The Tools of Government
Workbook 2
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Government Insurance Workbook
By Ron Feldman

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Introduction

This workbook is a companion to The Tools of Government: A Guide to the New Governance, edited by Lester M. Salamon. It includes original source documents that illustrate the operation of a government program that embodies insurance as a tool of government. It is designed to help the reader better understand the process for implementing and managing a government insurance program.

Government insurance is a tool through which government agrees to compensate individuals or firms for losses from certain specified events. Eligible recipients are typically charged a fee, or premium, for participation in the insurance program. Government insurance programs can be operated directly by government agencies or indirectly with the aid of private insurers. In either case, government typically bears the financial responsibility for covering any claims that exceed the pool of resources assembled in the program. Other tools of government, such as tax expenditures and grants, can transfer risk from firms or individuals to the government. However, government insurance is distinct from these other methods because of its greater reliance on risk pooling. In a typical risk pooling arrangement, a group of individuals or firms use a central organization to split losses when a particular event, such as a flood, occurs.

The insurance tool is quite complex in its goals and its mechanics. The primary goals of most government insurance programs are to: (1) improve economic efficiency by providing risk-management services, (2) provide subsidies to targeted groups, and (3) remain "self- financing." However, there are tradeoffs among these goals. For example, increased subsidization to targeted groups reduces the potential of the insurance tool to either pay for itself through premiums or to enhance efficiency. It may also be difficult for the insurance tool to provide effective risk management because of the technically challenging mechanics of the insurance tool such as rate setting.

This workbook illustrates the major mechanics of the insurance tool including the following:

Writing the Regulations and the Insurance Policy

Pricing: Setting Insurance Premiums

Distribution: The Related Tasks of Selling, Servicing, and Marketing Insurance Policies

Underwriting: Will Insurance Be Offered and in What Form?

Reviewing Claims (Adjustment)

Evaluation

The workbook also reviews why the government uses the insurance tool and provides examples of evaluations of the tool.

Document Listing and Description

This workbook includes 20 documents related to the operation of the National Flood Insurance Program (NFIP), managed by the Federal Emergency Management Agency's Federal Insurance Administration and Mitigation Directorate. The documents are grouped into seven categories, as outlined below. This section lists the documents and briefly describes each set.

A. Why Does the Federal Government Provide Flood Insurance?

1. Excerpt from National Flood Insurance Act of 1968 & Flood Disaster Protection Act of 1973

2. Testimony of Jo Ann Howard, Federal Insurance Administrator before the Senate Banking, Housing and Urban Affairs Committee's Field Hearing, Crookston, Minnesota, August 25, 1999

3. Excerpt from the National Flood Insurance Reform Act of 1994

In most countries, private firms offer insurance to allow firms and individuals to better manage their risks of loss. Government provision of insurance is an exception. Consequently, governments that employ this tool attempt to articulate the rationale for choosing the tool. The first document in this section is an excerpt from the legislation that created the NFIP (A1). This excerpt details the Congressional findings that supported the passage of this bill. The second document in the section provides a less formal discussion, through Congressional testimony, explaining why the government offers flood insurance (A2). A particularly important aspect of government insurance is the use of private insurance firms to market and administer the program. Government oversight is exercised in a variety of ways including specifying the terms of the standard policy through legislation. The third document is an excerpt from legislation in which government expanded the coverage to include the cost of compliance with land use and control measures created by state or community authorities (A3).

B. Writing the Regulations and the Insurance Policy

1. Proposed Rule to Extend Coverage to Cost of Compliance

2. Final Rule to Extend Coverage to Cost of Compliance

3. The Standard Flood Insurance Policy - Dwelling Form

4. "Coverage Information?" from the NFIP's Information for Consumers

Policymakers use legislation to establish the general rules on risks to be covered, eligibility, forms of risk sharing, and so forth when designing each specific insurance program. These design features cannot remain general because insurance coverage is provided by means of legally enforceable agreements and rules. The program regulations and the insurance policy allow the insurer and the insured to understand what is expected of each other. The first item in this section (B1) is a proposed amendment to the program regulations needed to implement a 1994 statutory change in the coverage provided in the policy. Item B2 is the final version of the amendment adopted after providing an opportunity for the public to comment on the proposed changes. B3 is the standard flood insurance policy for dwellings. The policy must be written in legal and technical language and such wording may prove daunting to customers seeking information about coverage. For flood insurance, the government insurer also provides a lay- person's guide to coverage (B4).

C. Pricing: Setting Insurance Premiums

1. Excerpt from Report of the General Accounting Office, "Flood Insurance: Financial Resources May Not Be Sufficient to Meet Future Expected Losses"

2. Cost and Premium Information from the NFIP's Information for Consumers

The additional premium for the new coverage authorized by the 1994 amendments for cost of compliance was set by law as "not to exceed $75 per policy." The NFIP administrators then determined the amount of coverage that premium would support. However, the process usually begins with a determination of how much coverage is needed. The premiums are then set based on actuarial data. Setting premium rates is perhaps the most important task facing the administrator of the government insurance program. An insurance program cannot finance itself unless the premiums charged equal the costs for claims and administration. Such premiums are referred to as "actuarially fair premiums." There are numerous techniques for setting premiums, but all require collecting data on the likelihood of the insured event occurring. The excerpt from a report by the General Accounting Office (C1) describes the data collection and analysis carried out by the NFIP. The second item in this section provides examples of how the NFIP quotes premiums to potential customers (C2). Because the likelihood of an insured event occurring changes over time, the government insurer must continually update their premiums.

D. Distribution: The Related Tasks of Selling, Servicing, and Marketing Insurance Policies

1. Print Ads "Life is Not Waterproof" and "Water, Water Everywhere: Test Your Flood IQ," "Mat Story" distributed by the NFIP, Plans for "Cover America II."

2. Federal Insurance Administration Marketing Guidelines for Private Firms

3. Excerpt from the Financial Assistance/Subsidy Arrangement or "Write Your Own Agreement."

4. Excerpts from the Policy Renewal and Cancellation Chapters of the Flood Insurance Manual

Some government insurance programs must sell their products and there are several distribution systems and methods they can use to accomplish that goal. Government insurers, for example, use many of the same methods available to private insurers to market their product, such as advertisements. The first item of this section offers examples of advertisements used by the NFIP (D1). Government insurers that sell their products often make use of the private sector's distribution system to interact with potential and current customers. Effective use of private third parties requires the government insurer to manage the actions of the third party. The NFIP uses private insurance agents and companies in its distribution. The NFIP issues guidelines to firms and agents on how they can market flood insurance (D2). The NFIP also signs a contract with the insurance firms governing the allocation of risks and returns from insurance sales and the servicing of insurance policies (D3). Finally, the NFIP provides guidance to third parties as to how they should provide on- going service to customers in the cases such as policy renewal or cancellation (D4).

E. Underwriting: Will Insurance Be Offered and in What Form?

1. Excerpts from the General Rules and Rating and Chapters of the Flood Insurance Manual

2. Obtaining Information to Write and Rate Flood Insurance Policies, Forum on Desktop Rating of Flood Insurance Policies (Notice of forum with request for ideas and participants published in the Federal Register, October 27, 2000)

The government insurer must apply its contract and pricing schedule to a particular firm or household. This process is called underwriting. One of the key underwriting decisions is the determination if an applicant for insurance is eligible for a policy. A second key underwriting task is determining the appropriate premium rate for the applicant. The NFIP provides a manual to insurance agents that helps them determine both applicant eligibility and pricing (E1). New technologies have altered the manner by which government insurers carry out the underwriting task. The second document in this section describes the NFIP attempt to develop a "desk-top" underwriting system (E2).

F. Reviewing Claims (Adjustment)

1. Excerpt from Claims Chapter of the Flood Insurance Manual

2. "Announcement of Repository and Claims Training" from the NFIP's Information for Insurance Companies

The insurer has to determine the validity of claims made against it and the amount of money the insurer owes the insured party. This activity is called claims adjustment. The government insurance program can develop its own in-house adjustment force or rely on adjusters who also service private insurance contracts. The NFIP relies on private adjusters. To ensure that adjusters are carrying out their tasks in a manner consistent with its expectations, the government flood insurer provides general guidance to adjusters through its manual (F1) and (F2).

G. Evaluating Flood Insurance

1. Written summary of themes from the "Flood Plan Management Forum" Sponsored by the NFIP on June 8, 2000

2. Excerpt of "Evaluation of Community Rating System Credited Activities During Hurricane Floyd" prepared by the Hazard Mitigation Technical Assistance Partnership, Inc. (Contract No. EMW-95-C-4678, September 25, 2000)

3. Policy and Claim Statistics on the NFIP, published by the NFIP

Insurance programs can be evaluated according to how well they accomplish their goals. The first document in this section reflects the informal feedback and evaluation that the NFIP received from flood insurance experts in the field (G1). The second document is a more formal evaluation of a specific aspect of the flood insurance program. Specifically, how successful were mitigation efforts of local communities in reducing losses from Hurricane Floyd (G2)? Finally, government insurance programs, including the NFIP, collect data on their performance on a regular basis which allows for their evaluation (G3).

Discussion Questions

1. In the many countries, the vast majority of insurance against property damage is provided by private firms. Did elected officials and the administrators of the federal flood insurance program offer a clear rationale for government provision of flood insurance (A1 and (A3)? Are these rationales convincing? What are the major issues in the operation of the Flood Insurance Program identified in the testimony of the Director in item A2? Are these issues unique to the flood insurance or would you expect to find them in other government insurance programs?

2. Compare the language in the Act (A3) with the language in the Code (A1). Explain the differences. Why is Section 555(b) of the Act not found in the Code?

3. In 1994, a new law expanded the coverage of government flood insurance to include the cost of compliance with state and local floodplain management requirements. The Federal Emergency Management Agency drafted regulations to implement the new coverage. What major implementation issues did the Director of the program address in the proposed regulations (B1)? Did the proposed regulations deal with those issues in a manner that was consistent with the apparent intent of the new law (A1 and A3)?

4. As required by the Administrative Procedures Act for most proposed regulations, the Director invited public comment on the proposed regulations. The public offered some criticisms. In the final regulations (B2) the Director summarized those criticisms and responded to each one. Were the answers of the Director to the criticisms responsive to the issues raised? Were the answers clear and convincing? Were any changes made to the proposed regulations as a result of the public comments? Were the final regulations consistent with the new law (A1 and A3)? List the design issues identified by the Director.

5. Compare the language about the new cost of compliance coverage in the final regulation (B2) to the relevant language in the Standard Policy (B3). The differences are the result of the Agency's subsequent attempt to comply with an Executive Order to simplify regulations and use plain language. Did the Agency succeed? What additional changes, if any, would you make to improve the readability of the policy?

6. A key task in using the insurance tool is the creation of insurance policies, such as those for flood insurance (B2). What kinds of resources (e.g. staff skills and data) must a government agency have to carry out tasks such as policy writing? Is it likely that government insurers will have access to such resources? Why or why not?

7. The government agency must constantly adjust the terms of the insurance policy in response to new events and behaviors of the insured. However, as a government agency, the NFIP must follow time-consuming procedures, such as publication of rule changes for comment (B1), in making such adjustments. Do you think government insurers should be treated like other government organizations when they make changes to their policies? What are the risks of giving the government insurer exemptions from these legal processes? What are the risks of slowing down changes deemed necessary by the government insurer?

8. How was the premium set for the additional coverage for cost of compliance? (A1, A3, B1, and B2)? How was that process different from the typical process for setting premiums? Some policymakers want government insurance to pay for itself while other policymakers want the government to provide subsidies to those who purchase the insurance policies. How might this tension affect the premium setting process for the NFIP (B4)? How might this tension arise in evaluations of the insurance program or in the performance statistics of the insurance program (G2 and G3)? What are the potential costs of not setting insurance premiums to pay for expected costs of the insurance program? How should policymakers consider these costs when deciding which tool to use?

9. What policy issues are raised when the government tries to sell a product such as insurance to the public? Is advertising flood insurance products appropriate for the government (D1)? Describe activities and actions carried out by private insurers in marketing insurance that you would not find acceptable if performed by a government agency.

10. The standard objective of the insurance underwriting process is segmentation of the potential participants by risk. Potential applicants are sorted by their chance of making a claim. Individuals with higher risks would pay higher premiums. However, two of the basic objectives of many government insurance programs, including flood insurance, are to maximize participation and to offer low cost insurance to those who may not otherwise participate. Do you see evidence of the tension between these objectives in government flood insurance (E1)?

11. The efficiency and integrity of claims reviews can have a significant effect on the ability of a government insurance program to keep costs and revenues in balance and on the legitimacy of the use of the insurance tool in government programs. The flood insurance program uses private sector adjusters to review and settle claims. In the operation of the expanded coverage for costs of compliance and the other coverages provided by the program, what risks to the government are inherent in the use of non-government personnel for the important process of claims adjustment? What steps could the government take to minimize those risks (F1 and F2)?

12. According to the Director of the NFIP, 85 private insurance companies sell 94 percent of the NFIP policies (A2). What does the authorizing legislation (A1) say about the role of the private sector in the operation of this program? What difficulties would managers of the government insurance program face in managing third-party insurance firms used to carry out tasks necessary to operate the government insurance program? Written guidance and contracts offer two methods by which the government manager can meet these challenges (D3 and D4). How effective do you think training in conjunction with guidance might be for managing the activities of private sector parties (F1 and F2)?

13. What are the primary procedural issues in the evaluation of a government insurance program (G1 and G2)? The NFIP works with local governments to limit damage from floods. Are these efforts successful according to NFIP evaluations (G3)? What challenges might arise from the interaction between the federal insurer and state and local government authorities? What are the substantive issues? What do the data in G3 suggest about the success or failure of the flood insurance program? Do the data reveal anything about the success of the extended coverage for cost of compliance? What additional data or information would be needed to evaluate the cost of compliance coverage?

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