Category Archives: insurance

The True Cost of Government Guarantees — Take 2

As part of the fallout from last August’s bankruptcy of the Federally-backed solar firm Solyndra, the Obama Administration appointed Herbert Allison, a Republican banker and former Treasury official to review the Department of Energy’s loan guarantee program. His report was completed at the end of January and released earlier this week. It contains many useful observations and recommendations and is criticized as well for what it doesn’t contain.

I want to use this post to focus on one specific issue: the correct measure of the cost of a government loan guarantee. In an earlier post about a recent CBO report on the nuclear loan guarantees I described how the current, legislatively mandated method for calculating the budgetary cost significantly understates the cost because it ignores the full cost of the risk imposed on taxpayers. Future payouts on the guarantees are discounted at US Treasury rates, but the true cost of those future payouts should include a market risk premium. I used the CBO report to estimate that the underestimate of the cost of the guarantees for the new nuclear plant at Vogtle amount to $640 million. The Allison Report tells us something about the underestimate on other parts of the portfolio.

The key comparison is between the last column of figures in Table 4, where the cost is estimated using the legislatively mandated FCRA method that ignores the price of risk, and the last two columns of figures in Table 6, where the cost is estimated using the FMV or fair market value method that uses the market price of risk. In total, the FCRA subsidy cost is $2.682 billion whereas the FMV subsidy cost is between $4.970 and $6.839 billion. Taking the FMV cost as the benchmark, the FCRA cost ignores between 46 and 61% of the full cost to taxpayers because it ignores the price of risk.

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The True Cost of Government Guarantees

The August bankruptcy at the solar panel manufacturer Solyndra has generated a predictable political kerfluffle, since the company had received $527 million in loan guarantees from the Obama Administration. The political issues raised by the case are fair game. But I’m more interested in a more general issue:

What is the true cost to taxpayers of loan guarantees?

Obviously, we learn the cost of a particular loan guarantee, like the one for the bankrupt Solyndra, ex post—it’s the amount of money the government has to payout to the creditors. But what is the right estimated cost ex ante?

Coincidentally, August was also the month that saw the CBO publish a report on the true cost to taxpayers of Federal Loan Guarantees for the Construction of Nuclear Power Plants.

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Insuring against snow storms with futures?

NPR ran a story this week on how airlines and other business are using futures contracts on snowfall “as a type of insurance policy against the weather.”

Weather derivatives can be a useful instrument for hedging, and hedging is a kind of insurance policy. But it is useful to keep in mind how a futures contract is different from an actual insurance policy.

A futures contract is written on a very specific commodity price or other well specified index. The snowfall futures contract is based on measured snowfall at a given location–such as Chicago’s O’Hare Airport–within a given month. It has a payoff that is very mechanically tied to that index. If snowfall impacts an airline’s business by cutting into revenues from flights, then buying a futures contract on the amount of snowfall may help reduce the total volatility of cashflow.

The catch is that the correlation between the loss of business and the amount of snowfall is imperfect. The futures contract doesn’t payout the amount of an airline’s losses. It’s payout is determined by the index, and the index isn’t always a good signal of the airline’s losses. The number of flights canceled is likely to be greater if the snow is concentrated in a couple of heavy storms than if it is spread out evenly throughout the month. But the futures contract payout will be the same in both cases. Similarly, two storms with comparable snowfall may have very different impacts on the complicated network of flights:

This is where insurance policies have an advantage. When I have an automobile accident, my insurance company covers the damage, whatever the damage–less my deductible. If snowfall causes roof damage to my house, my homeowner’s insurance covers the repairs. It doesn’t make the payout contingent upon total snowfall in the month, regardless of whether I have any damage or not. The payout is contingent on the scale of the damage. When hurricane Andrew struck Florida in 1992, causing enormous damage, it was the scale of the damage actually done that caused the large insurance payouts, not the measure of windspeed or quantity of rainfall. A hedging strategy using futures contracts doesn’t have this flexibility to make the payout contingent on the actual losses incurred. This is another example of basis risk.

Of course, in order for insurance contracts to offer this extra benefit of making the payout match the loss, they have to hire adjusters to investigate claims. Obviously there is room for a disagreement between me and my insurer over whether my auto or home claim is really covered by my contract and reimbursable, and what is the actual size of the loss. This distinctive feature of insurance–that the payout is directly tied to the amount of damage–is a costly feature. The transactions costs–in the form of adjusters, appraisals and disputes–are high. Futures contracts have low transactions costs by making the payout contingent on an easily measured index. But the tradeoff is that a payout linked to this index doesn’t quite match the losses.

Catastrophe risks: the US National Flood Insurance Program

An interesting analysis of the US National Flood Insurance Program by Erwann Michel-Kerjan appeared in this Fall’s issue of the Journal of Economic Perspectives. One key issue in evaluating the program and its payouts versus premiums is assessing the probability of extreme events–always an issue in catastrophe insurance. Another key issue is incentives to game the program rules, something that also arises persistently in legislatively mandated insurance. In this case it is the use of outdated maps. And, the well known issue of reduced incentives to take actions to minimize the risk of loss. In the conclusion, the author points out that several other countries use private insurance markets for the same risks.

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