Finger stopping wooden dominoes from falling over, photo by simarik/Getty Images

commentary

(The RAND Blog)

Key Questions to Ask in Designing a Pandemic Risk Insurance Program

Photo by simarik/Getty Images

by Lloyd Dixon and Bethany Saunders-Medina

July 27, 2020

Congress is considering establishing an insurance program that would make business interruption (BI) coverage for pandemics less expensive and more widely available. For example, Rep. Carolyn Maloney (D-NY) has introduced the Pandemic Risk Insurance Act (PRIA), a program modeled after the Terrorism Risk Insurance Program (TRIP) established in the wake of the 9/11 terrorist attacks. Several major insurance industry groups, on the other hand, have proposed the Business Continuity Protection Program (BCPP) (PDF), an approach that utilizes the insurance mechanism to issue policies and pay claims, but puts all the risk on the federal government. And, a major insurance provider has recently released a hybrid proposal (PDF) that includes elements of both proposals as well as some distinctive features.

As we concluded in our previous post, policymakers might first weigh the advantages and disadvantages of using an insurance mechanism to provide compensation for losses due to a pandemic. Here, we have identified several key questions that policymakers could next consider when designing a pandemic risk insurance program, including the relevant policy objective and factors that policymakers could weigh in deciding how best to proceed. For the purposes of this post, we illustrate potential program features using the BCPP and the PRIA proposals (Table 1).

Table 1. Key Features of Two Proposed Pandemic Risk Insurance Programs

Feature Business Continuity Protection Plan (BCPP) Pandemic Risk Insurance Act (PRIA)
Risk sharing Federal government covers all claim costs and there is no mention of a program cap. Federal government pays 95% of claims costs over an insurer deductible that is set at 5% of the insurer's direct earned premium (DEP); there is a program cap of $750B.
Pricing Premiums would be charged, but the basis for premiums is not specified. Insurers set rates for the risk they retain; there is no premium charged for federal backstop.
Mandatory offer Yes Yes, but only by participating insurers
Mandatory purchase No No, and there is no requirement that the BI policies that are purchased cover wages and benefits.
Claims adjustment Parametric trigger with no need for claims adjustment. Payments are available for up to 80% of payroll and other expenses depending on selected coverage option. Payments are made for losses incurred using the same coverage terms and conditions as for business interruption losses due to other perils.
Lines covered Business interruption insurance including event cancellation, but not workers compensation or general liability (GL). Business interruption insurance including event cancellation, but not workers compensation or general liability (GL).
Differentiation by firm size None None

Should the Private Sector Bear Some of the Risk?

Policy Objective

Move part of the financial responsibility for pandemic losses from the public to the private sector and give insurers incentives to carefully adjust claims.

Proposals

Private industry would bear no risk under the BCPP. In contrast, potential industry outlays under PRIA could be substantial. At 5 percent of DEP, the insurer deductible would amount to roughly $12.5 billion (if losses were spread proportionally across insurers), and the 5 percent copay up to PRIA's $750 billion cap would add up to an additional $36.9 billion. Under either program, insurers would also likely face workers compensation, general liability (GL), and other claims in addition to these business interruption claims.

Considerations

Private sector outlays are potentially substantial under PRIA, but even so, they may be modest in comparison to the approximately $700 billion in potential government outlays through the program. What is more, the government may be called on to pay losses over the $750 billion cap in a nationwide pandemic that has the potential to cause trillions in business interruption losses. Policymakers might also consider whether it is worthwhile to set up a program in which private sector outlays may end up being modest relative to overall outlays. But, it should be recognized that in the event of smaller or better-contained pandemics, the deductible and co-pay could make a noticeable dent in overall outlays. Private sector participation could also be expected to align insurer and government incentives in adjusting claims. However, the BCPP's payment trigger is an innovative approach for addressing this concern (discussed below). In determining the appropriate amount of private risk sharing, a balance could be struck between reducing taxpayer outlays (a higher private share is better) and inducing industry to offer the coverage (a lower private share is better).

Should the Government Charge a Premium for the Risk It Bears?

Policy Objective

Impose program costs on those who benefit from it, provide incentives for businesses to reduce pandemic risk, and accumulate funds to pay for future claims.

Program Features

The BCPP envisions a premium, but the basis for the premium is not described. Under PRIA, insurers would charge a premium to cover both the proportion of the risk that they bear and the expenses of writing policies and adjusting claims. As with TRIP, PRIA does not authorize the federal government to charge a premium for the backstop it provides.

Considerations

Business interruption insurance provides a valuable service to businesses, as its coverage typically includes expenses such as utilities, rent, and lost profit. However, it often does not cover wages for employees (senior managers with firm-specific capital may be covered), with the expectation that the firm may be able to lay off employees during a business interruption event. It is thus reasonable to expect firms to pay for the value provided by typical business interruption insurance. But it should not be expected that firms will necessarily pay for a policy that covers wages, salaries, and benefits of all workers. If an objective of a pandemic risk insurance program is to cover wages, salaries, and benefits of all workers, there is a good argument that premiums for the program should not aim to cover full program costs.

Traditional insurance theory holds that risk-based premiums are desirable because they require businesses to consider the full cost of their decisions and provide incentives to avoid or mitigate risk. In the case of pandemic risk, however, these arguments do not seem persuasive. There is little basis on which to set risk-based rates for pandemic losses, and mitigation measures could have unexpected negative consequences. For example, although risk-based rates could conceivably be lower in rural areas, encouraging firms to locate in those areas could have negative impacts on climate change and ecosystem health. Mitigation would seem best handled by public health officials in this setting, rather than on price incentives through an insurance mechanism.

Despite these arguments against risk-based pricing, there are good reasons for government to charge at least some premium for the risk it bears. Premium revenue may be able cover the costs of smaller, regional events; premiums require firms to consider the tradeoffs of purchasing more extensive coverage; and a premium sends a signal that the firm is purchasing something of value. While this discussion suggests that policymakers should not expect premiums to cover the full cost of the program, it provides no guidance on how large those subsidies should be. That question might best be answered by considering premium levels that would result in widespread take-up.

Should Insurers Be Required to Offer Coverage?

Policy Objective

Ensure that coverage for pandemic-related business losses is widely available.

Proposals

Administered through FEMA, coverage through the BCPP would be available to all eligible businesses. Widespread availability of coverage under PRIA is not guaranteed. Insurers may decide not to participate in the program, and even those that do may offer coverage at premiums that are unattractive to policyholders.

Considerations

Barring requirements to offer coverage at a pre-determined price, success in making coverage widely available under PRIA may hinge on coming up with a risk sharing scheme that results in insurers wanting to participate and being able to charge premiums that are attractive to private industry. The potential for captive insurers to undermine the performance of the program should also be considered. Captive insurers, which can provide terrorism coverage to a single insured, have come under much criticism (PDF) in TRIP. These captives can effectively game the system by charging low premiums and not providing coverage to other entities. The result is a low DEP relative to the amount of terrorism exposure and thus a low TRIP deductible. If no provisions are made to address this issue, the same concern could arise in PRIA, possibly resulting in coverage that is primarily available to the large business entities that can afford to set up these captives and leaving small and mid-size businesses without access to affordable coverage.

Should Businesses Be Required to Purchase Pandemic Coverage?

Policy Objective

Widespread take-up of pandemic risk insurance.

Proposals.

Neither proposal would require businesses to purchase coverage.

Considerations

TRIP has been successful in promoting substantial take-up rates for terrorism insurance, which rose from 27 percent in 2003 to 78 percent in 2017. That success is due to the modest amounts (PDF) charged for terrorism coverage. Whether a similar result occurs for a pandemic risk program depends on the pricing of the product. Given the unpopularity of mandates and the inability to make a credible commitment that assistance will not be provided to the uninsured, the best hope here is to put high priority on designing a program that results in products and prices that are viewed as reasonable by businesses and lenders. If coverage is widely available at reasonable rates, lenders may require coverage as a condition of business loans.

The current version of PRIA requires participating insurers to provide BI coverage for pandemic risk on the same terms, conditions, amounts, and limits as for other causes of loss. As discussed in the section on premiums, however, BI policies do not necessarily include payment of the wages and salaries for the majority of employees. Thus, even if PRIA succeeds in inducing wide-spread take-up of BI, it might not succeed in ensuring widespread wage and salary replacement during a shut-down. Policymakers will need to consider whether the BI policies issued by participating insurers must cover wage and salary replacement.

How Should Claims Be Adjusted?

Policy Objective

Pay legitimate claims quickly with minimal transaction costs.

Program Features

PRIA would rely on the traditional claims adjustment process for business interruption claims and pay for losses incurred by each policyholder. The BCPP would use a type of parametric trigger: Once a public health emergency was declared, claims would be paid in the affected industries without regard to actual or expected change in business revenue. Payments would be based on the previous year's tax return, and each business would be free to choose the percentage of payroll and expenses to be replaced up to 80 percent. There would be no need to evaluate the actual incurred losses of a particular firm.

Considerations

Adjustment of business interruption claims in typical indemnity policies requires specialized expertise. In some cases, business revenue during an incident is compared to revenue in the previous year. In others, forensic accountants compare actual revenue during the incident to projections of what revenue would have been had the incident not occurred. This process can be expensive and time-consuming. In addition, even though the insurance industry has considerable claims-adjusting infrastructure, the potential number of claims in an economy-wide pandemic is enormous, bringing into question whether insurers could adjust business interruption claims in a timely manner. The BCPP's parametric approach addresses this concern, but it does raise some potential issues of its own. For example, a restaurant might be very successful in expanding its take-out or delivery service during a pandemic and thus in effect receive insurance payments for losses that did not occur. While the parametric approach is attractive, the traditional claims adjustment processes envisioned in PRIA could perhaps be expedited by simplifying BI policies or taking advantage of emerging technologies to more quickly and efficiently process claims.

Should Workers Compensation and General Liability Insurance Be Included?

Policy Objective

Make available the types of insurance that businesses need to recover from the pandemic and sustain economic activity and provide a mechanism for compensating insured parties.

Program Features

BCPP and PRIA both provide coverage for business interruption and event cancellation. Neither includes workers compensation or GL coverage.

Considerations

Both BCPP and PRIA respond to legislative efforts in several states to require insurers to cover business interruption losses due to the COVID-19 outbreak even if the policies exclude losses due to viruses and communicable diseases. As a result, these two pandemic insurance proposals focus on business interruption and event cancellation. But policymakers should also consider whether additional lines of insurance should be addressed. In addition to business interruption and event cancellation, TRIP, for example, applies to workers compensation and GL. The number of workers compensation claims due to COVID-19 is expected to be large; further research may be needed to understand whether federal risk sharing is needed to stabilize the market. Previous research has highlighted the importance of TRIP in the workers compensation market, and the results may well apply to pandemic risk. GL policies typically exclude viruses and bacteria, and previous RAND work has shown these liability concerns rank high for businesses. The resulting exposure could discourage some firms from reopening quickly or fully. The lack of insurance coverage could also reduce the compensation available to injured parties. Further research also may be needed to better understand the extent to which the inclusion of liability coverage in a pandemic risk insurance program is needed to lower barriers to economic recovery and growth and to provide a source of compensation to parties injured by negligent behavior.

Should Eligibility or Benefits Differ by Firm Size?

Policy Objective

Target program benefits to firms that need it.

Program Features

Neither BCPP nor PRIA differentiate eligibility or benefits by size of firm.

Considerations

Larger firms have access to tools and resources that allow them to better weather the business shutdowns caused by social distancing orders than smaller firms. They may have better access to capital markets and bank loans and have well-established rainy-day funds that allow them to keep workers on the payroll for extended periods during a shutdown. Thus, an argument can be made that a government-subsidized pandemic risk insurance program should be limited to smaller firms. However, although small in number, the largest firms account for a considerable share of overall employment and payroll. There may be great social and economic benefit in making sure the largest firms are able to maintain payroll during a shutdown. In deciding whether to allow the largest firms to enroll in the program, it could be useful to better understand the extent to which large firms maintained their payroll during the current incident. In addition, policymakers could evaluate whether the great disparity in the number of small versus midsize and large firms warrants different approaches for adjusting and paying claims for the two types of firms.

Conclusion

Given the challenges that private insurers face in providing business interruption and event cancellation insurance for pandemic risk, some type of government backstop program may be necessary if pandemic risk insurance is going to ever be widely available to U.S. businesses. The discussion on the need for and the desirable features of a pandemic risk insurance program is fundamentally about the role that insurance should play in providing compensation for losses due to this risk. There are many potential advantages of having insurance play a central role in addressing this risk as well as the many other catastrophic risks that face society. Policymakers and insurers might best view this discussion as an opportunity to better understand whether and how the insurance mechanism can remain an integral part of catastrophic risk management and compensation.


Lloyd Dixon is director of the RAND Center for Catastrophic Risk Management and Compensation and a senior economist at the nonprofit, nonpartisan RAND Corporation. Bethany Saunders-Medina is a policy analyst at RAND.

Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.