The primary purpose of private insurance companies is to make a profit, but many types of risks cannot be insured profitably. To make a profit, private insurers must charge a premium that is affordable to those seeking insurance, but large enough to cover losses, pay expenses, and to make a profit. Private insurers can cover some losses profitably because although the losses of an individual are unpredictable, the losses suffered by a population can be reliably estimated using the law of large numbers — statistics — to estimate both the frequency of losses and the amount of those losses, such as for motor vehicle accidents.
So there are 2 types of loss events that cannot be privately insured: those that are certain to occur and those that occur so infrequently that statistics cannot reliably predict neither their occurrence nor the amount of damage, especially for loss events where the amount of damage is highly variable, such as from hurricanes, floods, or earthquakes. Hence, governments provide insurance for these types of catastrophes, either explicitly through programs implemented by the governments, or implicitly, by mitigating the losses of voters through ad hoc responses to disasters.
Risks that are highly likely to occur are also uninsurable by private insurance companies, such as the risks associated with old age. Therefore, in some of these cases, the government provides insurance. Medicare, for instance, provides health insurance for people who were at least 65. No private insurance company would cover this age cohort, because people eventually suffer health problems if they live long enough. Moreover, most people reach a certain age where they can no longer work, so the federal government provides Social Security, a form of long-term care insurance.
Another primary advantage of government insurance is that the government is permanent, since they can maintain their solvency through taxation or through the printing of money. Therefore, government insurance insures pensions through the federal Pension Benefit Guaranty Corporation, and every state maintains insurance solvency funds that pays insurance claims, within limits, to policyholders of failed insurance companies.
Sometimes government insurance is implicit. Governments must sometimes intervene to prevent potential economic catastrophes, such as bailing out banks that are considered too big to fail, thus allowing bankers to take large risks for potentially large profits while forcing the federal government to bail them out if they bet wrong, which is what happened during the 2007 - 2009 financial crisis.
The provision of government insurance also allows governments to influence a particular segment of the economy where they lack jurisdiction or constitutional authority. For instance, to promote homeownership among lower income Americans, the federal government guarantees mortgages, thus allowing lenders to loan money to consumers with less than stellar credit, borrowers who they would otherwise avoid to reduce their own risk.
Government insurance also allows the entire cost of the insurance to be used to cover risk and the administration of the program, thereby lowering the cost or the premiums by that portion that would otherwise yield profits for the private insurance industry. Presumably. However, government programs are often inefficiently run by unionized bureaucrats who often do not have the incentive or the training to try new things, especially in the use of computer technology, which is one of the reasons why governments often lag behind the private sector in this regard.
Additionally, some states also offer some insurance programs. One of the most extensive is the insurance covering the failure of insurance companies. Like the federal government, states also provide certain types of insurance that insurers are not willing to cover, such as California's coverage of earthquakes and insurance companies operated by Florida and Louisiana that cover damage from hurricanes and floods.
In many cases, states also offer insurance that competes with private insurance companies. Most notably, half the states sell workers compensation insurance as a means of keeping costs lower for businesses, which helps to attract other businesses to the state. Additional examples of state insurance include automobile insurance by Maryland, life insurance by Wisconsin, and title insurance by Iowa.
There are many government insurance programs, but only a few of the major federal programs are described below.
Federal Crop Insurance
Crop insurance was created by the federal government in the 1930s to help farmers recover from the Great Depression and the Dust Bowl. The Federal Crop Insurance Corporation (FCIC), created in 1938, manages the program. Crop insurance was developed to mitigate the risk of natural disasters and declines in market price. The Risk Management Agency of the United States Department of Agriculture (USDA) manages the FCIC. Crop insurance was designed to replace ad hoc legislation after agricultural disasters to support farmers. Approved crop insurance companies employ agents who sell the policies to farmers and use loss adjusters to determine the extent of losses and to pay claims.
The FCIC sets contract standards and premium rates and it approves new crop insurance contracts. It also subsidizes the farmers premiums, up to 62% on average. The federal government also pays 100% of the delivery cost of the federal crop insurance, otherwise known as administrative and operation (A & O) expenses.
Crop insurance is based on a contract between the farmers and the insurance providers, giving either party the right to cancel the contract at the end of each crop year. If it is not canceled, then it is renewed automatically. Although insurance policies are constantly changing, the farmer must agree to insure all eligible acreage of a specific crop planted in a particular county. The requirement to insure all of a particular crop is to reduce adverse selection; otherwise, the farmer may elect to insure only those crops and locations that are more likely to fail.
The insured farmer is indemnified against losses that exceed the deductible amount during that crop year. Additionally, the losses must have been caused by perils beyond the control farmer. Additionally, recent contracts have also covered loss in value because of lower market prices. Indemnification is also provided if the farmer is unable to plant the crop or the crop suffers a loss of quality because of adverse weather. Exact details of this type of coverage depend on the type of crop.
The crop insurance contracts are either developed by the FCIC, which are published in the Code of Federal Regulations, or they are developed by private insurance providers, which may replace or supplement the FCIC policies, but they must be approved by the FCIC. Crop insurance is sold by private insurance agents and brokers. The FCIC also provides reinsurance to approved commercial insurers who use FCIC-approved plans.
What distinguishes federal crop insurance from other insurance products is that the private insurance companies that sell the crop insurance must sell to any farmer at the premium set in advance by the federal government. The private insurance companies have no authority to raise a premium or impose underwriting standards, regardless of risk.
In 2014, the federal government paid $6.3 billion in premium subsidies for farmers and $1.4 billion for the administrative and operating expenses to private insurance companies.
National Flood Insurance Program
The National Flood Insurance Program (NFIP) provides affordable insurance and encourages communities to adopt and enforce floodplain management regulations. A natural way to avoid most damage from floods is to prohibit construction in floodplains, but the NFIP is predicated on the assumption that the economic benefits to be gained from floodplain development outweighs the damage from occasional floods. As part of the Federal Emergency Management Agency (FEMA), the NFIP was established in 1968, but modified extensively over the following decades.
Insurance based on the NFIP is based on the agreement between local communities and the federal government requiring that communities must adopt and enforce floodplain management ordinances to reduce future flood risks in new construction and Special Flood Hazard Areas (SFHA). For years, the federal government responded to flood disasters by constructing flood control works, such as dams, seawalls, levees, and other like structures, but this approach did not decrease losses or discourage unwise development. NFIP was designed as an alternative to disaster assistance by mitigating future flood losses through building and zoning ordinances. By providing affordable flood insurance, the federal government can exert some control over local communities that it would not otherwise have within its constitutional authority.
Special Flood Hazard Areas (SFHA)
FEMA identifies flood hazard areas within the United States or its territories and marks such areas on Flood Insurance Rate Maps (FIRMs) as having a 1% chance of being flooded annually. The FIRM is the official map of a community delineating special hazard areas and also sets the premiums for specific risk zones.
Private property and casualty insurance companies service the flood insurance policies, both underwriting policies and processing the claims, but the federal government reimburses the companies for any underwriting losses.
The NFIP is regulated under FEMA rules and regulations, but FEMA does allow state licensed insurance companies agents and brokers to sell flood insurance. Agents and brokers must abide by state regulations when selling federal flood insurance. Participation in NFIP is based on the community rather than on individuals because only the community can enact building ordinances and zoning regulations to reduce losses from floods.
If the community fails to comply with FEMA requirements, then the community may be suspended from the program. However, it is generally given at least 1 year to comply with any shortcomings.
Policyholders and communities that join the Community Rating System (CRS) may receive a discount on the flood insurance ranging from 5% to 45%. Only owners of eligible property located in participating communities can protect their buildings or contents through the flood insurance program. Renters can also insure their property against flood loss.
Factors that determine the amount of the premium include: amount of coverage; deductible amounts; the flood zone; location and age of the building; building occupancy; and the foundation type of the building.
Federal law does not mandate that owners of property located within flood zones buy flood insurance, but all federally regulated, supervised, or insured financial institutions and Federal Agency lenders require flood insurance for any buildings located in a participating NFIP community and in the SFHA.
Each flood insurance policy has a 1-year term that covers only one building and its contents, and there is a 30 day waiting period before coverage becomes effective. There is no minimum amount of coverage but lenders may require coverage up to the mortgage amount. Additionally, flood insurance payments must be escrowed if the lender requires escrow for taxes, insurance premiums, and other loan charges.
Individuals who receive disaster assistance in designated flood zones are required to buy and maintain flood insurance for as long as they live in the building.
The Export-Import Bank , Otherwise known simply as the EXIM Bank, of the United States is an independent agency and federal corporation of the executive branch of the federal government, created in 1934 to provide aid in financing and credit to facilitate exports. EXIM is the official export credit agency of the United States that accepts credit and political risks that the private sector is unwilling to cover. However, all transactions must have a reasonable assurance of repayment. The EXIM Bank also lends money to foreign governments to buy American products. In spite of the name, the EXIM Bank finances or promotes exports, not imports.
To compete with other countries doing likewise, the EXIM Bank supported tied-aid packages, where the country receiving the aid must spend the money on products and services from the United States or its territories. It also finances the purchase of aircraft and special projects, such as environmental and nuclear. The EXIM Bank provides direct financing to foreign buyers of American goods and services. The Bank may also provide credits to countries that are suffering from a temporary deficiency of US dollars, which would otherwise impair trade.
Overseas Private Investment Corporation
The Overseas Private Investment Corporation (OPIC) provides financing, political risk insurance, and support for private equity funds to promote United States businesses in emerging markets. A United States government agency organized to protect Americans who invest in foreign countries against loss by political risks, such as war, revolution, expropriation, insurrection, or the convertibility of foreign currency in the dollars.
Established in 1971 as an agency of the United States government, the main purpose of OPIC was to enhance the development of emerging markets while also benefiting American businesses, helping to alleviate poverty and promoting world peace through creating a greater economic interdependence.
OPIC helps to develop good ideas from individual businesses that can help the development of emerging markets while also reducing much of the risk. It also helps to expand economic and political ideals, such as promoting the participation of women in the economies and to develop a rule by law.
Terrorism Risk Insurance Program
Before the 2001 terrorist attack on the World Trade Center and the Pentagon, insurance companies provided terrorism coverage virtually for free, since it was considered to be highly unlikely. Because the 2001 terrorist attacks caused insured property losses exceeding $25 billion, insurance companies started to exclude terrorism coverage. Even reinsurance companies were unwilling to reinsure policies in major urban areas deemed to be a focus of terrorist attacks. Consequently, some businesses could not obtain financing without protection against terrorism attacks. Since the economy was already faltering in 2001 and 2002, Congress enacted the Terrorism Risk Insurance Program (TRIP) as a reinsurance program that would reimburse insurance companies for losses suffered by providing terrorism coverage. TRIP was enacted in 2002, and extended several times, with the latest expiration date being December 31, 2020.
The reason why terrorism is so difficult to insure is because the acts are relatively infrequent and they are not random in nature, since they are deliberate attacks. Hence, it is difficult to calculate the probability of a terrorist attack and what the maximum claim would be, especially since terrorists would be more likely to select targets that would maximize loss of life and damage. Additionally, only people who are most at risk of terrorist attacks would be likely to purchase the insurance, leading to adverse selection. For these types of risks, insurance companies and reinsurers generally use risk models as an attempt to calculate the likelihood of a terrorist attack, but it is virtually impossible to gauge how accurate these risk models will ultimately be. The federal government's reinsurance program limits the maximum loss for insurers. The industry must retain a certain amount of risk through deductibles and copayments, known as the insurance marketplace aggregate retention. With the 2015 extension of the Terrorist Act, this insurance marketplace aggregate retention limit increases annually in steps, ultimately reaching $37.5 billion in 2020.
Small Business Administration (SBA) Surety Bond Guarantee Program
Large construction projects can be costly. If the contractor cannot complete the project on time, then the project owner may suffer a financial loss. However, in many cases, it is difficult to ascertain whether the contractor can complete the work satisfactorily, especially if the project is unique. Therefore, almost all large public projects and many large private projects require that the contractor be bonded. A surety bond is a type of bond created expressly for this purpose. The contractor pays the premium for the bond to the surety company, but the surety insures the project owner if the contractor fails to complete the project satisfactorily.
A surety bond is a contract signed by a contractor, called the principal, and a surety company, to insure a third-party, called the obligee, that a project will be completed pursuant to the contract; otherwise, the surety will pay another contractor to complete the work. However, a surety company will only issue a bond for creditworthy contractors, particularly those with significant assets. Consequently, many small business owners are prevented from bidding on projects because they cannot be bonded based on their own creditworthiness.
To promote small business and to promote more competition, which generally leads to lower prices for the project owners, which, in many cases, will be federal, state, or municipal governments, or agencies thereof, the Small Business Administration (SBA) guarantees bid, performance, and payment bonds issued by preapproved surety companies for qualified small businesses. Bid bonds guarantee that the contractor with the winning bid will actually sign a contract to perform the work. Payment bonds insure that the contractor will pay all of its subcontractors or other workers working on the project, who would otherwise sue the project owner for payment. A performance bond guarantees that the contractor will finish the project pursuant to the contract. The SBA guarantee is free for bid bonds, but the SBA charges 0.729% of the contract price for payment or performance bonds. The SBA also charges 26% of the fee that the surety charges to the principal.
Government Insurance Promotes Socially Desirable Goals
Most government insurance programs are designed to promote socially desirable goals and they usually use private insurance companies to sell and manage policies and manage claims. In many cases, the government insurance program serves as reinsurance to motivate private insurance companies to offer these types of insurance without taking on a large or unknown risk. Many of the smaller programs are instituted for only a limited duration. Some past insurance programs that have been discontinued, include war risk insurance, that was offered during World War I and II, federal crime insurance program, from 1971 to 1997, and the federal riot reinsurance program, 1968 the 1983.