding value, and that any Federal involvement would be much less additive and much more replacing of what private markets would otherwise do.

    So the question that I think the committee will face in drafting legislation is the tension between the goals of universality and the goals of not displacing the private market.

    Mr. HILL. Thank you.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you very much, Mr. Hill.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman.
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    Mr. Secretary, I appreciate your comments and particularly your comments on the legislation, and I think in hearing the discussion of the Members that we should be cautious today in being concerned about some States benefiting under this program, because there are many other programs that some States benefit from and others do not. So if we start getting into ticking off States, we are going to find out we are going to put ourselves in a jam in the States we represent.

    I will give you an example. With the Federal flood insurance program, which doesn't necessarily benefit every State, it is a subsidized program, it is very important to my State, and so I think we should be cautious.

    I also think the comments that Mr. Vento made are on point. Again, I would reference the flood insurance program with respect to mitigation. In Houston, Texas, for instance, we have a situation: We have a moving flood plain because we have no land use control, and so you have constant upstream development that occurs, changes the flood plain, and there is nothing we can do about it. But the taxpayers from around the country tend to subsidize.

    But the way I see this program, in looking at this legislation, it would appear there is, at least initially, not a subsidy. There may be an implicit subsidy of some part, but not an explicit subsidy. I guess ultimately if everything bad were to happen, that could occur.

    But, Mr. Summers, if you could explain further in the technical questions in your appendix, you have three points that I am curious about. One is that Treasury would propose that the Secretary not be able to deviate pricing of premiums downward but only upward, and I guess that addresses in part the rebate question that Mr. Vento raised.
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    Second of all, the issue of risk load, and then the question of the budgetary impact, is it possible to structure the legislation and to structure the fund in such a way, perhaps, like the BIF fund, where the funds are secure, that they are not used for other purposes, to structure the Secretary's and the commission's pricing so that it reflects the capital adequacy of the fund.

    Mr. SUMMERS. My impression is, those difficulties should be surmountable, although in not all of those difficulties could I give you a precise means of surmounting. It is an issue that I think requires very careful political thought.

    You mentioned the example of the BIF fund. One of the concerns in this area, given that we are talking about catastrophes that have a very low probability of taking place, is that after 15 or 20 or 25 years, when there has been no catastrophe and the premiums have been paid and have been accumulated in a fund, one senses there is the possibility that since the fund has substantial resources, there might be a feeling it was no longer appropriate to charge premiums; and that, of course, would be wrong because with 1 in 100 events, it would not be remarkable that 25 years could go by without such an event taking place.

    So I think we have to think very carefully about what the right mechanisms are for ensuring that that is managed well. And of course the questions of scoring are questions on which much of the expertise resides up here in the budget process and at OMB, but I think these are manageable issues, but not easy issues.

    Mr. BENTSEN. It would seem, in particular with the capitalization of a fund, obviously there are some legislative things we can do to tighten it up to ensure the funds are allocated properly and accounted properly. And I agree that after 25 years, you could have delegations from certain States who might say, well, gee, we haven't had an earthquake in 25 years and now we have paid in the premiums to such an amount that we are way overcapitalized, although you might, I guess, want to look at a formula. Because your risk exposure should be rising as well, hopefully the property values are increased at the same time the fund balances are increased, so you might consider that.
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    It might be helpful if we do move forward on this legislation—as I guess the Chairman has indicated we are—that Treasury, in the response you are going to provide the Chairman, that you might be willing to provide some specific language or ideas to address that.

    Mr. SUMMERS. We will do that.

    Mr. BENTSEN. Thank you.

    Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you, Mr. Bentsen.

    Dr. Weldon.

    Mr. WELDON. Mr. Chairman, I will pass.

    Chairman LEACH. Thank you.

    Mr. Maloney.

    Mr. MALONEY. Thank you, Mr. Chairman.

    Mr. Secretary, thank you very much for your testimony, and thank you in particular for your testimony to the effect that H.R. 219 provides a foundation. And I look forward to working with the Treasury Department as that foundation is developed, and the first thing I would do, just by way of comment, is to reinforce Mr. LaFalce's and Chairman Leach's comment that that cooperation on the development of the legislation is very important to us, and we look forward to that.
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    My question has to do with the mitigation issue. Literally, the old proverb is, an ounce of prevention is worth a pound of cure, and therefore, from a financial as well as a human point of view, I think that the mitigation issue is critical and a critical element of the legislation.

    You have expressed what I believe you referred to as ''technical concerns'' about the mitigation language in the bill as it stands. I would be very interested in an amplification of those concerns, and I would also be interested in the Treasury's view as to any other framework of mitigation. What other things relative to mitigation should the committee take up in its deliberations?

    Mr. SUMMERS. Let me, if I could, just make very clear that we very much share your concern, and I think if one looks at the legislative history in this area, rather elaborate mitigation procedures have been very much under discussion and, frankly, have run into a variety of obstacles of practicality and of politics. And I don't have a specific alternative to suggest today.

    Our concern was, as I think I mentioned earlier, that if you have the legislation—if you have the funds diverted from the disaster fund, then they are not there in the disaster fund to meet the disaster, and you also change the whole process in the sense that you have appropriated funds and appropriated outlays, and all those kinds of problems seem to us to be large.

    But I think in the context of the Federal Government's continuing review of its disaster policies and its impact on building codes and the like, there is a set of things that can be done. And while I don't know that we have any original thinking to offer on that, and it is not really—this part of the issue, frankly, is not something that really falls within the Treasury Department's competence. What I would be happy to do is provide you with some summary of the set of provisions that were under discussion earlier.
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    Mr. MALONEY. Fine. I just want to take the opportunity to point out that the bill, as it sits today coming out of the subcommittee, is different than the bill going into the subcommittee; and one of the critical differences is that the mitigation funding is, in effect, only available beyond the actuarial soundness of the fund, so the prior concerns about mitigation money coming out and therefore not being available to the corpus of the fund for indemnification is not exactly the situation as it sits in the bill.

    Mr. SUMMERS. I think you make a very important point, Congressman Maloney. We still, I think, worry that if you don't provide—if you establish the principle that any part of the accumulation of this fund, either an actuarial thing or a risk load, which covers the prospect that you might not have gotten the actuarial part right, to establish the principle that those funds can be spent, that may be a somewhat slippery slope, and that is why we view it with a lot of caution.

    Mr. MALONEY. I understand that point of view, and I think that goes back to something Congressman Vento said, and goes to the whole issue, then, of rebates and other kinds of misuse of the fund; and that goes really to the general issue of the management in finding a way to guarantee the integrity of the management of the fund.

    But I would say that that is the direction that I would look to for the solution, rather than not providing an effective financing vehicle for mitigation efforts.

    Mr. SUMMERS. I think that is a fair comment. I would not want to dispute that at all.
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    Chairman LEACH. Thank you very much.

    Mr. Sherman.

    Mr. SHERMAN. Thank you, Mr. Chairman.

    I think the Federal Government has two roles. One is as concerned with its citizens as a Government and concerned with human beings, we should want to reduce disaster losses, make sure those disaster losses that occur are insured, provide Federal aid for uninsured losses, knowing that if we don't provide that aid, the financial loss will have to be absorbed by the same people that absorbed the psychological trauma of the disaster itself.

    This bill, I think, goes a long way toward trying to make sure that losses are insured losses, rather than uninsured losses.

    I hope we would also be acting to try to reduce and mitigate the risk, but just because a bill doesn't achieve everything doesn't mean it doesn't achieve important results.

    The other role for the Federal Government is as the world's largest financial entity. It should be pointed out the Federal Government has OPIC agency, along with a number of others, where it decides to get into the insurance business, in part because it is the largest financial entity in the world and can shoulder risks that various private sector companies cannot, and even earn a profit, in part because it has an interest in making sure insurance is available so as to allow a particular economic activity to proceed.
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    As I understand this bill, the premiums that will be charged will be actuarially sound and, if anything, may allow the Federal Government to make a profit; and if the Federal Government is nothing more than the world's largest private investor, it might be a good deal. But I think the other thing to point out is, the Federal Government is not just an investor in reinsurance; it also, as a Government, suffers the cost of uninsured losses. And my question goes beyond anything that I would ask the Secretary to respond to orally, because I think it will take some analysis by your department, and that is to take a look at how much the Federal Government has to gain by having more disaster insurance purchased by homeowners.

    First, in the area of FEMA and other Federal agencies, what does the Federal Government save by not having to provide as much aid in the upcoming disaster? And then, second—and I know this was alluded to by one of my colleagues earlier—looking at the tax system, where there are substantial tax deductions for those that incur uninsured losses, but if the loss is insured, the homeowner is made whole and the Treasury does not suffer a loss.

    What I would propose is that you take a look at the disaster most impressed on the minds of my constituents, the Northridge Earthquake, and analyze, both in terms of the expenditure side, FEMA, and so forth, and the tax side, what would have been the Federal cost if the number of homeowners that had disaster insurance had been 20 percent less than actual; or what would have been the Federal savings, both in terms of increased revenue and reduced cost, if 20 percent more homeowners had purchased disaster insurance prior to that earthquake. And I think we may come to a bill that not only is scored revenue neutral, but is perhaps scored as a—and my guess is CBO would not be this sophisticated—but should be scored as a bill that provides substantial benefit to the budgets of the future.
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    I have very little remaining time, and perhaps you have a few general comments, but I know this will take an analysis of the Department.

    Mr. SUMMERS. Congressman Sherman, you raised a very important set of issues. The tax point you make is not one that I am aware that anyone has thought about, although it seems to me to be a very important point; and we ought to be able to try to make some kind of estimate of the magnitude of it.

    The people have looked to some extent on the expenditures side, and there are effects, but I think—and we will study this more carefully in response to your question—that the effects are not as large as one might at first suppose, that the vast majority of the Federal money after Northridge went for various kinds of improvements in reconstruction of infrastructure, of various kinds of compensation for costs to State and local government entities, and that the amount that went to homeowners to compensate for costs that would have been insured by homeowners' insurance, is—at least from the preliminary looks that have been described to me, these costs are actually not large.

    There is an additional potential interaction having to do with a possible—you know, possible public sector roles in the event of insurance company insolvencies, which is an additional interaction that goes in, and I think the general point that you are making, which is that, in part, in the event of a substantial catastrophe, the Federal Government will have very large liabilities; and to the extent it can be compensated in advance for those liabilities, any amount at all that is better than not being compensated seems to us to be a fair and important one, and I think is at least briefly noted in my prepared statement as one of the rationales for Federal Government in this area.
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    Mr. SHERMAN. About how long will it take for this massive project I have asked for?

    Mr. SUMMERS. Oh, we will get it to you as rapidly as we can. I shudder to make an estimate because of a rule I learned as a student, when somebody said to me when an estimate is given of how long something will take, what one should do is double it and move to the next higher unit of time, so days become weeks and weeks become months, and since then I have learned to be careful about giving estimates as to how long things will take, but we will do it as rapidly as we can.

    Mr. SHERMAN. Thank you.

    Chairman LEACH. Thank you very much.

    Did anyone else want to add anything?

    If not, let me just say in summary that I have been impressed with the discussion that has occurred. It seems self-evident to me that there is a possibility in the making of a win-win situation, one in which homeowner insurance premiums can be reduced, one in which risk can be removed from parts of the insurance industry, and one in which taxpayers can conceivably actually earn money in a program, rather than lose.

    On the other hand, if this kind of approach is misshapen, you could have significant taxpayer liability, and so certainly the details are essential in how we proceed; and for that I am appreciative of the testimony today and the commitment of future input from the Department of the Treasury. Thank you very much.
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    Mr. SUMMERS. Mr. Chairman, thank you very much and let me just thank you for this opportunity and the Members of the subcommittee, who I think have made a great contribution in bringing this to this point. And I would like, in particular, also to thank the Members of your staff and the Members of the subcommittee staff who have given a great deal of thought to these issues and with whom we look forward to working in the future.

    Chairman LEACH. Well, thank you, Mr. Secretary.

    Chairman LEACH. I would now like to ask the second panel to come to the table.

    Our second panel includes representatives of State-operated catastrophe programs, which would be eligible to purchase the Federal reinsurance envisioned in the legislation. I should mention, at the request of our Ranking Member, Mr. LaFalce, the Insurance Commissioner of New York was invited by the committee to testify, but was unable to attend because of a scheduling conflict.

    Mr. Donald Dowdell is Deputy General Counsel of the Florida Department of Insurance and is testifying on behalf of Florida Commissioner Bill Nelson.

    Mr. David Knowles is the Chief Deputy Insurance Commissioner for the State of California and is testifying on behalf of California Commissioner Chuck Quackenbush. In 1995, as an assemblyman, Mr. Knowles authored legislation to pave the way for the creation of the California Earthquake Authority.
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    Chairman LEACH. Gentlemen, welcome.

    Mr. Dowdell.


    Mr. DOWDELL. Mr. Chairman, Members of the committee, thank you very much for the opportunity to speak to you this morning concerning this legislation. What I would like to do is just to summarize pertinent facts based on Florida's experiences, which I think indicate the wisdom of an approach such as is suggested in this legislation.

    Hurricane Andrew, when it struck south Florida, caused $20 billion worth of damages, including $16 billion worth of insured damages. Hurricane Andrew is considered to be about a 1-in-50-year event and it was a Category 4 hurricane. Andrew was by no means a worst-case scenario. If the course of the storm had veered one degree to the north, and had made it to the Miami-Fort Lauderdale area, damages would have been about $52 million.

    Chairman LEACH. Excuse me, if I could interrupt just briefly. If you would, pull the microphone a little closer. Thank you.

    Mr. DOWDELL. Thank you.

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    As bad as it was, it could have been worse. But following Hurricane Andrew, the damages that we saw caused the insolvency of 11 insurance companies, who were rendered insolvent in whole or in part as a result of their inability to pay claims resulting from that hurricane. Two additional insurance companies, State Farm Fire Casualty and Prudential Property and Casualty Insurance Company were saved from insolvency only as a result of significant cash contributions by their parents.

    Following Andrew, the voluntary market for homeowners' insurance in Florida basically collapsed. Insurers who had an overconcentration of risk and sought to secure additional reinsurance coverage were unable to do so. Many insurers sought to terminate all of their existing obligations and leave the State. Virtually no coverage was being written anywhere in the State, including the areas in north central Florida, where the risk is minimal, for new policies.

    We passed a law which limited the ability of insurance companies to cancel policies and put a cap of 5 percent on the total number of their existing homeowners' policies, which could be canceled in any one year. That law remains in effect today.

    Despite that statutory limitation, we had to create a residential property joint underwriting association to provide coverage to those insureds whose policies were terminated and also to individuals purchasing new homes.

    The population of that joint underwriting association grew to a high of about 930,000 policies in 1996. Through aggressive and innovative depopulation efforts, we managed to get the population back down to a current level of about 339,000 policies. But while we were doing that, the population of a second JUA that provides coverage against the peril of wind only, increased to about 450,000 policies.
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    One success we have had has been the Florida Catastrophe Fund, which we created in 1993. The fund provides low-cost reinsurance coverage to insurers that are providing homeowners' coverage and other residential coverages in Florida. The premiums paid by those insurers accumulate tax free, and right now that fund has about $2 billion of cash on hand. In addition, as a result of a recent IRS ruling and the CAT Fund's ability to issue assessments to policyholders, they now have an ability to raise about another $8 billion through the issuance of tax free bonds, if those funds are necessary.

    Florida has done about everything we can do at this point to deal with the threat of hurricanes, but we are nowhere near able at this point to handle a mega-hurricane. An event of that magnitude would exhaust the current claims paying ability of the Florida CAT fund and the two JUAs and result in an inability to pay all the claims that occurred.

    Further, if there were such a mega-hurricane, the funds of those mechanisms would be totally exhausted, they wouldn't have any funds available to pay claims from a subsequent event. While that is not likely in any given year, the models indicate that it will no doubt occur, and the only question is when; and if the claims can't be paid and repairs, not made, mortgage defaults and economic disruption will no doubt ensue.

    I would like to point out Florida is not alone in this regard. I have heard testimony and comments earlier. It has estimated a Category 4 or 5 hurricane striking New York, New Jersey, Texas, going in any populated area would cause damages in the range of $40 to $50 billion, and there is similar liability for earthquakes in Washington and also on the New Madrid fault, where an earthquake would cause about $69 billion in damages.
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    Insurance is founded on principal spread of risk, and the current capacity of the reinsurance industry and the current capacity of any one State is inadequate to be able to effectively spread the risk of loss from truly catastrophic hurricanes.

    We support this legislation. We think it is going to give us the ability to handle the 1-in-100-year storm and pay claims, hopefully, and restore some market stability and some stability in pricing. Thank you very much.

    Chairman LEACH. Well, thank you very much, and we are appreciative of your testimony and we want you to extend our best to Bill Nelson, who is a distinguished ex-colleague. Thank you.

    Mr. Knowles.


    Mr. KNOWLES. Mr. Chairman and Members, as the Chairman mentioned, my name is David Knowles. I am Chief Deputy Insurance Commissioner. I serve with Chuck Quackenbush, who is our elected Insurance Commissioner of California.

    In order to give you a snapshot of the California experience, I would start by saying that for many years prior to 1994, linkage was public policy in California, meaning to say, there was a mandated requirement to offer earthquake coverage. For every policy of homeowner insurance that was sold, the insurer had to offer to sell a low deductible, frankly very low premium, underpriced policy of earthquake insurance. We didn't know how underpriced it was until the Northridge event, because in the aftermath of the Northridge quake, it was evident there was a fundamental flaw in the way in which earthquake insurance had been written and in which it had been priced.
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    Two brief examples I will give to quantify: There is a Thousand Oaks-based company named 20th Century Insurance Company which, upon the advice of the best scientists at the time in the early 1990's, the earthquake modelers, in order to protect themselves against risk of loss with earthquake and their book of business, which was centered heavily—overconcentrated admittedly, but centered heavily in the North L.A. County-San Fernando Valley area, the earthquake modelers with the best of science said, you need a $100 million reinsurance policy in order to protect yourself from an 8.0 earthquake on the Richter Scale.

    An earthquake came along January 7, 1994, known as the Northridge quake that was 12 times smaller than an 8.0, it was a 6.8 on the Richter Scale event, and 20th Century Insurance Company paid out 10 times the amount of their reinsurance policy. They were barely left standing after that event; by way of selling off various divisions and other creative plans, they are still selling auto insurance in California today.

    But the massive degree of overexposure to which companies were subject was becoming apparent. Many companies ended up paying out more in claims in Northridge alone than they had collected Statewide in the last 25 years prior to that for earthquakes.

    By this time, our homeowners' market was shutting down because if the price to sell homeowners' was that a company had to massively overexpose itself and risk the 20th Century experience, or worse, they were willing to walk away from the homeowner market. Our fair plan in a 2-year period of time quadrupled in its population. The nonadmitted market was moving in at a premium price that was several times, in many cases, the normal homeowner policy that was available.
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    It became quite clear there existed in California a strong association between the threats of insolvency to the insurance industry and the interests of consumers in California. The last thing any of us wanted, regardless of our philosophical strife, was for consumers to have to line up one day to get pennies on the dollar for their losses for which they had paid premiums in good faith; and that is why the Consumers Union came along and sponsored this conservative Republicans' bill known as AB–1366, a mini policy bill which wrote down the coverages, wrote up the deductible from 10 to 15 on the mandated earthquake offer. They, at that time, despite the fact that part of their testimony today says that coverages are not adequate or affordable, thought the coverages were adequate and affordable that they sponsored in that bill, and it became the platform of coverages on which the California Earthquake Authority today is now based, as we work together to go on from allowing the private companies to offer the mini policy with a reduced mandate to offer, as well as creating the authority that you know of today as the CEA or California Earthquake Authority. It is a tax deductible, privately funded, publicly managed entity writing earthquake insurance for Californians. It occupies about 71 percent of our market share, and together with the other 29 that write the private mini policy, resulted in a dramatic and total reversal of market conditions.

    I wish I had time to go into greater detail to address Mr. Kennedy's concerns, which he mentioned, about participation. In fact, Californians are buying this product. Between the private market and the CEA purchases we are at pre-Northridge levels. There is always a spike in purchases for catastrophe insurance, notably earthquake in California, following an event; and there was a big spike of about a million extra policies following the Northridge quake for about a year or two, as well, but we are back into the market in full steam.

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    In summary, I would say the CEA is up and running and has dramatically reversed the problem of constricting homeowner and earthquake markets in California, and we can stand two 250-year probable maximum loss events today. And you might say that is great and sufficient protection, but we believe that H.R. 219 proactively sets up a Federal reinsurance pool to protect homeowners nationwide against the loss of their homes to inevitable natural disasters; and it is a farsighted measure that addresses this critical issue before a disaster hits, rather than attempting haphazard recourse after the fact. We will greatly extend what we can do for our consumers in California, and we will greatly improve our ability to protect them and extend coverages to them in the years to come. We are here in support of moving the bill forward.

    Chairman LEACH. Let me thank you very much, and also if you would give our best to Mr. Quackenbush, who testified before us about a month ago and who is playing such a lead role on the Holocaust issues, among others.

    I think it appropriate to introduce our new brain trust that has joined this committee. This is a daughter and best friend, who is also a daughter for the day, and we expect to learn a great deal from all age groups' perspectives. They indicated that their father is not talking relevant issues and that brought before the committee should be the question of whether a report card should be issued or not.

    In any regard, I thank you all.

    Let me ask Mr. McCollum if he has any questions.

    Mr. MCCOLLUM. Thank you, Mr. Chairman.
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    Let me ask you about Florida's participation in any of the programs contemplated: H.R. 219, as it now stands, or possibly modified, as Secretary Summers indicated he desired, by a certain excess-of-loss contract opportunity. How would the State of Florida finance any purchase of whatever premiums and whatever protection was purchased, be it directly into the fund that is contemplated by H.R. 219 or through an excess-of-loss contract?

    How would you finance that purchase? Would the cost of that be passed on? Would the CAT fund itself retain the cost to absorb it? Would the insurers be required to line item to the public in buying a policy, X amount of this cost is now passed on to you, and here is the extra price for that insurance premium? How would it be financed?

    Mr. DOWDELL. Congressman, there's any manner of ways it could be financed. What I can say for certain is the way the bill is structured, it gives us flexibility. There is no question in my mind that the coverage afforded by the CAT fund can be coordinated readily with the reinsurance program and its ability to purchase reinsurance, which is described in this legislation.

    Legislation, I suspect, would provide for the cost of that layer of reinsurance to be built into premiums and included in the premiums paid by policyholders; that is how we currently recoup the CAT fund premiums and the other residual market premium payments.

    Mr. MCCOLLUM. So that would be included in the premiums that policyholders pay, ''policyholders'' in this case being individual homeowners, as opposed to the insurance companies; is that correct?
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    Mr. DOWDELL. That is correct.

    Mr. MCCOLLUM. Would Florida be prepared to bid on an auction if an auction market were created, be that for the CAT fund directly or into the H.R. 219 system; or be that on excess-of-loss contracts, if they were a mechanism?

    Mr. DOWDELL. Congressman, I know that the auction mechanism that was originally proposed last year, we had some serious reservations with that; and I know there have been some modifications to that in this bill. I really couldn't say at this point. We have only had the bill a short period of time. We haven't had a chance to analyze that.

    I don't think we would have a need to—basically, I think, with the reinsurance program that is there, that would just provide a layer of coverage above what the CAT fund is already providing, and between the availability those funds and the CAT funds, we would be able to handle virtually any event.

    Mr. MCCOLLUM. Mr. Knowles, in California your system works differently than Florida's system, quite a bit. Does that make you more or less comfortable with the precise version in H.R. 219, or does it meet your needs too because it is tailored that way?

    Mr. KNOWLES. We are not comfortable with the precise version of what we see presently, and therefore I am excited about what the Treasury Department is going to do to join together with many of you to work on language to go forward from here. Quite frankly, if I may be so bold to suggest it, both I and the commissioner, Chuck Quackenbush, feel that the best long-term solution to the problem that we face, notwithstanding the wonderful efforts that you gentlemen have gone to to try to erect a solution here, is simply tax-exempting the accumulation of reserves or catastrophes by the private sector, by private companies.
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    Europe does it. It works. It takes a long-term view of protecting its citizens from disaster, and I believe this Nation ought to do it as well and reflect it in our tax policy.

    However, in the meantime, talking about political reality and what is achievable, we laud your efforts and we look for some marriage of the ideas to come together, and that is why we are here supporting the concept.

    Mr. MCCOLLUM. Well, I appreciate your frankness about it. I certainly support changing the tax laws of those reserve funds as well, but you are absolutely right about the practical problems of doing that with regard to the moment in Congress, balancing the budget, and so forth.

    So we are here trying to modify this bill in a way that will be acceptable to you and to Florida and to the other States involved. We are just needing your guidance on how to do it. And as I think the Chairman indicated earlier when Secretary Summers was here, any specific legislative changes, any language, you don't have to write a whole bill for us, but either Mr. Dowdell or Commissioner Knowles, either one of you in your respective States suggesting to Mr. Lazio, myself, Chairman Leach, specific lines that you think and ideas you think might help improve this bill, I presume—I don't want to presume for Mr. Lazio, but I think we both would be welcoming those suggestions if you have them.

    I want to thank both of you for coming today.

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    Our States, Florida and California, are greatly in need of some form of protection for capacity for insurance and for ways that will help if we have two events or the ''big banana,'' as they say in California, happening.

    Mr. KNOWLES. Thank you, Mr. McCollum and Mr. Lazio for both of your efforts in this area and specifically for welcoming us to participate in suggesting language. We will do our best to be supportive and prompt in that effort.

    Mr. MCCOLLUM. Thank you. Thank you, very much.

    Thank you, Mr. Chairman.

    Mr. LAZIO. Mr. Vento.

    Mr. VENTO. I will yield to Mr. Sherman.

    Mr. LAZIO. Mr. Sherman.

    Mr. SHERMAN. Thank you.

    Mr. Knowles, it is always good to see a representative from the California State government here in Washington.

    Mr. KNOWLES. Yes, sir.

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    Mr. SHERMAN. As I understand it, the CEA now purchases reinsurance for, is it $2.5 billion?

    Mr. KNOWLES. That is correct, just below $2.5 billion, and it has a claims paying capacity of $7.4 billion, but the reinsurance component is $2.5 billion.

    Mr. SHERMAN. Now, the other $5 billion of, quote, ''paying ability,'' you are not sitting on $5 billion in cash that you and Chuck can kind of roll around in?

    Mr. KNOWLES. You know, that would probably be nice in a more perfect world, but that is not the case.

    Mr. SHERMAN. Where does the rest of the paying capacity come from, if it is not sitting there in cash?

    Mr. KNOWLES. The rest of it comes primarily from contingent liability to the participating companies. In the event of an earthquake event, that would be of a certain size, and depending on how big and how many insured losses were covered in that event, they would be assessed perhaps billions of dollars.

    Mr. SHERMAN. And you said the CEA can now handle two 250-year events?

    Mr. KNOWLES. That is correct, and together with the change of going from the historic 10 percent deductible up to the 15 percent deductible that is present in the private industry policies as well as the CEA coverages, getting rid of swimming pools, rented structures, Norman Rockwell china, not covering those, the combined force of that indicates that today we could withstand, with the CEA claims paying capacity, a full three Northridges.
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    Mr. SHERMAN. So in terms of trying to make the system better for consumers, it would be nice if you could handle four Northridges, but three seems sufficient. I don't know anybody who thinks that earthquake insurance in California is a good deal. I mean, there are people who buy it, but they are always complaining about it. And part of the cost is what you are paying for reinsurance. As I understand it, you are paying 10 times actuarial cost and more in order to get that reinsurance. If the Federal Government went into the reinsurance business, how much would you hope to save?

    Mr. KNOWLES. Well, it is interesting that you would use a figure of 10 times actuarial cost. I am sure someone went to great efforts to prepare a number like that. But what is an actuarial cost and what isn't an actuarial cost, one of the best guides that I have used and that I have seen used over the years is not only actuarial, what we know of actuarial science per se, but also what the market finds necessary to charge for it; and we are paying 11 and 14 percent respectively for various layers of reinsurance, in and through the CEA. As to whether that is 10 times the actuarial cost, there wasn't anyone else to offer it at any price and this is the first time in history a reinsurance commitment of this magnitude has been made for reinsurance specifically.

    Mr. SHERMAN. So when you say 11 percent, for example, you are saying to get $100 million worth of reinsurance coverage, you are paying $11 million per year?

    Mr. KNOWLES. That is right.

    Mr. SHERMAN. You have looked at the statutory language before us. We passed this bill. Any guess as to what you would be paying the Federal Government for reinsurance, and do you think it would be between 11 and 14 percent or closer to the 2 percent that we have heard earlier?
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    Mr. KNOWLES. I think it would be closer to the 2 percent that we heard earlier. You know, I have not studied it to the point where I could say that it would be 2.9 or 1.8, but I think that it would be closer to the 2 percent that we heard earlier. And we have a situation here where there is no other entity available that we know of on this planet to offer that kind of capacity and to frankly provide to Californians these additional layers of capacity that could take from us the $7.4 billion claims-paying capacity all the way up to perhaps $25 billion.

    Mr. SHERMAN. So, Mr. Knowles, this bill is going to save California consumers or the CEA, and hopely indirectly California consumers, a couple-hundred-million-dollars every year. Are you wildly in favor of this bill?

    Mr. KNOWLES. I would not characterize my emotions or the commissioner's as being wildly in favor of the bill. We are wildly in favor of the concept of the Federal Government playing a role, because as you know, Congressman, California consumers—and again, the CEA is populated today by 955,000 policyholders, in addition to an entire segment of the market that is not non-CEA. There are a lot of people interested in protecting themselves to the point of they are putting out hundreds of dollars a year to buy earthquake policies, and they feel that they have done their part, and they feel that the State government has done its part.

    It was cathartic, frankly, to bring two-thirds of both houses together around that CEA bill, I'll tell you. And now, frankly, a lot of us look to the Federal Government, not necessarily to open the storehouses of the Treasury, but in a wise and productive and deliberative manner, as these gentlemen have let, to execute its role in this matter as well.
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    Mr. SHERMAN. I think you deserve praise for creating the CEA in Sacramento, and certainly a $200-million reduction in the cost to California consumers will cause a lot of my people in my district, for example, to actually buy the insurance and stop being as nervous as they are not wanting to overpay and at the same time not wanting to go without coverage.

    Thank you, Mr. Chairman.

    Mr. LAZIO. Thank the gentlemen.

    We have a vote that is on right now, but we do have a few more minutes.

    Do we have any questions. Mrs. Kelly.

    Mrs. KELLY. Yes, thank you, Mr. Chairman.

    I do have a question. I have listened to your testimony, and I can see from your testimony what your funds can handle, but we are talking about Federal legislation here. And I want to know what your estimate of the level is about where you think that the Federal Government ought to be stepping in. What number are we talking about in terms of where you think the Federal Government ought to come in? Do you have any thoughts on that?

    Mr. DOWDELL. As I understand, the way the bill would operate as currently written, there would be a layer of up to $25 billion above whatever the State's retention was. And right now Florida has got about a capacity of $10 billion; it will be around $11 billion by around the end of this year. I would think in order to be able to have reinsurance coverage for a mega-hurricane, the ability, if we need it, to be able to get up to that level is about right.
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    Mrs. KELLY. Would you definitely buy the Federal insurance that was at the end of the plan in H.R. 219?

    Mr. DOWDELL. I couldn't say that we would definitely buy it. My expectation would be that, yes, we would, assuming that it was priced appropriately, because our experience, I think, has been like many others'. Reinsurance has been unavailable, or to the extent it is available, it has been unaffordable.

    Mrs. KELLY. What about you, Mr. Knowles?

    Mr. KNOWLES. I think the answer to your first question is that that amount has got to be different for different States. The different States are insuring different risks, have different population sizes, have different numbers of insureds in their books of business. And the very nature of the risk of their insuring can cause more or less damage to structures. So I think that it is something that as we work through the specific language of the bills, those attachment points have got to be specified for the various structures that this would provide—that the Federal pool would provide a reinsurance layer to.

    Mrs. KELLY. Mr. Knowles, do you consider the cost of reinsurance that is currently available too high?

    Mr. KNOWLES. I would consider it too high when I am buying, and maybe not high enough when I am selling, depending on what side of the table you are on. And, you know, these guys have got to stand up to all of those claims one day, if we walk in and have that event. So that is the $64 billion question sometimes, isn't it? The point is that I believe that it can be done on a more frugal scale. Right now it is working for California.
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    Mrs. KELLY. So you think it is a rip-off?

    Mr. KNOWLES. It is working for California. And, you know, there was no one else to step up to the plate and offer us that kind of coverage for that kind of price, as far as the reinsurance layer goes. It was the first time ever in history that this kind of package was put together to insure these kinds of risks, particularly in this magnitude. So we are thankful for the structure, for the presence of the reinsurance layers being there at this price, and it is working. We think that we can actually improve on this recipe.

    Mrs. KELLY. Just one quick thing. I want to know what mechanisms you have in place to continue funds if you exhaust your resources. What have you got to continue the funds if the resources for them are exhausted, anything in place?

    Mr. DOWDELL. We do not have anything in place, and that is why we support this legislation. It would enable us to be able to avoid exhausting the available funding and funding mechanisms we have,.

    Mrs. KELLY. Thank you, Mr. Knowles,.

    Mr. KNOWLES. Similarly, if there is in California a huge earthquake that we have never seen before, or a series of earthquakes, it would quickly deplete CEA claims-paying capacity. The statute calls for claims to be out of that point on a pro-rata basis, and for the closure of the authority. So there is no contingency plan beyond that, and that is where we are looking to the Federal Government to perhaps have some sort of partnership role. And that is why we are here in support of H.R. 219 today.
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    Mrs. KELLY. Thank you very much.

    Thank you, Mr. Chairman.

    Mr. LAZIO. Thank the gentlelady.

    We have eight minutes left on this vote. I am going to hold the hearing in recess until 1:15, and we will come back about 1:15 for the remainder of the questions. The hearing is in recess.


    Chairman LEACH. Mr. Lazio.

    Mr. LAZIO. Thank you, Mr. Chairman. And I want to thank both of the panelists, Mr. Dowdell and Mr. Knowles, for their knowledgeable and thoughtful testimony.

    I guess what I would like to discuss, because of the creation of three State programs, the liquidity problem in California, Florida and Hawaii as a result of recent natural disasters.

    I would like to ask your assessment of their reinsurance capacity in each of your particular regions. I think it is probably important to think about reinsurance, not just in terms of having national availability, but availability for a particular region and this so-called ''risk-of-ruin'' issue that is very much inherent in the pricing of reinsurance. I would ask Mr. Dowdell first, what, in your opinion, is the capacity of private reinsurance right now in the Florida marketplace?
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    Mr. DOWDELL. Congressman, our experience has been that the reinsurance has not been readily available that is required in order to adequately spread the risk of loss from a truly catastrophic hurricane. I think that is probably a result of two things: One, the demand is for the upper levels. I mean, prior to Andrew, all the models said the maximum losses would be about what they were in Hugo. Now they realize that is wrong. The models have all increased dramatically, and everyone is scrambling to get those layers of reinsurance for the truly catastrophic loss, and there is just not enough capacity to assume that amount of exposure.

    Mr. LAZIO. I take it if there were more reinsurance, you would buy it if it was affordably priced?

    Mr. DOWDELL. That was the other point I wanted to make. If we could have gotten it, we wouldn't have needed to establish the CAT fund, but it was unavailable, and we, as a result, had to establish the Florida catastrophic fund to provide that layer.

    Mr. LAZIO. The CEA purchases private reinsurance. I am just talking about some of the pricing issues, and I take it that would be true as well with the California Earthquake Fund, that if there was more affordable reinsurance, that you will be buying it, it would be in the marketplace?

    Mr. KNOWLES. It would have to translate either into additional coverages that we are not able to offer today, lower-rated premium, more consumers being able to be covered by the CEA, or some combination of the above.

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    Mr. LAZIO. So you have reinsurance that you buy. It is all from one entity?

    Mr. KNOWLES. No, it is from several different entities.

    Mr. LAZIO. No. The number I received, and I am not sure if it is accurate or not, was that an annual premium was approximately $460 million for about a billion-and-a-half dollars of reinsurance. Is that accurate?

    Mr. KNOWLES. Unfortunately, the more handsome guy that was sitting behind me has left to catch a plane. He is the CEO with the California Authority. He could tell you with precision, but your number sounds right. I am informed that is closer to two years' premium than one year's premium.

    Mr. LAZIO. So it is a very costly undertaking, in your opinion, because of the so-called ''risk-of-ruin'' that needs to be built into pricing by reinsurers making it virtually unaffordable to buy more reinsurance?

    Mr. KNOWLES. It becomes prohibitive to try to put together a structure through solely reinsurance placements, as well as, you know, one has to contemplate is there the willingness on the part of the reinsurance industry and, therefore, the capacity to make such extensions of risk.

    Mr. LAZIO. I take it it is sort of self-evident, again, that if the insurance was available, and premiums were not so costly, you could pass on those savings to individual homeowners in the form of lower deductibles or lower premiums?
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    Mr. KNOWLES. That is true, and obviously the CEA is operated as a nonprofit, tax-exempt entity. However, far be it from me to criticize the reinsurance industry for the price at which we have reinsurance available in California. At this point we are glad they are there.

    Mr. LAZIO. It is what it is.

    Mr. KNOWLES. If we can grind them down, we will grind them. I am glad they are there.

    Mr. LAZIO. One of the points here in terms of the capital markets going to individual reinsurers who have this risk of ruin concept built into the prices are not in the position to offer sufficient levels of reinsurance at affordable prices that make it useful for you to shift risk, to offer risk policies to individual residential owners?

    Mr. KNOWLES. I am not sure I caught the import of the question there.

    Mr. LAZIO. The point is that the bottom line is that reinsurers have limited capacity right now, a fraction of the potential risk in a State like Florida or in a State like California. There is enormous room to grow in terms of the current State funds and the ability to offer more reinsurance, and the problem really is a dual problem; one of reinsurance capacity overall, and perhaps, more importantly, more efficient pricing for reinsurance contracts. Is that a statement that you would agree with it?
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    Mr. DOWDELL. It is a statement I would agree with, Congressman. Insurers can only buy reinsurance with the premium that they obtain from the policyholders. It has got to be built into the rate. And at some point in time when the insurance is inappropriately priced, it is effectively unavailable.

    Mr. LAZIO. Thank you very much.

    Chairman LEACH. Thank you very much, Rick.

    If there are no more questions for these witnesses, let me thank you very much. You have got a long way, and you represent the two States that are most affected, and your presentations will be taken seriously by this Congress. Thank you both.

    Mr. KNOWLES. Thank you Mr. Chairman, Members.

    Mr. DOWDELL. Thank you.

    Chairman LEACH. Our third panel will begin with the background of existing State insurance programs and a description of exactly how the legislation would complement State efforts. The panel will continue its testimony from executives from both small and large insurance companies and will conclude with testimony discussing private market capacity and other capital market solutions to catastrophe exposure.

    Mr. Kevin Campion is Senior Vice President of Paragon Reinsurance Risk Management Services, Inc. Mr. Campion has directed the services which Paragon has provided to the Florida Hurricane Fund since its inception in 1994. Since 1990, Mr. Campion has also been actively involved in mechanisms to provide reinsurance to residual markets and governmental entities.
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    Mr. Joel Freedman is a Senior Vice President and Director of Government Affairs for the Hartford Financial Services Group.

    Mr. Robert Pike is Senior Vice President, Secretary and General Counsel of Allstate Insurance Company. Mr. Pike is a member of the executive committee and former Chairman of the board of Governors of the National Association of Independent Insurers and has previously testified on behalf of the insurance industry and before both Federal and State legislative bodies.

    Mr. Rade Musulin is Vice President and Actuary of the Florida Farm Bureau Insurance Company. Mr. Musulin worked closely with Senator Stevens during his consideration of disaster legislation in the previous Congresss.

    And Mr. Roger Joslin is Chairman of the Board of the State Farm Fire and Casualty Company, Director and Senior Vice President of State Farm Mutual Automobile Insurance Company, and a member of State Farm Life Insurance Company. Mr. Joslin also serves as Chairman of the board of the National Disaster Coalition and Chairman of the board of the Insurance Information Institute.

    Ms. Sylvie Bouriaux is group manager of research and product development of the Chicago Board of Trade. And Ms. Bouriaux's group focuses on the development of new products in the equity area and in the insurance and real estate market.

    Mr. Frank Nutter is President of the Reinsurance Association of America. REA is a nonprofit trade association of domestic property and casualty reinsurers. Mr. Nutter is Chair of the National Natural Disaster Coalition, an effort to develop a program to respond to catastrophic earthquakes, hurricanes and volcanic eruptions in the United States.
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    Ms. Isolde O'Hanlon is a Managing Director of the Global Insurance Division, Chase Securities, Inc. Ms. O'Hanlon directs the development of products and services to assist the insurance industry in managing its exposure to catastrophic property risk.

    And finally, Mr. Jack Weber is President of the Home Insurance Federation of America. Mr. Weber is a recognized expert on disaster and insurance issues, has participated in numerous forms, and has also appeared before several committees of the Congress.

    Welcome to you all.

    Chairman LEACH. Mr. Campion, we will begin with you.


    Mr. CAMPION. Thank you, Mr. Chairman.

    As mentioned, I am a senior vice president with Paragon Reinsurance Risk Management Services in Minneapolis, Minnesota. Paragon is a wholly owned subsidiary of E.W. Blanch Holdings. We are a leading provider of risk management services. My roles with E.W. Blanch include Paragon's efforts for the Florida Hurricane Catastrophe Fund, for which we provide administrative and actuarial consulting services. Paragon was asked by the Subcommittee on Housing and Community Opportunity to model the structure and vision of H.R. 219.
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    I would like to briefly describe now what H.R. 219 would do. It would create a Federal reinsurance backstop above State disaster programs and auctions. Federal reinsurance coverage would not begin for any State until that State incurred insured residential losses that exceeded that State's retention or deductible, if you will. Those retentions would be set to be the greater of $2 billion or a magnitude of a 1-in-100-year loss for that State, so a loss with the probability of 1 percent or less. Premiums would be collected for each of these States, and they would be actuarially based. These rates would be set by a new National Commission on Catastrophe Risks and Insurance Loss Costs and would be at least two times the annual expected average loss for those States, plus expenses.

    The Loss Costs Commission would also set an actuarially determined minimum or reserve price for any of the auctions, for those States.

    Let me now elaborate on the State auction concept and illustrate how it might work using a hypothetical example. Suppose that South Carolina were to create a State-operated auction program, and let's assume that the Loss Commission determined that South Carolina must pay $200 million for the $25 billion of Federal coverage provided in H.R. 219.

    South Carolina may auction that limit off in 10 separate contracts, each for 1/10th of the total limit. If the State collects more than the $200 million that the Loss Commission said was actuarially sound, then 90 percent of any excess from that auction would go to the Federal Disaster Fund and 10 percent, or $1 million, of that would be retained by the State for loss mitigation purposes. Of course, the initial $200 million would also go to the Federal Disaster Fund. If then a hurricane were to strike South Carolina and losses were to exceed that retention by a billion dollars, each contract would be worth 1/10th of that $1 billion, or $100 million.
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    So each company owning one of those contracts would receive $100 million if they had insured losses of $100 million as well. For both the backstop over State programs and the auction, Federal liability would be capped at $25 billion per year after a four-year phase-in period. The liability during that phase-in period would be determined by the Secretary of the Treasury.

    Now, let me address two questions regarding pricing and operational issues. The first is, would the pricing for these coverages be adequate? It would be the responsibility of the Loss Costs Commission to assure that the rates were actuarially sound, and I believe the catastrophe models today could be used effectively to develop adequate rates, especially when you add a risk load equal to 100 percent of what the expected price for loss is. That means that average losses could be twice as large or twice as frequent as the modeling would suggest and the premium would still be adequate. The simulations of this bill that I will discuss later also supports this claim.

    Another question is, would this type of a mechanism be operationally feasible? Already three States that account for 20 percent of the U.S. population, including the two States with the largest national hazard exposure, have successful State programs. As a reinsurer, the Florida Hurricane Catastrophe Fund has already dealt with issues similar to those which would be addressed or faced in the implementation of H.R. 219, and our experience with them makes me feel that these issues could be resolved.

    Finally, let me describe the work that Paragon did to model this legislation. In this effort we relied exclusively on the results of the risk analysis performed by Risk Management Solutions, RMS, of Menlo Park, California. Their work is used by more than 300 insurers, reinsurers and financial companies worldwide, including FEMA and the National Institute of Building Standards.
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    Paragon took the losses produced by RMS and developed a computer model to simulate what the Federal reinsurance program based on H.R. 219 would do. Basically what the model does is walk through ten year simulated periods during which the premiums go into the fund, losses are paid out of the fund, and interest is either earned or paid on the balance of the fund. Loss events for each year were simulated using a Monte Carlo statistical method for hurricanes in the Atlantic and Gulf Coasts and in Hawaii and earthquakes in California, the New Madrid fault zone and the State of Washington.

    We analyzed how the Federal program would likely perform over this 10-year period under three different scenarios. The first was be only for States that currently have State funds, those being California, Florida and Hawaii. For the second scenario, we added three additional States with high catastrophic exposure and that have considered State programs, New York, Louisiana and Texas.

    And in the final scenario, we included all 25 States with significant hurricane or earthquake exposure. We then simulated ten-year cash flows to that Federal reinsurance structure. And we did it for each scenario 50,000 times. So said another way, each scenario analyzed the effects of hurricanes and earthquakes over a 500,000-year period according to the probabilities of the RMS modeling.

    The results were as follows. As you can see in the chart over to my right, the average surplus in the program at the end of ten years, of each of these ten-year periods was $5.7 billion for the first scenario in which Florida, California and Hawaii participated.

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    If you were to add New York, Louisiana and Texas, the ten-year average rose to $7 billion, as you can see in the green bar over there. If all 25 States were to have joined, the modeled surplus would climb to $13.3 billion. And I think these results are somewhat intuitive, in that if the program collects twice what the actuarial premium is, the more States to join, the larger the premium and the larger the surplus would be expected to be.

    With regard to losses to the program, the programs sustained no losses in 95.7 percent of all years under the three-State program and 88.5 percent of the years in the 25-State program. The likelihood that the program would require a loan from the Federal Government to cover any shortfall in any single year over that 10-year period ranged from 2.4 percent for the three-State scenario to 3.1 percent for the 25-State scenario. So said another way, you would not expect a loan for a three-State scenario except for once in 40 years, and then once in 30 years for 25 States.

    And I am pleased to be able to testify here, and I would be happy to answer any questions. Thank you.

    Chairman LEACH. Well, thank you very much, Mr. Campion. And let me say, without objection, all of your full statements will be placed in the record.

    We have a problem with another vote on the floor, but there may be several during the day, and so what I would like to do is recess, pending this vote, and then we will return probably in about 12 to 14 minutes. And then we will proceed to Mr. Freedman. And so the hearing is in recess pending the vote.

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    Chairman LEACH. The hearing will reconvene. Our next witness is Mr. Joel Freedman. Joel, please proceed.


    Mr. FREEDMAN. Thank you, Mr. Chairman. My name is Joel Freedman. I am a senior vice president at The Hartford. The Hartford is one of the Nation's oldest and largest insurance company. We are possibly the fifth largest property-casualty insurance company and the seventh largest property insurer.

    Of course, my written statement was filed yesterday, and I would like to respond. Rather than respond to technical points, let me just see if I can transport people in the audience and the Chairman into the future for a second.

    On September 23rd, in the year 2000, at approximately 1:50, exactly 29 months from today a massive category 4 hurricane will slam into the Florida coast at Miami Beach. The wind speed at the time of impact will be 150 miles per hour.

    Chairman LEACH. Sorry to interrupt. We have some sightings that we will be testifying later. But please proceed.

    Mr. FREEDMAN. Thank you, Mr. Chair.
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    Chairman LEACH. And you work for what company?

    Mr. FREEDMAN. The Hartford. As you'll see, Mr. Chairman, some correlation——

    Chairman LEACH. The world wants to insure in Connecticut and not Iowa? But please, proceed, thank you.

    Mr. FREEDMAN. As I said, my written remarks have a little more foundation to it.

    Chairman LEACH. Fair enough.

    Mr. FREEDMAN. Tornadoes will be spawned inland reaching velocities of up to 200 miles an hour and will be as severe as the tragic ones we have seen this spring. Lives will be lost. Thousands upon thousands of houses will be destroyed, automobiles and other personal property will be ruined. Schools and work places will be leveled or impaired, interrupting education, employment for hundreds of thousands of Floridians.

    The economy of south Florida will be simply devastated. Emergency workers and claims adjusters will speed to the region's rescue, but the magnitude of the damage will be over three times that of Andrew. Adjusters will move through the rubble and downed power lines to view the damage and issue checks.

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    But the region will be slow to recover, with people displaced from their homes, schools and businesses and work. Every industry from banking to utility to food services will feel the brunt of the storm, and every small or large business will suffer.

    Let me deal only with the impact on the insurance industry. Insured claims of $50 billion will profoundly impact the property-casualty industry. This U.S. industry covering personal and business risks throughout the world has capital approximating $300 billion. Since State and Federal law effectively precludes us from building catastrophic reserves, we will have to reach into our net worth.

    Now, while this in itself may not sound earthshaking, the aftershocks will be serious. Some companies will disappear. Others will be significantly impaired, depressing their stock and return to shareholders, both individual and institutional, such as pension plans. Most will be forced to sell assets quickly to cover claims, forcing the financial markets into a tailspin. On top of direct claim payments to their own customers, surviving companies and their customers will have to pay assessments to the various Florida insurance pools.

    These financial aftershocks will not be confined to the insurance industry. The impact of the tragedy will be felt in every State where business and individuals depend upon insurance, such as Iowa, where State and local governments require debt financing and where insurance companies are located.

    Chairman LEACH. Excuse me, if I could interrupt, since you have referenced my State. We have a larger insurance industry per capita than Connecticut, but please proceed.
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    Mr. FREEDMAN. Thank you, Mr. Chairman. But I believe that Connecticut has more property-casualty insurance companies.

    Chairman LEACH. I am sure of that. Excuse me.

    Mr. FREEDMAN. And that is perfectly OK.

    Chairman LEACH. I am confused, which set of insurance companies are more profitable over the last decade? Is it Principal or an insurance company in Connecticut? Please proceed, I am sorry.

    Mr. FREEDMAN. Is that a question, Mr. Chairman?

    Chairman LEACH. I might just at this point, because there are so few Members present, give you all an IQ test. And the test is very simple. What State has the most progressive laws to locate insurance companies in?

    Mr. FREEDMAN. That is Iowa.

    Chairman LEACH. Thank you. I raise this just because some of you were thinking of expanding and relocating, and it is just a fair question. But please proceed, Mr. Freedman.

    Mr. FREEDMAN. As I am sure you know, Mr. Chairman, the Iowa Commerce Department and Insurance Department have been particularly aggressive in the past decade or so visiting probably all the companies in the audience and at the table today, and they have been very successful.
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    Chairman LEACH. We also have statistics showing what States' work productivity are the highest in. Please proceed.

    Mr. FREEDMAN. Thank you. Even States which may be immune to national disasters could likely experience availability and affordability issues. Connecticut, where one of every six jobs is dependent on insurance, and which may have fewer jobs than perhaps Iowa, but it is still the most insurance dependent State, will see its economy crippled.

    This prediction is hardly the pulp of science fiction writers or mystics. Dozens of scientists, meteorologists and seismologists have predicted an event of this magnitude just described or similar catastrophes from other States, such as California, New York or Missouri. Remember, we can expect a hurricane with wind speeds the size of Andrew's once every seven years, and the earthquake with the intensity of Northridge every ten years.

    My industry colleagues on the panel know it, and most of the people in this room know it; what we don't know is where and when it will occur. The test will be if Congress acts before nature does. While we could do a little to deter the event itself or the loss of lives and much of the havoc, Congress and State legislatures can minimize property damage through improving building standards and enforcement and incentives for property owners.

    More importantly, this committee and the House can follow the lead of Congressmen McCollum and Lazio, as well as your late colleague, Bill Emerson, to provide a Federal backdrop for States and insurers seeking to write in those States. No State, not even our largest, has the financial and insurance capacity to meet the challenge of the storm or earthquake I've described. But working within the elements of H.R. 219 and the concepts of H.R. 230, the States will be more readily positioned to weather the storm and insurers will be more willing to provide long-term protection in catastrophe-prone areas.
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    And I am heartened today by the testimony of Secretary Summers. He agrees with both the gravity of the situation and the need to marry the best features of both H.R. 219 and H.R. 230. Now, detractors will allege today or perhaps allege that insurance catastrophe predictions are too alarmist. It is somewhat ironic that we rely on computers to fly us in airplanes, manage our financial world and run our Government, but not to predict disasters.

    Others will suggest insurance and reinsurance is presently plentiful and affordable in catastrophe-prone areas. If so, we would not be here today and insurance regulators, such as those in Florida, would not be seeking to roll back our rates. Still others will claim that these two proposals are no more than Federal bailouts for California, Florida and Hawaii, and property insurers. But the beauty of the proposals is that they unfold a Federal umbrella at no cost to the Treasury over the long term while shielding the economy from the events I previously outlined.

    In summary, The Hartford's twin objectives have been flexibility and action. We have been willing to work with anyone in the Congress or in the industry to develop a catastrophe proposal and applaud the committee's progress. So far the disasters I described earlier will occur, the only question is where and when, and the time to act is not the question, it is now.

    Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you very much Mr. Freedman.

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    Mr. Pike.


    Mr. PIKE. Thank you, Mr. Chairman, my name is Bob Pike and I represent the Allstate Insurance Company, which is the Nation's largest publicly traded property and casualty company, domiciled in the State of Illinois.

    At the outset, I think I would like to acknowledge certainly Congressman Lazio, Congressman McCollum and Congressman Fazio. They have provided the bipartisan leadership that brought us here today. This has been an arduous journey. It is one for me that started eighteen years ago.

    At that time, I participated in an insurance group of mainly academic types who tried to probe the possibility or probability that the insurance mechanism, its private sector, could not respond to the truly catastrophic effects that some natural disasters can occasion. Those eighteen years of meetings and many iterations of cost modeling, statistical analysis, compromise and consensus have brought us here today.

    I resurrected my notes from eighteen hears ago, and I looked at them to see what were the basic principles that we academic types and legal types and actuarial types thought was important if we were going to have a national comprehensive program that really could respond in the event of a mega-disaster, one that could save both the social and economic infrastructure, not only of the insurance industry but, more importantly, of the communities that are so devastated by such a disaster.
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    They were as follows: One, that the Federal program should be one that included very limited Federal involvement; two, that it had to be a financially sound, actuarially based, prefunded system of financing the Federal portion of the role in order to minimize, if not reduce, the total cost of the taxpayer; three, it had to preserve and enhance the private marketplace; and four, it had to help both the availability and the affordability of homeowners' insurance.

    I think if I can provide any perspective, it is not on the technical side, although I was Chairman of the task force that was appointed in California that led to the creation of the CEA, the California Earthquake Authority. I worked very closely with both the Chairman of the Insurance Committee in the Florida House and the insurance commissioner in the establishment of the Florida Catastrophe Fund, as well as legislation that is currently being considered. But my perspective, I think, would be more useful to the Committee if I identify some of the myths and misconceptions that have arisen over this particular bill, H.R. 219.

    Congressman LaFalce today suggested, and he was very correct to do so, that the history of the insurance industry is to suboptimize both our political and economic influence to the extent we have any. Yet, those who say that the insurance industry is divided on H.R. 219 are in error, I believe. The homeowners' insurance industry, most of which are around this table—small companies from the farm bureaus, large companies like ourselves, and the insurance agents—are behind H.R. 219. Where our differences exist, they exist on the edges. So it is important to differentiate between those of us in the insurance industry who actually sell the homeowners' product and those who don't. Those who criticize the proposal that is before you generally aren't major providers of homeowners' insurance.
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    Two, it is suggested that this legislation is an industry bailout. Nothing could be further from the case. What we have today is a problem with no solution, and if the problem occurs, as we know inevitably it will, what will happen is we will go and the taxpayer will go to you with the hand out, and you will have to respond.

    What H.R. 219 does is to provide the actuarially sound financing for such a system at no risk to the Federal Government.

    We hear also that there is plenty of capital around to provide coverage for that 1-in-100-year-risk. That is simply not the case. We are the largest insurer in the State of New York. We have $475 million in reinsurance excess of our retention. We can't buy any more. Right now, the State of New York, while it is functioning, is going in a dysfunctional direction. Fannie Mae and Freddie Mac have said to Allstate that they won't accept—or probably won't accept—any more Allstate risk because of our 5 percent deductible on homeowners' coverage.

    Our growth in the State of New York is far greater than any market would acknowledge as a part of the competitive marketplace. We know other insurers are not writing it. And as I said, the reinsurance capacity needs are not there. I think it is important also to realize this isn't a Florida, a California or Hawaii problem. Our members take us back to Iniki, take us back to Northridge, take us back to Andrew. But let's not forget the entire East Coast which is just as susceptible to these catastrophic effects as those three, as well as the heartland of our country, the New Madrid Fault, which Congresswoman Emerson talked about today.

    The last iteration of the New Madrid Fault resulted in church bells ringing in Boston, scaffolding falling here in the Capitol, and a change in the direction of the Mississippi River. There are events that can take place for which the private sector simply can't respond, and the only way to correct that is a bill similar to the one you are proposing today in H.R. 219.
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    Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you, Mr. Pike, for that very poignant analysis.

    Mr. Musulin.


    Mr. MUSULIN. Thank you. My name is Rade Musulin, and I am Vice President and Actuary of the Florida Farm Bureau Insurance Company. I am a member of the Casualty Actuarial Society, and the American Academy of Actuaries. My company is——

    Chairman LEACH. Excuse me, Mr. Musulin, if you could pull it a little closer.

    Mr. MUSULIN. Excuse me.

    My company is part of the Southern Farm Bureau Group, which insures property risks in southeastern States exposed to both hurricanes, as well as earthquakes. I am here before you today representing the Southern Farm Bureau Group and the National Association of Independent Insurers, a nonprofit trade association representing more than 560 insurance companies throughout the country.
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    Farm Bureau Insurance Companies provide many Americans with property insurance coverage through single State or regional companies. Companies like ours are crucial parts of the insurance marketplace, and I appear before you today to present the perspective of companies like ours operating on a regional basis.

    My experiences in Florida have convinced me that the best approach to solving this problem is one that uses public resources to complement rather than replace private sector capacity. I have seen firsthand the effects on Florida's economy and State government operations for being unprepared for Hurricane Andrew, and we have paid a dear price for that.

    I have three key messages for you today, first, that we support efforts to enact legislation to better prepare for extremely large and devastating natural disasters; second, that we are very pleased to see that the subcommittee, in reporting H.R. 219, included provisions for excess-of-loss catastrophic reinsurance contracts; and, third, that we strongly agree with the subcommittee that the State level is the most appropriate geographic focus for the sale of reinsurance contracts and disagree with those who have argued that such contracts should only be made available on a national basis.

    I would like to briefly elaborate on these points. First the Federal Government can play a very constructive role in partnership with States and the insurance industry in ensuring not only that the claims get paid in the storm, but that the system can function efficiently the day after the storm to avoid disruptions to consumers of the type we saw in Florida. Though crafting legislation has proven to be very difficult over the years, it is critically important to millions of Americans who live in disaster-prone areas.
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    Having participated in the creation and implementation of the Florida Hurricane Catastrophe Fund, I can attest to the challenges and difficulties that may face other States if they elect to create State funds. While Florida Catastrophe Fund has been very successful, what has worked in States with the most severe problems may not be best for the rest of the country, and for this reason we agree with the subcommittee that Federal excess-of-loss contracts should be a key component of natural disaster legislation. They would allow the Government to enhance the claims-paying capacity in many States without the need for additional State government programs, while not interfering with the State's ability to maintain existing programs or to create new ones.

    We urge the Banking Committee to adopt the concept contained in H.R. 219 for a State focus for these excess-of-loss contracts so that single State or regional operations like mine can participate without having to bid on what are likely to be more expensive national contracts.

    H.R. 219's current requirement for the States to create and administrate State auction programs we believe adds an unnecessary and expensive requirement that States act as intermediaries between the Treasury and private insurers. And for this reason, we urge that H.R. 219 be amended to allow insurers and reinsurers to purchase excess-of-loss contracts directly from the Treasury Department. We believe this change will bring broader insurance industry support for H.R. 219.

    There has been a great deal of debate over the trigger for these contracts, and I will not attempt to state a number today in my testimony. However, we believe that the Treasury contracts should be triggered by substantial losses which would threaten the solvency of the insurance industry and its ability to continue to serve policyholders.
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    In closing, I note that consumers in many States are facing property insurance availability problems, and these problems will explode if there is a severe catastrophic event of the type that was described here a few moments ago. This issue is critically important, and even though it is difficult to craft a solution, it should be a high priority for this Congress and the Administration.

    Thank you.

    Chairman LEACH. Thank you, Mr. Musulin.

    Mr. Joslin.


    Mr. JOSLIN. Thank you, Mr. Chairman.

    As introduced, I am Chairman of the Board of State Farm Fire and Casualty Company, the largest writer of homeowners' insurance in these United States. State Farm strongly supports the principle of a Federal role in backing up in a financial way large, very large natural catastrophes. We very much appreciate and applaud the bipartisan consideration of and support for this concept. While H.R. 219 is not perfect, it is good. We certainly hope that the pursuit of perfection does not cause us to avoid accomplishing the good.

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    Federal financial backstops should follow several principles. First, the resources of the Federal Government should come into play only very rarely. Second, the price of Federal backstop mechanisms should properly reflect expected losses, not subsidies for catastrophe-prone areas while recognizing the superior capacity of the Federal Government to absorb the timing risk of mega-catastrophes; a subject that Dr. Summers alluded to with great understanding. And, third, the backstop mechanism should have certainty and continuity, so as not to evaporate during or following a major event.

    H.R. 219 represents a very sound approach. It meets the first two principles head on; it can be strengthened as to the third principle. Insured losses for major natural catastrophes in several regions of the country, such as California, the Southeast, including but not limited to Florida, and the midwestern earthquake zone could reach as high as $75 to $100 billion.

    Events of this magnitude far exceed the claims-paying capacity of most private insurers serving these markets, and we would emphasize, all existing State funds. Other regions facing potentially devastating catastrophic losses include the upper Atlantic Coast, and the Gulf States. And there are smaller markets with very high potential losses in relation to the size of the markets, such as Hawaii and Alaska.

    Although the U.S. has witnessed major events, such as the New Madrid Earthquake of the 1800's, the 1906 San Francisco Earthquake, the 1938 Long Island hurricane, Iniki and Andrew in 1992, and Northridge in 1994, the fact that these events come to mind and not others demonstrates how rare these very large occurrences are.

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    Yet after the events of 1992 and 1994, homeowners' insurance markets in Hawaii and major parts of Florida and California became dysfunctional. State-sponsored mechanisms to assume and pool the most severe of these risks were the responses necessary to reopen insurance and thus real estate markets. These necessary, but limited mechanisms would barely be able to respond to events the size of Andrew and Northridge, let alone the very possible much larger catastrophes. They would for many years have absolutely no ability to cope with a second event.

    Although State funds cannot provide a total solution to the natural catastrophe problem, theoretically there is more than enough capacity, meaning capital, in private markets to insure or reinsure the worst of natural disasters.

    This theory fails in practice. Primary insurers in the aggregate have substantial capital, but relatively little of it is devoted to homeowners' insurance in mega-catastrophe-prone areas. Many companies do not write homeowners' insurance at all. GEICO is a prominent example of that. Those that write may avoid catastrophe-prone areas due to limited capital, concern about earnings volatility, or fear of politically motivated rate suppression. Others, such as some who participate in the very competitive markets of Illinois and Iowa, simply don't view Florida and New York and California as part of their natural markets.

    Few years of profitability without an event the magnitude of Northridge or Andrew does not diminish the need for Federal backstop for a 1-in-100-year event. Following Andrew some commentators in Florida observed that except for one event, the Florida insurance business has been profitable. So it has. That one event, however, consumed more capital than State Farm Fire and Casualty Company had accumulated in over the 60 years of its existence in the entire country. Private reinsurance is not the answer, because reinsurers have a relatively small capital base, and they must reasonably balance their portfolios.
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    Finally, the capital markets, pension funds and other institutional investors, have large financial resources but very little has reached the catastrophe insurance market and the price has been high; 8.2 times the estimated average annual loss costs in the one significant transaction to date.

    After a major event, the price of such securities, if available at all, most likely would be higher. Too often financing of a natural catastrophic loss is described as accumulating over a period of years the amount of money necessary to pay the loss. Unfortunately, a 100-year or a 10,000-year event can occur in the first year. No private enterprise can earn a competitive rate of return in the business of insurance sitting on this quantity of stagnant capital.

    Moreover, the United States tax policy further aggravates the problem. In most years, insurance of high magnitude, low incidence events generates tax liabilities on profits that do not exist. And having been in Washington on more than a few occasions on issues of tax legislation, no matter how much I might like some cure in this arena, that is a land mine on which many of us fear to step.

    H.R. 219 is a major improvement of the status quo.

    Chairman LEACH. Yield for a moment there. You have generally won, Mr. Joslin, the insurance industry does well.

    Mr. JOSLIN. I am not sure about that. In 1997, the loss carryback provision was reduced from three years to two years which has a significant impact on what our capacity is to respond to large natural disasters, with due regard, sir.
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    The most important features of H.R. 219 are Federal reinsurance for State funds set up to insure or reinsure catastrophic risk, and a price based on estimated average annual losses plus a reasonable margin for the contingency of loss estimation error. I call that consumer friendly pricing.

    We, of course, could support excess-of-loss contracts as an approach. H.R. 210 has that feature in it. That probably could be improved upon and perfected, but nevertheless is certainly something that we would not reject.

    H.R. 219 could be strengthened if it better addressed the very small possibility of multiple mega events in the same year. The mere possibility of unfunded catastrophic losses sends tremors through the insurance and lending communities. The committee should consider transforming the bill's $25 billion limit per year into a per event limitation as opposed to per year.

    The proration of claims for people who have bought insurance and thought they had insurance is just as devastating for insurers or State funds as it is for the policyholders of the California Earthquake Authority.

    In conclusion, a 100-, 500-, 1,000-, 10,000-year event by definition occurs very rarely, yet such an event could occur tomorrow. Now is the time for Congress to act when the country is free from the trauma of a major catastrophic event.

    Mr. Chairman, we commend your work and we are available to assist in any way we can.
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    Chairman LEACH. Thank you, Mr. Joslin. I appreciate it.

    Ms. Bouriaux, are we pronouncing that closely?

    Ms. BOURIAUX. Very good, actually.


    Ms. BOURIAUX. Mr. Chairman, Mr. Lazio, Members of the committee, as Group Manager of Financial Products for the Chicago Board of Trade, I direct the Exchanges' research and product development efforts in the insurance area.

    The CBOT appreciates the opportunity to discuss the latest developments in catastrophe reinsurance alternative products, most specifically the PCS catastrophe insurance options currently traded at the CBOT.

    In 1848, the CBOT was founded to provide rational, effective and ineffective mechanisms for buying and selling physical agricultural commodities. Today, we sponsor trading in over 60 different futures and options markets, including a centralized market for buying and selling catastrophe risk. These markets provide an efficient, reliable mechanism for transferring the risk and generating price information that is disseminated around the world to provide a benchmark for market decisions.

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    In the aftermath of Hurricane Andrew in 1992, the insurance industry began to devise sources of funding, recognizing that increased reinsurance capacity was needed. At the same time, capital markets, including the Chicago Board of Trade, recognized this need and introduced new products, such as the Board of Trade CAT options, swaps or bonds to expand reinsurance capacity and improve market efficiency.

    In fact, in the spring of 1992, even prior to the occurrence of Hurricane Andrew, the CBOT had already begun to develop capital market solutions. The first CAT products began trading at the Exchange in December of 1992. The second version of this contract, based on aggregated insured catastrophe loss estimates compiled by the Property Claims Services, or PCS, began trading in September of' 95. Today, the CBOT's product mix includes options for nine different regions and States, National, East, Southeast, Northeast, Midwest, West, Florida, Texas and California, and we probably could add as many as we can.

    PCS options can be used as synthetic reinsurance covers to protect and compensate insurance industry participants against catastrophes that would trigger up to $50 billion of insured losses in each of those nine regions and States.

    In the past two years—I'm sorry, other exchange-based initiatives have followed in the CBOT footsteps. First, in 1996, the Catastrophe Risk Exchange, or CATEX, was created in New York. A year later, the Bermuda Commodity Exchange opened its doors to trade insurance options basically conceptually similar to the ones we trade at the Board of Trade.

    Generally, exchange-traded CAT instruments differ from reinsurance in that they are more standardized and not negotiated as traditional reinsurance. The buyer and the seller of these contracts do not negotiate the specific terms of their contracts, but only their price, or if you want a premium.
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    CBOT options are very similar to the aggregate excess-of-loss contracts described by Mr. Summers in his earlier testimony. They allow an insurance or a reinsurance company to buy a layer of protection between two attachment points or, as we like to call them in our financial jargon, strike prices. If aggregate losses fall within that layer, the insurance company will be compensated, minus, of course, a premium paid up front. Collecting this compensation is assured by the financial backing of the AAA-rated Board of Trade Clearing Corporation, which insures the total integrity of the market.

    The tradability and price transparency of the CBOT contracts has attracted new sources of capital from beyond the traditional reinsurance market. Investment funds, commodity and pension funds, as well as other risk-takers use CAT contracts as another way to diversify the portfolio risk. Reinsurance capacity channeled through the CBOT, although small to date, about $80 million since September of 1995, is growing rapidly, as open interest in the PCS catastrophe insurance options, which is—if you want a measure of the capacity handled through our market, grew by 65 percent between 1996 and 1997. This number is even more remarkable as the traditional catastrophe reinsurance market has considerably softened over the last two years.

    To date, we have seen transactions in all nine regions and States offered at the exchange. Unfortunately, regulatory and accounting barriers deprive many potential users of the benefits of the CAT contracts at the Board of Trade. Only California, Illinois and New York have expressly addressed an insurance company's authority to engage directly in exchange-traded derivative products, insurance derivative products. In each of these jurisdictions, such authority has been limited to hedging transactions.

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    In addition, the National Association of Insurance Commissioners, the NAIC does not treat CAT contracts like reinsurance for accounting purposes. For example, if insurance companies manage their risk exposure by purchasing traditional reinsurance, they are rewarded by being allowed to increase the level of coverage that they write. No such increase is granted to companies managing their risk exposure through CAT contracts at the Board of Trade, thereby penalizing companies for using CAT contracts and certainly discouraging the number of potential companies from utilizing these risk management tools. These are issues the CBOT and others involved in innovative insurance risk management will try to continue to resolve.

    In addition, the Board of Trade is also cosponsoring an initiative currently dubbed the Chicago Board Insurance Exchange, or CBIE. The CBOT, using a consulting firm, is exploring the economic viability of the creation of this new insurance exchange in Illinois. Seeking insurance and capital market partners, the CBOT hopes to create and develop a risk distribution mechanism solely for novel forms of insurance, like, for example, company specific warrants or index-based warrants, which could be divided and retreated in a secondary market.

    The goal of the Chicago Board Insurance Exchange is to efficiently allow risk-seekers to treat the risk posted as insurance, while allowing risk assumers to be members of both the reinsurance community as well as the investment community.

    To date, as you may know, State insurance laws do not allow for private investors to directly handle the business of insurance, hampering access to this pool of available capital. If the CBIE evolves as planned, this initiative would provide an attractive alternative tax and regulatory environment to compete successfully with offshore locations, such as Bermuda, which are currently attracting such U.S. insurance business.
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    The CBOT and other exchange-based initiatives offer creative risk mitigation alternatives to insurers that can supplement traditional reinsurance coverage. Such contracts can also be extremely beneficial to the reinsurer, who can, at a low cost, transfer some of its risk to the financial markets, thereby freeing resources to write additional direct catastrophe coverage to primary insurance companies. Our experience continues to demonstrate that a market for innovative instruments to manage insurance risk does exist, and that investors have an appetite for that risk.

    Thank you.

    Chairman LEACH. Well, thank you, Ms. Bouriaux, and it is important that we hear counter-perspectives presented and I think you presented a very thoughtful one.

    Mr. Nutter. You two may be talking from the same handbook. I don't know. Please proceed.


    Mr. NUTTER. From related ones.

    As a representative of the domestic reinsurance industry, we support the need for a high level Federal role in providing catastrophe reinsurance, excess of that available in the private market and through State catastrophe insurance funds.
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    This position is rooted in the following principles, that natural catastrophes are insurable risks and reinsurable risks in private markets, that the Government's role should be to address the potential of insurer insolvency in the event of a mega-catastrophe, that catastrophe insurance should be provided to the public in a diversified marketplace, which avoids the concentration of risk. The private sector's role should be maximized at both the State and the Federal level. The Government should encourage pre-disaster mitigation, and any Federal role should address both personal and commercial insurance.

    Since the early 1990's, many private sector developments, positive developments in the private market, have added to the ability of insurers, reinsurers and the capital markets to provide capacity for insuring catastrophe risk. The insurance industry surplus has doubled since 1991, which includes the natural catastrophes of Hurricane Andrew and the Northridge quake, as mentioned in your opening statement, Mr. Leach.

    Most, if not all, insurers better manage their catastrophe exposure. New capital markets from such notable investment, banking and securities organizations, such as the Chicago Board of Trade, Goldman Sachs, Morgan Guaranty Trust, J.P. Morgan Securities, Credit Suisse First Boston, and AON Re Services, offer catastrophe insurance products and the potential for extraordinary additional capacity. Reinsurance capacity is at an all time high and prices have dropped to near pre-Hurricane Andrew levels.

    State studies show that in most markets insurers are providing coverages, new insurers are seeking new opportunities in many of these markets and consumers are being better served. The fundamental problem, in our view, remains the potential devastating effects of a mega-catastrophe that potentially compromises the integrity of insurance companies.
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    An excess-of-loss reinsurance approach such as that contained in H.R. 230 offers, in our view, the most constructive basis for providing Federal reinsurance to private markets and existing State funds.

    H.R. 219, on the other hand, is premised primarily upon Federal Government reinsurance of other Government programs and as such is too narrow. It would provide an incentive for many States to adopt State Government programs, thereby concentrating catastrophe risk in taxpayer-financed vehicles, rather than encouraging private market solutions. Appropriate private-public partnerships need to be created to ensure that insurance is widely available to consumers to finance recovery from natural disasters.

    Thank you very much.

    Chairman LEACH. Thank you, Mr. Nutter.

    Ms. O'Hanlon.


    Ms. O'HANLON. Thank you, Mr. Chairman.

    My name is Isolde O'Hanlon. I am a Managing Director in Chase Securities, Inc., which is a unit of the Chase Manhattan Corporation. I am happy to be here this afternoon to talk to you about catastrophe finance.
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    Over the last several years, Chase has been actively involved in California, Hawaii and Florida, in terms of assisting the pools in those States with both financing in the private markets, and the bank market, and also providing advice to them.

    Since 1994, Chase has raised in excess of $7 billion for the CEA, the FWA and the Hawaii Hurricane Relief Fund. These pioneering programs operating at the State level restore and ensure the continued availability of residential property insurance. These pools provide insurance both to regular homeowners, as well as in the case of the Florida Hurricane Catastrophe Fund, provide reinsurance to all firms operating in the State of Florida.

    California, Florida and Hawaii, as you have already heard today from many of the participants have experienced severe catastrophic losses over the last several years, and the State markets in those three jurisdictions have responded.

    In 1992, following Hurricane Iniki, the Hawaii Hurricane Relief Fund was formed. The California Earthquake Authority was formed following the Northridge Earthquake. However, the situation and the devastation in Florida that resulted from Hurricane Andrew was quite different even from what happened in both of those States, and the response there was equally large.

    In the case of Florida, two new pools were formed after Hurricane Andrew, the Florida Hurricane Catastrophe Fund to provide, as I said before, reinsurance, but also because of the severe disruption in the primary homeowners' market, there was a reason to actually legislate a primary insurance company, and the Florida RPC JUA was formed, growing to be the third largest insurer in the State of Florida.
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    In addition to that, the territory of the Florida Wind Storm Underwriting Association was expanded from dramatically from the Florida keys to cover 29 of Florida's 35 coastal counties.

    Given current demographic trends in the United States and particularly the recent increase in real estate development in coastal and other catastrophe-prone areas, the potential for loss in these areas has grown exponentially. In order to avoid excessive exposure to one particular catastrophic event, reinsurers, and even for that matter, primary insurers create geographic or zonal limits to the amount of coverage they provide. The limit is typically set to ensure a single catastrophic event will not deplete a specified portion of the reinsurer's capital. The increase of exposures in certain areas has created a larger disconnect between the needed level of coverage in certain areas and the availability to buy coverage at a desired price or premium level.

    This is particularly apparent if we compare the situations as they exist today in Hawaii and Florida. For example, the Hawaii Hurricane Relief Fund today can purchase reinsurance coverage well in excess of its 1-in-100-year event of $650 million. Such is not the case as exists today in Florida. The Florida Wind Storm Underwriting Association, which has seen a marked decrease in supply in reinsurance over the last several years, is barely able to approach sufficient reinsurance to cover the 1-in-100-year event, which is at approximately $5 billion today. Since the introduction of financing for catastrophe pools, several billion dollars has been raised.

    Most recently, risk transfer products have also been introduced to the markets in the form of what you may have heard referred to as catastrophe bonds or CAT bonds. These products actually provide risk transfer and there is no repayment associated with them, so they are very different than the syndicated lines of credit, than the pre-event notes or, for that matter, the reinsurance that has been provided in the past. The investors who are investing in these securities will bear the risk of catastrophic events.
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    It is important to note that although the risk transfer products which have great potential in the market, today the market is in the early stages of development and there are probably 60 to 80 investors today who invest in these types of securities.

    As the capital market product continues to grow and evolve, we will see increased benefit in the form of reduced price for both State and individual corporations.

    The obvious question becomes, that has been talked about today, what is the breaking point that defines an extremely low frequency and high severity event, and very often today we have heard other speakers talk about the 1-in-100-year event. I think an important thing for the committee to keep in mind is what does the 1-in-100-year event mean in different geographic jurisdictions. And what I mean by that is the 1-in-100-year event is something very different in Florida than it is for, say, the State of Wyoming, and very different in terms of the economic magnitude.

    Much has been made today about talking about the availability and the affordability of homeowners' insurance immediately following an event and whether or not the introduction of either State or Federal programs interferes with the private market's ability to provide insurance.

    I wanted to just take a couple moments and comment on the importance of looking at actuarial modeling, including looking at rate setting in both individual States as well as with the Federal program, and just mention that in the case of the programs that we have heard talked about here today in California, with the CEA and Florida with the Hurricane Catastrophe Fund as well as the Florida Wind Storm Underwriting Association and with the Hawaii Hurricane Relief Fund, all of those markets experienced extreme disruption after the various events and catastrophe modeling was used for all of those entities on a post-event basis to determine the appropriate rate structure. It wasn't always popular but it was the right thing to do, rather than charging a rate, which is inefficient or below the appropriate market rate and having the taxpayers foot the bill at a later date and time.
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    There has been much discussion today also about loss mitigation. I just wanted to point out in the case of all the funds we talked about today, they are all required by State statute to set aside a certain portion of their revenues to provide for loss mitigation. Most of these funds, since their inception, I mean, the Florida Hurricane Catastrophe Fund, the CEA and the HHRF have been loss free. In the case of Hawaii, that has led to an accumulated surplus in excess of $100 million. And there has been some discussion in the Hawaii State legislature about what to do with the $100 million, and whether or not that should go into the general State revenues. It is pretty clear in the legislation before the HHRF that is not an appropriate use of the funds and what they are looking at now is to provide credits to policyholders to enable them to pursue loss mitigation.

    Just one last comment, which is to say that the $7 billion in financing that has been completed in the form of bank financing and pre-event bond financing, which has been done for the pools in Florida is along the lines of traditional corporate financing and those entities are taking a security interest in future policyholder assessments, which basically spread the risk of loss over time.

    Thank you.

    Mr. LAZIO. [presiding]. Thank you very much.

    Mr. Weber.

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    Mr. WEBER. Thank you, Mr. Chairman.

    I want to start by saying that on behalf of the Home Insurance Federation of America, which represents the large homeowners' insurance companies in this country, we would like to express our deep gratitude to both you, Mr. Lazio, and Mr. McCollum for your leadership on this issue, for sticking with it at a time when a lot of people said there wasn't a problem. I think that today's hearings indicate that you were right, that there is a problem, and therefore we are very encouraged by today's hearing.

    I think that one of the reasons that this particular panel was convened was to try to give you some perspective on exactly what the arguments are in terms of the capacity of the private financial markets to deal with this problem, and I think that our role today is to try to give you some sense of where those limits are.

    We believe at HIFA that there is a role for the capital markets. It is an important role, but we also think it is not in all cases the best solution if our goal is to have affordable insurance for all Americans. If our goal is to truly be prepared for the mega events, we think that a Federal role is in fact necessary.

    The laws of economics indicate where the limits of private sector capacity are. This morning we will show you, through some very real examples, where we think the limits of the private market are.

    Large natural disasters are a matter that cannot be handled efficiently without the stabilizing influences of a Federal Government. The U.S. Army is not listed on the U.S. Stock Exchange for a very good reason. We did not go to the moon using bonds. There are certain issues in which the Federal Government must play a role and we believe that catastrophic disasters are one of them.
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    In terms of the financial markets, there is a difference between identifying an appropriate niche for these sources of capital and proclaiming them a savior to the problems of growing insurance availability, and I think if there is one thing that is most significant about anything any of the panelists here today have said, it came from Mr. Joslin, who is not a member of HIFA, but I want to emphasize what he said about Hurricane Andrew, in that Hurricane Andrew cost his company more than all of the money that the largest homeowners' insurance company in the country had collected for 60 years nationwide, and that is a telling statement, I think, about the nature and the size of the events that we are talking about. And by the way, that was a 30-year event in Florida, not 100-year event.

    I would also like to point out that two of HIFA's members, Allstate and Safeco, are the largest buyers of private reinsurance in the United States when it comes to homeowners' insurance companies, so that HIFA members know something about the capital markets, what they cost, and why we have the problems that we do today.

    It is no accident, in our opinion, with all due respect to the previous panelists, that the Chicago Board of Trade, who has been in this business of trying to market catastrophe bonds for now three or four years, has never sold more than $30- to $40-million worth of contracts in any given year. Thirty or $40 million, I would respectfully submit, is one one-thousandth of what we expect a major hurricane strike in Miami to cause in terms of losses.

    It is no accident that the Catastrophe Risk Exchange, an enterprise started two years ago by a former deputy insurance commissioner in New York, has 300 sellers, but only two buyers to date. There is a rational explanation for why the number of catastrophe bonds sold to insurance companies in the United States can still be counted on one hand, even though the marketplace is clamoring for solutions. And there is a reason that to date, the capital markets have only provided a billion dollars worth of capacity. A billion dollars does not get us very far at all in terms of the kinds of exposures that we are talking about.
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    The reason that these solutions have not caught on more quickly is that they make only marginal economic sense. If they made more sense, more people would be buying them, just as people are buying nearly everything else that Wall Street is offering these days. Few are buying because the transactions are not cost-effective, and they will not be cost-effective in the future because high cost infrequent natural disasters cannot be efficiently priced in the private market. This is not an indictment of capitalism. This is simply the truth, and it is not to say that at lower levels, reinsurance is not a cost-effective transaction. After all, reinsurance has been around for centuries. You can reinsure an office complex, you can reinsure an insurance company with a few hundred-million dollars worth of exposure, but it is entirely a different matter when we are talking about reinsuring an event that could destroy St. Louis or New Orleans.

    The pricing dynamics of reinsurance and similar capital instruments become problematic when dealing with catastrophies that occur less than once every hundred years. Investors are only willing to invest if the return on their money is comparable to what they could earn with alternative investments.

    The only problem is that homeowners' insurance is not sold to the public according to the same rules. Homeowners' insurance is regulated, and that is a point that I don't think has been mentioned yet today. It is priced on the basis of risk, not the desired rate of return in capital markets. What chance is there that a homeowner will have a claim and how large, on average, is that claim likely to be? These are the relevant questions in the homeowners' insurance market.

    For example, if there is a 1 percent risk of a certain size loss, the homeowner is charged approximately 1 percent of that potential loss each year. The same principles apply to every kind of insurance, it is what insurance regulators allow, consumers expect, and elected officials, whether they be Members of Congress, a State legislator or a governor, demand.
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    Financial markets and insurance markets do not operate on the same playing field when it comes to addressing large catastrophes that occur infrequently. These differences are particularly pronounced when we move into the higher levels. If a capital market is going to reinsure a $25 billion catastrophe, investors quite rightly expect a rate of return of at least as good as what they could earn elsewhere, but such a return is many times what insurance companies are permitted to charge homeowners and far more than the underlying risk that a claim will occur.

    To illustrate this, I brought along a couple of charts because I think it is very important in this discussion about what the capital markets are capable of to emphasize that the limiting factor is not the lack of money, it is the price. And if I could get a little help on those boards, I would actually like to move from that board to the next one, please, actually it is the third one.

    What this is is an illustration, real life illustration I might add, of the California Earthquake Authority, which is an excellent proxy for what an insurance company would face trying to ensure earthquake exposures for an entire area. And what you see from that chart is that the claims paying capacity of the California Earthquake Authority is $7.5 billion, and of that, $2.5 billion is reinsured.

    You will note that Mr. David Knowles, who was an earlier witness, testified to the fact the CEA is the largest buyer of reinsurance in the world. They buy more by a factor of three or four times what anybody else in the world buys. The premiums that are collected from consumers in California for earthquake exposures is $700 million. That represents a fourfold increase in the premiums that were charged just three years ago.
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    In order to buy $2.5 billion worth of reinsurance, the CEA pays $320 million a year. That is virtually 50 cents out of every dollar that is collected from California consumers, for simply $2.5 billion worth of coverage. That means that two-thirds of all losses to the CEA are not reinsured, and all events above $7.5 billion are not covered.

    If we could have the next chart, please.

    Now if you break down the reinsurance that the CEA is buying, there are two layers that the CEA buys. One is sold by Warren Buffett and his reinsurance company. It is a billion dollars worth of coverage. For that billion dollars of reinsurance, the CEA pays $115 million per year. That represents a 10.8 percent return on Mr. Buffett's money.

    However, the risk that Mr. Buffett will have to pay off on that billion dollars is only 1 percent, which means that even though the underlying risk is only 1 percent, the capital market is demanding 10 times that amount to provide that billion dollars of reinsurance.

    I think that what this indicates is that there is a limit to what any entity can afford to pay for reinsurance. If you are already paying 50 cents out of every dollar to buy $2.5 billion, how could it possibly be argued that the appropriate level for Federal reinsurance should be $10-, $15-, $20-, $30-, $40-billion dollars. If $2.5 billion of reinsurance costs 50 cents out of every dollar collected from consumers, then that must show that reinsurance at high levels is simply not affordable.

    But I don't think it is fair to argue that Mr. Buffett is not acting reasonably from his perspective. He has alternatives for that billion dollars that could easily return 10 or 11 percent, and so, therefore, I think that Mr. Buffett is acting rationally from his perspective, but I also think that the CEA is quite rational in saying that if they are incurring a 1 percent risk, but having to pay 10 times that amount for the reinsurance coverage, that this is not an affordable transaction beyond certain limits.
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    In closing, I would just like to emphasize that the key issues that the Committee has to realize and look at are, if in fact it is going to provide reinsurance, that reinsurance must be at a workable level relative to what is going on in the marketplace today. If you provide reinsurance at too high a level and at too high a price, you will not affect the availability of homeowners' insurance, you will not encourage more people to buy homeowners' insurance coverage, and the problems that we have today will continue.

    Thank you.

    Mr. LAZIO. Thank you very much.

    Mr. JOSLIN. Mr. Chairman, if it please you, without taking away from the general tenor of Mr. Weber's message, I believe that his reference to State Farm Fire and Casualty was money collected, which would be revenues. My statement was accumulated capital, which is underwriting profits, plus investment income, plus contributed capital, a significant difference between the two.

    Mr. WEBER. I stand corrected.

    Mr. LAZIO. Mr. McCollum.

    Mr. MCCOLLUM. Thank you very much, Mr. Chairman.

    With this large a panel and so few of us here, I hope we can have more than one round.
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    I will begin by asking Mr. Joslin, since you were the last one speaking here, a question. In his testimony earlier today, Secretary Summers indicated that the Treasury would like to see us modify H.R. 219 to provide for the sale of excess of loss contracts to all entities on an unrestricted basis. I presume that is similar to the request, in a way, that Mr. Musulin was just making, to not have this necessarily go through the States for auction purposes. If that were done, does State Farm have a problem with that? I realize the devil is in the details, but in the broad general principle.

    Mr. JOSLIN. First of all, I believe a sale through the Treasury, as Mr. Musulin suggested, would be less cumbersome than on a State-by-State basis. Whether or not the contracts are on a State-by-State basis, involving the State governments could be a very cumbersome process.

    In answer to this question of allowing broader than simply insurance companies or broader than simply State plans to be a participant in this process, it has been our view all along that if one is seeking an efficient auction market and if one is wanting an efficient use of the capital and reinsurance markets, the product should be available to all potential purchasers, which is the best way to assure there is not underpricing. Nobody is going to buy an overpriced excess-of-loss contract. There will be people who will come forward if it is obviously underpriced.

    Mr. MCCOLLUM. Mr. Pike, do you generally agree with what Mr. Joslin just said with regard to the unrestricted opportunities for excess-of-loss contract purchases, if we go that route?
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    Mr. PIKE. I don't really have a problem with a primary carrier being able to access the Federal excess-of-loss contract, rather than using the State as the vehicle for that.

    I do have a philosophical problem with the auction generally, if in fact it produces the result of having the biggest and the most wealthy participants dominating the auction. That would trouble me, even though we happen to be a very large company.

    I think the way H.R. 219 is designed is very appropriate. It sets a premium at twice that which is actuarily required, provides everybody the opportunity to access Federal reinsurance at a known, fixed, firm price, represents a premium on that which is required actuarially, and yet provides additional revenues to the Federal Government ultimately to pay for these losses when they occur. I have trouble with the auction concept because it may kick up the price of the contract far beyond the actuarially-driven rate. These extra costs will ultimately be passed on the the consumer.

    The beautiful part about two times the actuarially-driven rate is that it caps the rate to the consumer, and in the final analysis, we know that with the capital markets, their money comes and goes very quickly. As a homeowners' insurer, we can't. If we are in the State of Florida, we have to stay with our policyholders and we can't turn around and say, for example, after Hurricane Andrew, that the price of reinsurance went up 500 percent and we are going to pass that on to you because that is where the auction set it. So what we are really trying to do here is temper those increases to the consumer, and I think the two times actuarial driven premium accomplishes that better than the auction.
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    Mr. MCCOLLUM. Mr. Nutter, what do you think about the auction versus the two time actuarial rate that Mr. Pike is talking about.

    Mr. NUTTER. About the State auction or the notion of a Federal auction?

    Mr. MCCOLLUM. Either one. I think what Mr. Pike was just saying is he didn't think it mattered. He would be happy to have either Federal or State but he didn't like the idea of the auction, he wanted it to be set more precisely.

    Mr. NUTTER. Well, we certainly endorse the idea of the auction. It does facilitate the development of private market facilities. Mr. Weber talked about limitations of capital market products. It seems to me that a national auction would indeed facilitate the creation of private capital market capacity. We agree with Mr. Joslin that a State-by-State auction process seems cumbersome and probably divides up the capacity and it would be inefficient. We are sympathetic, particularly to Mr. Musulin's point that the small regional companies probably are the biggest part of the solution to this problem and therefore, having them have access to excess-of-loss capacity is very important.

    Mr. MCCOLLUM. All right. Thank you.

    I think my five minutes are up, and if we are going by that rule here, I will yield back, Mr. Chairman, with the understanding, I presume, we will have another round. Thank you.
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    Mr. LAZIO. Mr. Sherman.

    Mr. SHERMAN. Thank you, Mr. Chairman. I want to commend Chairman Leach for holding these hearings, but especially commend you two gentlemen for being so involved in this issue. We have a lot to gain by dealing with this problem, and I am sure there are many times when you thought that this Congress was not going to be moving a bill and now at least I am far more optimistic.

    I want to especially commend Mr. Lazio for putting together the bill that we are having hearings on today, and I hope you add my name as a cosponsor of that bill.

    I think that, certainly, the people in my community are going to benefit because half of them are paying too much for their homeowners' disaster insurance and the other half are going without.

    One thing that we haven't talked about much is the economic effect of the possible insurance crisis. We had an insurance crisis right after the Northridge Earthquake which caused the CEA to be created in California, but there is a tremendous national interest in making sure that people can insure their homes, sell their homes and finance their homes.

    And then finally, as was brought up with Secretary Summers, the Government has a strong interest in making sure people can get and do get disaster insurance, both to reduce FEMA's cost, but also to reduce the cost to the Treasury of people deducting their uninsured disaster losses. We prefer they have insured disaster losses if there have to be disaster losses at all.
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    I want to see, Mr. Weber, if I can understand your chart, as far as Warren Buffett getting a premium of 10.8 percent. I have heard the 10.8 percent referred to sometimes as a rate of return and sometimes as a premium. It is my understanding that it is a premium and that Mr. Buffett's $1.075 billion in capital is available for him to invest in other assets, as long as those assets are pledged. So he makes a rate of return by investing his billion dollars, and gets a premium by putting his billion dollars at risk, is that correct.

    Mr. WEBER. Well, it is safe to say that Mr. Buffett is actually not depositing a billion dollars in the coffers of the CEA, he is making a promise to pay off, if in fact an earthquake occurs, which means that while he has an obligation to make good on those payments, the money is not actually held by California.

    You are also right that when we talk about a 10.8 percent, that is a rate of return on that billion dollars. So it is 10.8 percent of the billion dollars is his annual revenue, what the California Earthquake Authority pays him for that reinsurance. That is different than the risk that Mr. Buffett will actually have to pay off, that billion dollars, and that risk is 1 percent.

    Mr. SHERMAN. The way I use the terms, I would just use the term premium and not the term rate of return, since rate of return usually applies when your capital is committed to a particular project and cannot be used for something else.

    I know a number of speakers have said that people would not buy overpriced reinsurance. I think we have got a number of panelists here eager to buy reinsurance at only double the actuarially valid value, and simply object to a system where they have to pay 10 times the actuarial valid value.
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    The other question that has arisen is whether it is desirable to provide reinsurance directly to insurance companies in the casualty business operating in those States that do not have a fund like CEA. And one concern I have, or at least question, is that in dealing with CEA, the Federal Government is dealing with a very large pool that can pay the first $5 billion per incident or at least per year or per decade on its own, without tapping Federal reinsurance. Would the Federal Government have to bear earlier dollar risk in order to provide reinsurance to the companies represented here?

    Mr. PIKE. No, it wouldn't. There wouldn't be any additional exposure to the Treasury in the event that would occur.

    Mr. SHERMAN. So if there were two equally sized States having equal earthquakes with equal amounts of coverage, one had a CEA and one had private companies buying their reinsurance directly from the Federal Government, the Federal Government's premiums would be the same and——

    Mr. PIKE. No, I don't think so. It would be risk-based and there would have to be a determination.

    Mr. SHERMAN. Assuming they have the same risk, have the same earthquake and the same homeowners'.

    Mr. PIKE. Assuming the trigger was the same and the exposures were the same, and all other things being equal, there would be a similar premium charged by the Federal Government for those contracts, again, assuming the trigger point was also the same.
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    Mr. JOSLIN. Could I also respond to that?

    Mr. SHERMAN. Yes, go ahead.

    Mr. JOSLIN. We are talking about an auction of excess-of-loss contracts as a concept, whereby the loss is based on an industry aggregate loss, as opposed to selling the contracts themselves driectly to individual insurance companies, I don't believe that there is anyone at this table that is supportive of the Federal Government selling individual reinsurance to individual companies. We should make that distinction, because individual company reinsurance sales would require the Federal Government to be negotiating with each and every insurance company as to what their spread of risk is, their exposure, and that would, I believe, bring down the furies of hell upon those who don't want the Federal Government to be too deeply involved in the insurance business.

    Mr. SHERMAN. So the theory in those States that didn't have a State agency would be that the Federal Government would deal with individual insurance companies but would have a particular contract with every company operating in that State that would not be company specific?

    Mr. JOSLIN. It would not be company specific, it would be available to all companies doing business or providing reinsurance within that area.

    Mr. Nutter, I am sure, feels strongly on the subject.

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    Mr. NUTTER. Just to try and clarify that. I think the excess-of-loss auction process would allow any individual company, if it felt it needed that coverage, however it was defined, to bid on, and therefore have it made available. If it choses not to, then it would not. But as Mr. Joslin says, I don't think anyone supports the notion that the Federal Government would directly reinsure individual companies. That is not what the legislation provides nor has anyone promoted.

    Mr. PIKE. May I?

    Mr. SHERMAN. Do we have time for one more panelist to respond?

    Mr. PIKE. Just a point of clarification. The way the bill was currently drafted, in fact it is likely the excess-of-loss contract trigger would be significantly higher than would be possible under the reinsurance plan portion of the program, making Federal involvement less likely, I believe.

    Mr. SHERMAN. Thank you.

    Mr. LAZIO. Thank you. Let me, if I can, just ask a few questions.

    I think at the heart of this, we are really talking about pricing, which is inherent in capacity, and an understanding that a very large catastrophic loss is unfortunately inevitable. Even worse, it may well be more than one incident, which is really the worst-case scenario, where an area is hit with two events in a major population center in the same year, and possibly even in the same State.
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    Is it true Mr. Nutter, that you believe the trigger from which the backstop should begin should be set at $37 billion?

    Mr. NUTTER. I appreciate the fact you asked me that because I do want to clarify that. Staff brought that to my attention as maybe a misunderstanding.

    I cited in the written testimony an example of how one would calculate a trigger using what I thought were conservative assumptions. But the point was that the insurance companies' retained earnings, called surplus, are really the cushion against shock losses. Therefore the surplus of the industry is an appropriate mechanism by which to calculate what a trigger would be.

    I used, arbitrarily, 5 percent at the primary level, an additional 5 percent as an example of what you would lay off to reinsurers or large companies retaining, and then factored in 2 percent, which is entirely speculative on my part, to allow for the development of the capital markets products. So the point was not that $37 billion is the right number. I realize $25 billion has been floating around here for a couple of years. That may not be the right number either.

    The point of my example was if you used industry surplus, it would adjust based upon the experience of the industry. If we had the mega loss and the industry surplus was depleted, the trigger would come down. Maybe it is lower than $25 billion. But if the industry surplus continued to grow, it would be higher than whatever numbers were used. That was the point of the example, not that 37 is the right number.
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    Mr. LAZIO. Let me ask Mr. Pike or Mr. Joslin if they can respond to that, and one of the implications, as we move up the ladder, in terms of the trigger, if it is at a $25- or $30- or $37-billion dollars for a company, what are the incentives for a company to write in an area that is disaster-prone?

    Mr. PIKE. Currently the insurance industry has about $310 billion worth of surplus. Some assume that this surplus is available to back up homeowners' insurance, and of course it doesn't. Only about 10 percent of the industry's surplus does, or about $30 billion. Of that $30 billion, the surplus is spread around the entire country. It is not all backing up just California or just New York. So there is really just a very small part of the overall industry surplus that backs up the homeowners' line product.

    The key, of course, is at what point do you have to protect, if you will, the solvency of those insurance companies, their ability to deliver an affordable product, their ability to deliver any kind of product at all for that matter. The trigger becomes a very important issue.

    We believe that given the level of surplus that is truly available on any given region, that that is probably what we generally use as the 1-in-100-year event, and that is a standard that has to be set by State. It can't be set nationally, we don't believe, because there will be different triggers in different States.

    So from our standpoint, we think the 1-in-100-year event is a good test to determine what that trigger ought to be. It certainly isn't a $35 billion trigger on a national industry surplus basis. It is probably far less and we think that trigger is movable, depending upon what State is buying reinsurance and under what circumstances.
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    You could have a California CAT fund or a Florida CEA that has a $10 billion retention that, at that point and above, there is no really available and affordable reinsurance available. That is where the trigger ought to kick in, but $35 billion we think is far too high.

    Mr. LAZIO. Anybody who would like to answer the question as to why is welcome. It appears there has been some maturation of the capital markets, but not nearly enough to make a dent in the demand for reinsurance—for risk being spread out over a wider population or a number of people.

    Mr. MUSULIN. I think one thing to remember here is the insurance system, the way it had been structured, up until about the mid-1980's, underwent very serious shocks with Northridge, Hugo and Andrew, and in solving some of that problem through the capital markets, it involves the development of considerable new mechanisms, new regulatory procedures in order to allow insurers to make use of those mechanisms under the State laws they were regulated under, and that is a somewhat complicated process. And I think that it might be unreasonable to expect that process to have been completely brought to fruition in less than ten years, and so I think some of this is an issue that the capital markets are going to require some time to adapt to this situation, and that may help to close some of the gap that Mr. Weber pointed out with regard to the price differentials, and so forth.

    Mr. LAZIO. Maybe I can ask Mr. Freedman. How would you characterize over the short and intermediate run, and I might set an arbitrary timeframe of between two and ten years, the possibility that the capital markets could assume all of the demand that is out there for reinsurance?
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    Mr. FREEDMAN. Speaking as only one company, I would say slight because of the progress we have seen over the past couple of years. I think Mr. Weber's chart shows it vividly. If the capital markets, at least Warren Buffett's company is getting higher than a 10.8 percent return, because he is going to have that billion dollars invested elsewhere. But he compares that, or the capital markets will compare, that against what other rates of return they can get, such as they are getting today in the equity markets. So there has to be a comparison between what you can get in an alternate investment vehicle and what the purchaser is willing to purchase. Of course, if we went out to the capital markets, you can only pass along so much of the expense of the capital markets coverage or so much the expense of reinsurance coverage, because the rates to some extent are suppressed in many of the States. That just doesn't become a good match between what the customer and seller want to pay.

    Mr. NUTTER. Mr. Lazio, do you mind if I supplement that answer?

    Mr. LAZIO. No, I don't.

    Mr. NUTTER. Two answers. One is that most analysts would say that the fairly soft pricing in the property catastrophe reinsurance market has made it more attractive for insurers to buy the reinsurance than it is to go to the more expensive capital market products and that if that changes, it is likely to enhance the development of the capital markets.

    The second thing is that there clearly was, it seems to me, a novelty premium associated with the capital market vehicles in this first go-round. I believe analysis would show that the prices of the capital market products are coming more in line with corporate bonds, as opposed to equities, and therefore you are going to see them more attractive to a broader segment of the investor market.
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    Ms. Bouriaux may have a comment on that and she would be more knowledgeable than I would.

    Mr. LAZIO. The only significant transaction I am aware of is the USAA transaction, and that was, as I understand it, very costly in terms of a premium, a very costly transaction. The point that we keep coming back to is the fact that insurance regulators regulate the cost of homeowners' policies, and those costs, the anticipated or the requested rate of return in the capital markets, can't necessarily be passed through to consumers. Is that true?

    Ms. BOURIAUX. Mr. Lazio, the pricing of the CAT bonds has really narrowed since the USAA offering. I think the USAA offering was 500 business points above LIBOR. The latest transactions we have seen is a lot lower than that. And also there has been some secondary market trading that really has narrowed the pricing of those bonds as well.

    And what Mr. Nutter just mentioned, which is a novelty of those CAT bonds, is very important and USAA, for example, was the first company to recognize that they were willing to pay such a high premium because they have a long-term view of what could happen in the future, and I think we tend to forget right now that we all have a little bit of a short-term view, but initiatives like CAT bonds or the Board of Trade products, we are there when the market was tightened. And I just want to make clear, for example, at the Board of Trade, if I could relate one experience that we have, the largest volume of transactions we did was about two hours before Hurricane Fran hit the shores and we traded in two hours 3,300 options for an equivalent capacity of about $15- to $16-million. Granted, it is pretty small. We are talking about a market that at the time was about 12 months in its infancy, but I think that shows you and the companies that you will see in the future those kinds of private market responses.
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    Mr. LAZIO. My last point would be there is obviously growth in the markets, which I think gives us some cause for optimism, but we have a short-term problem as well and we can only hope that we have enough time to watch the maturity of the capital markets to meet the demand that is out there.

    I am going to turn back to Mr. McCollum to ask a couple more questions.

    Mr. MCCOLLUM. Thank you, Mr. Chairman.

    Mrs. Kelly asked me to ask a couple questions for her. She had to run out. One is in the capital markets area and it may have been covered by that answer, but I am not 100 percent sure.

    She wanted, Ms. O'Hanlon, for you to answer the question. It had to do with whether Chase had done any private market catastrophic deals. I don't know what she was getting at exactly, but that is the way the question was worded.

    Ms. O'HANLON. I think probably she was talking about catastrophe bond deals, though it is not totally clear. And just to follow-up, the USAA deal was priced at about 550 basis points over LIBOR. The most recent deal which was done was for Trinity Re, which was primarily Florida risk, and that was priced at about 300 basis points. That is the deal that Chase most recently completed.

    The USAA deal, in my understanding, is about to come to market in a couple months and will be priced substantially below the 550. We are seeing risk premiums that are more in line with what I talked about, about the 300 or perhaps less than that, perhaps down to 250 basis points, and I think there is a lot to be said for what Mr. Nutter said about the first time the USAA deal was done in terms of the novelty premium associated with that.
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    Mr. MCCOLLUM. One of the other questions was to Mr. Weber. She wanted you to identify your members and I assume you can submit that for the record for us. I am not going to sit here and ask you to regurgitate every one of the big members that is a member for you.

    Mr. WEBER. It would be my pleasure. We represent Allstate Insurance, which is the second largest company in the homeowners' insurance market, Farmers Insurance, which is the third largest, Safeco, Metropolitan Property and Casualty, and the Independent Insurance Agents of America.

    Mr. MCCOLLUM. One of the follow-up questions she had, does HIFA believe there is a need for other State funds besides the three that are there now? I guess it goes to the ultimate question of which direction we are headed, is there a desire to move, to have a State fund, more State funds created; does HIFA believe that is the case or not?

    I think that is what she wanted to know.

    Mr. WEBER. Well, first of all, I think that none of us want to see a proliferation of State programs. I think it's important to point out that States that have acted did so because had they not acted there would be no market for homeowners' insurance coverage. We don't think that H.R. 219 would encourage a proliferation of State programs. That is not our goal.

    But I think that we are aware that the three places where major catastrophes have struck in the 1990's are the three places where those markets are not working. If we have our next major catastrophe strike in Louisiana or North Carolina, then we can probably expect similar problems in those States.
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    Mr. MCCOLLUM. While we've got the microphone down at the end, Mr. Nutter, I would like you to clarify one thing. It's my question, not Ms. Kelly's here. But would, in your expectation, if there isn't an excess-of-loss auction market feature put into place in one form or another here, would the reinsurance companies participate in such an auction market and buy contracts?

    Mr. NUTTER. I think they would be most enthusiastic participants. In the process they would see it as additional capacity for themselves. They would see it as additional capacity for their client companies, which tend to be the Farm Bureaus, the small regional and local companies that they traditionally serve as their bread and butter clients.

    Mr. MCCOLLUM. And they're much more likely to do that if there is an auction, is that correct? More likely to participate in an auction than in the model that does not have an auction?

    Mr. NUTTER. That is correct.

    Mr. MCCOLLUM. Mr. Campion, you have modeled an approach for us for H.R. 219. Have you modeled an excessive loss approach?

    Mr. CAMPION. With regard to what we modeled, we assumed that the auction would follow in effect the same format in terms of the amount of money collected as the individual States would pay in if it was a State fund. For example, the fact that there would be a minimum price at a reserve price of two times the actuarial premium, we assumed that was what was collected in our analysis, because we had no way of knowing how the auction would work, or how much excess premium could be collected. That was the assumption we used.
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    Mr. MCCOLLUM. So, you have not another kind of assumption that maybe would be different from what Mr. Pike—I think the two times was his basic assumption?

    Mr. CAMPION. That is correct.

    Mr. MCCOLLUM. But you might do one down the road; if we gave you some other factors to go with, you could use your system to do that?

    Mr. CAMPION. Yes, certainly we could do that, the assumptions would have to be what were the premiums collected in those auctions.

    Mr. MCCOLLUM. Ms. Kelly asked me to ask you if your company brokered the CEA reinsurance?

    Mr. CAMPION. Yes, it did.

    Mr. MCCOLLUM. Some thought, she says, that that was a ripoff, and she asked if you agreed if it was?

    Mr. CAMPION. No, I don't believe it was a ripoff. And I think one of the things for those people to keep in mind, and I think Deputy Commissioner Knowles put it very well, which is, the price for those purchasing coverage appears very high, and for those selling coverage appears low. And I think for those people that make comments like that we can always find an opportunity for them to put their capital at-risk through reinsurance mechanisms, if they think it's such a great deal.
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    Mr. MCCOLLUM. Just for the record, you did get a commission; it was brokered?

    Mr. CAMPION. Yes, that is correct.

    Mr. MCCOLLUM. And this is my last set here, if I can to follow-up Ms. Kelly's line of questioning, Mr. Chairman. With regard to State Farm and Allstate, she notes that there are surpluses that each of you have, which I think we all know, and she notes that State Farm has a $37.6 billion and Allstate has a $17 billion surplus. I don't know the accuracy of those figures, but that is what she has down here. And she asks if the surpluses are being carried for catastrophic risk, if that is the reason for the surplus, and that is essentially what the question is I believe.

    Would either of you gentlemen care to respond to that?

    Mr. JOSLIN. Both companies are very large writers of automobile insurance, and I think both of us have said that the insurance business segregates, tends to place its capital behind various business opportunities, and certainly all of that surplus is not designed to support the homeowners' losses in a given geographic area. It is a much, much broader business obligation.

    Mr. MCCOLLUM. Would you agree, Mr. Pike?

    Mr. PIKE. Except I wish we had $16.5 billion. We have $12.5 billion in statutory surplus numbering.
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    Mr. MCCOLLUM. OK, that is fair enough. In conclusion, and I come back to myself now. I have asked mixed questions here, but a few that she asked me to and I'm sure I didn't cover all her questions. If her staff is here, I apologize, I don't have time to do that, but I did try.

    I want to thank each of you. I know the companies here and Mr. Nutter, in particular, who represented, and a number of companies who aren't represented here today have just been doing exceedingly overboard efforts with Mr. Lazio and myself to come up with various ways we can make all of this work. And you have all been very capable and willing to come forward and tell us that you will participate in a variety of different versions of this and to help us craft something that we ultimately can use.

    So I want to again thank you publicly for doing that. It is obvious that each company and each marketplace is a little different. But working together, we are going to come up with one yet. Thank you very, very much for doing this, and thank you, Mr. Chairman.

    Mr. LAZIO. And thank the panel as well.

    We have two votes stacked, and the first 15, the second 5, I think the earliest we will be able to come back is about 4:00 o'clock. So the hearing is in recess to hear the last panel until 4:00 o'clock.


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    Chairman LEACH. The hearing will reconvene our final panel to discuss the impact of natural disasters and lack of available homeowners' insurance in local economies, including real estate markets, financial institutions and home construction. The panel will also present the consumers and other perspectives of this legislation. Our panel consists of Ms. Babette Heimbuch, who is President and CEA of the First Federal Bank of California, which specializes in single and multifamily real estate secured loans. Mr. Christopher Lewis is a Senior Manager of the Risk Management Group for Ernst & Young here in Washington. Ms. Kathy Whatley is a broker under Buck & Buck, Inc., a family realty firm in Jacksonville, Florida. Mr. Pierre Lanaux is President of Lanaux Construction in Lousiana.

    Mr. J. Robert Hunter is currently the Director of Insurance at the Consumer Federation of America and a consultant in public policy and actuarial issues. Mr. Charles Brown is Vice President of Baker Welman Brown Insurance and Financial Services. And Mr. Jordan Clark is President and cofounder of the United Homeowners Association.

    Let me just say we have had an extraordinary day and a long one and we have been interrupted by votes, as all of you understand, in other issues that relate to Congress at this time. All of you have problems as well, and I am told Mr. Lanaux has a plane to catch at 5:00 o'clock. And if there is no objection of the other panel, I would like to begin with him, and then we will proceed in order as put forth.

    Mr. Lanaux? Without objection all of your statements will be placed in the record fully, and you're certainly free to summarize if you choose. But please go ahead.

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    Mr. LANAUX. My name is Pierre Lanaux, and I am President of Lanaux Construction. I am a builder from New Orleans, Louisiana and have been involved in the residential construction industry for over 15 years. I am pleased to appear on behalf of myself and the 190,000 member firms of the National Association of Home Builders.

    I have been asked to confine my remarks to the Housing Subcommittee's print of H.R. 219. H.R. 219 was marked up by the subcommittee earlier this year and represents a combination of the elements of H.R. 219, as introduced, and H.R. 230, the Natural Disaster Protection and Insurance Act. This subcommittee print would create a Federal backstop through reinsurance to eligible State insurance programs in the event of a major catastrophic event.

    The legislation is designed to foster accessible and affordable homeowners' insurance. H.R. 219 addresses the problems associated with the unprecedented number and magnitude of natural disasters the United States has suffered since 1989. For example, the massive property destruction resulting from Hurricanes Andrew and Iniki and Northridge Earthquake caused insurance companies to either discontinue doing business in these disaster-prone areas or to drastically cut back on the policies they insure, causing dislocations and severe consequences for homeowners and perspective home buyers.

    States have already established or are in the process of instituting some form of insurance program or catastrophic fund. The National Association of Home Builders is pleased that H.R. 219, as currently crafted, contains no Federal mandate relating to State and local building code compliance and adoption provisions for disaster-prone areas.

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    At the same time, H.R. 219 begins to address the very real needs associated with the availability and affordability of homeowners' insurance for coverage of certain perils. For this reason NAHB can support the overall objectives of H.R. 219 and the process for moving the bill forward.

    There are certain aspects of H.R. 219 on which NAHB has no formal position. My testimony is, therefore, confined to those provisions relating to State hazard mitigation plans. These provisions would also have a direct impact on housing affordability and our livelihoods.

    As noted above, H.R. 219 is silent on mandatory Federal code requirements. H.R. 219 addresses mitigation by requiring each eligible State insurance program to devote at least 10 percent of its net investment income to the State program measures to mitigate losses from natural disasters in that State. This requirement is conditioned upon the allocation not interfering with the actuarial soundness of the fund.

    H.R. 219 would leave to the discretion of the pertinent States what type of mission programs they should adopt. NAHB agrees with that approach, which allows States to establish programs without Federal intrusion.

    Traditionally, the health and safety of the general populace has been the prerogative of the States. This longstanding principle is well-founded as it is important to remember that each State/region is subject to differing perils, as well as varying degrees of risk. What might be an effective or necessary mitigation plan in Florida may not be an appropriate or effective plan in Louisiana or Texas.
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    With respect to the development of mitigation programs, NAHB argues that mitigation programs should not be focused exclusively on new construction, but that strategies should address existing structures which comprise the vast bulk of housing stock. Such programs could include emergency preparedness response programs, design and construction education programs, voluntary programs with insurance premium reduction incentives, enhanced code official certification requirements or a whole host of strategies. However, these programs should be left to the States to develop to address the particular nuances of their localities.

    In my own State of Louisiana, for example, property damage from hurricanes and the consequent flooding is one primary source of concern. The cost of homeowners' insurance has dramatically increased since 1992. Louisiana has responded to this problem by establishing a disaster insurance program funded by voluntary participants who are either commercial enterprises or homeowners. These funds are only available, however, for high wind areas near the Gulf Coast. To my knowledge, there is no special mitigation program other than in enforcement of existing building codes.

    Finally, I would like to add our support for a proposed change to H.R. 219. The National Association of Realtors, like the NAHB, is concerned that homeowners' insurance be accessible and affordable. We agree that the legislation should require a study evaluating the availability and affordability of insurance and the extent to which the State and private insurers are addressing the problem. Such a study was part of H.R. 230, and we hope that a similar provision could be incorporated into H.R. 219.

    Again, I thank you for the opportunity to present these views of the housing industry on this important issue.
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    Chairman LEACH. Thank you. We will note. That is appreciated, and I am sorry Mr. Baker isn't here to welcome a fellow Louisianian, but we are very honored with his work in the committee.

    Ms. Heimbuch.


    Ms. HEIMBUCH. My name is Babette Heimbuch, and I am President and Chief Executive Officer of First Federal Bank of California, headquartered in Santa Monica, California. My institution has 24 branches and holds in excess of $4 billion in assets. I am also a member of the board of directors of the Western League of Savings Institutions on whose behalf I appear today.

    I would like to thank Chairman Leach for scheduling this hearing and giving this important public policy issue a thorough airing. I would also like to thank subcommittee Chairman Lazio, and Representatives Fazio, McCollum, Campbell for their leadership on this bill. Finally, we appreciate the constructive input the Administration is providing, especially the positive suggestions of Secretary Summers this morning. I very much value the opportunity to participate in this hearing on an issue which is of great concern to California lenders.

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    Depository institutions, whether they are located in seismically-prone regions like California, Missouri or Tennessee or hurricane areas such as Florida or the Carolinas or New York, face the potential of crippling losses should the traditional safety net of private homeowners' insurance fail.

    I am here to tell you that that system is indeed failing. Over the last decade in California, we have experienced earthquake disasters that have caused many billions of dollars of losses. These events caused severe deterioration in the availability of earthquake insurance coverage. So much so, in fact, that in 1995 the California Department of Insurance reported that 95 percent of the insurance companies in the State would not underwrite new homeowners' coverage.

    As you might imagine, the consequences of this insurance market failure were quite alarming to the financial institutions. As of the third quarter of 1997, there are 62 Federally and State chartered savings institutions in California which together hold some $195 billion of real estate loans, of which $185 billion are residential. FDIC insured financial institutions in California, savings banks and institutions, thrift and loan companies together hold nearly $330 billion in real estate loans.

    To illustrate the magnitude of a failed insurance market, let us suppose the consequences of a major earthquake which causes $50 billion in losses. Such losses could translate into potential losses to homeowners, banks, thrifts of billions of dollars of property if homes were abandoned by their owners for lack of funds for repairs. And these problems would be exacerbated in a real estate market where home values and owners' equity are declining. Depository institutions would not be the only casualties. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation would also be at risk. Major losses would be incurred by the Federal Housing Administration and the Veterans Administration.
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    Finally the Federal deposit insurance funds would be placed at great risk. Indeed, it is not an exaggeration to say that the greatest risk to the funds protecting America's financial institutions is not financial collapse but large scale disaster.

    I would like to illustrate some of these problems I have alluded to by describing the experiences of my own institution, First Federal Bank of California. My bank suffered losses in excess of $16 million from the Northridge Earthquake of 1994. That represents 8 percent of the bank's net worth. The bulk of those losses were from loans on apartment housing for low-income families. The majority of losses from single family loans were condominiums.

    The coverage now being offered by the California Earthquake Authority would not have protected the bank against these losses. California has tried to solve the problem in its own way, but quite frankly the solutions in place that have already been described by others this morning are not enough.

    The California Earthquake Authority has indeed alleviated the problem of homeowners being able to find insurance at any price, but they provide less coverage at a higher cost than what was available prior to the earthquake. Deductibles are higher and the program does not cover multifamily structures. Even more alarming, the fund cannot cover losses from an earthquake that causes more than $7.5 billion in losses.

    But these problems are not of the CEA's making. The reality is that no State has the means of creating a program capable of handling the true mega-catastrophe. The CEA buys more private reinsurance than any other entity in the world, yet that coverage is only $2.5 billion and costs 50 cents out of every premium dollar collected.
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    We recognize that some have criticized H.R. 219 for its reliance on State-operated Government entities rather than the private sector. We are not experts on the pros and cons of funding mechanisms. But we do believe that there is a role for both State and Federal Government. Only Government can design and compel responsive insurance programs that provide adequate, affordable natural disaster insurance.

    We urge you based on our experience to focus on these general principles as you proceed. Legislation should reflect good public policy. The development of a natural disaster program should be rooted in the principle that those who live in areas at-risk provide protection for themselves rather than on relying on the eventuality of Federal disaster relief.

    A Federal solution is needed. An effective and comprehensive response to the risks posed by natural disasters is beyond the ability of any State. Insurance must be widely available at reasonable rates, adequate incentives to mitigate risks should be provided, and the program should include multifamily, as well as single family residences. This provision is already included in H.R. 219, and I urge you to make sure it remains in the bill.

    Thank you.

    Chairman LEACH. Well, I thank you. And I am hard-pressed not to say that you are the second extraordinary female bank president from California who has testified before this committee recently.

    Ms. HEIMBUCH. Thank you.
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    Chairman LEACH. We are very appreciative. And second, your comments about the implications of the big one on the deposit insurance funds had not been well brought to the committee's attention prior to testimony today, and I think is of signal significance. Thank you.

    Ms. HEIMBUCH. Thank you.

    Chairman LEACH. Mr. Lewis.


    Mr. LEWIS. Thank you, Mr. Chairman, Members of the committee for the opportunity to appear before you today to discuss this important topic of whether and how the Federal Government could improve our Nation's ability to finance the losses created by large national disasters.

    As many of the other panelists have asserted, a strong economic and financial case for Federal involvement in improving the allocation of disaster risk in the United States can be made, especially in the areas of predisaster mitigation and the financing of large insured losses from catastrophic events. However, the need for Federal involvement is limited in scope and requires a very carefully designed program that does not interfere or distort the existing private insurance markets or regulatory structure.
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    To assist in this effort, I appear before you today on my own accord, not representing Ernst & Young, any client or interest group, to give you the benefit of my experience in studying this issue over the past several years, both as a member of the White House Working Group on Natural Disasters and as a private risk management consultant in the insurance industry.

    Over the past ten years, the United States has witnessed a significant rise in the magnitude of insurance industry losses from natural disasters. In nominal dollars, nine out of the 10 largest U.S. catastrophes in history have occurred since 1989. In fact, after adjusting for house price inflation, insured losses over the 1989 to 1995 period totaled almost $75 billion, more than five times the average real insured losses during the prior four decades. More importantly, however, is the fact that one of the major factors driving this increase in disaster loss is a continued development in high-risk areas of the country, a problem that continues today.

    Ultimately, the losses from natural disasters are always paid by only one constituency. That is the American people. However, the method through which the costs of natural disasters accrue to American people, either through taxes, insurance premiums or direct losses, is critical in optimizing the overall welfare of society.

    For example, if all losses were financed through the Federal post-disaster assistance, which, in turn, is financed through general tax revenues, the general tax code would determine who bore the costs associated with disaster losses. In this case, the burden of financing and disaster risk would not be linked to the individuals creating the disaster exposures and individuals would continue to increase society's overall disaster exposure by building in high-risk areas, clearly an undesirable situation.
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    Alternatively, if disaster losses were completely financed up front through the purchase of insurance at an actuarially fair premium, individuals would have to factor the costs of insurance into their decisions on where to locate and how much disaster mitigation to incorporate into their building decisions. As a result, individuals would have an incentive to build in lower-risk areas of the country, reducing the growth in the country's overall disaster risk and optimizing the allocation of risk in the economy.

    Ideally, a comprehensive system for financing catastrophic losses would create strong incentive for individuals to mitigate or reduce their exposure to loss from disaster events, would improve the efficiency and effectiveness of how losses that do occur are financed, and would provide for quick response of assisting individuals that do need assistance in the wake of a disaster.

    The question before the committee is how can Federal policy help foster a market-based solution that meets these objectives? Addressing this question requires a closer examination of the problems within the insurance markets that are preventing such a solution today.

    In financing property/casualty disaster risk, insurance companies are the primary intermediary in the U.S. economy. Individuals living in disaster-prone areas are exposed to considerable losses from disaster events. In providing disaster insurance, an insurance company offers to assume a portion of this risk in exchange for a premium.

    After accumulating these policyholder positions, the insurance company can diversify its disaster risks through its pooling, risk identification, risk identification and segregation, risk monitoring and risk mitigation.
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    The insurance company's ability to diversify insurance through polling is extremely effective when risks are independent and often identically distributed like fire insurance. However, in the case of large idiosyncratic risks, like disaster insurance, where multiple policies are affected by the same event, the benefits of pooling are significantly less; for these events diversification must occur across time, with insurers financing disaster exposure through the purchase of reinsurance, the issuance of capital market securities or through stockholder equity.

    For most disaster risks, the problem does not reside in whether the events are insurable, but whether the insurance company can establish an effective mechanism for accomplishing this intertemporal smoothing of claims. Historically, insurance companies have relied largely on reinsurance and self-insurance. However, given limited liability and exposure constraints, even large industry and reinsurance companies lack the capacity to accomplish the intertemporal diversification of loss that is needed.

    In response, considerable attention has been focused on creating alternative market mechanisms, including a focus on the development of capital market securities. The prospect of finding another source of capital through disaster derivatives or securitization was alluring to reinsurance firms because of the sheer size of the capital markets.

    Catastrophe securities also were seen as offering advantages to institutional investors. Recognizing these advantages, insurers in investment banks have made considerable investments in developing new capital market products that are attractive to both insurers and investments.
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    Following several years of lackluster performance, the catastrophes securities market registered significant progress as a new asset class in 1997. During the year the market registered over $1 billion new issuances, including transactions by USAA, Swiss Re, Winterthur and Tokio Marine.

    All indications suggest that 1998 will exceed the $1 billion mark set in 1997, and if the catastrophe market continues to follow the evolutionary path of other asset-backed securities markets, new issuance could grow significantly in the next five years.

    Notwithstanding this potential, the security market faces many obstacles that need to be overcome before a fully developed market can be established. For example, the market lacks a standardization in risk measurement in structuring, the lack of a generally accepted index on which to base payouts, and sometimes excessive transactions cost when compared to reinsurance. Even if the private capital market is able to grow over the next several years, catastrophe securities are unlikely to provide the answer to financing truly catastrophic events.

    Given the shortcomings within the existing markets for financing disaster claims over time, insurance companies, reinsurers, States and other constituents have raised the issue of a Federal role in the financing of disaster insurance. Historically, the insurance industry has a post-Federal intervention in the insurance marketplace. However, the large-scale disruptions caused by Andrew and Northridge have prompted many members of the insurance industry to call for some form of Federal assistance.

    Evaluating the potential role of the Federal Government in financing catastrophic risk is an important issue in examining the current problems facing the insurance industry and in the financing of catastrophic risk more broadly. Two current shortcomings in the allocation of catastrophe risk become apparent, the lack of internalization of risk and individual decisionmaking, and the absence of a mechanism that would allow insurance companies to smooth claims over time; in addition to cost effective mitigation, the encouragement of actuarially priced insurance in one mechanism for improving the internalization of risk at the individual level. However, this requires insurance companies to have the capacity to offer those policies without jeopardizing their solvency.
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    To develop a Federal program that can expand the capacity of the insurance industry without interfering with the regulatory framework of the insurance industry while continuing to support innovation and development in the insurance and capital markets presents a considerable challenge. Equally as difficult will be developing an approach that is narrowly defined and targeted at providing a mechanism for intertemporal risk diversification without encouraging additional risk-shifting to the Treasury. In this respect, the Federal Government's unique position in the debt markets is a great advantage. However, the difficulty is designing a program sufficiently targeted to only utilize this unique borrowing authority.

    Other issues that such a program would have to face would be avoiding any replacement or displacement in the insurance industry, including favoring one segment of the industry over other segments, setting appropriate attachment points and caps in the Federal Government's overall exposure, maintaining the current State regulatory framework with the critical link between State regulation of solvency, insurance rate approval and the State guaranty fund structures maintained, fostering the development of innovation in the capital markets, pricing the program at normal market rates, avoiding the creation of another Federal bureaucracy, and creating a budget-neutral program are all important obstacles.

    In conclusion, there is a strong economic and financial argument for the Federal Government to play a role in financing catastrophic risk; however, the challenge for the committee is how to correctly define this role so as to encourage cost effective mitigation in the development of a narrow mechanism that would allow the insurance industry to smooth large disaster claims over time.

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    Mr. Chairman, I thank you for the opportunity to appear today. And I welcome any questions after the rest of the panelists.

    Chairman LEACH. Well, thank you very much, Mr. Lewis.

    Ms. Whatley.


    Ms. WHATLEY. Thank you, Mr. Chairman, for the opportunity to present the views of the National Association of Realtors on H.R. 219. We want to thank you, Mr. Chairman and Chairman Lazio, for your leadership on this issue of the National Disaster Insurance, and we also want to thank Congressman McCollum in his efforts that he has taken to find a solution that has plagued the State of Florida since 1992.

    I am Cathy Whatley. I am a realtor from Jacksonville, Florida. I work with buyers and sellers of homes every day, except today. I am here today. I am also the 1998 regional vice president for the National Association of Realtors for Region 5. That encompasses a number of southeastern States, as well as the Virgin Islands and Puerto Rico.

    The deterioration in the availability and the affordability of homeowners' insurance in disaster-prone areas is an issue of very real concern to the National Association of Realtors. Many of our members specialize primarily in the business of assisting sellers and buyers in residential real estate transactions.
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    It is this business focus that motivates NAR's interest in the resolution of this problem. Although I am testifying today on behalf of the real estate industry, I can't emphasize enough that the ultimate victim of the homeowners' insurance crisis is the consumer who is frustrated in his or her attempt to realize the dream of home ownership. And when anyone, whether it is a young family or any other potential homeowner, is precluded from owning a home because homeowners' insurance is either too difficult to obtain or too costly to afford, we all suffer the consequences. The inability to obtain affordable homeowners' insurance is a serious threat to the residential real estate market.

    Not only does it impair all the market for single family detached homes, but the condominium, co-op and rental markets are affected, as well as new home purchases, resale transaction and housing affordability are negatively impacted in several ways.

    First, homeowners' insurance is a necessary component in securing mortgages when buying a home. If a potential home buyer is ultimately unable to obtain the required insurance, because the insurance is either unavailable or unaffordable, the sale will not be completed. As a result, credityworthy potential home buyers are priced out of the market. In a recent NAR survey, respondents reported that an estimated 2450 transactions fell through because of difficulty in obtaining disaster insurance. Seventy-five percent of those respondents cited that it was unaffordability for the reason.

    Second, homeowners' insurance is tied directly to the cost of owning a home. If a homeowner is unable to maintain insurance required by the mortgage lender, the mortgage is in default. Disaster insurance coverage is optional. Potential buyers may choose not to purchase a home simply because the insurance they consider essential is too costly; others may choose to go unprotected.
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    Third, insurance costs impact rental rates. Insurance costs incurred by landlords are ultimately passed on to tenants. Consequently, increased insurance costs results in higher rents.

    The National Association of Realtors supports H.R. 219 for several reasons. It protects against mega-catastrophes. State programs that have been created to address the problems are well-intentioned first steps, and homeowners' insurance is currently available in these States. However, neither State disaster programs nor the private insurance industry have the capacity to cover the risk presented by mega-catastrophes far more damaging than Hurricane Andrew or the Northridge Earthquake. The creation of a Federal disaster reinsurance program today will help prevent future interruptions in the availability of homeowners' insurance.

    H.R. 219 also promotes fiscal responsibility. By establishing a program which promotes available and affordable insurance coverage for those at risk of property losses from a natural disaster, the bill would minimize future unforeseen disaster assistant expenditures and keep us on course to balance the Federal budgets. It is time to begin planning for future disasters and provide insurance to those at risk so that they can be adequately prepared when that time arrives.

    NAR's primary concern is the availability of affordable homeowners' insurance. Any Federal program that is created must be designed to achieve that goal. To that end, we suggest that H.R. 219 be amended to require an agency study evaluating the availability and affordability of insurance and the extent to which States and private insurers have responded to the problem, we must safeguard the cornerstone of the American dream.
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    NAR supports the Federal response to the disaster insurance crisis which helps to make the dream of home ownership a reality for more and more Americans. We urge the Banking and Financial Services Committee to take action this year on this important issue.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, Ms. Whatley. And I know Mr. Foley wants to welcome you.

    Mr. FOLEY. Welcome to my real estate colleague to Washington, DC. and for her insightful testimony in support of the bill. I think it is vitally important for all of us in Florida and all of us in the Nation to establish this as a significant part of public policy. So I again thank Cathy for joining us, and thank the Chairman for his indulgence.

    Chairman LEACH. Thank you, Mr. Foley.

    Mr. Hunter.


    Mr. HUNTER. Thank you, Mr. Chairman. It is a pleasure to be back in this room where I was Federal Insurance Administrator and was politely browbeaten many times from that chair where you are sitting. I was Federal Insurance Administrator during the 1970's and ran the National Flood Insurance Program, which could serve as instructive as you design the bill, and it is good that this committee has that experience and expertise.
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    I also served as Texas Insurance Commissioner, and so I am interested in how this will impact the insurance industry, but also I am here representing both the Consumer Federation of America and Consumers Union to raise the issues from a consumer perspective.

    I want to congratulate the various people that have been congratulated several times, Mr. Lazio, you, Mr. Chairman, and Mr. McCollum. A lot of good things have happened because of the Congressional interest over the years in this issue. The Wharton School is conducting research into the kinds of questions that have blocked passage of the bill historically, such as the impact of hypothetical large catastrophes on the market and the capacity of the private sector to handle the risk, and so on. They have also been doing a great deal of research into the securitization of the catastrophe risk, which has a lot a potential.

    FEMA has prepared a national mitigation strategy, as a result of their concern and your concern. It is a beginning, but it requires enforcement. As you know, in Florida had there been enforcement of the existing building codes, estimates are that at least 40 percent of the Hurricane Andrew damage would have been avoided in Florida. The American Red Cross has incorporated natural disaster loss mitigation as a core program now in its work. And most property casualty insurance companies have created and are supporting the Institute for Business in Home Safety, which is working on mitigation issues.

    And then there is the Public-private Partnership 2000 initiated by 19 Federal agencies and the IBHS, which is a series of 14 educational forums which we are in the middle of right now on the questions that you are here discussing. So there is a lot, as a result of your efforts, that is already going on in the marketplace of ideas and thoughts and so on. So that is very good news.
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    Additionally, there is some bad news. The bad news is we have a system in this country that has an imbalance in it. I have data attached to my testimony that shows that wind is pretty much covered with private insurance, and places like Texas and Mississippi and Louisiana are paying $7.00 or more per-thousand dollars of home value to protect themselves from that by insurance. And then there is a chart that shows that most wind is covered by private insurance and there is very little Federal disaster relief.

    But there is a lot of Federal disaster relief, and there is considerable cross-subsidies between different States and different parts of the country, which I point out in my written testimony. The annual cross-subsidies from disaster relief range from an average per household subsidy to North Dakota of $104, to California of $100. But States like Connecticut and New Jersey and New York are paying in a lot more into the disaster relief system, because disaster relief isn't charged like premiums. It is not risk-related. There tends to be these cross-subsidies, and so it is very important for any plan that you work on to figure ways to reduce those taxpayer subsidies over time. You are always going to have taxpayer emergency costs after a big disaster, but the idea of moving toward more insurance and disaster relief is a good one.

    There are certain principals that consumer groups believe should underlie any good bill. The first is that adequate insurance protection to the public should be a requirement of Federal backup. You should make sure that the bill has some requirements that adequate insurance be available to consumers in these high-risk areas for the very reasons you have just heard about.

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    There has been a very strong move toward very weak coverage. The California Earthquake Authority has a 15 percent deductible. I was the actuary that worked for the State of California analyzing the California Earthquake Authority. The average payout expected from all earthquakes is only about 40 percent. That means 60 percent is left over for the homeowners to bear, and the taxpayers.

    And we have the very odd situation when you have these high deductibles where the Federal Government comes in for disaster relief below the insurance. That is not a good idea. The Federal Government should be coming in at the high level, not at the low level. So moving in the direction of not paying disaster relief below deductibles would be a good idea.

    The second principle is that strong mitigation should be a component of any bill. To back up insurance in a high-risk area of the country without controlling against unwise new construction is going to increase taxpayer liabilities as well as insurance rates in the long run, and you need to make sure that you are not encouraging unwise construction.

    We have learned from the flood program, which I administered, that when your rate is too low, people build, and that happened on barrier islands while I was administrator. We had an error in our rates, they were too low, and people rushed in to build as a result of it, and that was a very bad thing for the country. So you have to make sure that there is some kind of mitigation.

    New construction should be rated at full risk rates to make sure that construction is safe. You should absolutely require that at least new construction be rated at full rates.
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    Then the enforcement of building codes is an important thing that needs to be considered. Again, 40 percent of the claims from Hurricane Andrew would have been eliminated had the current building codes in that area been enforced, according to the research. We need incentives for existing structures to retrofit, particularly in earthquake areas. One of the problems with the CEA is there is no real retrofitting discounts available today.

    Now, third, we should maximize the private sector approach. We have heard that all morning. There has been an amazing growth in surplus even in the years of Hurricane Andrew and Northridge. The surplus of the insurance industry went up dramatically. There has been $60 billion of disasters in this decade, the most in any seven-year period in history. And yet the insurance industry's surplus has more than doubled.

    We need to take that into consideration in setting the triggers. A.M. Best calls the industry now excessively capitalized. Catastrophic reinsurance rates have been falling dramatically, and there are alternative methods and sources of backup such as the securitization of risk.

    Finally, we need to learn from the National Flood Insurance Program and incorporate those lessons.

    H.R. 219 fails to meet these four key principles in several key respects. First of all, the bill increases taxpayer liability, and exacerbates the cross-subsidies already inherent in disaster policy, because the bill has no goals for mitigation, no real plan to reduce the Nation's losses, and that is a serious problem.
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    The bill has no accompanying plan to show how the taxpayer will fare year by year under the bill's provisions. The goal ought to be to reduce the taxpayer liability over time, and it ought to be a plan that would show if this bill was passed how the taxpayer ultimately would have a lower, not a higher liability. The bill triggers, as low as $2 billion, greatly impedes private market developments. In my testimony I do an actuarial calculation where I think the trigger should be $40 billion, and the $37 billion you heard from earlier testimony by RAA is pretty close to that.

    The bill sets up no standards for State pools, thus pools, such as the California Earthquake Authority, which actually increases taxpayer liability, are covered. I think there should be some standards for how the pools should look to gain federal taxpayer back-up.

    And then the bill does not guarantee insurance to anyone. It only guarantees insurance companies will be able to tap the Treasury in the event of a large event. So the Consumer Federation and Consumers Union oppose H.R. 219 as it is currently drafted. And most insurance companies don't support it, except for a few giant insurers like Allstate and State Farm, who aggressively marketed to homeowners in high-risk areas in the 1980's, creating what the Florida Academic Task Force termed as an oligopoly in the hurricane-prone areas of Florida.

    H.R. 219 interferes with the private market, it does not make insurance available. Congress can do much better. You can adopt a plan that lowers the risk of death in property damage through mitigation. You can develop an integrated approach to insuring natural disasters. You can minimize Federal involvement and maximize private solutions. You can set the Nation on a course where ultimately the taxpayer will be off the hook for all but the emergency relief and shelter aspects of natural disasters. When we have a situation like we had this morning, where the representative of the Florida insurance department was unsure whether he would even buy the coverage if H.R. 219 passed, it makes you wonder, because if he isn't going to buy it, who will?
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    When the representative of the California says the problem is not that he wants reinsurance because he can't get it but he wants to cut the cost of reinsurance that he's getting from the private market, when the data from the California rate hearings shows that the California Earthquake Authority didn't buy reinsurance from the low bidders. There is a serious problem.

    So, I thank you. I think the country is really moving forward, and I encourage you to consider major amendments along the lines of what I suggested.

    Chairman LEACH. Well, thank you very much, Mr. Hunter, and your thoughts will be thoroughly reviewed.

    We have a problem with another vote in the floor. Before turning to you, Mr. Brown, are you going to be more than one or two minutes? Then I think out of fairness to you, we will recess at this time and return in 10 to 15 minutes. The hearing is in recess.


    Chairman LEACH. The hearing will reconvene. We left off just before hearing from Mr. Brown. Mr. Brown is recognized.

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    Mr. BROWN. Thank you, Mr. Chairman. I appreciate the opportunity to address the committee on natural disaster legislation.

    My name is Charles Brown. I am Vice President of Baker Welman Brown Insurance in Kennett, Missouri. I am an independent insurance agent. I have the privilege of representing hundreds of homeowners in my community with all different types of homes and all different values of homes. I am testifying today on behalf of the Independent Insurance Agents of America.

    I live in a nice little town, but unfortunately, it is located in what is predicted to be one of the worst affected areas of the New Madrid fault. We have our problems just like California and Florida when it comes to markets and insurance availability. In fact, ripples and tremors from the enormous potential for damage in the New Madrid fault area, coupled with the financial impact that Hurricane Andrew and the Northridge Earthquake had on our insurance companies, are still being felt by my clients and all the homeowners in eastern Missouri and the surrounding States of the New Madrid fault zone.

    We have seen our market for earthquake coverage on homeowners' policies dwindle at an alarming rate. This change has been a lot less dramatic than the market problems in Florida or California, but I want to stress that the changes in our market have been no less real to my clients. Let me explain what is going on in Missouri. It is a little bit different.

    First of all, we have seen companies actually in our market simply withdrawing, canceling agencies, canceling contracts. One company, American Family, which is a large writer, canceled all of their agents in southeast Missouri. They did this several years ago. They still haven't appointed any agents in my area.
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    A personal example: My agency was visited by a large national insurance company in 1997, and that company asked us to basically nonrenew all of our homeowners' insurance policies. They said they had taken a look at the earthquake risk in southeast Missouri, and there just wasn't any way to charge enough premium for the exposure.

    Another agency located in southeast Missouri had similar problems. One of their companies they represented told them they were going to cancel their contract because of poor losses. The agency owner happened to be a friend of mine. He said, ''Well, I haven't had poor losses. What's the problem?'' The company representative finally said, ''Well, really we've just got too much earthquake exposure. If you'll cancel all your homeowners' policies, you can keep the contract.''

    We do have, unfortunately, companies that are taking those types of actions. But the most widely used tactic we have seen in our homeowners' marketplace that companies are using to exit the market is by simply increasing the cost of their policy. A company can easily see their business canceled by using this tactic.

    Allow me again to share a personal example of what occurred in my agency. We had a regional company that was owned by another large national insurer. That national company decided to absorb this regional company. In the process, they increased the rates on all their homeowners' policies in southeast Missouri and northeast Arkansas, where they wrote business, by over 100 percent. Needless to say, when somebody who was paying $500 got a bill for over $1,000, they went shopping. It has caused lots of problems.

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    Our Missouri Department of Insurance has done several studies on this. The first one, they did back in 1996. This just shows you how fast our market has been changing: Their headline was ''Statewide Earthquake Insurance Market Relatively Stable.'' The next press release in August of 1997, their headline was, ''Earthquake Insurance Rates Up Sharply in Boot Heel''—where I live—''Coverage There Falls Off''.

    That leads me to one of my next concerns about our marketplace, that Mr. Hunter alluded to; that is increasing deductibles we are seeing companies use. It used to be we saw deductibles from 2 to 5 percent. Now we are seeing usually 10 percent, 15 percent, 25 percent. We have also seen companies limit coverage to just coverage on the building and limited coverage on the contents. I guess my question is, where are those homeowners going to get the money for those higher deductibles?

    With all this in mind and as last year's president of our Missouri Association of Insurance Agents, we decided to form a task force to look into what we could do in our State. We have had several meetings. We have had involvement with all of our major personal lines insurance companies—State Farm, Allstate, Farm Bureau, Shield of Shelter—all the major markets in working toward some type of program, similar to what Florida has for their hurricane fund, to handle earthquake insurance in Missouri.

    The basic reason we looked at this is because we weren't sure if we were going to see a Federal solution. After today's testimony from everybody, I am a whole lot more hopeful that we will. But we are working in Missouri. I want you to know that I think other States are seriously looking at what they can do to help their citizens with this natural disaster problem.
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    I just want to close by saying that I think we have a choice. The way I look at it with my clients, when I talk to them, those clients that tell me, ''Charlie, I just can't afford it,'' and I ask them, ''Well, you know, I'm a salesman. Well, what are you going to do?'' They say, ''Well, I figure Uncle Sam will bail me out later on.'' I think that is our choice. We can do something now or we can wait and just bail them out later on. Thank you.

    The LEACH. Thank you, Mr. Brown.

    Mr. Clark.


    Mr. CLARK. Thank you, Mr. Chairman. I am going to just give an overview of my statement and some my observations.

    I represent the end product of anything that is decided here today, and that is basically homeowners. Homeowners have the most to lose or gain no matter what is decided by Congress and the Administration. They can lose their house, which is their most valuable possession both economically and socially. Also they lose a lot of tax money since we pay about 90 percent of the income tax. So we get the double whammy.

    We have been involved in this issue for about nine years, the age of our association. We have worked closely with Senator Stevens, we were one of his four core group members, at his attempt to solve the problem. I admire you and I admire Congressmen Lazio and McCollum for taking the saddlebag after the untimely death of Congressman Emerson and the fact that we didn't succeed with the Stevens attempt, although I think we made progress and at least called attention to the issue.
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    It was very encouraging to hear Assistant Secretary Summers move a little bit off the dime as far as his acceptance of excess of loss. Had he given that testimony two years ago, maybe we wouldn't be sitting here today, we would already have passed a bill.

    I hope you are successful getting some paperwork out in replacement of principals. There are three possible solutions, as we see it, to solving the disaster insurance problem, which others have basically outlined, so I don't have to tell the committee or anybody else here how bad the situation is or could be. The liability out there not only for homeowners, but for, I think, the financial markets including Fannie and Freddie and FDIC was mentioned today, but I think Fannie and Freddie, especially in the secondary mortgage market, have some liability out there and should be very interested in what is going on.

    The three solutions we see, the possible solutions are not mutually exclusive, are rolling the problems with earthquake and wind disasters into a flood-type program. Since the flood insurance program has many critics, I don't think politically that is feasible today, although I think the flood program could work better, as you well know. The other possible solution is the favorable treatment of reserves as far as the insurance companies are concerned.

    As far as taxing the reserves, two years ago I would have said that is a dead issue. I think, as time goes by, maybe that is where we are going to end up. It may save the taxpayer a lot of money. It is probably the most acceptable as far as the insurance industry is concerned.

    The third is excess-of-loss contracts, which is a creation basically of Chris Lewis; he doesn't look that old, but I think he was the father of this about five or six years ago. That is one way—that is nothing more than reinsuring the insurance industry and/or the States with State programs. That is, of course, the essence of H.R. 219.
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    There is no question that whatever solution we come up with, it is a national solution. Disasters do not know State boundaries. They do not discriminate between State treasuries or the Federal treasury either, I might add. So we have to come up with a Federal solution.

    Those who think that people in California should pay for their own problems and people in Florida, and so forth; I think we just don't operate that way in this society and with our Government. Until we become a totalitarian Government, we are not going to nor should we. So we have to realize and perceive that if it is a national problem, it needs a national solution.

    Also, I might add that we pay for insurance. We have crop insurance. People in Scranton pay for that, people in Sacramento pay for it, and so forth. So there are pretty good insurance programs which we cross-subsidize.

    Unfortunately, the State programs that exist now don't meet another criterion which I think must be there for successful programs. That is, that any program that we decide on has to be actuarially sound or it is not going to fly in the market; it has got to be affordable to the customer or it is not going to be purchased, and it has got to be reliable. If we get a piece of paper saying, I owe you, after the storm hits Miami, it doesn't really do me much good as a homeowner.

    The California Earthquake Authority was created basically to disconnect the offering of model P&C coverage with earthquake coverage. We knew when we supported the CEA that would not solve the earthquake insurance problem in California. The deductible is out of reach. Fifteen percent of insurable coverage is about $40,000 for most California homeowners. If they don't have that, they are not going to be able to reach the insurance itself. So they make the decision not to buy it. Less than 30 percent of Californians are in that program, substantially less from what I heard this morning. So it is well intended but it is really not working.
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    Florida is substantially underfunded. It will work if there is no hurricane. We hope there isn't. But if there is, we have all got a problem. In Hawaii, the same.

    So H.R. 219, I think, is an excellent step forward. I think since it backstops State programs which are not working—and it is not H.R. 219's fault that they are not working; I just don't think they are working the way they should—one has to wonder whether it will work or not. But I don't want to throw water on it because I think that Congressman Lazio and others, including yourself, have worked hard.

    This is not an easy issue. We have got a lot of stakeholders with a lot of interests. We hope that you will continue to go forward.

    I was the last witness at the Stevens hearing. I hope I am not the last witness at the House's attempt to solve this problem in this Congress and the next Congress.

    We will support H.R. 219 as far as trying to make it better. We will gladly work with the Chairman, with Mr. Lazio and the dedicated staff, I might add, to try to solve this problem. I think we can bring some experience and at least some of the work that we have had committed on this over the last nine years. We have made some mistakes, but I think we also know where to go on it.

    I appreciate the opportunity to speak once again on the subject matter. I suppose we will be back again in the future. I look forward to working with you on coming up with a reasonable solution.
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    Chairman LEACH. Thank you very much, Mr. Clark. You have a long history on this issue. That is appreciated.

    Mr. McCollum.

    Mr. MCCOLLUM. Thank you, Mr. Chairman.

    Mr. Brown, do you expect Missouri to enact a catastrophic fund, a CAT fund or is that in the cards?

    Mr. BROWN. Well, that is what I hope. That is what we are working toward. We have politics there just like we do here. But we do think that is a good possibility. We have a lot of interest within our industry in the State. We think they recognize there is a problem. Our goal is to introduce legislation for this next session of the Missouri General Assembly. We are going to find out in a hurry.

    Mr. MCCOLLUM. This morning Mr. Summers testified that he thought that the base bill, H.R. 219, ought to be modified to provide for the sale of excess-of-loss contracts to all entities on an unrestricted basis. Right now the way, as you probably know, H.R. 219 works is that for those States that have CAT funds, they buy the contracts and there is a certain specified method of doing it; and then there is an auction possibility that the State would run within certain very narrow parameters.

    Do you have a problem with that modification? Would that make a difference in Missouri one way or the other, whichever route, either we stuck with the bill as it is now or do what Treasury seems to want? Are you familiar with these XOL contracts?
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    Mr. BROWN. A little bit. I am an insurance agent, not a reinsurance expert. But from what I understand about it, I do have a little bit of concern with the auction method. To be quite frank with you, that is one of the reasons we thought we would like to see a State program.

    My fear with the auction was that we might see some insurers take advantage of it and other insurers not take advantage of it. The problem that presents to me and to my clients is, it might be that my companies don't—for one reason or another, they are too small or they are too big to qualify under—when you are looking at classifying as a small company in the auction process.

    One of the reasons we are looking at a State plan in Missouri is that it has something for every insurance company, period. So we get everybody involved. In a way, I look at it, we are guaranteed to do something about the market.

    Mr. MCCOLLUM. I can see why you want to do that. I, at the same time, know that we are dedicated to crafting whatever we do here that provides a wide variety of participation. We don't want a narrow participation, either.

    Mr. BROWN. Oh, no. I think both methods ought to be there, because I think there are companies in other States where the political realities are, there is not going to be any type of State plan to deal with their catastrophe

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    Mr. MCCOLLUM. Like Tennessee or Arkansas?

    Mr. BROWN. Possibly.

    Mr. MCCOLLUM. I hear they are not likely to do that.

    Mr. BROWN. They may have their difficulties in putting something together because of the location of the fault and the population centers that are involved; and we happen to have St. Louis in ours, which gives us a lot more leverage, political leverage, in our Missouri General Assembly. I think you need to have both so that you can truly help everybody.

    Mr. MCCOLLUM. Ms. Whatley, you are a Floridian here, but I have got to ask you this, wearing your other hat as the official representative today of the realtors.

    As I indicated, Mr. Summers testified this morning. You probably heard him; I don't know if you were here for that, but he felt that the legislation should be modified to provide—and I keep reading this so I get it right—''for the sale of excess-of-loss contracts to all entities on an unrestricted basis rather than the kind of restriction in the bill right now.''

    Does that make any difference, from your perspective, whether we modify that, or not as long as we got a bill out that the insurers would participate in?

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    Ms. WHATLEY. Congressman, I think we would support any Federal program that would effectively address the availability and affordability of the insurance. We do see the problem being so large that we think it is going to take the Federal Government coming in to help to provide some stability to prevent future discrepancies. But the vehicle by which you all—I am not an insurance expert, nor is the National Association of Realtors.

    Mr. MCCOLLUM. That is fair enough.

    Mr. Lewis, you worked some time ago on the subject of these excess-of-loss contracts. Do you agree or disagree with Mr. Summers' comments this morning that H.R. 219 ought to be modified to provide for the sale of excess-of-loss contracts to all entities on an unrestricted basis?

    Mr. LEWIS. I would agree with that comment. I think it would build in a little bit more efficiency in the distribution of the protection to companies on a needs basis. It would allow companies to actually bid for and get the coverage that they need, and it would allow more competition within the market, between States and between companies, so that that coverage does in fact get out to the companies and the homeowners that need that protection.

    Mr. MCCOLLUM. What do you say to the concerns Mr. Brown expressed, worries that insurers naturally might have, the agents might have, that companies wouldn't participate in an auction? I know we have had quite a few of them say, ''We would.'' In fact, we have spent a lot of time, Mr. Lazio and I have, working on that question. But what do you say to his concerns?

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    Mr. LEWIS. I think that they are legitimate concerns. I think that it gets to the nature of how you structure the auction. We have not spent a lot of time discussing how an auction would be structured to accommodate the needs of smaller insurers. But that is something that is an important thing to focus on so that it can be designed in a way that meets the need of small insurers, large insurers, reinsurance companies and States.

    Mr. MCCOLLUM. Can you succinctly state how you do that?

    Mr. LEWIS. First of all, there is going to be—I think Deputy Secretary Summers talked about the benefits to reinsurance companies that expands their capacity to provide reinsurance to the smaller companies. Reinsurers are providing the bulk of the protection for smaller companies already. To the extent that they get additional capacity through an XOL program, they will be able to provide that capacity on down to smaller companies.

    Other options include letting smaller companies have, I wouldn't want to call it preferential, but independent ability to enter the auction, so that they would in fact be competing with their peers as opposed to larger companies. But again the details of how you actually work that out would have to be——

    Mr. MCCOLLUM. I know my time is up, but Mr. Nutter is saying that reinsurance companies would buy these XOL contracts. Is how you see it, indirectly that is going to benefit the small insurance company? That is part of what you are saying, isn't it?

    Mr. LEWIS. That is correct.

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    Mr. MCCOLLUM. Thank you very much, Mr. Chairman.

    Chairman LEACH. Thank you, Bill.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you, Mr. Chairman. I am sorry I missed most of the hearing today, because this is an issue that is very important and close to my heart. I would like to just make some observations that I hope the committee Chairman and subcommittee Chairman will take into consideration.

    First and foremost, I find myself on the defense; I feel I should be on the other side of the aisle now, because suddenly the Government is asked to come and solve a problem and create a program to solve a problem instead of reliance on the free market system. Although I am not remiss to admit that in some instances I think the market, free market, does not solve all problems, clearly I do not think that the Government should jump in headfirst into this type of program unless several things happen.

    One is that there be some form of equity out there for all taxpayers and that this is not just an attempt to put off the burden in States like Florida, Texas, California or the East or West Coast States simply because they find themselves in a problem. Why should the market work? And what would it mean if the market worked?

    Let me give you an example. From the best that I can recollect, if we took Hurricane Andrew, I believe the damage caused by that hurricane was $24 billion. It is estimated that if that storm had struck the Miami area, 20 miles north of where it did strike, the damage would have been in excess of $48 billion. That is a huge amount of money that we will be called upon to pay if we get into the secondary insurance market.
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    But the whole purpose of insurance, or risk, if you will, and the need for the marketplace to prevail is that at some point in this country, we are going to have to decide that people are going to have to build according to certain types of codes and safety, certain mitigation programs will be put in place.

    It seems to me self-evident that we ought to look at the flood insurance program and recognize that we now have people that build on the outer coastal islands, and periodically, every five to ten years, they get wiped out; they go to the Federal Government, they get their insurance and they rebuild. We do not have the political will in the Congress nor do the States or communities have the political will to bar building in these high-risk areas.

    What are we doing in hurricanes and earthquakes? The East and the West Coasts, we are now under this type of a program, subsidizing otherwise capital that would not flow to these areas.

    I have seen a projection that if Andrew were to strike Miami 20 years from now, 20 miles north of where Andrew came in, the damage would be in excess of $150 billion. Why? Because we are going to be writing a lesser cost to allow capital to invest in Miami—great weather, great location—but why shouldn't we encourage that capital to be invested in Kokomo, Indiana, instead of Miami where it is at a high risk? And what we are doing is upsetting the marketplace and the balance.

    Normally capital would not flow and expend its investment in Miami if they had to carry the burden of what insurance in the marketplace would require. That is what nature forces the market to do, discourage people from their own stupidity or foolishness.
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    Here, when we move into a secondary operation as a Government, we are encouraging the market not to operate and therefore no force of nature encouraging people to make more intelligent financial risk decisions as a result of disasters, only because we have interpleaded the Federal Government to be the responsible party.

    In one instance, the most dangerous thing of this principle, I believe, is that, one, we have lost faith with the marketplace; two, we have caused a disconnect to occur; and three, we are fundamentally upsetting the natural nature of how this country should grow and develop. We are discouraging people from making the investment in Kokomo, Indiana, we are encouraging them to put their investment in a risk area in Miami, the risk of disaster, but certainly a more financially rewarding investment by going into the Miami area.

    If you think in terms of a building or an apartment, $10 million, where would you rather put it if you were an investor, in Miami Beach or would you rather put it in Kokomo, Indiana? You would have to be a fool not to say Miami Beach. The only time you will make that decision, however, is if the Government picks up the risk of that high cost of insurance; or else you won't be able to sell that property or mortgage that property because you won't be able to cover that risk. That is what the natural market would do.

    We are perverting the natural market from operating and, therefore, subsidizing people to make improper investments which will put greater capital at risk of disaster, and two, really imbalance the population in the development of this country.

    Mr. MCCOLLUM. Will the gentleman yield on that?
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    Mr. KANJORSKI. Certainly.

    Mr. MCCOLLUM. I respect him a great deal. One of the things I just want to make sure he understands is that what Mr. Lazio is trying to create, and certainly what I want to modify to the degree necessary to make sure it is true, is that the insurance companies pay premiums into the fund and that the taxpayers don't subsidize this in this instance.

    It is a lot different than the flood insurance program. I hope you are aware of that. I really want to be sure you know that that is what we are trying to do.

    Mr. KANJORSKI. I have worked with this. But I think that both of us are not naive enough to realize that once we provide the secondary insurance here and create these funds and with the further development of wealth in this country and risk, that the Government is never going to get out of this program. If local communities can't require good building codes, if they can't implement mitigation programs to reduce the exposure of the risk, I don't know why you think the will of Congress is any stronger than that. We are going to weaken and subject all the taxpayers of this country to underwrite forces that oppose the natural market.

    Let me give you an example. I have spent time in Hawaii after the last hurricane in Hawaii. Every meeting I went to—bankers, insurance companies, realtors, builders—they all say, ''You have to put a secondary market of insurance in place. Why? Because we have this $100 million apartment building, and we can't sell it because nobody is going to pick up on the mortgage unless we insure it against the risk of hurricane disaster.''

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    I say, you know, for that individual or that corporation at risk, that is a very dangerous thing. But why are we allowing next week the next $100 million or $200 million hotel to be built in a risk area in this country?

    We have identified 16 high-risk areas for disaster. We know that just as a matter of random sample, these 16 areas are going to suffer extraordinary disasters over the following years. Now, why are we forming a policy to encourage capital to improperly invest in that area by not paying for that risk? I have no objection if someone wants to put a $200- or $300-million hotel in Honolulu, as long as the taxpayers of this country and the taxpayers of my district aren't covering that investment by offering the reinsurance. Because when they do that, it is to the disadvantage of capital to flow into the areas of this country that would be lesser in risk, and would apply the opportunities and finances to benefit average Americans who will be paying for this extraordinary risk. I just think that my friends on the other side of the aisle, the people who really claim to always believe in market forces, to be advocating a program of getting the Government involved in secondary insurance is shocking to me.

    I can understand that we have a problem. Maybe we have to look at how we cover that problem. There are certainly ways of doing it, including our involvement in these risk circumstances that occur on a regular basis. But why we should establish the Government involved in secondary insurance so that there will never be an incentive for a more intelligent decision of where to put your capital and encourage growth rates like Miami to continue to explode in growth, encourage areas like California to continue to explode in growth because the initial investment is being protected and insured and able to be financed with the false protection of the rest of the American people in the secondary insurance market, I think it is just a wrong proposition.

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    I may say, further, why aren't we looking at all disasters? Why are we only looking at hurricanes, earthquakes and tornadoes? I will tell you why. That is where the financial forces of the country are located and have risk. They are very much interested. The banking communities and everyone else that holds the paper on those things are in serious condition and asking the Federal Government, even though they are great private capitalists and entrepreneurs and want a free marketplace, but when their investment is at risk, they want the United States Government to come to them in a big way.

    Let me give another example, and I know I am over my time. Mr. Chairman, we made that mistake with the nuclear power industry. This Government provided secondary insurance that limited the risk and as a result we have power stations built in this country on earthquake faults. The only reason the engineers and the owners of that capital made that investment in those areas is, after $7 or $8 billion, they had no more risk. They threw it off to the Federal Government.

    Although that is more extreme now than even indicated under this legislation, the same principle applies. What we are doing is grossly interfering with the free marketplace which will affect and distort the practices of the population existing today and on into the 21st century, falsely, mistakenly, and I daresay hypocritically, if this is supported by my friends of the free market side.

    When I, as a Democrat, generally find advantage for Government programs, alas, but suddenly we have interests here that want the Government to impose themselves with a major investment and a major program, I just think we haven't thought this issue out enough. I certainly don't think we've taken it to all the considerations that we should. These poor folks that are living in Idaho and Montana that aren't going to have these things, they are going to be called upon to insure these speculative investors in San Diego, in Los Angeles and in Miami. I do not think that is right. But worse than not being right, I think it is a distortion of the population growth and how it should be distributed in this country and how the equity and wealth of this country should be distributed. Once that mistake is made, we will never put the genie back in the bottle.
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    Mr. LAZIO. [Presiding]. I thank the gentleman. Let me, if I can on my own time, try and correct what I think are certain misperceptions, the first of which is that there is any commercial coverage involved in either one of these versions. They are completely residential. The program is completely voluntary. It focuses on a 1-in-100-year incident, 1 percent of the risk; 99 percent of the risk continues to be in the private sector, or controlled by the States.

    The reason why there are State programs is because the private sector insurance market dried up. In the months after Northridge—and Ms. Heimbuch will probably confirm this—95 percent of the private insurance homeowners insurance marketplace in that surrounding area disappeared. It creates—again, I think Ms. Heimbuch and Ms. Whatley both have testified to this point—it has created a spiraling effect, values are destroyed, people cannot sell their homes, destroying the tax base.

    This is often the sole source of savings for people, certainly their largest investment. I think it certainly is not my intention and certainly is not Mr. McCollum's intention to substitute for the private marketplace. The fact is that it is not there. The reinsurance capacity is not there.

    Mr. KANJORSKI. Will the Chairman yield?

    Mr. LAZIO. Yes, I would be happy to yield to the gentleman.

    Mr. KANJORSKI. Why isn't it there?
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    Mr. LAZIO. I will explain to you as has been explained to me from the experts. The reason is that companies cannot risk the ruin of having a $50- or $100-million loss per company that would wipe them out, whereas the Federal Government, because of the size, its ability to spread out the risk, is in a much better position to do that.

    In our bill, in H.R. 219, we are saying, fix the actuarial rate and double it, so that you are getting more than you might if it was strictly a market rate. Hopefully, this will phaseout over a period of time. But the fact is that there is an enormous problem and there would not be a California Earthquake Agency or a Hawaiian fund if there was sufficient capacity in the private marketplace. That is why all these people have been testifying.

    Mr. KANJORSKI. Mr. Chairman, would you yield?

    Mr. LAZIO. Yes, I will be happy to yield to the gentleman.

    Mr. KANJORSKI. Isn't that basically saying that that is why Lloyd's of London doesn't want to be a secondary insurance in these types of disasters they have experienced? Even their great resources were not enough to be secondary insurers. And isn't the argument saying that the Government has to provide a subsidy?

    Mr. LAZIO. What it says, if I can reclaim my time, is that the Government has a role in providing that the market acts more efficiently.

    The problem of this is that when you have a situation where you have Warren Buffet offer, whatever, I forget what the numbers were exactly, but a billion or a billion-and-a-half dollars, whatever it was, in reinsurance, at a rate of $300-million-a-year-plus for premiums, that clearly is being done because people like Warren Buffet and a few others who won't even get into the market because they can't suffer the risk of loss have to calculate what the financial return must be in order for them to absorb a potential wipeout.
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    That is something the Federal Government does not have to do. So it is able, after the States have a plan in effect, after people are willing to put up their own money, people are being asked to pay premiums, it will fund—we have run, as we have heard testimony before, there have been thousands of models that have been run, and the case, if only three States participate in this plan over ten years, a $5.5 billion surplus. That may or may not happen because we can't be assured of the timing of an incident.

    But the very fact is that if you walk away from a California or a Florida or a Pennsylvania, after they get hit with a major hurricane and say, ''You're on your own,'' I cannot imagine the Federal Government will not come in as it has in the past with a major bailout, not—without having premiums paid in voluntarily because we have not been provided, we do not have the structure in place, and there is an insecurity in the marketplace and insurance companies pull out, I can't imagine the Federal Government, as a community of communities, walking away from a Florida saying, hey, tough, you know what, you have to hitch up your wagon; and you're going to have to move, Miami; you're going to have to move, Fort Lauderdale; you're going to have to move, Los Angeles.

    Seventy-five percent of the population of the country is within 100 miles of the coastline. That is not going to change because of an effort at mitigation. Is mitigation important? Absolutely. But we should not delude ourselves that through mitigation we are going to change the fact of the major population centers and major infrastructure that is at risk. If we don't plan for the inevitable, we are going to be highly irresponsible in the manner in which we deal with the problem and the people that are left behind, especially those folks who have their homes as their sole source of equity.
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    Mr. KANJORSKI. Will the gentleman yield?

    Mr. LAZIO. I will yield to the gentleman.

    Mr. KANJORSKI. Mr. Chairman, that is really my point. I do appreciate, and quite frankly, I would rather the Federal Government move in to correct a disaster area and support the disaster area but not build a methodology that we are talking about building now, which will almost give carte blanche to unreasonable development and continued development in areas of the country that are at high disaster risk.

    What I am suggesting is, we find some methodology to, whether up to some date insurance is available, but then communities have to restrict the growth that they have in the high exposure areas. To just turn loose a Government-subsidized secondary insuring market is to send a notice across the land that regardless to what high risk you may want to put your investment, there is going to be somebody standing there that is going to pick up that investment and you are going to take the natural controls of the free market system away, the Buffet $300-million premium isn't going to apply anymore and you are going to have the same low rate in a high disaster area as you have in a non-high disaster area. As a result, it is going to warp the way capital is expended in this country and where population growth occurs.

    Mr. LAZIO. I would say, if I can reclaim my time, this is, I think, the main bone of contention that I have with the gentleman's argument, and that is that we already have population centers in place. We are not going to move major cities. The liability or the exposure is already there. No matter what we do in terms of mitigation, we are talking about around the fringes of exposure. The $60 or $70 billion earthquake in San Francisco, the $50 billion hurricane in Florida, as a result of hitting a Miami or a Fort Lauderdale or a major population center, those population centers, that infrastructure, those homeowners, are not going to pick up and move certainly over the next ten years to an area that may be less disaster-prone. We are simply going to be in a position where we go in—I would remind the committee, I was up in North Dakota when those people, those poor folks were flooded. Those people were wiped out. Many of those families got $4-, $5-, or $6,000, which is what FEMA pays when people get wiped out.
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    Mr. KANJORSKI. Mr. Chairman, would you yield?

    Mr. LAZIO. Yes, I would yield to the gentleman.

    Mr. KANJORSKI. I am not attempting to relocate or reconstruct existing communities. I am talking about prospectively. The policy has to be of this Congress and this Nation that we can't encourage unmitigated growth because there is a Government subsidy that will support that growth. We have to find a way to allow the free market to operate. The way the reinsurance free market will operate is the premium will be so high as to discourage people from relocating to Miami. But quite frankly, Mr. Chairman, if you give me the opportunity to go to the middle of Montana, I like Montana, I should pick perhaps another State, maybe the middle of Pennsylvania so that I can prejudice my own State and build a quarter-of-a-million-dollar home or to go to Miami Beach and build a quarter-of-a-million-dollar home, normally as a citizen I look at what risk I have and what my mortgage will cost me and what my insurance will cost me.

    If you create a circumstance where the Federal Government, by subsidy, creates a secondary market of insurance that doesn't cause them extreme distortion in cost—I would rather live in the nice climate of Miami—what you are going to do is continue to have compacted growth in those high-risk areas.

    I am not against doing something. What I am against is doing something without realizing the long-term ramifications of what we do in the distortion of investment of capital and the location of people. I think we are talking about something now that is going to affect decades ahead of Americans.
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    I have worked very close because I have a disaster in my area of floods. I know how difficult it is to get people to relocate from a flood plain—damn near impossible. Quite frankly, maybe we can let the people who were there remain there, but we shouldn't encourage the population to double, triple or quadruple because people want to live in a flood plain. We have got to force or allow the private market and the free market to operate to cause the economic discouragement of exposing assets to that type of disaster or risk.

    What we are doing now is not answering that question. We are solving an immediate problem and not anticipating the long-term ramifications of the solution we are offering. It will continue the distortion of growth and the pattern of growth in this country.

    Mr. LAZIO. If I can reclaim my time, I know my time has probably run out. I want to at least ask one or two questions of the witnesses. I haven't had a chance to ask anyone.

    Maybe Mr. Brown and Mr. Clark, both, if you would care to respond to some of the things that have been said here.

    Mr. CLARK. I hesitate because I was born and raised in the 11th Congressional District in Pennsylvania, which did suffer from Hurricane Agnes; and the Federal Government did come to their rescue, thankfully, rebuilt Wilkes-Barre, part of my hometown. I agree that you have to tread carefully with Mr. Kanjorski's concerns. But also this is directed toward residential construction, so the commercial aspect is not there. It is an attempt to solve a problem. There are extraordinary numbers of homeowners without insurance in disaster-prone States.
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    There are an extraordinary amount of homeowners with limited and inadequate insurance and unreliable insurance. Whether we like it or not, we are going to spend money, and Mr. Kanjorski knows this better than I do, in coming to their rescue. We are not going to say no. We spent about $45 billion over the last I guess four years in emergency appropriations, supplemental appropriations above and beyond the budget. That comes out of every taxpayer's money, including the people from the 11th Congressional District. And vice versa, when something happens in the 11th District, we come to their rescue, too.

    It is an extraordinary problem. I think he has got some legitimate points, but I think your bill, since it does address residential homes and not commercial, that some of those fears should be allayed—respectfully.

    Mr. BROWN. I would just like to comment on that. I can understand why people want to move to sunny California or Florida and why you wouldn't want to encourage that from the standpoint of subsidizing that. But I look at my own State of Missouri. I don't think that is really going to be a problem, if we had this, that all of a sudden we are going to have a lot of people wanting to move to Kennett, all of a sudden. It would be nice, but I really think since the program is a residential type of program, we have got to take care of the people that are already there. We have got major populations in all those places.

    I do understand what you are saying. We have got to do something about mitigation. We have got to teach homeowners what they can do, and everybody has a responsibility in that. I do as an insurance agent, our insurance industry, and the Congress, everybody; we do have to do more for mitigation. There is nothing I think that is sillier than paying somebody that is on the wrong side of the dam for a flood, and the same holds true for an earthquake or a hurricane. But we have to help those people make those changes and that takes time.
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    Mr. LAZIO. If I could, I just want to ask Ms. Heimbuch because you have had this experience through the bank, living through Northridge, the impact that it has on the financial institutions. I wonder if you could just speak to that once again, about the implications of a major or maybe possibly two major natural disasters in your State, what that might mean for financial institutions.

    Ms. HEIMBUCH. I think that you have to look at it from the point of view that, number one, with this program, we are not asking that people don't pay a premium for it. We are not asking they don't pay for this insurance. But right now they don't have much opportunity to get very much coverage. Therefore, from a financial institution's point of view, I am an insurer. I am not allowed to be in this business but I am in it for no premium. So everyone who has a loan from me who doesn't have disaster insurance after their equity is wiped out, I am the insurer, I am the one who takes the loss. I think that we saw that very clearly in the Northridge Earthquake, and for all the financial institutions in the area who had those loans.

    There are certain types of properties that are more at risk, and after the earthquake, Freddie Mac tried to impose some sort of a requirement that there be disaster insurance on condominiums, or they wouldn't do the loan; and legally they weren't able to do it and marketwise they weren't able to do it. So I think from a financial institution's point of view, without some sort of program, we are at great risk because we essentially are the insurer and we are doing it for no premium.

    Mr. KANJORSKI. Could I ask a question?

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    Mr. LAZIO. Sure.

    Mr. KANJORSKI. It is interesting, because I had the experience of a disaster in my area. We went back, we tried to find out whether the banks had enforced flood insurance, and we found out that only 19 percent of those people that were actually located in the flood plain and had a disaster bothered to take flood insurance out.

    What kind of enforcement are the banks going to do? Are you going to police this? Are you going to take the responsibility that you will not issue any mortgages unless the disaster insurance is taken out and the premium paid in accordance with the highest value of the property?

    We can't get that in other disaster areas. I think what is going to end up is, you are going to cover your loss, and that is what you are going to enforce. So this is—I agree, this is going to be an ability for the financial institution to protect its risk. But you are not going to go out there and tell somebody, you have to take out disaster insurance in accordance with the real, true value of the property so that the fund grows and is sufficiently actuarially sound and the premiums paid. Everybody, the builders, the developers, the investors and the residents are going to make their own decision as to how much insurance they will take or can afford to take for their own self-interest.

    Ultimately, you are going to have cherry-picking. Only those extremely high-risk homes, areas and disasters are going to be covered adequately to keep this fund alive or, insurance-wise, sound. It is going to fall on the responsibility of the taxpayers, anyway. Nobody in the country believes that if a disaster occurs in California that we won't go in with $50 or $100 or $200 billion.
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    And, if I may, how can we be naive enough to think that although it starts out as a residential bill, there won't be those people that come along and say, gee, I have 5 apartments, I have 20 apartments, I have 30 apartments, or I have a little office building, I have a medical center, I have a little hospital, and say you should cover this and that a future Congress is going to say, well, there is no private market developed, so we are going to have to start enlarging this program. Particularly, Mr. Chairman, on the other side of the aisle, you have told us for 60 years that once programs start, they grow.

    Mr. LAZIO. I would just say to the gentleman that the alternative is to do nothing and to leave a place like Los Angeles completely uncovered. I think that is what, by logical extension, the gentleman's position could be argued to be.

    Mr. KANJORSKI. That is the point I want to make. I think this is one of the most important issues that the country, in social planning and development, really faces. It is something that should be looked at in great depth, that whatever policy—and I believe the Government has a role in this, and I believe we should come in to start the process, but that we shouldn't do it to pervert the market effects of discouraging the bad location or the bad investment of capital or the bad investment of people.

    Mr. LAZIO. Let me, if I can, I would say to the gentleman, I wish somebody were here from the California earthquake fund agency, I am sure they would say that the creation of a State program did not distort or force people to migrate in any particular area of California. As a matter of fact, it provided liquidity and it provided the assurance so that there was continued economic strength.
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    I will bet if we asked Ms. Whatley, which I am happy to do, from a realtor's standpoint, in an area that is disaster-prone, the failure to take action to provide after the State has already acted, after the State already has put their full faith and credit on the line for the first—in the case of Florida—$10 billion, after the private sector is already in there, people are paying premiums.

    The situations—less than 1-in-100 are going to be all covered by those State programs; we are talking about situations over, in excess of a State's capacity after they have already been proactive, after they have already made plans, in excess of their capacity to deal with that and the inevitable, as we say, $50 billion ''big one.''

    The question is, do we prepare now or do we react to that when the inevitable happens by making a political statement and rushing something through without the type of safeguards that I think we have in the bill and we will add to the bill before it is completely enacted?

    Mr. KANJORSKI. Mr. Chairman, I just can't believe that you are going to really see an honest growth of a reinsurance or secondary market. I think the insurance people and Lloyd's of London are awfully wise people. I certainly have a great deal of respect for Mr. Buffet. I think to even have the secondary insurance market start in disaster areas is going to be extremely difficult.

    Mr. LAZIO. It is already there.

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    Mr. KANJORSKI. But if we provide a subsidized program and get it started, I don't see it ever growing.

    Mr. LAZIO. I say to the gentleman, it is already there, if I can reclaim my time.

    In California, for example, they buy reinsurance as part of their fund. There is securitization in Florida and in California, I believe. The capital markets are trying to grow. As a matter of fact, one of the major discussions here is to ensure that the capital markets and the reinsurance industry continue to grow into the demand that exists.

    I am all for that. But certainly as we have heard in testimony all day long, the capacity is not there in the private sector right now to permit insurance companies to write policies for homeowners'—I underline ''homeowners' ''—in these areas without the confidence of knowing that they have these programs standing behind them. It just doesn't exist.

    And the alternative—again, I relate back to the Northridge; I think it is a recent and stark contrast to the concept of sort of doing nothing—95 percent of the companies stopped writing in the area.

    Mr. KANJORSKI. Mr. Chairman, if I can just say, what is going to stop the expansion of areas like La Jolla, California, and others that would be exposed to this disaster from doubling, tripling, quadrupling over the next 10, 20, or 30 years if we provide a subsidized system that allows for that insurance to take care of that disaster? It is not an easy question.
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    But I am saying when you are taking off the free market premium cost, you are cutting loose for people to relocate to and develop an industry to locate to disaster areas because there is going to be a way of having people build homes that are already in impacted areas with high exposure and high disaster costs if disaster occurs. As I said, 30 years from now, when a storm like Andrew moves into the Miami area 20 miles north of where it came in, you are going to have $150 billion exposure. The reason is that Miami is going to triple in size. We have no way, if we don't use the free market forces, to discourage that from happening.

    Mr. LAZIO. I understand the gentleman's point.

    Let me thank the panelists for your patience. It has been a very long day. I appreciate the testimony. All the written testimony will be included in the record.

    Again, have a safe ride home wherever that might be. This hearing is in adjournment.

    [Whereupon, at 6:20 p.m., the hearing was adjourned.]